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Operational Due Diligence Insights       In This Issue                                       Welcome to Our First Issue- I...
2 - Operational Due Diligence Insights                                                              levels of compliance. ...
February 2012 | 3Power - Continued from page 2...                            While UPS range in price and capabilities, it...
February 2012 | 4multiple types including, natural gas powered and dieselpowered. Depending on the type of generator      ...
February 2012 | 5Master-Feeder - Continued from page 4...                         •   Can you track the allocation of fund...
February 2012 | 6                                                            analyzing fund legal documents and financialN...
February 2012 | 7Security Risk - Continued from page 6...                     approach towards protecting data is often fo...
8 - Operational Due Diligence InsightsSecurity Risk - Continued from page 7...                     the words and terms whi...
February 2012 | 9                                                            example the valuation work performed byAnalyz...
10 - Operational Due Diligence Insights On the Calendar Please see below for a list of upcoming operational risk items of ...
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This is Corgentum Consulting's inaugural newsletter, containing articles on operational due diligence.

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Operational due diligence_insights_corgentum_feb_2012 (2)

  1. 1. Operational Due Diligence Insights In This Issue Welcome to Our First Issue- Increased Fund Regulatory Welcome to the inaugural issue of Corgentum Consultings Operational Due Requirements Complicate Diligence Insights. This newsletter will serve as a resource for news, opinions Compliance Diligence and insights focused on issues related to operational risk and operational due diligence on fund managers including hedge funds, private equity funds- Backup Power Generation - Are and traditional managers. Funds Prepared for Blackouts?- Diagnosing Information Security Increased Fund Regulatory- Business Continuity and DR- Financial Statement Risk: Requirements Complicate The Master-Feeder Conundrum Compliance Diligence-Focus on Private Equity In the context of investors attempting to evaluate the sum total of operational-Term of The Month: Reserves risk in fund managers, no area is currently more rife with changes than the legal and compliance area. The passage of Dodd-Frank and the subsequent-New Book Provides Tools to Evaluate flurry of governmental rules and regulations have metastasized into a complex Operational Risk in Private Equity compliance web that both funds and investors must navigate. From the funds and Real Estate Funds perspective, these new rules apply to many different fund manager types across asset classes including hedge funds, private equity funds, real estate-Analyzing Fund Administrators funds and more traditional fund managers. For investors performing During Due Diligence - Valuation operational due diligence, one of the key challenges to evaluate is whether a Independence fund not only has taken a pro-active-Operational Risk Calendar ...continued on next page
  2. 2. 2 - Operational Due Diligence Insights levels of compliance. Another less obvious addedRegulatory - Continued from page 1... benefit for investors may also be knowledge about how seriously a fund manager takes the concept ofapproach to comply with the new rules and regulations, compliance.but whether they have done so intelligently. One of the Said another way - if a fund manager takes the barekey challenges many fund managers have recently faced minimum approach towards internal complianceis the registration requirements recently enacted by the oversight, where else might they be cutting corners?SEC. In addition to the registration requirements, many Without comprehensive operational due diligence, thefund managers may have to comply with additional answer might not be as clear as investors might like.reporting disclosure requirements, including thosecontained in the revised Form ADV and Form PF. Fundmanagers seeking to initially comply with the SECs Backup PowerFebruary 14, 2012 registration deadline, likely took anumber of different approaches in their path towards Generation: Arecompliance. Many fund managers engaged one of thebevy of third-party compliance consultants. These third- Funds Prepared forparty firms have realized a recent boon to theirbusinesses, based on increased compliance Blackouts?requirements. Other fund managers, instead, likelyworked with law firms to assist them with this process. Business continuity planning and disaster recovery,Still, others may have utilized internal legal and often abbreviated as BCP/DR, is one area which iscompliance resources. In any case, now that we are past typically covered, or at least should be covered, duringthe registration deadline, investors may be tempted to the operational due diligence process. Reviews of aconsider the approach taken by a particular fund to funds BCP/DR infrastructures however, are a bitcomply with registration requirements to be a moot counterintuitive. The goal of evaluating a funds BCP/DRpoint. After all, the only point is that a fund has met the plans seems simple enough on its’ face - can a fundrequirements, isnt it? continue operations in the event of a disaster? However,Such an approach seeks to put the cart before the from this simple enough question comes a myriad ofhorse. With the registration deadline now behind them, quite complex technology, process and planningfund managers still have an enhanced series of ongoing considerations. One such area that we will focus on inreporting and compliance monitoring requirements. this article relates to backup power generation.Perhaps the most notable example of these ongoing The concept behind a fund managers backup powerrequirements includes, the new disclosure generation capabilities may seem to boil down to arequirements of Form PF. singular goal - can a fund manager keep the lights on ifDuring the operational due diligence process, investors the power goes out? From an operational due diligencecan likely gain a number of useful insights into a fund perspective, the question of how a fund managermanager’s attitude towards compliance, by evaluating approaches this issue can actually be further distilledthe way in which a fund manager worked to meet the into two distinct questions.initial registration requirements. By incorporating an First, does a fund manager have backup powerongoing review of a fund manager’s complianceenvironment in their operational due diligence process,investors will be able to monitor the way in which afund attempts to meet mandated regulatory minimum ...continued on next pageCorgentum Consulting
  3. 3. February 2012 | 3Power - Continued from page 2... While UPS range in price and capabilities, it is generally considered best practice for a fund manager to havecapabilities to allow for an orderly shut-down or dedicated UPSs for both their desktop computers andprotection of the firms hardware? Second, can the firm servers. Additionally, it is important for fund managerscontinue operations, and perhaps most importantly, to perform ongoing testing of UPSs to ensure that theyinvesting activities in the event of a prolonged power are appropriately holding battery power.outage? Let us consider each of these questions We can now turn to the second primary concern mostindividually. investors have to backup power generation - the abilityWhen considering backup power which provides an of a fund manager to continue operations in the eventorderly system shutdown, we first have to understand of a prolonged power loss. This area is most likely theexactly what hardware is being turned off. On its most more common of the two major investor concernsbasic level, fund managers generally have two primary related to backup power generation. To clarify, atypes of hardware: desktop computers and servers. prolonged power loss generally refers to a loss of powerWhen the power is suddenly cut to either of these types which extends for more than a few minutes.of equipment, bad things could happen if they were to Depending on the fund manager’s geographic location,immediately just shut down. First, important data that inclement weather such as snow storms or hurricanes,was not saved properly before the shut down could be may potentially cause power outages which can extendlost. Besides the loss of data, a sudden power loss could for a number of days. The problem, of course, is thatpotentially cause actual physical damage to the the entire world does not lose power all at once, andhardware itself. the markets remain open.To combat these problems, a fund manager can A fund manager who cannot continue tradingtypically install a piece of hardware known as an operations for an extended period of time is likely to beuninterruptible power supply, which is commonly at a severe disadvantage and may potentially pile upreferred to as a UPS. On their most basic level, a UPS serious losses. As an aside, for the purposes of thisprovides protection from a power loss. It does this by discussion it should be noted that while a fundautomatically switching on when the power is cut. Once managers approach to continuing operations mayswitched on, a UPS will minimally provide sufficient encompass a number of concepts not directly related tobattery power to the computer or server so that it may backup power generation including securing alternativebe properly shut down without data loss or hardware work locations and maintaining backup phone lines anddamage. internet connections. Returning to the issue at handThe length of battery power provided by a UPS can be though - what approaches is an investor likely torelatively short (i.e. - 15 minutes) or may even extend encounter during the operational due diligenceup to a number of hours. A UPS may not only serve as a process?backup to power loss. These devices can also protect The most common solution that fund managers take toequipment against power surges, spikes, and high address this issue is a backup generator. Backupfrequency power oscillation from other equipment. All generators are different from UPSs in that they actuallyUPSs are not created equally, and there are many have the ability to generate power for an extendeddifferent types including offline / standby UPS, Line- period of time. Emergency backup generators come ininteractive UPS, double-conversion online UPS, doubleconversion on demand, ferro-resonant UPS and dieselrotary UPS. ...continued on next page
  4. 4. February 2012 | 4multiple types including, natural gas powered and dieselpowered. Depending on the type of generator Financial Statementemployed, a number of different ongoing maintenancerequirements may be in place. With diesel generators, Risk: The Master-for example, it is important to ensure that thegenerator has an appropriate supply of diesel gas in its’ Feeder Conundrumtank. Additionally, diesel generators often need to be A commonly employed fund legal structure, which isstarted several times throughout the year to ensure popular among both hedge funds and private equitythat the equipment continues to function properly. funds, is the master-feeder structure. Under this type ofDepending on their location, a fund manager may have two-tiered structure, a master fund sits above a feedera dedicated generator or one which is shared with fund. Investors typically allocate capital to a feedermultiple tenants in the same office building. Often fund, which then takes this capital and makes antimes such large generators, which may be able to investment in the master fund. Ultimately, it is thegenerator power for periods of multiple days, can master fund that makes the investments on behalf ofrequire a significant investment of capital from a fund the whole fund complex.manager. Depending on the nature of the fundmanager’s strategy, some investors may consider the The master-feeder fund relationship is one which isimportance of such extended generator capabilities to replete with operational intricacies. When one gets intobe more or less important. the operational nuts and bolts of the ways in which these different fund vehicles interact, the complexity ofFor example, some investors might be of the opinion such relationships may at first be overwhelming. Puttingthat a high frequency trading hedge fund would likely aside the legal pros and cons of such a fund,suffer greater losses by having an extended power arrangements aside, during the operational dueoutage than a low frequency event driven manager. diligence process a number of other operationalRegardless, of the particular specifics associated with complexities may surface regarding this structure.each manager, it is generally considered best practicefor a fund manager to have both UPSs and a dedicated Many of these additional layers of detail typically centeremergency backup power generator. around accounting procedures. Examples of these items can include the allocation of trades among the funds,Investors that take the initiative to evaluate the way in distribution of profits and losses among the funds, thewhich a fund manager approaches loss of power issues, allocation of management and incentive fees, the taxlessens the risk of being left out in the dark when the allocation implications of multiple fund arrangement,power goes out. and tracking of the fund’s inflows from the master and feeder funds. While each of these considerations could merit their own separate discussion, in this article we instead want to focus on a different aspect of the master feeder relationship as reflected in the audited financial statements of funds. During the operational due diligence process, one of the key documents investors ...continued on next page
  5. 5. February 2012 | 5Master-Feeder - Continued from page 4... • Can you track the allocation of fund expenses from the master to the feeder funds?may seek to collect are the audited financial statements • What about the allocation of profit and losses?of the fund(s) under consideration. Typically an investor • At which level are fees such as management feeis considering allocating capital towards one fund and performance fee charged? The mastervehicle in particular. In a master-feeder situation, there level? The feeder level? Do the financialare typically at a minimum, fund vehicles that are statements accurately reflect yourappropriate for onshore or domestic investors and one understanding of this arrangement?which is more appropriate for offshore or foreign • Have the funds always been organized in thisinvestors. From a U.S. perspective, the onshore vehicle manner?is typically organized via a limited partnership or "L.P."structure where the offshore vehicle is via a Limited Making the situation more complex can be situations inLiability Company or "Ltd." which feeder funds invest in multiple masters or when investors make investments directly into the masterInvestors may tend to focus the bulk of their due fund skipping the feeders altogether.diligence efforts on a particular fund vehicle which ismost appropriate for them. This is a dangerous trap that Analyzing the relationship among master-feeder fundscan lead many investors astray. Not only is it considered is a good example of an area where investors shouldbest practice that investors consider all other pari passu coordinate their reviews of the fund’s legal documents,funds in the same complex (i.e. - a domestic investor such as the offering memoranda, and the review of theshould review the offshore fund as well), but also to audited financial statements. By taking the time toconsider the role of the master fund. understand the way in which a master fund and feederContinuing our example, when collecting and reviewing fund interact via audited financial statement analysis,audited financial statements; investors should request investors will likely be able to better target the focus ofboth the onshore and offshore audits. It is also their operational due diligence reviews to ensure thatadvisable for investors to collect and review the master they fully vet the intricacies of these relationships.funds financial statements as well. Once all of thesestatements have been collected, how is an investor togo about reconciling these statements? What exactlyshould investors look for?While the analysis of fund audited financial statementscan be a complex and time consuming exercise, thereare a number of basic checks investors can perform aspart of the operational due diligence process, to ensurethe basics of the master-feeder relationship arefunctioning properly among the multiple funds. Thesechecks can include: • Do the feeder funds own 100% of the master fund? • If not, are there other fund vehicles for which you have not reviewed the audited financial statements for?
  6. 6. February 2012 | 6 analyzing fund legal documents and financialNew Book Provides statements, as well as methods for evaluating operational risks concerning valuation methodologies,Tools to Evaluate pricing documentation and illiquidity concerns.Operational Risk in Filled with case studies, this book is required reading for private equity and real estate investors, as well as fundPrivate Equity and managers and service providers, for performing due diligence on the operational risks associated withReal Estate Funds private equity and real estate funds. This book also includes case studies in operational fraud and a companion website to the book includes sampleOperational due diligence reviews on checklists, templates, spreadsheets,private equity funds has been an area of and links to laws and regulationsincreased investor focus. Despite the referenced in the book.numerous benefits of performing suchreviews, some investors may still not be Private Equity Operational Dueconvinced of the benefits of performing Diligence: Tools to Evaluate Liquidity,operational due diligence on private Valuation and Documentation will beequity funds. Still, others may be unsure published by Wiley Finance and beas to how to best begin an operational released on April 10, 2012. The bookrisk review of a private equity fund. In is currently available for pre-order onparticular, investors which already operational due diligence onother asset classes, such as hedgefunds, may not have a clearunderstanding of the uniqueoperational challenges presented byprivate equity.To address these issues, Jason Scharfman (ManagingPartner, Corgentum Consulting), has written a follow up Diagnosingto his first book, Hedge Fund Operational Due Diligence:Understanding the Risks, which focuses on private Information Securityequity. This new book, Private Equity Operational DueDiligence: Tools to Evaluate Liquidity, Valuation and RiskDocumentation, addresses the unique aspects andchallenges associated with performing operational due Information technology is a quickly evolving area ofdiligence reviews of both private equity and real estate operational risk. Fund managers are often undertaking aasset classes. number of different technology projects at once. These can range from mundane software updates, to full scalePrivate Equity Operational Due Diligence seeks to hardware upgrades. Additionally with the increasedprovide readers with the tools to develop a flexible acceptance of virtual work environments and increasedcomprehensive operational due diligence program cloud usage, many fund management organizations arecustomized for private equity. It includes techniques for
  7. 7. February 2012 | 7Security Risk - Continued from page 6... approach towards protecting data is often focused almost exclusively on external threats. For example, iteschewing further investment in more traditional would be concerning if a hacker was able to log ontotechnologies and ramping up the resources allocated to the fund managers internal network and steal data.these emerging technologies. This is certainly an important concern. During the operational due diligence process investors can take aWith all of these changes taking place, investors may be number of steps to evaluate the quality of a hedgetempted to focus their efforts during the operational funds information security defenses from externaldue diligence process on these more cutting edge threats including:advances, in lieu of spending appropriate time andeffort reviewing technology basics. These basics can • Has the firm performed any penetrationtypically include an evaluation of the appropriateness testing? If yes:and quality of software systems utilized across a - has the firm employed a third-partynumber of operational functions including order firm to conduct an evaluation or did theymanagement, settlement and reconciliation and fund perform the testing themselves?accounting. Other traditional items which may be -what were the results of thecovered during an operational due diligence review penetration testing?include, hardware related items such as understanding • If not, does the firm have any plans to performthe types and number of servers utilized and the type of such testing in the future?network connections in place. A common item whichmay become lost in the due diligence shuffle between • What are the firms standard informationan increased focus on a fund managers use of new security procedures to prevent externaltechnologies and more traditional technology concerns attacks?is information security. • What types of firewalls are in place?A fund manager is not like a traditional factory - they do Another often overlooked area of information securitynot manufacture anything an end-user can touch. due diligence relates to segregating and protecting dataRather, a fund manager is in the investing business - and within the fund management firm itself. Often,this is a field that is centered around information. Funds particularly in a larger fund management organization,deal with all types of information- not limited solely to different employees will have access to certain pieces ofinvestment data. For example, they typically maintain related to daily operational procedures (i.e. - books This can be both to protect the confidentiality of certainand records, data from accounting systems, trade employees (i.e. - the administrative assistant does notconfirmations etc.) as well as information about their have access to everyones personnel files in the sameemployees (i.e. - employee addresses, payroll figures way a human resources professional would) as well asetc.), and data about who their clients are. During the more likely to implement checks and balancesoperational due diligence process, a key question to throughout the firm. In this regard, a fund manager whoconsider is how does a fund manager go about takes measures to protect or limit access to certainprotecting this data? Perhaps the more appropriate pieces of information would do so among the firmspreceding question should be, who is this fund manager employees itself. Some key considerations investorsprotecting this data from? may want to consider when evaluating the way in whichThe most common consideration that first comes to the ...continued on next pageminds of most investors is that a fund manager’s
  8. 8. 8 - Operational Due Diligence InsightsSecurity Risk - Continued from page 7... the words and terms which investors may have not previously encountered, or which tend to geta fund manager protects data internally include: overlooked in operational due diligence reviews. This issues word: Reserves • Are IT consultants utilized? If so, how does the firm monitor consultant gain access to and use Defined: Reserves refers to a cushion of cash that a proprietary data? fund can set aside typically, so that there is sufficient • Can employees utilize remote storage devices, capital to deal with unforeseen events. such as zip drives? What investors should know: Reserves are one of the • If employees can access the firms systems remotely, are equivalent data protection many landmine terms which can be buried in a funds procedures in place to system access from offering memorandum, which may be activated when within the office? an investor least expects it. Often times the language covering reserves will be in the form of a small,A fund manager that does not take measures to seemingly innocuous sentence in the fund offeringappropriately protect data from threats, both internal memorandum which reads to the effect of, "the fundand external, can have critical information literally walk may establish reserves for contingencies." The problemout the door. From an investors perspective, putting is that many times, the term "contingencies" is eitheraside any loss of competitive advantage from loss of completely undefined or loosely defined at best.investment related data, a fund manager that does notprotect data may be exposing their clients information What this means in practice is that, as with most thingsto others and run the risk of future fraudulent activity related to fund offering memoranda, the fund manager (or the General Partner or Board of Directors etc. asor even identity theft. By asking the right questions, an applicable) basically has broad discretion to put capitalinvestor can effectively diagnose whether a fund aside. Investors may think of reserves as a funds rainymanager approaches this subject seriously. day fund.Understanding Fund If the fund manager sets reserves aside that are too large, and depending on the other terms of the offeringTerms: Reserves memorandum, the fund manager could potentially halt redemptions entirely or not fully pay them out. Investors may want to inquire if their fund managersOperational due diligence is a multidisciplinary subject. ever established reserves for their funds- if so, whenAn investor beginning the operational due diligence and why?process for the first time may encounter subjects withwhich they have little to no familiarity. As the scope of It is also worth considering if a fund manager repliesoperational due diligence has become broadened in that they have no intention of ever establishingrecent years, even seasoned operational due diligence reserves, but this is just boilerplate language that theirprofessionals may encounter terms which they may be legal counsel made them put in - then perhaps anunfamiliar. The purpose of this section of Operational investor can have this language removed from theDue Diligence Insights is to cast a spotlight on some of offering memorandum altogether or limited in a side letter.
  9. 9. February 2012 | 9 example the valuation work performed byAnalyzing Fund administrators. Many investors may be unaware of this fact, but in determining the valuations of particularAdministrators positions most administrators typically have a small degree of discretion.During Operational This discretion typically comes into play, when anDue Diligence - administrator attempts to price a funds positions independently of the fund. For example, lets say a fundValuation managers records indicate that a certain security, which is typically priced via broker quotes, wasIndependence purchased and was worth $60.23 a share. Lets say that the administrator reaches out to other brokers independent of the fund manager and determines theSeveral years ago, certain investors may not have felt price is $0.01 less than the fund managers price, orthe need to actively evaluate a funds service providers. $60.23. The administrator may have the discretion toAs the importance of the duties performed by fund override the fund managers price and utilize their own.service providers has gained greater acceptance, so too Most administrators typically operate within acceptablehas the level of attention paid to them. In the current valuation difference bands. That is a certain amount ofenvironment, it is considered standard practice during discrepancy between the price determined by theoperational due diligence to expand a fund review to administrator and the fund manager is acceptable asinclude not only the fund management organization long as it is within predefined ranges. In most cases, theitself, but external service providers with which the administrators price (which is typically morefunds interact. One of the most important such service conservative), is the one which is utilized. Indeed, fundproviders is typically the fund administrator. administration agreements and offering memorandaThe role that fund administrators play in the may dictate as such. However, as there is discretion inoperational due diligence process is often a conflicted the process, in practice a negotiation often occursone. On the one hand, an administrator wants to between the administrator and the fund manager withconvey to investors their independence in the valuation regards to what the final price should be. In certainand fund NAV calculation process. On the other hand, cases, depending on the nature of the security and theadministrators are typically hired by the fund specifics of the administration arrangement, the fundmanagement companies themselves, the same entities manager may have final say over the administrator.and individuals they are supposed to act independent Some fund managers are actively engaged with theirof. administrators and speak to them several times a week.As such, during the fund administrator review process, Others may only talk to their fund administrators atinvestors may find it beneficial to review not only the month-end when fund NAVs are being calculated. Anactual operational processes and procedures in place investor which takes the time to evaluate not only thefor typical administration services such as fund nuts and bolts of fund administration procedures butaccounting and shareholder services, but to also gauge also, the degree of interaction and control exerted by athe level of involvement and control which a fund fund manager in practice may gain useful insights whichmanager exercises on this relationship. Consider for other investors may not uncover during the operational due diligence process.Corgentum Consulting
  10. 10. 10 - Operational Due Diligence Insights On the Calendar Please see below for a list of upcoming operational risk items of note and events: • Hedge Fund Operation Risk and Due Diligence Class - (New York, NY) Begins on February 8, 2012. Jason Scharfman to lecture on hedge fund operational risk and due diligence. New York University SCPS. • Investment Education Symposium - (New Orleans, LA) February 15 - 17, 2012. Jason Scharfman to moderate Investing in Alternatives panel. Presented by Opal Financial Group. • 2012 Investment Consultants Forum - (New York, NY) March 2, 2012. Jason Scharfman to speak on Hedge Fund Opportunities Presented by Opal Financial Group. • 6th Annual Private Equity Summit for Institutional Investors - (San Francisco, CA) March 26 - 27, 2012. Jason Scharfman to moderate Risk Management panel Presented by Opal Financial Group. • Release of Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation and Documentation April 10, 2012. More information available at: About Corgentum Consulting Corgentum provides investors with the industrys most comprehensive operational due diligence reviews of hedge funds, private equity funds, real estate funds and traditional funds. Corgentum partners with investors to improve upon the efficiency and effectiveness of the operational due diligence process. Our proprietary due diligence methodologies and innovative original research allows our clients to continually manage and mitigate their operational risk exposures. Corgentums unbiased and time-tested approach creates a substantial competitive advantage that enhances the risk management functionality of our clients. More information is available at Email: Main Tel. 201-918-5201 ©2012 Corgentum Consulting, LLC Corgentum Consulting