Fund-of-Funds Due Diligence Checklist for Hedge Fund Underlying Managers

A Fund-of-Funds Due Diligence Checklist for Hedge Fund Underlying Managers is a structured assessment framework used by fund-of-funds managers to evaluate potential hedge fund investments. It ensures systematic review of operational, legal, compliance, and investment-related risks before committing capital. The checklist supports consistent evaluation across managers and aligns with industry best practices for fiduciary oversight, including those outlined by US regulators and global industry associations.

The checklist typically covers core areas such as investment strategy clarity, risk management infrastructure, service provider qualifications (e.g., custodians, auditors, prime brokers), legal and structural integrity (e.g., offering documents, side letters), and ongoing monitoring protocols. Its use is particularly critical in multi-manager structures where the fund-of-funds acts as an intermediary investor and must independently verify the soundness of each underlying fund.

The checklist is organized into thematic domains that reflect material risks to capital and governance integrity:

• Investment Strategy & Process: Verification that the manager’s stated strategy is clearly defined, consistently applied, and supported by documented decision-making protocols. Includes assessment of leverage usage, position limits, and exit liquidity terms.

• Risk Management & Controls: Evaluation of the manager’s risk infrastructure, including value-at-risk (VaR) models, stress testing, scenario analysis, and limits enforcement. The SEC has emphasized that advisers must ensure risk management systems are integrated into investment operations.

• Service Providers & Outsourcing: Review of third-party providers-including custodians, prime brokers, administrators, and auditors-for financial stability, regulatory standing, and independence. Conflicts of interest, such as in-house administration or affiliated auditing, are flagged for heightened scrutiny.

• Legal & Structural Integrity: Assessment of offering documents (e.g., PPM, LPA), side letters, redemption terms, gate provisions, and fee structures. The checklist ensures alignment between contractual terms and investor expectations, and flags any preferential treatment or hidden fees.

• Compliance & Governance: Review of the manager’s internal compliance program, including chief compliance officer (CCO) authority, annual compliance review, and handling of material non-public information. Includes evaluation of board or advisory committee oversight where applicable.

• Operational Resilience & Technology: Assessment of cybersecurity protocols, data security, business continuity planning, and access controls. The SEC’s risk alert notes that inadequate operational controls are a common source of investor harm in alternative investments.

Industry-standardized due diligence questionnaires (DDQs) serve as the backbone for most fund-of-funds checklists. These frameworks-such as those published by AIMA and the Institutional Limited Partners Association (ILPA)-provide hundreds of granular questions across the above domains. AIMA’s DDQ, for example, was updated to a substantially revised format in 2018-2019 to reflect evolving market practices and regulatory expectations.

The checklist is not a static document; fund-of-funds managers often customize it based on fund strategy (e.g., equity vs. macro vs. credit-focused hedge funds), geography, and asset class complexity. For instance, a checklist for a leveraged loan strategy would include deeper scrutiny of collateral valuation methodologies and counterparty concentration, whereas a global macro checklist would emphasize position sizing and liquidity mismatch risks.

The due diligence process typically follows a three-stage workflow:

1. Initial Screening: Use of the checklist to triage incoming manager proposals based on minimum thresholds in strategy, scale, and controls. Managers failing key criteria are excluded early.

2. Deep Dive Review: Completion of the full checklist with supporting documentation (e.g., audited financials, risk reports, service provider agreements). This stage often involves interviews with the investment team, compliance officer, and operations staff.

3. Ongoing Monitoring: Reapplication of the checklist on a periodic basis (e.g., quarterly or annually), with trigger-based reviews following material events (e.g., key person changes, strategy shifts, regulatory investigations).

The ILPA Standardized Due Diligence Questionnaire includes templates for team member bios and document requests, which streamline the deep dive phase and improve consistency across managers.

Fund-of-funds managers report that the most frequent due diligence failures stem from:

• Overreliance on manager self-reporting: Without independent verification (e.g., confirming prime broker confirmations or custodian statements), misrepresentations can go undetected.

• Inadequate assessment of side letters: Preferential terms granted to certain investors (e.g., better redemption rights or fee discounts) may undermine fairness and create operational complexity.

• Neglecting operational risk: Technical failures, such as outdated trading platforms or untested backup systems, can lead to material losses even in well-managed strategies.

• Static checklists: Using outdated questionnaires that omit emerging risks (e.g., climate-related financial disclosures, crypto custody, AI-driven trading oversight).

Mitigations include maintaining a dynamic checklist updated against regulatory alerts (e.g., SEC OCIE observations), conducting unannounced site visits, and requiring third-party audits of critical infrastructure.

While essential, the checklist approach has inherent constraints:

• Resource intensity: Completing a full checklist for a single manager can require 40-80 hours of analyst and senior staff time, limiting scalability for smaller fund-of-funds teams.

• False sense of security: A completed checklist does not guarantee future performance or prevent black swan events; it only assesses current-state risk exposure.

• Lack of forward-looking insight: Most checklist items are backward-looking (e.g., “Has the manager ever been sanctioned?”). Proactive indicators-such as culture assessments or model validation rigor-are harder to quantify and often omitted.

To address these gaps, leading fund-of-funds integrate checklist findings with qualitative judgment, including reference checks with current investors and scenario-based stress testing of the manager’s risk framework.

• US Securities and Exchange Commission, Office of Compliance Inspections and Examinations (OCIE), Risk Alert: Investment Adviser Due Diligence Processes for Alternative Investment Funds (2014)
• Alternative Investment Management Association (AIMA), Due Diligence Questionnaires (2018-2019 update)
• Commodity Futures Trading Commission (CFTC), Sound Practices for Hedge Fund Managers
• Institutional Limited Partners Association (ILPA), Standardized Due Diligence Questionnaire v1.2