Private Fund Due Diligence: How Accredited Investors Evaluate Emerging Managers

Due diligence is the process prospective investors use to learn about a private fund and the people running it before deciding whether it fits their situation. For an emerging manager, this often means a closer look at the team, the strategy, the operations and the legal structure, since there may be a shorter track record to review.

Accredited investors are the people and entities who may generally participate in private fund offerings that rely on certain exemptions. Under SEC Rule 501(a), categories include individuals with income above $200,000 (or $300,000 jointly with a spouse or spousal equivalent) in each of the two most recent years with the same expectation for the current year, or net worth above $1 million excluding the primary residence. Since the August 2020 amendments, they also include holders in good standing of the Series 7, Series 65 or Series 82 licenses, and knowledgeable employees of certain private funds. Entities and family offices with over $5 million in investments or assets may qualify, as may registered investment advisers and exempt reporting advisers.

Offerings are commonly made under Rule 506(b) or Rule 506(c). Rule 506(b) does not permit general solicitation. Rule 506(c) allows general solicitation, but all purchasers must be accredited and the issuer must take reasonable steps to verify that status. Which path applies is a question for your securities counsel. Private fund investments are speculative and illiquid and can lose all of their value.

Investors have traditionally reviewed a standard set of offering materials. These often include a private placement memorandum, a limited partnership or operating agreement, and a subscription agreement with an investor questionnaire. Many managers also prepare a presentation or overview that explains the strategy and team in plain language.

Beyond the legal documents, investors commonly ask about the manager's background, how decisions get made, how conflicts of interest are handled, and how fees and expenses work. They may also ask about service providers such as the administrator, auditor and counsel, along with valuation practices, reporting cadence and compliance policies.

Some investors work through a formal checklist, while others rely on conversations, references and their own advisers. Investors may also ask how the fund reports taxes. Many funds issue Schedule K-1s to investors, and, where relevant, some ask about Section 1202 qualified small business stock (QSBS). Tax treatment depends on individual circumstances, so investors are generally encouraged to consult their own tax advisers. Past performance does not guarantee future results.

The right fund due diligence provider may help you see your fund through an investor's eyes. A visit or first conversation generally starts with listening: your strategy, your team, your documents and your timeline. A provider may then point out gaps, unclear explanations or materials that investors commonly expect, so you can decide what to address.

An accredited investor qualification provider may help you understand how investor status is typically confirmed and what a reasonable verification process can look like, especially if you are considering a Rule 506(c) offering. They may also help you think through how to keep records organized. Your securities counsel remains the right source for legal questions.

Questions worth asking any provider include: What is your experience with emerging managers? What exactly will you review, and what will you not cover? How are you paid, and are there any conflicts of interest? Are you a licensed professional, and in what areas? Remember that The Hastings Fund is an independent directory, not a broker-dealer, funding portal or investment adviser, and it does not recommend, endorse or rank providers or investments.