The Role of Background Checks in Hedge Fund Investor Due Diligence and Hedge Fund Manager Hiring

A thoroughgoing understanding of the backgrounds of principals and employees of a hedge fund management company has historically been a matter of prudence; increasingly, it is also a matter of regulatory compliance.  The “bad actor” disqualification provisions of the JOBS Act, Form ADV and the anti-fraud provisions of the Investment Advisers Act all require hedge fund managers to accurately understand the litigation, licensing, disciplinary, employment, educational, financial and other history of their actual and potential principals and employees.  For hedge fund investors, best operational due diligence practices involve examination of at least the foregoing categories of information for management company principals.  In addition, both managers and investors are well-advised to understand the backgrounds of decision-makers at service providers (such as prime brokers, law firms, administrators, accountants, companies that provide fund directors and others).  Importantly, background checks should not be a rote exercise: if they uncover red flags, those red flags should be pursued vigorously, and should, if serious and not subject to remedy, cause a change of plan (e.g., passing on an investment or a candidate, or terminating an employee).  In an effort to assess the market for important components of background checks as commissioned by investors and managers, the Hedge Fund Law Report recently interviewed Richard “Bo” Dietl, a former New York City police officer and decorated detective, and a seasoned veteran of the private fund background check business.  Dietl provided on-the-ground intelligence on specific goals and targets of background checks by investors and managers; coverage in background checks of nonpublic information; the top three “red flags” that investors are looking for in background checks on managers; best practices for managers in responding to identified red flags; background check pricing and resulting work product; state requirements for employee consent and disclosure to manager background checks; the interaction between background checks and the bad actor disqualification rule; frequency with which background checks should be updated; and whether background checks should be performed on fund directors.

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