March 26, 2024

Due Diligence Best Practices for Funds

Funds are useful in terms of democratizing hedging strategies and private market investments. They help well-informed and professional investors access highly desirable asset classes such as private equity, private credit and real assets whilst keeping a diversification strategy in place.

Certain funds – such as those offered by Saratoga Capital – are subject to heightened investor protections. They have enhanced governance protocols that include a manager and depository, both of which are fully licenced. They have very clear investment strategies, have periodic reporting obligations, and require participating shareholder approval in certain cases.

While funds provide certain protections, they may not be suitable for all investors. It is important for investors to conduct their own due diligence on a prospective fund, much like the diligence of private investment structures. Due diligence should focus on gaining a clear sense of a fund’s investment objectives and risks, management, fees and redemption options.

Investment Objectives and Risks

When considering an allocation to such a fund, the most critical factors to review are a fund’s investment strategy and objectives, as well as its expected risk and return profile.

There are several questions to ask to get a good sense of risk and return:

  • What is a fund’s long-term investment objective?
  • How does it get there with its investment strategy?
  • Is it focused on income, growth or a combination of the two?
  • How does the manager expect the fund to perform in various market environments?
  • What is the manager’s current market outlook, and does the manager expect the fund to perform well given that viewpoint?
  • What are the primary risks that this fund is exposed to, and how are they managed within the fund?

Once you feel comfortable that you understand the risk and return profile of a fund, you can determine if it aligns with your objectives.

Track Record and Fees

While evaluating the risk and return profile, you will get a general sense of how a manager views the markets and how they apply their skills to manage the fund. Funds that incorporate hedging or private investment strategies could potentially have minimal, if any, track records, so it is important to investigate the manager’s background and previous investment experience running a similar strategy or their past performance with other fund companies.

Fees are another key area of due diligence. Most funds will have three distinct types of fees: upfront or offering fees; operating fees; and liquidation fees. Upfront fees include commissions and marketing fees. Examples of operating fees include real estate property management fees, financing fees, or performance-based fees based on achieving pre-specified metrics. Liquidity fees include real estate disposition fees, loan termination fees, or other fees and expenses related to selling or liquidating fund assets. Fees can vary significantly by structure and asset type, so an important factor in reviewing fees is to compare similar funds.

Liquidity and Redemption

Another key area to review as part of your due diligence of a fund is its liquidity or redemption options. An example of key questions to ask include:

  • What, if any, redemption options does the fund provide?
  • At what frequency are redemptions offered, and what is the maximum amount of fund assets that can be redeemed in a given time period?
  • If a fund allows periodic redemptions and provides a certain amount of liquidity, how do they manage their cash?
  • What percentage of fund assets are needed to maintain liquidity, and what percentage has the fund held historically?
  • How does the manager balance liquidity while limiting the impact on returns of holding cash?

It is critical that you perform proper due diligence of a prospective fund’s investment objectives and risks, performance expectations, management, fees and redemption options. A full understanding of these characteristics will help you to properly position these funds into your portfolio, so that you stay happily invested for the long term.

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