Transcript of "Hedge fund operational_due_diligence_madoff_effect_corgentum"
Hedge Fund Operational Due Diligence:The Madoff Effect -An Analysis of Operational Due Diligence Trends June 2010
When Bernard Madoff turned himself in diligence process. As a result, manyto authorities on December 11, 2008 hedge investors remain unsure which factors arefund investors took pause to reassess their appropriate or important to cover duringapproach towards due diligence. Many of the operational due diligence process.the red flags that were present in the Making problems worse, those performingMadoff Ponzi scheme, as well as other operational due diligence have had sufferedrecent hedge fund frauds, were operational from a dearth of benchmark data wherebyin nature. Indeed recent failures of many they could effectively determine:legitimate hedge funds, where no fraud waspresent, can be attributed to inherent and What operational risks do investorsunmitigated operational risks. As a result, commonly review, during themany individual and institutional hedge operational due diligence process?fund investors, including fund of hedge What factors are more commonlyfunds, utilized the Madoff fraud as an reviewed than others?opportunity to refocus their attention Do certain operational due diligencetowards operational due diligence. frameworks tend to vet more riskOperational due diligence on factors?hedge funds primarily focuses on Are there any operational riskdiagnosing, analyzing and monitoring the factors that tend to be minimizedoperational or non-investment related risks during the due diligence process?of a hedge fund manager. How have recent frauds influenced the nature of operational dueWith this renewed and increased focus on diligence?operational due diligence, hedge funds How has pending financialreacted with a myriad of responses. Some regulatory reform influenced dueconcentrated on addressing, in due diligence?diligence questionnaires and marketingpitchbooks, what they thought would be This study attempts to answer these andinvestors key operational risk concerns. other questions by analyzing operationalOthers, hoping to placate investor concerns, due diligence data collected from over 200placed their faith in purchased operational hedge fund allocation organizations. Therisk certifications. A few hedge funds have data shows that in anticipation of strictereven pursued traditional manufacturing hedge fund regulation, investors arecertifications, normally held by focusing the bulk of their due diligenceadministrators, such as the SAS 70 efforts on legal, compliance and regulatorycertification. risks. Interestingly, the data also demonstrates a so-called Madoff Effect.This mixed bag of responses by hedge fundshas further fostered a lack of uniformity in Analysis shows that frauds, such as Madoff,the type and scope of factors analyzed by have caused investors to tailor their hedgeinvestors during the operational due fund operational due diligence process to focus on the red flags of recent frauds. 2|Page
While this approach has advantages, it dedicated operational due diligence staffassumes that fraud can be modeled and has are employed.led to marginalization of other equallyimportant operational risk factors. Modular – An operational due diligenceIntroduction A wide variety of approaches framework whereby the operational dueare taken by hedge fund allocation diligence process is classified into functionalorganizations that perform operational due components and parsed out amongdiligence reviews of underlying hedge fund different specialists with relevant domainmanagers. Previous research has focused specific knowledge.on analyzing the types of operational duediligence frameworks utilized by fund of Hybrid – A hybrid operational due diligencehedge funds. framework refers to an approach that encompasses some combination of theFund of hedge fund operational due three previously described approachesdiligence (dedicated, shared,frameworks can be modular) and mayclassified into incorporate the use offour distinct consultants.buckets: dedicated,shared, modular Hedge fund allocationand hybrid. This organizations can utilize thepaper focuses on data in this study toproviding an benchmarkanalysis of the the comprehensiveness andnumber and types scope of their operationalof operational due diligence processes.factors covered during an operational due Similarly, investors who allocate capital todiligence review. Brief definitions of each of pooled hedge fund allocators, includingthese frameworks are fund of hedge funds can utilize the data inoutlined below for reference: this study to evaluate the scope and comprehensiveness of their respectiveDedicated – An operational due diligence allocator’s operational due diligenceframework where a fund of hedge funds process.has at least one employee whose full timeresponsibility is vetting the operational risksat hedge fund managers. Organizations That Were Included In This StudyShared – An operational due diligence For the purposes of this study, the termframework where the responsibility for fund of hedge funds was defined as anreviewing the operational risk exposures at investment organization whose primaryhedge funds is shared by the same purpose is to allocate capital to a portfolioindividuals who have responsibility for of underlying hedge fund managers. Theinvestment due diligence. No full time types of institutions from which data was 3|Page
obtained included those organizations that 200 and 235 fund of hedge funds weremarket themselves as fund of hedge funds, utilized.as well as multi-family offices, endowments,foundations, corporate pensions, large Data Sourcesindependent financial advisory practices The data set utilized for this study wasand private banking organizations that pieced together from several differentmanage portfolios of hedge funds on behalf sources. The primary sources utilizedof their clients. The hedge fund managers included interviews and surveys withallocated to by the employees working atfund of hedge funds funds of hedge fundscould be of any organizations as well asinvestment strategy. other organizations,Fund of hedge funds as described above,that primarily which allocate to hedgeallocated to funds funds. Other data wasthat were not hedge collected fromfunds (i.e. - publicly availableprivate equity funds, databases, websites andventure capital funds, regulatory archives andreal estate funds etc.) via independentwere not included in research. As a general comment, allthis study. Finally, a globally diverse cross- percentages stated in this report have beensection of fund of hedge funds was included rounded to the nearest whole percent.in this study as there were no geographicrestrictions. Empirical Results: Framework Implication for FactorNumber of Fund of Hedge Funds Included Analysisin This Study The data demonstrates that across all studyIn order to respect the confidentiality of participants, regardless of the operationalboth those organizations that directly due diligence framework utilized, anparticipated in this study or upon which average of approximately eight operationalresearch has been performed, the names of factors were analyzed. Within particularspecific organizations have intentionally not frameworks, the number of factors varied inbeen disclosed. Furthermore, the exact line with expected predictions. For example,number of fund of hedge funds managers fund of hedge funds utilizing dedicatedutilized in this survey is not specifically frameworks, on average, analyzed six moredisclosed. This is to prevent reverse operational factors than the frameworkengineering of the specific identity of any neutral results, for an average total of 14one fund of hedge funds organization operational risk factors. Modularincluded in this survey. A range of the frameworks tied with the frameworknumber of fund of hedge funds reviewed neutral average, at eight operational riskhas been provided. In this study between factors. Hybrid frameworks fell just below 4|Page
the framework neutral average with seven reviewing the operational risk factors whichoperational risk factors analyzed. Finally were prevalent in the Madoff fraud duringshared frameworks, analyzed the least the post-Madoff time period.number of operational risk factors at fivewhich was three less than the framework Particularly, the data indicated an increaseneutral average. These results are in the category of “Cash controlssummarized in Exhibit 1. and management” an increase of 59.87% from the pre-Madoff to the post-MadoffExhibit 1: Number of Operational Factors era. This is followed by similar increases ofAnalyzed 64.52% for “Quality and length of relationship with service providers” andFramework Average Number of “Transparency and reporting” at 75.63%. Factors Reviewed These results are outlined in Exhibit 2. Within Each Framework* Exhibit 2: Operational Factors AnalysisAcross all 8 Shift Pre-Madoff and post-MadoffframeworksHybrid 7 Factor Categories Increase in reviewDedicated 14 frequency post-Modular 8 MadoffShared 5 Cash controls and 59.87% management*Number of factors and percentages have Quality and length of 64.52%been rounded to the nearest whole integer relationship with service providersThe Madoff Effect Transparency and 75.63% reportingThe next stage of analysis was to examinethe effect of fraud on hedge fund It should be noted that these increases canoperational due diligence trends. In represent both increased efforts in theseparticular, what effect would a large-scale respective risk areas as well as beginning afraud, such as Madoff, have on the type of review in this area anew.operational due diligence factors analyzed?Three prominent operational red flags Conclusionwhich were inherent in the Madoff fraudwere studied. This analysis incorporated Investors, influenced by recent hedge funddata from time periods both prior to the failures, have refocused their due diligenceMadoff scandal breaking on December 11, efforts on operational risk areas where2008 and the post-Madoff period. This leading operational red flags were present.limited example indicates a marked In particular, since the Madoff scandalincrease among fund of hedge funds in broke, this study shows that the number of fund of hedge funds reviewing hedge funds 5|Page
cash management policies and controls About Corgentumincreased by almost 60%. Corgentum is a provider of comprehensiveOther operational risk areas covered in the hedge fund operational due diligenceCorgentum study that have realized double- services to the hedge fund investors.digit increases in attention from investors Corgentum partners with hedge fundinclude transparency in reporting and the investors to improve upon the efficiencyrole of service providers such as auditors and effectiveness of the operational dueand administrators. diligence process. Our proprietary due diligence methodologies and innovativeCorgentums analysis also demonstrates original research allows our clients tothat certain operational risk areas continue continually manage and mitigate theirto be dangerously neglected during the operational risk exposures. The firm’sinvestor due diligence process. Less than 2% unbiased and time-tested approach createsof the fund of hedge funds included in this a substantial competitive advantage whichstudy considered the independence of a enhances the risk managementhedge funds board of directors during the functionality of our clients. Corgentum wasdue diligence process. Other frequently founded by Jason Scharfman one leadingoverlooked operational risk areas included experts in the field of hedge fundinformation technology infrastructure, operational due diligence and the author ofpersonnel turnover and the quality of Hedge Fund Operational Due Diligence:overall operations management. Understanding the Risks (John Wiley & Sons 2008). More information is available atReferences www.Corgentum.com.Scharfman, Jason, Analyzing OperationalDue Diligence Frameworks in Fund of HedgeFunds (May 1, 2009). Available athttp://corgentum.com/research/analyzing-operational-due-diligence-frameworks-in-fund-of-hedge-funds.htmlScharfman, Jason, Hedge Fund OperationalDue Diligence: Understanding the RisksWiley (December 3, 2008).Available at:www.wiley.com/buy/0470372346 6|Page