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FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds

A fund of hedge funds is conducting operational due diligence on a new manager. Which of the following findings should be regarded as the most serious red flag for potential fraud?

The related-party, inexperienced administrator is the most serious red flag because it removes independent valuation and verification of the fund's assets and NAV. The other features are normal commercial terms and do not impair control independence in the same way.

  1. AThe fund's administrator is a small firm that has never serviced another hedge fund, and the manager's affiliate owns a stake in itCorrect
  2. BThe fund charges a 2% management fee and a 20% performance fee
  3. CThe manager uses a prime broker located in a different country from the fund's domicile
  4. DThe fund permits quarterly redemptions with 90 days' notice

Explanation

An inexperienced administrator that is related to the manager undermines independent verification of NAV and fund assets, a classic enabler of fraud. Standard fee levels, a foreign prime broker and quarterly redemption terms are common and do not by themselves indicate weak independence of controls.

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