How Can Hedge Fund Investors Hone Their Due Diligence in Light of Alarming Rate of “Verification Problems” Discovered in Recent Study of Hedge Fund Due Diligence Reports?

In a draft paper dated October 16, 2009 and titled “Trust and Delegation,” four scholars analyzed the frequency of misrepresentations and inconsistencies on the part of hedge fund managers in the course of due diligence performed by institutional investors.  They did this by analyzing hundreds of due diligence (DD) reports prepared by a DD firm.  Most notably, they found that 21 percent of the hedge fund managers described in the reports they sampled misrepresented their past legal and regulatory history; 28 percent made incorrect or unverifiable representations about other topics; and 42 percent had had “verification problems” including either misrepresentations or inconsistencies.  This article describes in detail the more salient findings of the study and, more importantly, explores how hedge fund investors and managers can put those findings into practice.  For investors, this entails reviewing current approaches to DD to refocus on the most common categories of verification problems.  For managers, this involves focusing on knowledge management in order to avoid accidental or negligent misrepresentations, and recognizing the heightened importance of transparency and specificity in responding to DD inquiries.

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