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.

policies typically include some form of "know your investor" policy. This policy requires sufficient information collection by the adviser or 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 member jurisdictions receive extra scrutiny. Second, non-U.S. private investment companies require additional review. Third, senior foreign political figures and 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 prohibits certain financial institutions from dealing with . 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 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 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. contain questions about whether the investor meets various regulatory definitions. These include whether they are a , an , an , 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. and the Common Reporting Standard establish global tax information reporting standards. The creates 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 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 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 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 , 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.