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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

A due diligence team is evaluating a hedge fund whose manager refuses to let investors speak directly with the prime broker or administrator, saying that the relationships are confidential. Which action is the most appropriate response under sound operational due diligence practice?

The team should treat the refusal as a serious red flag and not invest unless independent verification of the service providers is allowed. Direct confirmation of assets and trades is core operational due diligence, and strong returns or manager-supplied assurances cannot replace it.

  1. AAccept the refusal if the fund's reported returns are consistently strong
  2. BRely on the manager's own written confirmation of service providers
  3. CTreat the refusal as a serious red flag and decline to invest unless independent verification of service providers is permittedCorrect
  4. DSubstitute a review of the manager's marketing materials

Explanation

Independent verification of service providers is a core due diligence step. Refusal to allow it prevents confirmation that assets and trades exist, and strong returns do not compensate, as the Madoff case showed. Manager-supplied confirmation is not independent.

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