By Frank Caccio
There have been various studies on hedge fund failures
over the last 6 years which have concluded, more often
Assurance in Operational Risk Management
than not, that the operational framework of a hedge fund
is the key determinant between success and failure. While
330 Madison Ave. investors often allocate time and resources into determining
the appropriate investment approach, and funds focus on
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generating positive alpha, all too often the operational
732-221-9625 (cell) infrastructure is ignored, creating risk for both fund
firstname.lastname@example.org managers and investors.
Investors and fund managers commonly accept the positive
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relationship between risk and return. Theoretically, the
Atlanta, GA 30309 return an investor demands for his capital should be higher
404.607.6940 if the investor is required to take on more risk. However,
when it comes to the operations of a fund, risks in this area
have no associated returns and cannot be justified
Alternative Diligence offers a full service due diligence
process for investors to determine the operational soundness
of the fund in question. Similarly, our firm is able to
partner with individual funds to develop an operational
approach which fits each such fund’s focus, size and
budget in order to prepare the fund for future growth.
While our professionals have spent years developing their
understanding of fund operations, there are several issues
that any fund or investor should apply to their due diligence
process or operational infrastructure.
The AlTernATive Diligence Hedge fund managers often come from large investment
10 c o m m A n D m e n T s : banks that automatically perform background checks when
Make sure you know someone joins a new trading group. In such situations,
who Is on your teaM independent hedge fund managers may not be trained to
consider these controls in a small environment.
The hedge fund business is built on a foundation of
1 trust. This trust must be present both externally
Beyond the actual employees, funds and their investors
must also monitor the capabilities of and relationships
(between investors and fund managers) as well as internally
with key service providers. The scope of services
(between individuals associated with the fund). A strong
offered by these service providers should be examined in
bond of trust results in confidence, efficiency, and is a key
conjunction with pricing to determine an appropriate match.
ingredient to the long-term sustainability and growth of any
For instance, funds which actively trade sophisticated
instruments should use an administrator and prime broker
Background checks are often used to determine the which are strong in these areas. Conversely, funds with
credibility and professional history of critical executives a more basic approach to investing should not pay the
and employees. A background check can be as simple as premium price for an administrator or prime broker geared,
checking criminal databases and regulatory filings, or it can respectively, toward sophisticated traders or derivative
include a more comprehensive approach. Additionally, our instruments.
clients engage us to check up on past employment history,
Service providers which should be examined in this light
verify education or professional credentials and look for red
include (but are not limited to):
flags or missing gaps which might signal more significant
risks. ◾ Prime brokers
◾ Legal counsel
When a background check fails to uncover anything
◾ Executing brokers
abnormal, this is a positive event for both the fund manager
as well as the investor because the bond of trust becomes ◾ Administrators
significantly stronger. On the other hand, if a background ◾ OTC counterparties
check reveals areas of weakness, an investor may not ◾ Technology support
terminate his relationship with the fund but may require
a candid discussion with the appropriate person in order Funds work together with service providers to make up a
to determine exactly what risks are in question. competent team. If all members of the team are working
cohesively towards a common goal, investors can feel
Investors should consider a fund’s policy on background confident that a fund’s operational risks are in check.
checks, which can be a strong indicator of internal controls However, incompetence by team members or undisclosed
within the fund. Does the fund perform background checks conflicts can lead to a breakdown in trust and potential
on all employees? What are the standards of these checks catastrophic losses.
and what type of ongoing monitoring is performed?
High profile historical cases of rogue traders or corrupt Knowing your team and performing the proper background
operational employees have made it necessary for each fund checks can lead to a strong bond of trust and allow investors
to have a strong policy on monitoring the integrity of each and fund managers to concentrate on generating positive
employee. investment returns.
requIre proper separatIon of dutIes In short, the most successful funds are often those that
are purposeful in management of conflicts of interest,
When managing a successful hedge fund, top and transparent in their disclosure of these conflicts.
2 leadership should not only avoid conflicts of interest, Management should consistently communicate the firm’s
but should also avoid even the appearance of conflicts of policies in regard to these conflicts, and investors should
interest by putting the proper safeguards in place. Investors carefully weigh the potential associated risks.
should require all funds to have an organized approach to
separation of duties in order to present the most effective,
InstIll a culture of IntegrIty
efficient and trustworthy offering.
An essential element to operational safeguards is to A culture of integrity must begin with senior
establish a clear separation between the investment team
3 management. Today, investors and managers alike
and the operational functions of the fund. This type of are realizing the importance of disclosure and transparency
separation can go far towards establishing trust between above the simple generation of alpha. In order to retain
managers and investors, and it sends a clear message clients and attract new capital, funds must be able to
to fund employees that management is dedicated to the demonstrate efforts toward instilling a culture of integrity.
integrity of the firm.
To be effective, a culture of integrity must be clearly
As part of this separation, fund reconciliations, Net Asset communicated and backed up with a defined approach
Value (NAV) calculations, and pricing should be determined to enforcement. The culture extends beyond the obvious
by individuals not engaged in investment selection. For issue of fraud to include a pursuit of excellence and a
illiquid or difficult to value positions, the fund may find it commitment to protect against errors and inaccuracies.
helpful to consult with a third party in order to ascertain an
Investors should look beyond a simple document explaining
appropriate value for certain investments. Disclosing such
a fund’s commitment to excellence, and determine what
third party arrangements with clients will likely go far in
resources are being devoted towards achieving this
building a reputation of integrity, and investors should not
commitment. A proper ethical framework includes an
be hesitant to request information regarding asset pricing
investment in both time and monetary resources applied to
all levels of the organization. When interviewing different
Additional considerations should include arms-length members of a fund’s team, investors should be able to
transactions with service providers. While strong determine a clear, consistent message of commitment to
relationships are important and should be fostered, conflicts a higher standard.
can arise when services are provided at the expense of
High employee turnover within a fund should be considered
investors. Trading with an executing broker who is a family
a red flag for any investor. An unstable environment could
member or close friend, but who does not offer the highest
easily be the tip of the iceberg and indicate much deeper
level of service or an attractive price, presents a clear
issues are in play. Investors should determine the cause of
conflict of interest.
such turnover and consider interviewing individuals who
For many funds, it is helpful to solicit bids from service have left the firm if possible.
providers on a regular basis in order to ensure that the
Rapid growth presents a particular challenge to a culture
current arrangement is competitive. Disclosing these types
of integrity as an increase in assets often corresponds with
of procedures is another way that managers can prove to
both an expansion in personnel as well as an expansion
investors that they take conflicts of interest seriously and
in opportunities for errors and fraud. During a rapid
are providing the best service possible to their clients. From
growth phase, management must make concerted efforts
an investor’s perspective, any comprehensive due diligence
to maintain focus on the ethical culture of the firm in
process should look closely at arrangements between
addition to focusing on the operational and investing duties
associated with that growth.
A fund which is successful in maintaining a commitment often. A robust technology program will use state of the art
to integrity and operational excellence throughout the firm encryption to keep information from falling into the wrong
while increasing the level of managed assets will likely face hands, and an off-site storage facility should be employed.
fewer regulatory issues, and may see higher levels of client Funds can determine whether to use a physical or electronic
retention. form of transmission, but the process should be well
documented and closely monitored.
develop coMpetent technology When dealing with outside processes and vendor systems,
and a busIness contInuIty plan
funds should use extra care and perform proper due diligence
to ensure that the systems are robust and the service
A properly organized and stable technology providers can be trusted to fulfill their roles with excellence
4 framework is the backbone of the fund’s operational and integrity. Fund management should take an active role
infrastructure. Whether the technology is managed in-house, in determining whether the vendors are providing up to date
outsourced, or a combination of both, continued stability product capabilities and giving notification whenever key
and security is vital to the integrity of the fund’s data and its personnel are no longer with the firm.
On a broader level, senior management should be intricately
The technology structure of every fund should have two involved with developing a fully operational Business
primary goals. Continuity Plan (“BCP”). The BCP should be robust and
◾ The first goal is to ensure that the fund remains regularly communicated with staff members so that in the
operational throughout a myriad of extraordinary case of a major unexpected event, each member knows
events such as power failure, systems breakdowns, exactly how to proceed.
and extremely high volume. This allows portfolio Typical BCPs include an off-site functional facility for
managers to execute trades, manage risk, and key personnel. The level and preparedness of this facility
properly protect against investment losses and to will vary depending on a fund’s size and strategy. Funds
capitalize on opportunities even during chaotic which engage in high volume trading on a daily basis
situations. The functionality of operational should have a trading facility with proper software in place,
procedures should also be protected in order to communications lines, and full functional capability. The
record all transactions, maintain proper audit trails, BCP should be regularly tested in order to ensure its quality
and control risks associated with trading, portfolio and effectiveness.
maintenance, and investor reporting.
For funds which trade less actively and that have lighter
◾ The second goal is to protect the integrity and operational burdens, it may be adequate and more cost
security of fund data from issues such as natural effective to have a smaller, scaled down facility available
disaster, theft initiated from within the firm or or to have reciprocal agreements with complementary firms
externally, corruption in existing data, or incidental offering emergency space and technology for a specified
publication of private fund or customer data. period of time. It is even acceptable to have key personnel
Risks associated with the integrity of fund data working from their homes as long as they are able to utilize
can range from inefficient operations and missing and access all critical data and technology with the proper
documentation all the way to criminal negligence safeguards in place.
and the potential closure of the fund.
Regardless of the size, all viable funds should have a well
In order to protect the fund’s strategic technology program, defined and integrated plan for technology infrastructure
systems should be in place which include redundancy in coupled with the BCP. Investors and managers alike benefit
processes as well as data. Periodic backups of all data from a technology approach built to handle a dynamic
should take place, usually on a daily basis if not more business environment as well as unforeseen events.
revIew all legal and resources the fund is willing to devote to ensuring the
coMplIance prograMs program is in place.
In addition to a detailed compliance manual, investors
Legal and compliance programs should be well
5 articulated and robust in order to protect both fund
should demand evidence that the firm is actually
implementing the processes and procedures outlined in
managers and investors throughout the tenure of the fund.
the program. For starters, every employee of the fund
There are several key components to these programs.
should have access to the compliance manual and sign a
Legal documentation should include the fund offering
statement indicating they have read and understand the
memorandum, partnership agreement, and subscription
compliance requirements. Top management should perform
agreement. The compliance program should include
a periodic review of the compliance process which not
components such as the compliance manual, code of
only covers compliance requirements, but also determines
ethics, and associated policies such as personal trading,
how successful the fund has been in enforcing these
trade errors, allocation, best execution, and soft dollars.
Consistency in the legal documentation is important,
Finally, a fund’s compliance program and legal
especially when considering how the investment program
documentation should stand up favorably against any
and risks are disclosed. For instance, risks which are
regulatory audit. Often funds will conduct internal mock
disclosed in the offering memorandum should mirror those
audits in order to prepare staff to quickly be able to
outlined in marketing materials. Investors should carefully
distribute documentation relating to compliance programs.
review all legal documentation alongside correspondence
In addition, funds may hire a third party to conduct a
from the fund and examine any inconsistencies.
simulated regulatory exam in order to uncover any areas
A thorough review of a fund’s legal documentation should of weakness not revealed by the internal process. Investors
evaluate issues such as investor liquidity rights (what type and managers can both benefit from a thorough and
of gates and other restrictions on capital withdrawals are scrutinized compliance program.
in place), conflicts of interest (are there other business
When an actual regulatory exam takes place, the fund
endeavors competing for management attention) and what
will receive documentation regarding areas of strength
type of liability or indemnification clauses are in effect (has
and weakness. If there is a deficiency letter, the fund will
the fund management excused itself from proper oversight).
be required to take action to correct the deficiency and then
Fund managers should follow a systematic approach to respond to the regulatory body. During any due diligence
keeping proper forms and documentation updated and process, investors should request disclosures of such exams
relevant. For instance, the firm’s ADV part I may need in order to gauge the level of shortcomings and determine
to be reviewed on a quarterly or annual basis, but ADV how adept management is at correcting these shortcomings.
part II should likely be revised much more frequently. A
Documentation and well articulated compliance procedures
disciplined calendar including dates for filing forms such
are important both from a fund perspective as well as for
as 13 F, D and G should be created and adhered to. Internal
investors interested in committing capital. But, even a
certifications such as employee acknowledgement of the
high quality legal framework with a robust compliance
code of ethics should also occur on a regularly scheduled
program is only as good as the management team
enforcing it. Compliance should be a priority at the senior
While the details of a compliance program should be management level, and should be adequately and regularly
adequately disclosed and monitored, the success of the communicated throughout the fund in order to properly
program will rely on the importance that management protect both investors and the fund from a lack
places on implementing the program, as well as the of operational control.
don’t Ignore red flags between fund and external service providers can also be
vulnerable to operational risks.
In the world of hedge fund operations, even a minor
6 mistake should be investigated. Small discrepancies
A culture of awareness must be present throughout
each operational aspect of the fund. Employees should
can add up to eventually become large operational risks,
be encouraged to bring concerns to supervisors and to
and individual issues can often be an indicator of much
approach senior management with relevant questions and
larger fundamental shortfalls. Heavy emphasis needs to be
concerns. Fostering a company-wide awareness of risk will
placed on mistakes which are caused by a lack of control
have a profound effect on minimizing opportunities for
and procedure as opposed to a simple clerical error.
losses from operational mistakes or fraudulent activities.
The importance of attention to detail and a willingness Ultimately, the largest risks to any fund or investor often
to find the source of operational deficiencies cannot be come as a result of ignoring a red flag.
overstated. Every deviation from existing policies and firm
procedures should be investigated with an eye toward the
establIsh proper controls,
potential risk to investors as well as risks to the firm.
procedures, checks and balances
When dealing with a red flag, or potentially risky behavior,
investors and management must determine exactly what A well defined organizational structure and workflow
the potential risk could entail. Operational risk can often
7 promoting straight-through processing will do
be quantified to allow management to place an appropriate wonders not only in terms of efficiency, but also in
price tag on the instance and determine what level of minimizing operational risks. Proper development of
resources should be used to reduce or eliminate the risk. internal controls, well defined procedures, and sufficient
However, the red flag which can pose the greatest danger redundancy for critical processes all lead directly to a fund’s
is one which results in a small loss which masks a major operational stability and success.
Checks and balances must be carefully planned and
As an investor, it is important to note the emphasis implemented in order to protect investors from fraudulent
placed on controls and procedures within a fund. A senior actions by individual employees, mistakes by well meaning
management team that is unwilling to allocate time personnel, or even ill-advised actions by service providers.
and resources to maintaining and improving the fund’s These checks and balances typically walk hand-in-hand
operational risk profile is a serious red flag. with a fund’s separation of duties along with a set hierarchy
of authorizations such as those associated with treasury
There are times when red flags arise due to a fund’s operations, trade execution, and NAV signoff.
relationship with service providers. Typically, the
relationships with the fund’s auditor, prime broker, and When developing a system of checks and balances,
administrator should be carefully analyzed. While there may fund managers should view many processes in terms of
be legitimate reasons for a fund using a different auditor, the calendar events with deadlines clearly communicated to
transition needs to be investigated. A high level of transition the necessary personnel. This organized workflow, when
between service providers can be an indication of fund executed in a timely manner, will lead to a more efficient
management attempting to cover up deficiencies and find organization and should make fraud more difficult as
partners who are willing to be complicit in or are unaware procedures have a set time bracket in which they are to
of the issues which have been uncovered. occur. Errors and omissions will also be more likely to
surface because the proper personnel and systems are
Risks can appear in multiple facets of the business. engaged at the right time to be aware of any inconsistencies.
Inadequate or failed internal processes leave opportunity
for error. Individuals such as estranged employees or rogue All critical functions (whether manual or automated) need
traders have potential to commit fraudulent activities. to have redundancy. The additional effort exerted when
Internal systems can experience failure, and systems duplicating tasks will likely be minor compared to the stress
on the fund if these critical processes fail. Management should be a priority at every level. As managers within a
should have a strong understanding of which functions fund structure are held accountable for processes under their
should be streamlined for optimal efficiency, and which command, personal responsibility needs to be encouraged
processes are critical enough to devote resources toward from senior leadership throughout all operational levels.
As part of this culture of responsibility, funds should
Finally, periodic testing of these controls should be periodically review the state of operational controls with
performed in order to determine how robust and effective a bent towards rewarding managers who are showing
the framework is. Results from these tests can be used to discretion and integrity within their scope of influence.
improve the existing framework and may also be used At the same time, managers who are unwilling or unable
as motivational tools for employees to reward proper to maintain control over the operational integrity of their
development and adherence to the standards set. department should be trained to increase the level of
responsibility or replaced.
know who Is watchIng the shIp Investors in any fund should carefully weigh the chain of
command and internal structure of the fund. Knowing who
Many hedge funds operate as relatively flat is responsible for monitoring controls and where risks are
8 organizations. Personal responsibility can be a most likely to occur is an integral part of determining the
powerful motivator and each employee should be level of investment, and the risks which such investment
empowered with the understanding that he or she makes a entails. Every investor should know who within the fund
difference in helping to build and strengthen the firm. There they can approach to get definitive answers regarding
should not only be accountability in every level within a operational control, and that senior management’s position
fund, but also a very clear chain of command in place. is that “the buck stops here.”
Regardless of the size of a fund or the scope of its payroll,
management oversight needs to be demonstrated.
defIne the valuatIon
Reporting procedures within each fund vary somewhat but a n d nav p r o c e s s
should also have a common theme. As reporting follows a
path from low-level operations through management and The independence of pricing and NAV calculations is
towards senior leadership, the level of detail may lessen
9 one of the most important issues investors face today.
or diminish. However, the impact of errors and potentially Pricing and NAV calculation can be some of the most
costly mistakes compared to a tightly run operations widely disputed processes within any fund trading less than
framework needs to be continually communicated via liquid assets. In order to establish and maintain a reputation
reporting or internal meetings. of integrity, funds should always allow the NAV to be
calculated or validated by an independent administrator.
Periodic reconciliations of every monetary function should At the same time, each fund should prepare its own internal
be monitored by senior management. Keeping track of calculation of NAV. The two accounting processes should
operational statistics can help to establish a baseline be compared in order to determine the accuracy of the third
standard and then motivate employees to exceed this party administrator.
standard. The statistics can also be an “early detection”
system allowing management to quickly notice a change in Whenever possible, individual securities should be priced
the number of exceptions and conduct an investigation as to using independent sources. For illiquid investments where
the source. pricing is widely unavailable, the fund must find ways to
demonstrate fairness and independence. There are some
Oversight may take on different roles depending on the sources for Over The Counter (OTC) derivatives that have
responsibility of each manager, but the function of oversight been established as independent pricing vendors. The fund
may also solicit multiple quotes from outside brokers and reconcIle, reconcIle, reconcIle
use an average of such quotes. These procedures should be
documented and performed by an outside administrator. Reconciliations can be a fund’s number one defense
10 against fraud, errors and loss of reputation due to
Some illiquid securities may require internal quantitative
misrepresentation of the fund’s NAV. This of course can be
models in order to determine the appropriate value. As these
detrimental to the survival of any fund. On a daily basis,
models are used, funds should strive to procure inputs for
funds should perform cash and position reconciliations
these models from outside sources. The models should be
which will help to prevent such issues as duplicate trades,
heavily documented with a robust rationale explaining the
oversized (or undersized) positions, and duplicate or
logic behind calculations.
missing cash transactions.
Every fund should have a written valuation policy and
In the OTC derivatives world and in the lesser developed
valuation committee that is responsible for defining the
markets, a fund should reconcile open contracts,
process, the independent sources, and all procedures used
outstanding trade confirmations, settlement amounts and
for pricing. The more illiquid securities are, the more
failed trades. A fund should also perform all valuation and
involvement and time commitment will be required from
performance measures in house, even though the functions
the committee. As a general rule, the committee should
will also be performed by an outside administrator. Having
include some members who are outside of the investment
duplicate sets of data and reconciling the two will go far
team in order to provide a more objective approach to
towards finding and correcting errors quickly.
determining pricing and to avoid the appearance of conflict.
Much of the reconciliation process can be automated to
As an investor, it is important to determine how the NAV is
ensure efficiency and accuracy. This allows individuals
calculated, as well as judge the independence and integrity
within the organization to devote more time and resources
of the administrator who compiles this information. While
towards analyzing sources of errors and correcting
senior management (preferably the CFO) of the fund
processes in order to prevent further problems.
should sign off on every NAV calculation, an administrator
should be strong enough to resist being influenced by fund Timing is critical when performing reconciliations because,
management who may desire a different outcome from the left unchecked, errors can multiply and cause serious
NAV calculation. damage within the fund. At the beginning of each trading
day it is important to know that position reports are correct
In short, funds should seek to eliminate conflicts of interest
and verified. Redundancy is important in this regard
by seeking independent sources for pricing and NAV
because both the operational side of the fund as well as
calculations. Investors should carefully inspect this process
the investment side need to be in agreement as to current
to ensure the process is clean, well documented, and
positions and cash balances.
verified by independent sources.
Individuals should know their own personal responsibilities
so that there is an accountability chain for these
reconciliations. Fostering an environment that emphasizes
integrity, personal responsibility, and honesty will go far in
creating trust between funds and their investors. An ethical
culture breeds success for investors and funds alike.
frank caccIo is the Managing Partner of Alternative
Diligence, a leading source for hedge fund investors and
managers seeking excellence in the due diligence process
as well as operational infrastructure. Drawing from his
deep experience and extensive network of multi-faceted
professionals in the alternative investment arena, Frank
offers a true “hedge fund practitioner’s” perspective when
it comes to determining the operational integrity of a fund.
Frank has served as the Director of Operations for
such firms as Tiger Management, as well as the Head of
Global Operations at Highbridge Capital. His experience
overseeing operations for a firm growing its assets three-
fold to $30 billion gave him a unique perspective into the
dynamics necessary for large funds to manage growth.
In addition to managing firms with assets measured in
the billions, Frank, as COO, has also been instrumental
in helping several smaller firms launch operations
and transition from managing new funds to thriving as
seasoned, high capital asset managers.
Alternative Diligence serves both hedge fund investors
seeking to determine the operational stability of funds in
which they have an interest and individual hedge funds
seeking to measure and improve the quality of their
operational infrastructure. A talented team of executives
with extensive experience in forming and managing hedge
funds allows Alternative Diligence to offer expert advice
designed to empower investors and funds alike to meet
and exceed their respective goals.