Know your customer (KYC)

Know Your Customer procedures serve as the foundation of fund compliance programs. These structured processes help investment managers accomplish three main goals: verify who their investors are, check where their money comes from, and confirm they meet eligibility requirements before accepting their capital.

Anti-money laundering (AML) Anti-money laundering (AML) Anti-money laundering (AML) refers to the set of laws, regulations, and procedures designed to prevent the conversion of illegally obtained funds into legitimate assets, requiring financial institutions to implement monitoring systems, customer due diligence, and suspicious activity reporting. policies typically include some form of "know your investor" policy. This policy requires sufficient information collection by the adviser or fund administrator Fund administrator A fund administrator is an independent third-party company that handles essential day-to-day operations for hedge funds. These companies calculate how much the fund is worth, serve investors, ensure regulatory compliance, and manage back-office operations. They work separately from the investment manager to provide oversight and protect investors. to assess the investor's background, identity, and the source of subscription funds. This due diligence information helps determine whether a potential investor should be permitted to invest or requires enhanced scrutiny.

Fund advisers conduct enhanced due diligence for certain high-risk investors. These categories include several types of potentially problematic investors. First, investors located outside Financial Action Task Force (FATF)International body that establishes global standards for combating money laundering and terrorist financing. member jurisdictions receive extra scrutiny. Second, non-U.S. private investment companies require additional review. Third, senior foreign political figures and politically exposed personsIndividuals who hold prominent public positions and may present higher corruption risks. face enhanced screening. Finally, investors residing in or organized under the laws of non-cooperative jurisdictions or FATF-designated high-risk jurisdictions require additional verification.

Many investment advisers prohibit certain investor types entirely. The Bank Secrecy ActFederal law requiring financial institutions to assist U.S. government agencies in detecting and preventing money laundering. prohibits certain financial institutions from dealing with shell banksBanks that have no physical presence in any country and are not affiliated with a regulated financial group.. Although hedge fund advisers are not specifically covered by this regulation, most advisers prohibit business with prohibited foreign shell banks. They also avoid foreign banks that provide services indirectly to such banks.

Advisers also generally require additional due diligence when the investor's wiring bank meets certain criteria. Specifically, this applies when the bank is not incorporated in a jurisdiction that is an FATF member, or when the bank does not have its principal place of business in such a jurisdiction.

Enhanced due diligence procedures apply to additional high-risk categories beyond those mentioned above. These include any investor whose subscription funds originate from or route through accounts at prohibited foreign shell banks, offshore banks, or banks organized under the laws of Non-Cooperative Countries and Territories (NCCTs)Jurisdictions identified by international bodies as having inadequate anti-money laundering controls. jurisdictions. Additional scrutiny also applies to banks subject to special measures under Section 311 of the BSA/PATRIOT Act.

Several other categories trigger enhanced review. These include investors subject to special measures under Section 311, foreign banks subject to enhanced due diligence under Section 312 of the BSA/PATRIOT Act, and investors in jurisdictions subject to Financial Crimes Enforcement Network FinCEN FinCEN (Financial Crimes Enforcement Network) is a bureau within the U.S. Department of the Treasury responsible for collecting, analyzing, and disseminating financial intelligence to combat money laundering, terrorist financing, and other financial crimes, with evolving authority over hedge funds and investment advisers. advisories. Finally, investors whose subscription fund sources appear potentially illegitimate require additional investigation.

KYC procedures integrate into the subscription process through detailed questionnaires and documentation requirements. Subscription agreements contain questions about whether the investor meets various regulatory definitions. These include whether they are a qualified purchaser Qualified purchaser Qualified purchasers are investors who meet specific wealth thresholds under the Investment Company Act of 1940. These investors are required for participation in Section 3(c)(7) funds. Generally, individuals must own at least $5 million in investments, while institutions must own at least $25 million in investments. , an accredited investor Accredited investor An accredited investor refers to an individual or entity that meets specific financial thresholds set by securities regulations, qualifying them to invest in unregistered securities offerings such as hedge funds, with standards including minimum income or net worth requirements. , an employee benefit planRetirement, pension, or other benefit plans established by employers for their employees, often subject to ERISA regulations., or a taxable or tax-exempt U.S. investor or non-U.S. investor. The agreements also verify compliance with applicable anti-money laundering laws and regulations.

The subscription agreement also includes representations and warranties that serve as legal protections. The investor must represent that they are purchasing fund interests for investment rather than resale. They must confirm they have read and understand the partnership agreement and offering memorandum. Additionally, they must attest that they have the knowledge and experience to make the investment and that they rely exclusively on the fund documents for investment decisions.

Multiple regulations drive KYC requirements, creating a complex web of obligations. The Bank Secrecy Act provides the U.S. foundation for AML requirements. The USA PATRIOT Act enhanced KYC requirements for financial institutions beyond what the Bank Secrecy Act originally required. FATCA FATCA The Foreign Account Tax Compliance Act (FATCA) is U.S. legislation requiring foreign financial institutions, including offshore hedge funds, to report information about financial accounts held by U.S. taxpayers or foreign entities in which U.S. taxpayers hold substantial ownership, with non-compliance resulting in significant withholding penalties. and the Common Reporting Standard establish global tax information reporting standards. The FinCEN Customer Due Diligence RuleRegulation requiring financial institutions to identify and verify beneficial owners of legal entity customers. creates beneficial ownership information (BOI) reporting BOI reporting Beneficial ownership information (BOI) reporting refers to disclosure requirements under the Corporate Transparency Act that require certain foreign entities registered to do business in the United States to identify and report the natural persons who ultimately own or control the entity to FinCEN. As of March 26, 2025, U.S. hedge funds and other domestic entities are exempt from these requirements. requirements. EU Anti-Money Laundering Directives provide a comprehensive European framework.

While hedge fund advisers currently are not subject to the same AML program requirements as banks and broker-dealers, many have voluntarily adopted comprehensive AML programs. They do this to meet investor expectations and protect against legal and reputational risks. This landscape is changing significantly: in August 2024, FinCEN issued a final rule requiring most SEC-registered investment advisers and exempt reporting advisers Exempt reporting adviser An exempt reporting adviser is an investment adviser that doesn't have to complete full SEC registration, but still must meet some basic reporting requirements. This status typically applies to advisers who only manage private funds with less than $150 million in U.S. assets, or advisers who exclusively manage venture capital funds. to implement comprehensive AML programs. This rule was originally set to take effect January 1, 2026, but was subsequently postponed until 2028. When implemented, this rule will formalize many KYC practices that hedge fund advisers have adopted voluntarily.

Depending on the fund's investment strategy, some advisers have implemented enhanced procedures for certain investments, including private investments. These procedures help ensure the fund avoids investing in or transacting with business partners that may have violated OFAC sanctions OFAC sanctions OFAC (Office of Foreign Assets Control) sanctions are economic and trade restrictions imposed by the U.S. government against targeted countries, regimes, individuals, and entities, requiring hedge funds to implement compliance programs to screen investors and avoid prohibited transactions. or engaged in money laundering activities. Performing adequate due diligence on investments is critical for two reasons: gaining sufficient knowledge of investment opportunities and better assessing the legitimacy of companies and the adviser's prospective transactions with them.

The practical implementation of KYC programs requires sophisticated systems and procedures to manage regulatory data volume and screening requirements. A comprehensive compliance program typically includes several key components. First, it requires written anti-money laundering policies and procedures tailored to the fund's operations and risk profile. Second, it needs designation of a compliance officerThe person responsible for overseeing a firm's compliance with applicable laws and regulations. responsible for program oversight and regulatory coordination. Third, it must provide regular training for employees on anti-money laundering requirements and red flag identification. Finally, it requires independent testing of the program's effectiveness through periodic reviews.

The Compliance Officer is often the Chief Compliance OfficerThe person responsible for overseeing a firm's compliance with applicable laws and regulations., CFO, COO, or Chief Administrative Officer. This person coordinates the program and serves as the point of contact for potential compliance issues.

KYC is not a one-time process but requires ongoing monitoring and periodic refresh of investor information. The initial verification when an investor first subscribes is just the beginning. Investment managers must continue to monitor investors throughout the relationship to identify any changes in risk profile or suspicious activity patterns.

Many funds utilize specialized compliance technology and third-party service providers to supplement internal capabilities. This helps ensure comprehensive coverage of regulatory obligations, especially as the volume of data and screening requirements continues to grow. The Financial Action Task Force is an international organization comprised of representatives from financial, regulatory, and law enforcement communities worldwide that serves as the world leader in developing effective anti-money laundering programs.

Some investment advisers conduct enhanced due diligence even for investors located in jurisdictions that are FATF members. This occurs when these jurisdictions are perceived by the adviser as presenting higher risk for money laundering, despite their FATF membership status.