A Global Perspectives White Paper                        The Rise & Rise of                       Operational Due         ...
ContentsIntroduction              2   "Sunlight is the best disinfectant"Who should be visited?    2   US Supreme Court Ju...
Ignore consultants or hedge funds that        In this case the Hedge Fund Manager hadtry and tell you a phone call is good...
and how they manage (which is after           One final point to remember is around assetall), the Fund’s official books a...
Just like at the Administrator, the           Finally, all Investment Managers andimportant question here is -            ...
DIY versus Bought in                       ConclusionAn important question for any potential    In summary, when embarking...
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The Rise & Rise of Operational Due Diligence - A Global Perspectives White Paper - July 2012

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The Madoff scandal exposed the Alternative Investment Industry to widespread allegations of substantial neglect, in terms of its Due Diligence processes. Understandably since then, Operational Due Diligence (ODD) has moved from a neglected, peripheral activity to centre stage within the industry.

The main aim of Hedge Fund Operational Due Diligence is to ensure that the fund is being managed in accordance with best practice operationally and that all aspects of its operation are above board.

This White Paper will consider what a Hedge Fund Investor or Fund of Hedge Fund Manager needs to do, who they should visit and what they should ask?

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The Rise & Rise of Operational Due Diligence - A Global Perspectives White Paper - July 2012

  1. 1. A Global Perspectives White Paper The Rise & Rise of Operational Due Diligence “Who to meet & what to ask”. By Shane Brett, Founder Global Perspectives www.globalperspective.co.uk Date 28th July 2012
  2. 2. ContentsIntroduction 2 "Sunlight is the best disinfectant"Who should be visited? 2 US Supreme Court Justice Louis BrandeisInvestment Manager 3Administrators 3 IntroductionAuditors 4Software Vendors 5 The Madoff scandal exposed the Alternative Investment Industry to widespread allegations ofOngoing ODD 5 substantial neglect, in terms of its Due DiligenceDIY versus Bought in 6 processes. Understandably since then, Operational Due Diligence (ODD) has movedConclusion 6 from a neglected, peripheral activity to centreNext Steps… 6 stage within the industry. The main aim of Hedge Fund Operational Due Diligence is to ensure that the fund is being managed in accordance with best practice operationally and that all aspects of its operation are above board. This White Paper will consider what a Hedge Fund Investor or Fund of Hedge Fund Manager needs to do, who they should visit and what they should ask? At Global Perspectives our Senior Staff have experience running the global ODD programmes for some of Europe’s largest Fund of Hedge Fund Managers. We have asked the hard questions and seen it all before. Who should be visited? A substantial part of successful Hedge Fund ODD is a judgement call. You know the facts, but how do you really make yourself comfortable that your investment will be managed properly? Our view is that you cannot accurately determine this with a phone call. To gain comfort with the people who will be directly and indirectly managing your investment, you must go on-site. For an investor to evaluate whether to proceed with an investment, they need to meet with all of the parties associated with the fund (outlined below). It is not enough to meet with the Investment Manager.
  3. 3. Ignore consultants or hedge funds that In this case the Hedge Fund Manager hadtry and tell you a phone call is good difficulties understanding why we would notenough. It is not. approve an investment until this policy was changed - but changed it was. Thankfully thisAs any experienced ODD practitioner level of amateurism is in the past and willwill tell you - you need to see the whites disappear completely as the industry maturesof people’s eyes. and becomes dominated by large Institutional Investors. Another area to focus on is around access. Will the Fund Manager give you free, independentInvestment Manager and unrestricted access to the Fund’s Service Providers?The Investment Manager will likely sendyou their standard AIMA questionnaire If not, then this is a major problem.in advance of your meeting. While this isa useful starting point it is imperative tosee beyond this. We have had successful, well-known Hedge Fund Managers try and stop us speaking to their administrators (“you would only be distractingYou are interested in understanding the them from their work on the Fund”). This is notdetailed operational processes of the good enough and should be a red flag to anyFund Manager – from initial subscription savvy investor.to the fund, right through to theportfolio’s investments and the processof eventual redemption. Thankfully this sort of active prevention is becoming rarer and rarer, as Hedge Fund Managers chase allocations and Investors standIn asking your questions (and seeing their ground.beyond that questionnaire) It isimportant to follow the flow of cash intothe fund and understand operationally Lastly, remember when you plan your visit to thewhat will happen as the money is Investment Manager it should be built aroundinvested, valued and finally returned to the following core tenet –you as an investor. “Don’t tell me, show me”.One area to pay particular attention to isthe Fund Manager’s protocol Everything the Fund Manager (andsurrounding the movements of cash Administrator) tells you must be backed up withfrom the fund. Although this sounds clear, verifiable evidence. You need to see theirobvious, it is scandalous the level of systems, see their processes and see theirstandards that existed in parts of the controls.industry before the global financialcrisis, regarding how & when money If all of this sounds cumbersome, that’s becausecould be moved from a Fund. it is. It could also save you from being a victim of the next Madoff.In one memorable instance the Founder& Manager of a $4 billion dollar hedgefund we spoke to was allowed to moveup to $5 million dollars of the Fund’s Administratorsmoney to any account worldwide - withjust his signature (“but sure he wouldonly be stealing from himself” was their As the role of the Administrator increases inoutrageous excuse). importance in our industry, a large part of ODD is now focused on the Administrator’s processesGlobal Perspectiveswww.globalperspective.co.ukEmail: Shane@globalperspective.co.ukPhone: +44 20 3239 2843Mobile: +353 (0) 87 115 2173
  4. 4. and how they manage (which is after One final point to remember is around assetall), the Fund’s official books and segregation. The endless, legal black holerecords. which confronted many Hedge Funds after Lehman’s collapsed could have been preventedNow that the US self-administered fund if assets had of been properly segregated. It ismodel has (thankfully) gone the way of vital you ensure that there is no co-mingling ofthe Dodo, Institutional Investors want to assets at your administrator. You must see clearsee a robust, efficient and responsible evidence that your assets will be segregated inthird party administrator in place for an account in the name of the Fund.every potential Hedge Fund to review.Some Administrators boast about theirinternal propriety systems, others Auditorspromote their “best of breed” industrysoftware. What is important to each Even today many Investors complete their ODDinvestor is different and this will largely process by speaking to the Fund Manager anddependent on your individual risk the Administrator only. That is not enough.appetite. Hedge Funds (particularly in the US) are oftenMost Administrators in the Hedge Fund audited by small (and very well regarded)industry report being inundated with specialist audit firms, which are well outside theODD requests in the last few years. Big 4 in terms of scale and coverage.Many of the larger shops have set upspecialist internal teams to facilitatethese visits and co-ordinate the The driver here is of course the Madoff debacleresponses. and his infamous unknown 3 person audit firm in Florida (complete with an 88 year old lady and only one practising accountant).This is great, but it’s important to lookbeyond the standard responses andactually see how their controls work and As a potential investor you need to betheir processes take place (just like at comfortable that your auditor can perform theirthe Investment Managers). function in accordance with industry best practise. They are your main layer of protection as to the correct operational execution of theOne trend we have noted recently is the fund.attraction of Administrators with largeparent banks. Investors want to knowthere are very deep pockets behind their Auditors are peer reviewed every couple ofAdministrator (ironically as more and years. You should be able to see the results ofmore administrators seek to limit their this process and make yourself familiar with theliability in their administration findings. Ignore attempts at obfuscation andagreements). insist to see the report (or at least the Executive Summary). This will not make you any friends, but now that all the large Audit firms are LimitedGiven the demands from Institutional Liability Companies, it is up to you to ensure youInvestors identified, above it is are happy that have your investment isunsurprising that a wave of protected. Your financial comeback in court isconsolidation has enveloped the limited.Administration industry. LargeAdministrators are buying smaller outfitsand many independent shops are The Auditor should be able to flag any pastquietly up for sale. issues that have arisen with the Investment Manager (or generally within the industry). You should feel comfortable that the fund’s audit firm fully understands all aspects of the industry and the assets and instruments being traded.Global Perspectiveswww.globalperspective.co.ukEmail: Shane@globalperspective.co.ukPhone: +44 20 3239 2843Mobile: +353 (0) 87 115 2173
  5. 5. Just like at the Administrator, the Finally, all Investment Managers andimportant question here is - Administrators will have a Business Continuity Plan in place (if not then you shouldn’t be“Who is watching the watcher”? considering an investment). Nowadays many of these disaster recovery programmes areThe short answer is – you are. outsourced to third parties at specific off-site locations.That is why detailed ODD is soimportant. You need to familiarise yourself with their plans and speak to their providers. How often is their plan tested (it should be at least annually)? Have they had any emergencies in the past? How did they cope? What did they learn?Software Vendors One US Fund Manager we spoke to had toThe Asset Management industry is move their business to the BCP location for 3becoming more and more dependent on days after a murder was committed elsewhere inits software. Our suggestion is that you their business park and the police closed thespeak to the vendors of the main whole area for 72 hours, while forensicssoftware used to value and price your gathered evidence.potential hedge fund. Essentially this willbe the Administrators software. The unthinkable can happen.If it is proprietary then you will want toknow how it is supported. This includesmeeting the individual’s responsible forkeeping it running smoothly and secure. Ongoing ODDIf it is an off the shelf system then you It is important to emphasise that ODD is not aneed to familiarise yourself with this one-off exercise that is finished at the moment ofcompany and its background as well as investment. Too many Fund of Hedge Funds /ensuring it is well managed and solvent. Investors make this mistake (despite claiming to the contrary).For both types of software you will wantassurances that the vendor has a clear ODD is an on-going and iterative process.development plan to update their We can’t repeat this point often enough to oursoftware so it encompasses all clients.forthcoming regulatory requirements.These should be met quickly and You should be visiting the Fund Manager,efficiently and incorporated into the Administrator and Auditor on at least an annualsoftware well in advance of legislative basis, with calls/visits in between as required byrequirements becoming law. changes to their business (e.g. a major Partner resigns, a NAV is restated etc).Understand the vendor’s testingprocesses and its speed to market. This way you establish a deep and on-goingThere is so much regulatory change relationship with the Fund Manager and theirtaking place across the industry this is service providers. It is then far easier tocrucial (e.g. FATCA, AIFMD, Dodd ascertain when something is wrong.Frank etc).Global Perspectiveswww.globalperspective.co.ukEmail: Shane@globalperspective.co.ukPhone: +44 20 3239 2843Mobile: +353 (0) 87 115 2173
  6. 6. DIY versus Bought in ConclusionAn important question for any potential In summary, when embarking on Hedge Fundinvestor to ask is whether to carry out Operational Due Diligence you need to ensureODD by themselves or call in an you speak to all parties that provide services toexternal party? the Fund. You need to make yourself comfortable with those people, their story andMany investors will try and do this work their strategy. This includes getting past thethemselves. Some of the larger FoHF’s basic questions to gain a thoroughhave even set up specialist in-house understanding of their operational processesODD teams. and procedures.One of the main problems for investors If you don’t get the transparency and comfortor fund managers trying to execute top you require, you must walk away from theclass ODD is that they do not have the investment.required extensive operationalexperience. They might understand Next Steps…investment strategy, but this does notmean they will understand operational Global Perspectives can assist you bybest practise - or more importantly - providing independent Operational Duerecognise when something is out ofplace. Diligence services for all your potential Alternative Investments.A real difficulty for many investors istrying to recognize a substantial We have also partnered with the onlyoperational risk when they see it. dedicated ODD software solution in the market. This outstanding database andIn addition, conducting the ODD yourself reporting solution centralizes and managesmeans you have a lack of independent all your ODD data.judgement. You already think the fund isa good investment; otherwise you Contact us for more information.wouldn’t have reached this stage in theallocation process. This can cloud yourjudgement. Sign up for our monthly White Papers at-It is also far easier to recommendholding up an investment if you are an http://www.globalperspective.co.uk/#!white-external party. It is much harder if you papersreport to an internal manager keen toinvest. Or email: - shane@globalperspective.co.ukFinally, be aware that some investmentconsultants now offer ODD as a service.Why any self-respecting investor wouldpay an investment consultant for thisservice - when they stand to gainhandsomely if the investment goesahead - is beyond our understanding.This is a blatant, screaming conflict ofinterest. Don’t fall for it.Global Perspectiveswww.globalperspective.co.ukEmail: Shane@globalperspective.co.ukPhone: +44 20 3239 2843Mobile: +353 (0) 87 115 2173

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