Top 10 List for Mastering Operational Due Diligence

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Presentation by Stone House Consulting at the 2nd Annual Hedge Fund Operations and Technology Conference in April 2009.

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  • Escalation procedures – people don’t do their jobsPart of what they are assessing is risk awareness and attitudes toward riskWhat are you doing differently in the wake of Madoff, Lehman, Stanford, Bear, etc.?
  • Conflicts – examples – personal trading, giftsWas Bernie Madoff’s auditor REALLY independent?Consider registration – and behave like you areAppropriate discipline for violations, especially compliance
  • Obtain written representation from investors that they understand the risks of investing in the fund:Receipt and understanding of the PPM and organizational documentsHave the understanding and knowledge to evaluate the merits and risks of their investment and can bear such risksUnderstand the terms of investment including minimums, withdrawals rights, liquidity provisions, allocation, fee structure, etc.Pricing If new instruments purchased that require additional methodologies, develop new policies at the time of purchase Multiple sources of prices for non-exchange-traded instruments
  • Adequate #s Based on volumes, level of automation, need to segregateSegregation of duties:Trade settlement is handled by non-investment staffIdeally, trade settlement is not handled by reconciliation or fund accounting staff eitherTrade confirmations sent directly to trade settlement staff – not investment teams 2 staff for wires (do electronically) AND free deliveries Pricing staff should not report into investment teams
  • With which legal entity have you contracted?Who are the sub-custodians?Note that changing auditors, etc. can raise red flagsDue diligence should include:CreditworthinessTheir procedures, policies, staffing, consistency, DD on THEIR vendorsPeriodic review of AML practices by third-party providers where appropriate
  • Who should be there?Ideally, one person is there all day (salesperson)Identify possible points where conflicting info might be providedEnsure day remains on schedulePose questions to subsequent participants or backdrop on what was coveredCoordinate follow-upPre-screen follow-upThey will want to meet staff – at least handshakesEnsure someone is still managing the money Assess skills of internal people to meet prospects and clients (should be part of your hiring process)Knowledge and backgroundJob functionAbility to stay ‘on message’Ability to avoid saying or doing something stupidPeople skillsPolishWell spokenAppearance/dressTable mannersFeed them – but not lavishly!Time for breaksPossible tourBe careful about leaving papers aroundGreat opportunity to have new staff learn about the firmConsider a signed NDA before too much is revealedMake sure your processes and procedures are clear and consistently appliedAnd review them regularly – with updates as necessaryMinimum annual reviewReview when errors occur – to keep from happening againReview then others’ errors are announced in the marketplaceReview when you launch new products, systems, etc.Review when you change staffing levels – up or down
  • Top 10 List for Mastering Operational Due Diligence

    1. 1. Top 10 Listfor MasteringOperational Due Diligence<br />2nd Annual Hedge Fund Operations and Technology Conference<br />21 April 2009<br />Holly H. Miller, Partner<br />Stone House Consulting, LLC<br />21 April 2009<br />1<br />© 2009 Stone House Consulting, LLC<br />
    2. 2. Interesting Points<br />Operational risk is defined as ‘risk without reward’<br />More than 50% of hedge fund failures relate to operational risks with a primary contributor being a basic lack of segregation of accounting roles between the front office and the back office1<br />The administrators represent as many potential problems as the hedge funds<br />21 April 2009<br />2<br />…and this slide was prepared BEFORE the Madoff scandal!<br />1 Data based on a March 2003 study by Christopher Kundro and Stuart Feffer with Capco (www.capco.com). The study is based on 100 hedge fund failures over the past 20 years.<br />© 2009 Stone House Consulting, LLC<br />
    3. 3. A Word of Advice<br />Prepare!<br />Lists<br />Counterparties with ISDAs,<br />Service providers<br />Vendors<br />Systems<br />Organization charts<br />Workflows<br />PPMs<br />Agenda<br />Make sure you are on the same page<br />Agree who talks about what<br />21 April 2009<br />3<br />© 2009 Stone House Consulting, LLC<br />
    4. 4. #1 – Plan for the Worst<br />Disaster<br />Fraud<br />Staff loss<br />Unfavorable markets<br />Regulatory changes<br />Counterparty failure<br />Prime broker failure<br />Escalation procedures<br />Think about all the things that can go wrong – and talk about them<br />21 April 2009<br />4<br />© 2009 Stone House Consulting, LLC<br />
    5. 5. #2 – Independent Oversight<br />Independent review of:<br />Investment management activity<br />Investment guideline compliance<br />Adherence to discipline<br />Execution quality<br />Risk monitoring<br />Pricing<br />Conflicts<br />Independent fund administrator<br />Independent auditor<br />Periodic internal review – and testing – of processes<br />Formal committees<br />Pricing<br />Best execution<br />Conflict<br />Investment review<br />Risk <br />21 April 2009<br />5<br />© 2009 Stone House Consulting, LLC<br />
    6. 6. #3 - Document<br />Processes and policies - including escalation procedures (and review these periodically)<br />Compliance<br />Risk monitoring<br />Subscription / redemption (including KYC, AML and Patriot Act)<br />Trading (including orders and executions)<br />Settlement<br />Cash movements and securities delivery (including margin and collateral)<br />Reconciliation (including all collateral)<br />Corporate action monitoring<br />Month-end closing<br />Pricing<br />Fund accounting (including review of external administrator work)<br />Counterparty selection and approval<br />21 April 2009<br />6<br />© 2009 Stone House Consulting, LLC<br />
    7. 7. #3 – Document (continued)<br />Service level agreements<br />Internal<br />External<br />Events<br />Orders, trades and confirmations<br />Reconciliation (including review)<br />Pricing (what was obtained and from whom)<br />Fund accounting (review of external administrator work)<br />Investment and research meetings<br />Committee meetings (e.g. minutes)<br />Trade errors<br />21 April 2009<br />7<br />© 2009 Stone House Consulting, LLC<br />
    8. 8. #4 – Staff Appropriately<br />Adequate headcount<br />Including operations, accounting, compliance and IT<br />Knowledge, skills and experience<br />Complex strategies require additional expertise<br />Training<br />Cross training<br />Understand best practices<br />Supervisory qualifications<br />Segregation of duties<br />Clearly identified CCO and CRO<br />21 April 2009<br />8<br />© 2009 Stone House Consulting, LLC<br />
    9. 9. #5 – Discipline and Consistency<br />Discipline with a repeatable process – and make sure your stats back that up!<br />Buy and sell disciplines<br />Investment guidelines<br />Consistent pricing process<br />Consistent trade allocation policy<br />21 April 2009<br />9<br />© 2009 Stone House Consulting, LLC<br />
    10. 10. #6 - Ensure a Level Playing Field <br />Provide all investors with a consistent level of information<br />If additional transparency is provided to one investor, managers should be willing to offer it to all investors upon request<br />21 April 2009<br />10<br />© 2009 Stone House Consulting, LLC<br />
    11. 11. #7 – Disclose<br />Changes to valuation policies<br />Key personnel changes<br />Service provider changes<br />Changes to biographical or disciplinary information regarding the firm or key staff<br />New side letters or parallel managed accounts that grant terms to certain investors that could, in certain circumstances, adversely impact other investors,<br />Occurrence of operational issues that could impact the fund<br />Discovery of fraud or wrongdoing within the firm or by a key service provider<br />When in doubt...<br />21 April 2009<br />11<br />© 2009 Stone House Consulting, LLC<br />
    12. 12. #8 – Due Diligence<br /><ul><li>On investments</li></ul>Not just for fund-of-fund managers<br /><ul><li>On key service providers</li></ul>Prime brokers<br />Custodians<br />Fund administrators<br />Auditors<br />IT vendors<br />Counterparties<br />Others<br /><ul><li>Service provider due diligence should include (at a minimum):</li></ul>On-site visits<br />Initial and annual follow-up<br />Documentation of due diligence performed<br />21 April 2009<br />12<br />© 2009 Stone House Consulting, LLC<br />
    13. 13. #9 – Shadow Records<br />Investment accounting<br />Partnership accounting<br />Features:<br />Full audit trail<br />Automated maturity, expiration, income, withholding and reclaim processing<br />User security based on roles<br />Backups<br />Record retention<br />GIPS® compliance and verification<br />21 April 2009<br />13<br />© 2009 Stone House Consulting, LLC<br />
    14. 14. #10 - Metrics<br />Quantify, measure and monitor material risks taken by the fund on a frequency appropriate to the fund’s characteristics<br />Risk monitoring should be appropriate to the fund’s strategy, investments and characteristics<br />Recognize relationships and risk factors may change over time, so review the process regularly<br />Non-quantifiable or measurable risks should still be monitored<br />Business volumes, cost drivers and stress ratios, e.g.<br />Trades<br />Wires<br />Subscriptions / redemptions<br />Accounts / funds<br />Investors<br />Fail rates<br />Match rates<br />Staff<br />21 April 2009<br />14<br />© 2009 Stone House Consulting, LLC<br />
    15. 15. Two Last Pieces of Advice<br />Practice what you preach<br />Be honest<br />21 April 2009<br />15<br />© 2009 Stone House Consulting, LLC<br />
    16. 16. About Stone House Consulting<br />Strategic, operational and IT consulting for investment managers and hedge funds<br />Breadth of knowledge. We have proven, hands-on experience across all instrument types and all investment vehicles, including institutional separate accounts, mutual funds, hedge funds, private equity funds and SMA (‘wrap’) accounts.<br />First-hand experience. We have worked as consultants – and we have worked on the buy side. We understand the competing demands, requirements, deadlines and priorities that our clients face every day. And we have seen the pitfalls first hand.<br />The Cornerstone program. Our flagship program, Cornerstone, is designed to ensure asset managers reduce their costs by 10-30% within a year.<br />21 April 2009<br />16<br />© 2009 Stone House Consulting, LLC<br />
    17. 17. Holly H. Miller<br />Holly H. Miller is a partner at Stone House Consulting, LLC, providing strategic, operational and IT consulting services to investment managers and hedge funds. Prior to founding Stone House Consulting, she was Chief Operating Officer at M.D. Sass Investors Services, managing $15 billion in hedge funds, private equity funds, traditional separate accounts and SMA (‘wrap’) accounts across 18 investment strategies and 15 investment management firms, including Waterfall Asset Management, Resurgence Asset Management, Re/Enterprise Asset Management, Crow Point Partners, Arcadia Asset Management, Ascent Real Estate Partners, Denahi Global Investments, Taurus Funds Management, Three Kingdoms Capital and M.D. Sass-Macquarie Financial Strategies. During her 30-year career, Ms. Miller was East Coast Region Manager for Citisoft, Inc. where her clients included Nuveen Investments, Dimensional Fund Advisors, Lord Abbett, T. Rowe Price and DuPont Capital Management. She has also managed operations teams for Bank Julius Baer, J.&W. Seligman and Citigroup. <br />Ms. Miller’s understanding of all aspects of the investment management and hedge fund business from investment decision-making to sales and marketing to trade settlement to performance measurement, coupled with her seasoned project management skills, result in a powerful ability to assist clients with long-term strategic planning, evaluating outsourcing, streamlining operational processes, selecting and implementing systems, cutting costs and reducing risk.<br />21 April 2009<br />17<br />© 2009 Stone House Consulting, LLC<br />
    18. 18. Contact Details<br />Holly H. Miller<br />Partner<br />+1 610 358 1791 phone<br />+1 917 587 2411 cell<br />+1 509 479 1831 fax<br />hmiller@stonehouseconsulting.com<br />Stone House Consulting, LLC<br />Strategic, operational and IT consulting for investment managers and hedge funds<br />www.stonehouseconsulting.com<br />New York | Philadelphia | Wilmington<br />18<br />21 April 2009<br />© 2009 Stone House Consulting, LLC<br />

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