The Art of Due Diligence

We cannot prudently invest without some guideposts from the

past. But we cannot intelligently judge the value and applicability
of those guideposts without current and ongoing personal
knowledge of the hedge fund manager. Greenwich Alternative Investments

Introduction
Professional due diligence is one of the best forms of hedge fund risk management.
However, no amount of due diligence should replace the importance of experience and
judgment when investing with a hedge fund manager. Greenwich Alternative Investments is a
seasoned hedge fund investor and has been at the forefront of hedge fund research, data
collection and due diligence since 1995. We have collected information on thousands of
funds and performed hundreds of due diligence assessments for institutional investors
worldwide. Although weve learned a lot from our past experiences, we also know the
dynamic nature of hedge fund investment requires us to adapt our due diligence processes
accordingly. The aim of this paper is to help investors understand the art of due diligence that
ensures they are presented with meaningful information upon which to base investment
decisions.

Balanced approach

No one-shoe-fits-all

The Greenwich Alternative Investments due

diligence approach balances quantitative
with qualitative factors, viewing quantitative
analysis as a valuable complement, rather
than a substitute for, qualitative
assessment. Simply stated, if the
qualitative aspects dont check out,
quantitative factors do not matter. In our
evaluation of a hedge fund investment, we
place great emphasis on the ongoing
personal knowledge of the hedge fund
manager, his trading strategy and
investment process.

The universe of hedge fund strategies is

enormously broad and requires a thorough
understanding of the dynamics across many
different types of capital markets. No one
single method of due diligence inquiry is
applicable across all strategies, and no one
linear approach to due diligence
questioning can be applied. Rather,
Greenwich Alternative Investments due
diligence is an iterative process, shifting
focus as the analyst directs within the
context of the investment opportunity and
the risks associated with it. Judgment and
experience figure decisively in every step.

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Initial Due Diligence

We start the due diligence process with the Greenwich Value score, a quantitative ranking
of hedge funds derived from an internally developed proprietary model. This model ranks
funds within their respective strategies and divides each of the strategy groups into quartiles.
The top quartile hedge funds within each strategy are the target candidates from which the
due diligence process begins.
The purpose of initial due diligence is to verify key investment conditions and to review
factors that would cause rejection of a fund. Some of the key terms include fee structure,
liquidity parameters, redemption fees, lock-ups, size of the fund, inception of the strategy and
verifying the strategy is properly classified. Ensuring a fund is properly categorized
according to GAIs strategy classifications is particularly important in order to maintain the
purity of our strategy groups. We require at least one year of audited financial statements,
independent portfolio valuation procedures and that the manager will allow Greenwich
Alternative Investments to independently verify the fund assets. Failure to meet these
requirements cause immediate termination from the due diligence process.
During initial due diligence inquiries various factors are examined - including the types of
securities held, position concentrations, portfolio liquidity, use of derivatives and any instances
of litigation, fines or investigations. These portfolio characteristics are viewed within the
context of the strategy to ensure they are consistent with the stated strategy. For example, if
a manager represents they are a long/short equity strategy and the portfolio holds private
placements or convertible bonds, this would cause us to further evaluate the situation. In
addition, we examine the capacity of the fund and where the manager will look to close the
strategy to new investments.
Once the initial due diligence information is gathered, our Investment Committee meets to
evaluate the potential candidates and select the funds upon which the full due diligence
process will begin. During this evaluation stage our Investment Committee will reject in
excess of 75% of the potential candidates.

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The Due Diligence Process Begins

Due diligence starts with an extensive collection and verification of data from multiple sources
such as offering documents, audited financial statements, marketing materials, investor
correspondence, professional / investor references and contact details for the fund
administrator and auditor.

Management / Organization
The organizational foundation and the quality of the firms human capital will contain, perhaps,
the strongest insight about the funds prospects for success. Backgrounds of key individuals
within the firm are reviewed to determine their level of experience and knowledge as well any
overlapping responsibilities. We look to see if team members have worked together in the
past and their individual expertise. In addition, it is important to understand the division of
authority as it relates to management of the portfolio. The segregation of duties such as
compliance, portfolio management, operations and business management are also reviewed.
We want to clearly understand to what extent the investment management team is dedicated
to their trading and any other issues that may interfere. We seek to understand the history
behind the establishment of the firm, its evolution over time and what role the founders or
principals play today. In addition, the ownership structure of the firm and any strategic
partnerships are reviewed.
Not only do we focus on the targeted fund in which we intend to invest, but also review the
entire product line and asset base of the firm. This includes other strategies and business
lines and how they relate to the overall firm. The staffing breakdown dedicated to the fund in
which we may invest and outsourced components are also examined. Inquiries are made into
employee turnover and the resulting impact upon the firm. When analyzing the organization it
is also important to understand how employees are compensated and how the firm rewards
employees. We look to see that employees are motivated to align their own interests along
with that of shareholders. It is also important to see that the portfolio management team is
personally invested in the strategy to further reinforce this alignment of interests.

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Strategy
When it comes to the funds strategy it is essential to understand the managers philosophy
behind their trading and objectives. We inquire about whether the strategy has changed over
time or if it is anticipated to change in the future. We want to ensure the managers historical
track record is representative of the current trading style and evaluate any potential changes.
Discussions are held about the types of market conditions in which the manager expects to
excel and those in which the strategy is expected to struggle. We also talk about the current
opportunity set for the funds strategy and the prospects going forward.
While reviewing the managers investment process it is extremely important that we are able
to identify a clearly defined methodology. Some of the factors addressed in the investment
process include how trade ideas are generated, what type of research is utilized, how the
strategy is implemented, how positions are monitored and how the manager formulates an
exit strategy.
When discussing the portfolio we inquire about all of the different instruments traded in the
book to ensure they are consistent with the strategy. In addition, what is the funds targeted
return objective and volatility profile? Inquiries are made about the geographic focus of the
fund to determine whether it is relatively consistent over time or opportunistic in nature.

Risk Management
Effective risk management is one of the cornerstones of a successful hedge fund operation.
We believe it is extremely important to understand the managers approach to risk
management; how they gauge risk in the portfolio and what components they consider to be
the most important. A successful hedge fund operation combines trading talent and a
rigorous risk management structure along with an effective oversight function. This means
maintaining separate people responsible for portfolio management and risk management
oversight.
In regards to leverage the first step is to understand how the manager defines leverage, as
this will vary widely across different types of strategies. What have been the historical ranges
and more importantly what is the maximum allowable leverage in the fund? When the
portfolio reaches this maximum range what actions are taken? We want to make sure the
portfolio manager has predefined rules in place with respect to leverage. In addition we also
inquire about the methods by which the fund obtains leverage?
When discussing the liquidity of the portfolio we analyze whether the strategy and instruments
traded are in line with the managers stated liquidity parameters. In addition, we review
whether the liquidity terms offered by the fund are considered to be reasonable. For example,
if the manager is dealing in less liquid securities, has the fund implemented appropriate
redemption provisions to prevent a run on the bank, which could negatively impact the
remaining investors? All of these steps are designed to ensure that we have a firm
understanding of the portfolios liquidity characteristics.
Related to the liquidity of the fund is concentration. This is another key component to
understand how far the manager will allow a position to grow. Some managers can develop a
tendency to fall in love with positions and lose sight of the potential threat this poses to the
portfolio. Accordingly, we want to see that manager has predefined hard parameters in

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place and a plan to deal with a position one it reaches the maximum size. In addition, are
there restrictions such as geographic, sector or other limitations placed upon the book?
It is important for us to understand the extent to which the portfolio is hedged and the different
types of exposures the portfolio is engaged. Is the fund taking on interest rate, credit,
currency, liquidity or event risk and to what extent is the portfolio hedged? For example,
when looking at a strategy such as risk arbitrage does the manager hedge the entire deal,
only a certain portion or none at all? Each of these scenarios poses a dramatically different
risk profile.
We also inquire about the extent to which the portfolio is stress tested and various risk
management techniques the manager may employ. If stress tests are utilized, what scenarios
are run, what exposures are tested and how often does this testing take place? In terms of
risk management techniques, are there any diversification parameters, stop losses or other
methods utilized? Finally, we want to know what the manager views as the greatest risk to
their portfolio and how they mitigate this risk.

Operations
The operational components of hedge funds are a critical aspect, as this is historically this has
been one of the most frequent areas where hedge fund failures have occurred. Improper
controls, oversight, or enforcement create a potentially disastrous situation. Accordingly, it is
important to examine multiple facets of a hedge funds operations.
Portfolio valuation procedures are a critically important aspect discussed in detail with the
fund to firmly understand who is responsible for conducting the valuations, the frequency of
pricing, sources of the pricing information and the degree to which the valuation is
independent of the investment manager. After having conversations with the investment
manager, we will independently verify the fund assets and valuation procedures with the
administrator.
Wire transfers protocols are another important component to review in order to assure proper
controls are in place to protect the fund assets. We expect to see procedures such as
requiring authorized signatories in order to transfer assets as well as daily cash reconciliation.
The funds use of soft dollar arrangements is addressed including the specific terms and the
extent to which these arrangements are utilized. In addition, if any arrangements are in place
to receive compensation based upon directing fund trades, this certainly becomes an area to
further investigate. If the fund makes use of side letters it is important to understand whether
certain investors are provided preferential liquidity terms and the extent to which these letters
have been issued.
Trading procedures are discussed to understand the chain of events for a trade from inception
through to the custodian. It is particularly important to see that the firm has experienced and
adequate back office staff which allows the portfolio manager to focus on the management of
the fund. We inquire about the firms segregation controls between trading and back office.
These segregation controls are a particularly important component to prevent incorrect
valuations, which could lead to hiding losses. In addition, software packages, proprietary
models and trade allocation systems are reviewed.

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The asset breakdown of all firm investments is identified and discussions are held about the
capacity of the strategy. We want to clearly understand how the firm intends to manage the
growth of their strategy in a prudent manner. In addition, we discuss the funds investor
profile (institutions, fund of funds, high net worth, corporations, endowments, etc.) and the
percent each represents in the fund. This is important to us because we believe from a
business perspective it is critical to maintain a diversified investor base such that no single
investor or segment of investors has undue influence.
Discussions are held with the compliance officer to review the firms compliance manual and
to understand the firms various compliance policies. We want to ensure that compliance
policies are being effectively monitored and enforced.
The firms disaster recovery plans are discussed including alternative office locations, back up
of critical data and systems and reestablishment of communications with service providers,
trading counterparties and staff. We believe an important component of a disaster recovery
plan is to ensure someone is specifically responsible for periodic testing, maintaining and
updating the plan. When discussing these plans we determine how long it would take to
restore management of the fund and see to what extent the firm has actually tested the plans.
The complexity of disaster recovery plans will vary depending upon factors such as the firms
reliance on technology, complexity of the strategy, number of counterparties and frequency of
trading to name a few.

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Onsite Visit
No due diligence investigation would be complete without a personal onsite manager visit.
This allows us to evaluate first hand the portfolio management team and the operational
structure of the firm. During the visit we meet with the firms investment team as well as the
Chief Compliance Officer or Chief Operating Officer to review the firms compliance manual.
Some of the compliance inquiries include discussing the firms policies with respect to
employee trading, internal code of conduct, disaster recovery, soft dollars, investor privacy
and formalized valuation policies. Other inquiries take place with in regards to software
packages utilized by the firm, segregation controls between trading and back office, trade
execution and allocation procedures, money transfer protocols and controls. The offices are
evaluated in terms of their functionality, professional nature and use of technology.
We view an investment with a manager as a partnership and accordingly want to clearly
understand the principals goals and objectives for the firm. Discussions include future
strategic plans, for example adding new strategies or personnel, and evaluating how this
might impact our investment. A core theme that we continually ask ourselves during the
onsite visit, is this manager building out the necessary infrastructure and personnel to
maintain a successful long-term business? We are committed to investing with managers that
actively believe in this concept.

Background Checks
The basis of Greenwich Alternative Investments background checks is to take the information
provided by the investment manager and to independently verify it with third parties. We
carefully review the funds marketing materials and offering documents to create a list of
individuals and entities upon which to conduct regulatory and background checks. Regulatory
bodies are contacted to verify proper registrations and determine if there have been any
complaints, investigations or fines. Some of the regulatory agencies include the Securities &
Exchange Commission, Financial Services Authority, National Association of Securities
Dealers and National Futures Association to name a few. Legal databases are searched in
order to uncover any potential civil or criminal proceedings, judgments or bankruptcy filings.
In addition, an extensive news search takes place seeking to identify any articles of interest
related to the individuals or the fund. The educational and employment background of the
manager(s) is verified to ensure their represented biography is, in fact, accurate.
The past two years of the funds audited financial statements are reviewed in detail for any
qualifications or negative opinions. Year-end assets, subscriptions, redemptions and NAV are
compared to those reported by the fund in order to verify their accuracy. We pay particular
attention to any type of disclosure such as pricing provided by the manager or notations of
illiquid securities. In addition, the auditor is contacted to verify that they in fact have been
engaged by the fund and completed the audit.
Professional and investor reference interviews serve as a valuable source of information to
gain a deeper insight into the manager and the operations of the fund. We speak with
professional references such as former employers who are familiar with the managers
abilities, personality and work ethic. Investor references allow us to determine whether
investors receive timely and accurate information, how responsive the fund is to their inquiries
and whether the investor has identified any problems or issues with the fund. In addition, we

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look to see how proactive the fund is to communicate with investors when there is a notable
loss in the portfolio or significant market event.
The fund administrator is interviewed in order to clearly understand their role and
responsibilities as it relates to the fund. For example, is the administrator responsible for
transacting subscriptions and redemptions, maintaining the shareholder registry, serving as
the pricing agent, or other services? We also independently verify the fund assets reported
by the manager with the administrator to ensure the representations made are in fact true.
When it comes to the NAV calculations, we identify the sources of the position and pricing
information and the extent, if any, to which the investment manager is involved. This is a
critically important issue to understand, as historically the NAV calculations have been an
area where hedge fund fraud has been uncovered. There have been a number of high profile
examples where managers were providing their own pricing or overriding the administrator,
which ultimately led to the collapse of the fund. Thus, we ensure a firm understanding of the
NAV process and the procedures and protocols in place to adjudicate pricing discrepancies.
Service providers have been another area where hedge fund fraud has been encountered.
Accordingly, we expect the fund to deal with industry-recognized providers for their auditing,
administration, custodial services and prime brokerage. If any of these providers are outside
of industry norms we take further action to determine their reputability, suitability and whether
in fact they are acceptable. In addition, turnover in key vendor relationships is scrutinized to
clearly understand and evaluate any such circumstances.

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Due Diligence Approval

Once the due diligence procedures have been completed the fund is ready to be presented to
our Investment Committee, which is composed of the senior members of the firm. The due
diligence approval meeting is an interactive process in which the various committee members
pose questions seeking to expose any areas of potential weakness or concern. Issues that
have arisen during the course of the due diligence process are brought to light and
adjudicated and at times may require additional follow-up with the fund. Once all of the
committee members issues have been satisfactorily addressed there is a formal voting
process to approve the fund. A unanimous consent is required to approve a fund and place it
on the Greenwich Alternative Investment platform.

Ongoing Risk Management

Once an allocation is made to a fund on the Greenwich Alternative Investment platform, we
maintain a program of monthly ongoing due diligence. Quantitative and qualitative factors are
gathered on the funds seeking to identify any potential style drift or areas of concern. A few of
the quantitative factors monitored include fund and firm assets, gross long / short exposures,
position concentration (geographic, sector or industry) and liquidity. During the course of our
monthly reviews, examples of circumstances that would cause us to become concerned
include leverage increasing beyond the managers historical norms, position concentration
becoming exceedingly high or notable personnel turnover in the firm. Each of these cases
would require contacting the fund to gain additional insight into the situation and to make a
determination as to whether we should remain invested in the fund. On a monthly basis
Greenwich Alternative Investments Risk Management Committee meets to review the
platform managers in which we are invested and adjudicate any potential issues.

Conclusion
The ongoing development of new strategies and instruments in the hedge fund community
continue to reinforce the need for a thorough and disciplined approach to due diligence.
Greenwich Alternative Investments due diligence process is intensive and time consuming;
however, we consider it a necessary component in order to protect the interests of our clients.

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About Greenwich Alternative Investments

Founded in 1992, Greenwich Alternative Investments (GAI) was the first to collect data and
perform large-scale research on the broad universe of hedge funds. Today, GAI is
recognized as an alternative investment expert with one of the most comprehensive hedge
fund platforms available and is the provider of the Greenwich Global Hedge Fund Index, an
industry-standard benchmark of the hedge fund asset class. In addition to the index
publishing and research division, GAI is a leading hedge fund investment advisor and provider
of index-linked hedge fund products and services to investors worldwide. Greenwich
Alternative Investments Advisors, LLC is registered as an Investment Advisor with the SEC.

About the Greenwich Platform

GAI has one of the oldest and most extensive hedge fund management platforms in
existence, tracking over 7,000 funds worldwide. This number includes only hedge funds as
they are generally defined, and excludes fund-of-funds as well as certain other types of
investments such as private equity funds, venture capital funds, separately managed account
strategy composites, etc. Both quantitative and qualitative information is included for each
fund in the database. In addition to the Greenwich Indices, the database is used to conduct
general research on the hedge fund industry, such as studies on the size and characteristics
of the hedge fund universe. The quality of our hedge fund information is well recognized
internationally as a frequent source of industry information and is widely used in media,
business and academic publications.

About the Greenwich Hedge Fund Indices

Institutional investors, hedge fund managers and media worldwide recognize GAI as an
authoritative source for hedge fund indexing. GAIs flagship indices, the Greenwich Global
Hedge Fund Indices, are considered among the financial industrys oldest and most widely
utilized composite benchmarks of global hedge fund performance. Initially compiled in 1994
and published in 1995, the Greenwich Global Hedge Fund Indices provide over 18 years of
aggregate risk and return history, used to track performance of the overall hedge fund
universe. Updated twice monthly, the indices and strategy sub-indices reflect the respective
returns of their underlying hedge funds, net of all manager fees. The indices are calculated
through simple (as opposed to dollar-weighted) averaging and do not include Fund-of-funds.
The Greenwich Investable Index (GI2), a proprietary investable product offered by GAI,
provides interested parties with an investable benchmark for the hedge fund industry,
designed to track the Greenwich Global Hedge Fund Index. This document outlines the
methodologies used to construct and calculate (I) the Greenwich Global Hedge Fund Index
and (II) the GI2.

For more information contact:

Greenwich Alternative Investments
Nine Greenwich Office Park
Greenwich, CT 06931
Tel 203.869.9877
www.greenwichai.com