EUROPE – The level of sophistication institutional investors apply to operational due diligence when investing in hedge funds has increased significantly in recent years, which has in turn spurred funds-of-funds and consultants to build up their own due diligence teams, a new report has found.

A survey conducted by Deutsche Bank among senior professionals at European funds-of-funds and consultants identified a "fundamental" shift in the depth and nature of due diligence carried out by hedge fund investors. 

The study found that 73% of funds-of-funds and 80% of consultants now have operational due diligence teams in place that operate separately from the investment due diligence process.

Additionally, operational due diligence teams are now viewed as a partner and peer to the investment team and actively vetoing investments, while a robust infrastructure, established service providers and a culture of compliance and governance are now vital considerations in the investment process.

The study highlights the "significant" power such teams hold within the investment process, with the ability to veto investments if a prospective manager fails their review. 

The main reasons for applying a veto lie in the lack of self-administered and self-custodied funds, using an unknown audit firm or a board with no independent directors.

But the unwillingness to provide transparency, the valuation issues and the insufficient investment of personal wealth are other barriers for investment.

Chris Farkas, head of European hedge fund consulting at Deutsche Bank, said: "The research highlights how important the fundamentals are to the operational due diligence process – from having the right people in place to a proven audit trail.

"The growing importance of operational due diligence comes at a time when investors are better educated than ever in all aspects of a fund's business."

This, in turn, means due diligence takes longer, with 66% of investors taking between three and six months to complete due diligence on a manager.

Deutsche Bank attributed these changes to the 2008-09 credit crisis and notable hedge fund losses, which led institutional investors to re-think the way they evaluate hedge funds.

Daniel Caplan, European head of global prime finance at Deutsche Bank, said: "Institutions have embraced hedge funds as a source of positive risk-adjusted returns, and this runs hand in hand with a greater focus on control and compliance.

"Investors have a rigorous toolkit of evaluation techniques, and hedge funds have responded by vastly increasing transparency and access."

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