Electronic copy available at: http://ssrn.com/abstract=1456414
2services such as TASS, HFR, and CISDM report such things as fund styles, leverage andfees, historical performance, and related advisor entities, they ultimately rely on the fundsthemselves to voluntarily provide this information.In part because the SEC does not allow hedge funds to engage in generalsolicitation, they have historically relied on trusted referrals as a prime distributionchannel. This reliance on referrals, and the limited transparency with respect toperformance and operations, are potential reasons why the Madoff scheme could last solong. Relatively few third party entities had access to performance statistics, informationabout firm auditors, pricing policies, self-administration and custody. In an environmentlacking multiple, comparable sources of information about an agent’s credibility, trust iseven more important, as are mechanisms to verify trustworthiness.In this paper we analyze a comprehensive database of due diligence reports onhedge funds provided by a major investigation firm. Due diligence (DD) firms specializein gathering and verifying information potentially relevant to operational risk assessment.They are typically retained by clients who are considering an investment in a hedge fund,and who wish to gather more information beyond what is provided by the fundprospectus and by regulatory filings.
While the academic literature has widely studiedthe roles of regulators, auditors and informal reputation within financial markets, researchon third-party investigation is comparatively recent. For example, using essentially thesame database, Cassar and Gerakos (2008) document correlation between hedge fundinternal controls and manager fees, arguing that the extent of operational risk controls isendogenous.
Typical clients are funds of hedge funds, investment banks, and wealthy individuals.