Conducting Proper Due Diligence on Third-Party Service Providers
Gabriel Kurland, CAIA
Hedge Fund Appraisal
Feb 2011
In a typical hedge fund structure, the board of directors will delegate the different functions necessary to the day-to-day activities of the fund to a selection of third-party service providers. In practice, the directors, too often, are selected at the very end of the fund's creation process and therefore usually have little to say in the final choice of the service providers. The hedge fund managers, especially the start-up ones, could gain by reversing the selection process on his head and bringing in the independent directors early on. By doing so, the manager will be able to benefit from the experience of the directors, demonstrate his commitment to strong corporate governance and bring some independence in the pre-launch phase.
The delegation of the day-to-day activities of the fund to service providers should not be confused with a delegation of responsibilities. Delegation without proper oversight of the delegated functions is ineffective and a breach of the directors' fiduciary duties which can lead to unpredictable consequences. Directors should feel comfortable with the investment manager's initial choices and have in place the proper monitoring process to ensure that the service providers continue to deliver on their promises. In most cases, the oversight of the outsourced functions is performed by the investment manager who has the day-to-day working relationships with the different service providers. In that case, the directors should require regular reporting.
