The Changing Landscape of Private Fund Investor Due Diligence

The importance of private fund investor due diligence in the investment allocation process, in capital formation, and in private fund litigation has reached unprecedented levels and is still increasing. Using two datasets, my paper ‘Private Fund Investor Due Diligence – Evidence from 1995 to 2015’[1] provides the first and only theoretical and empirical evaluation of the evolving private fund investor due diligence requirements and the applicable legal environment in the United States. The datasets I use are: (1) private investment fund advisers’ SEC Form ADV II filings from 2007 to 2014 (N=100392); and (2) the publicly available litigation record pertaining to private fund investor due diligence from 1995 to 2015 (N=572). I highlight important changes in the quality and quantity of private fund investor due diligence in SEC Form ADV Part II and evaluate the corresponding litigation record as well as expert guidance on applicable best practices.

In the paper, I provide evidence that, from 2007 to 2014, an increasing number of SEC Form ADV II filers deemed investor due diligence worth mentioning in their filings, and an increasing number of such filers qualitatively intensified their due diligence disclosures in Form ADV II brochure filings. The data suggests that SEC Form ADV II brochure filers have taken investor due diligence disclosures in Form ADV II much more seriously since the year 2010, and especially since 2012. Filers appear to have seen a need to increase the quantity of investor due diligence disclosures in Form ADV II between 2011 and 2014.

The data on case law I examined in the study between 1995 and 2015 suggests that private fund investor due diligence has reached new and lasting prominence in the court system. Madoff-related cases in the aftermath of the discovery of the Madoff Ponzi scheme in 2008 help explain the significant increase in the prevalence and importance of private fund investor due diligence after 2009. Private fund investor due diligence is intended for investor protection. My study has demonstrated that the legal standards applicable to private fund investor due diligence are somewhat inconsistent and suboptimal and merit clarification.

Major failures or ‘red flags’ in private fund investor due diligence among private fund advisers include: the lack of written policy or processes in place to ensure compliance; little to no experience on the part of the individual conducting the due diligence (especially on the particulars of hedge funds); use of basic spreadsheet formulas unable to account for subjective data or systematically update information; not checking paper statements or election records to confirm trade data; not checking credentials, nor performing background checks on fund staff; dealing with firms with no third party controls (broker-dealer, custodian, administrators) or substantive auditors (with no auditing history); failure to assess fund performance against common benchmarks; and failure to assess how a fund could make money in declining markets.

The heightened emphasis on private fund investor due diligence as demonstrated in my study could foreshadow the possibility of standardization of private fund investor due diligence. Lacking standards for private fund investor due diligence can partially be attributed to private funds’ unique position in markets - unlike mutual funds, private funds evolved as unregistered entities, free from most regulatory oversight. Accordingly, private fund investor due diligence evolved without regulatory oversight. By analogy with banks’ risk evaluation, fifteen years ago banks operated with general risk evaluation strategies but no uniformity and no applicable standards, whereas today banks’ risk evaluation is heavily regulated, and has been turned into a science. Private investment fund due diligence may follow the same evolution. If so, private fund advisers will likely pass associated costs through to their investors.

Wulf A. Kaal is an Associate Professor at the University of Saint Thomas School of Law.