White Paper, Achieving Operational Excellence


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I recently produced a white paper on hedge fund operational risks. It\’s called 10 Commandments for achieving operational excellence

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White Paper, Achieving Operational Excellence

  1. 1. 10 Commandments for achieving operational excellence By Frank Caccio
  2. 2. IntroductIon 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 6th Floor the appropriate investment approach, and funds focus on New York, NY 10017 generating positive alpha, all too often the operational 732.577.8350 732-221-9625 (cell) infrastructure is ignored, creating risk for both fund fcaccio@alternativediligence.com managers and investors. Investors and fund managers commonly accept the positive 1230 Peachtree St. NE Suite 2445 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 www.alternativediligence.com have no associated returns and cannot be justified or ignored. 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.
  3. 3. 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 successful fund. 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.
  4. 4. 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 procedures. 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 service providers. associated with that growth.
  5. 5. 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. ongoing operations. 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.
  6. 6. 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. requirements. 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 basis. 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.
  7. 7. 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. operational flaw. 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
  8. 8. 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. redundancy. 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
  9. 9. 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.
  10. 10. 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.