What it is
Operational due diligence (ODD) is a review of the business and infrastructure of a hedge fund, as distinct from its investment strategy. Investment due diligence asks, "What does the manager do and why?" Operational due diligence asks, "Is the fund set up to run safely, accurately and honestly?"
Typical areas include governance and ownership, compliance programs, valuation practices, trade processing, cash controls, the fund's administrator, auditor, custodian or prime broker, legal documents, insurance, cybersecurity and business continuity. Reviewers also look at the backgrounds of key personnel and how conflicts of interest are handled.
Hedge funds are generally private funds. They are usually offered under exemptions such as SEC Rule 506(b), which prohibits general solicitation, or Rule 506(c), which allows general solicitation if all purchasers are accredited investors and the issuer takes reasonable steps to verify that status. Offerings are made only by the issuer through its own offering documents, and the documents are an important part of any operational review.
How it’s traditionally been approached
Large institutions have often kept dedicated operational due diligence teams or hired specialist firms. They commonly use written questionnaires, document requests, calls with the manager's operations, compliance and finance staff, and sometimes an on-site visit.
Reviewers frequently verify information with outside parties. They may speak with the administrator or auditor, check regulatory filings and public records, look at professional references, and run background checks on key people.
Individuals and smaller organizations have approached the topic in different ways. Some rely on their own licensed advisers, some use consultants, and some do a lighter review on their own. Each approach involves trade-offs in time, cost, access and depth, and none of them removes risk.
How the right fund manager may help
The right fund due diligence provider may help you organize a review into a clear, repeatable framework. This can make it easier to know which documents to request, which third parties to speak with, and which questions are worth asking. A provider cannot guarantee that a review will uncover every problem.
A first conversation is generally about scope. A provider may ask about your goals, your experience with private funds, and how deep a review you want. They may explain what they can and cannot independently verify, and what they would need from the manager to do their work.
Useful questions to ask a provider include: What does your process cover? How do you verify information rather than just collect it? How do you handle conflicts of interest and who pays you? What are the limits of your work? How will findings be reported to me? Ask them to put the scope in writing, and review the results with your own licensed investment, legal and tax advisers.
The bigger picture
Looking closely at a fund's operations can affect more than your finances. Many people find that not understanding how their money is held and valued is a quiet source of stress. A clearer picture of the structure may bring some peace of mind, even though it cannot remove uncertainty.
It can help to decide ahead of time how much risk and illiquidity feels tolerable, and to involve people you trust in the decision. If financial worry is affecting your sleep or relationships, Providers.plus may be a useful place to look for wellbeing support. No approach is right for everyone.
Keep in mind
- Private fund investments, including hedge funds, are speculative and illiquid and can lose all of their value.
- Operational due diligence reduces certain kinds of risk but cannot eliminate them, and it says nothing about investment results. Past performance does not guarantee future results.
- Nothing here is an offer to sell or a solicitation of an offer to buy any security. The Hastings Fund is an independent directory, not a broker-dealer, funding portal or investment adviser, and does not recommend, endorse or rank investments.
- This is not investment, legal or tax advice. Tax treatment, including how K-1s are reported, depends on individual circumstances, so consult your own licensed advisers.
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Create an investor account →Frequently asked questions
What is operational due diligence on a hedge fund?
Operational due diligence on a hedge fund is a review of the non-investment side of the business, such as governance, compliance, valuation, controls and service providers. It aims to assess whether the fund is set up to operate reliably and transparently. It is separate from evaluating the investment strategy.
Why is operational due diligence important for hedge funds?
Operational weaknesses, such as poor controls or unreliable valuation practices, have historically been a source of problems for funds, independent of the strategy. A review may help you spot warning signs before committing capital. It cannot guarantee that problems will be found or avoided.
What does an operational due diligence review usually cover?
A review usually covers the firm's ownership and governance, key personnel, compliance program, valuation and trade processes, cash controls, and the roles of the administrator, auditor, custodian and legal counsel. It often also looks at fund documents, insurance, cybersecurity and business continuity planning. The exact scope varies by reviewer and by fund.
Who can invest in a hedge fund?
Most hedge funds are offered only to accredited investors under SEC Rule 501(a). Categories include individuals with income over $200,000 (or $300,000 with a spouse or spousal equivalent) in each of the prior two years, or net worth over $1 million excluding the primary residence. Since the August 2020 amendments, holders of Series 7, 65 or 82 licenses, knowledgeable employees of the fund, and entities or family offices with over $5 million in investments or assets can also qualify, as can registered investment advisers and exempt reporting advisers.
What is the difference between Rule 506(b) and 506(c) for hedge funds?
Rule 506(b) does not allow general solicitation, while Rule 506(c) does. Under 506(c), all purchasers must be accredited investors and the issuer must take reasonable steps to verify that status. Both are exemptions that the issuer relies on, and you should read the offering documents closely.
Can I do operational due diligence on a hedge fund myself?
You can learn the basics and ask informed questions yourself, but a full review often needs access, expertise and independent verification that are hard to replicate alone. Many people work with a fund due diligence provider and their own licensed advisers. The Hastings Fund is a directory and does not perform reviews or give advice.
Educational resource. The Hastings Fund shares general information and connects people with independent fund managers. It is not professional advice. Talk with a qualified professional about your own situation.