1. Hedge funds trade securities in volumes that are a multiple of their traditional asset management counterparts. In addition, hedge funds have less regulatory oversight than traditional asset managers.
2. A sound operational due diligence (“ODD”) process can serve as an effective mechanism to mitigate the risk of investing in hedge fund frauds.
3. Here are some detailed insights and recommendations pertaining to Due Diligence practices on hedge fund managers focusing on their policies and process.
OPERATIONAL PROCEDURES
1. Reviewing the “operations” of a hedge fund company can help ensure that the policies and procedures in place will properly support the trading and investment activities of the manager. Investors should be sure that they have a solid understanding and comfort level with the following operational items:
2. Organizational Hierarchy - Monitor personnel changes, key-man clauses, compensation schemes and hiring needs very closely, and be confident that the hedge fund manager is focused on building a strong and viable business with proper staffing across investment and non-investment functions. It is also important to check for a clear segregation of duties, with no conflicts of interest.
3. Trade Processing - A thorough review of the entire life-of-a-trade process from the time a trading idea is generated, to when it is entered into the trade systems, executed and reconciled. Due diligence should include tracking multiple trades through the hedge fund manager’s order management systems and middle office systems, as well as the reconciliation of trades.
4. Trading Authority - This is to ensure that there is a segregation of execution and trade entry duties, and to gain an understanding of who has the authority to place trading limits on traders. Finally, one should review the trade reconciliation process as well, including frequency and management oversight.
5. Valuation Policies - In reviewing the investment strategy and instruments in which a hedge fund manager invests, one should determine the frequency, suitability and integrity/ objectivity of how the portfolio is priced. In addition, it is important to ensure the ultimate price used is accurate based upon the pricing methodology (average, offer/bid, model, etc.), and that a policy governing how price discrepancies are resolved is in place.
2. Organizational Hierarchy - Monitor personnel changes, key-man clauses, compensation schemes and hiring needs very closely, and be confident that the hedge fund manager is focused on building a strong and viable business with proper staffing across investment and non-investment functions. It is also important to check for a clear segregation of duties, with no conflicts of interest.
3. Trade Processing - A thorough review of the entire life-of-a-trade process from the time a trading idea is generated, to when it is entered into the trade systems, executed and reconciled. Due diligence should include tracking multiple trades through the hedge fund manager’s order management systems and middle office systems, as well as the reconciliation of trades.
4. Trading Authority - This is to ensure that there is a segregation of execution and trade entry duties, and to gain an understanding of who has the authority to place trading limits on traders. Finally, one should review the trade reconciliation process as well, including frequency and management oversight.
5. Valuation Policies - In reviewing the investment strategy and instruments in which a hedge fund manager invests, one should determine the frequency, suitability and integrity/ objectivity of how the portfolio is priced. In addition, it is important to ensure the ultimate price used is accurate based upon the pricing methodology (average, offer/bid, model, etc.), and that a policy governing how price discrepancies are resolved is in place.
6. Valuation Process - the valuation process should be transparent and well-articulated, reviewed by a third-party (administrator, prime broker), and reconciled on a daily basis.
7. Cash and Collateral Management - Conduct a full review of all cash control procedures to understand how cash movements are executed, and what safeguards are in place to monitor and control the cash movements. Managers should have a clearly written procedural manual as well as a requirement for multiple signatories for all cash and collateral movements. In terms of multiple signatories, ideally at least two signatures should be required to authorize cash/collateral movements, with at least one signature from a non-investment principal such as a CFO and a designated back-up authorized signatories as well.
8. Key Employee trading policy and back-up planning - Policies should be established to cover designated brokers, pre-approval processes covering employee trading and minimum holding periods. Verify that copies of the client brokerage statements are received and reviewed by the firm, to ensure that the policy is properly adhered to by the firm employees.
9. Business continuity/contingency planning - Verify backup systems are tested for their accessibility to all critical applications and files are frequently transferred to a back-up off-site secure facility can make recovering from a disaster or business interruption far less painful, for the manager and the investors.
8. Key Employee trading policy and back-up planning - Policies should be established to cover designated brokers, pre-approval processes covering employee trading and minimum holding periods. Verify that copies of the client brokerage statements are received and reviewed by the firm, to ensure that the policy is properly adhered to by the firm employees.
9. Business continuity/contingency planning - Verify backup systems are tested for their accessibility to all critical applications and files are frequently transferred to a back-up off-site secure facility can make recovering from a disaster or business interruption far less painful, for the manager and the investors.
ACCOUNTING/FINANCE REVIEW
1. Looking underneath these statements may uncover deficiencies that can help ward off business interruptions, or even uncover inconsistencies or red flags in financial reporting that may signal unethical practices or fraud.
2. Fees and expenses analysis - Investors need to thoroughly review fees/expenses, to confirm consistency with stated management and incentive fees. Investors should also confirm how fees are calculated.
3. Pass-through fees - It can be fairly broad, encompassing everything from operating expenses, to staff salaries and bonuses. Typically, employee compensation is paid out of the management and incentive fees generated, but several hedge funds pass these expenses directly through to the fund, leaving the bulk of the management fees and incentive fees for partners/principals of the management company. investors should understand whether passthrough fees can be charged to the fund.
4. Financial statements (footnotes/delays) - It is important to review footnotes carefully for any disclosures/assumptions used in financial statements which may reveal items that need to be addressed more thoroughly.
5. Audit firm / audit opinion - The audit opinion (“clean vs. qualified”) should be carefully reviewed.
REVIEW OF FUND TERMS AND OFFERING MATERIALS
1. It is also important to have the right professionals, ideally with a legal background, reviewing the offering materials provided by hedge funds to make sure that the terms of the offering and fund structure are not off-market or unusual in a way that would subject investors to undue risk.
2. Items to review include management structure, fee structure and discretion, liquidity provisions (including soft or hard lock-ups, gates and key man provisions, if any), Fund structure and suitability.
THOUGHTS
1. Often managers who are talented investors have limited experience operating a business.
2. Investor can serve as both a source of capital, as well as a source of knowledge about operational best practices.
(Source: JPMORGAN)
