Hedge Fund Operational Due Diligence

How to diagnose and monitor key hedge fund operational risks

With the various scandals taking place with hedge funds, now more than ever, both financial and operational risks must be examined. Revealing how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds, such as multi-jurisdictional regulatory coordination, organizational nesting, and vaporware, Hedge Fund Operational Due Diligence includes real-world examples drawn from the author's experiences dealing with the operational risks of a global platform of over 80 hedge funds, funds
of hedge funds, private equity, and real estate managers.

Preface xiii

Chapter 1 What Is Operational Risk? 1

Brief History 2

Modern Definition of Operational Risk in a Hedge Fund Context 7

Operational Due Diligence versus Operational Risk 8

Key Areas 9

External Risks 12

Internal Risks 23

Blended Risks 36

The Five Core Themes 45

Chapter 2 The Importance of Operational Due Diligence 49

Why Should Investors Care about Operational Risk? 49

Morton’s Fork or a Hobson’s Choice? 50

Outright Fraud Still Exists 51

Hedge Fund Fraud Cannot Be Modeled 52

Small Discrepancies Add Up 52

Lack of Standardized Regulation 54

Each Hedge Fund Is Different 55

Ability to Generate an Informational Edge 56

Potential to Reduce Losses and Increase Returns 57

Considering Operational Risk Factors Presents a Different View into a Firm 57

Common Misconceptions 58

Other Considerations: There Is Not Necessarily a Positive Correlation between Assets and Operational Quality 60

A Study in Operational Failure: Bayou Hedge Fund Group 60

Affiliated Broker-Dealer 61

Large Discrepancies in the Performance of Onshore and Offshore Funds 62

Declining Capital of Broker-Dealer 63

Board of Directors: Members and Actions 63

Lavish Expenses of Broker-Dealers 63

Fake Audits Prepared by a Phony Auditor 64

Background Questions 64

Lack of Investor Communication 64

Ties to People Barred from the Securities Industry 65

Revision of Conflicted Marketing Materials 66

Other Anomalies 66

Chapter 3 Who Is Qualified to Perform an Operational Due Diligence Review? 69

Essential Skills 73

Primary Skills 74

Primary, Secondary, Blended, and Other Skills 84

In-house versus Outsourcing 85

Evolution of Independent Operational Rating Agencies 86

Benefits of Third-Party Rating Agencies 86

Criticisms of Third-Party Rating Agencies and Operational Due Diligence Providers 87

Factors to Consider before Performing an Operational Review of a Hedge Fund 90

Chapter 4 Creating an Initial Operational Profile 91

When Does an Operational Due Diligence Review Begin? 91

Documentation 92

The Piñata Problem 93

Due Diligence Questionnaire: To Use or Not to Use? 99

Background Investigations 101

Other Considerations 106

Importance of Onsite Visits 107

Which Office to Visit 108

Manager Interview Process 109

What Topics Should Be Covered During an Onsite Review? 111

Sample Topic Questions 113

In What Order Should These Topics Be Covered? 117

Service Provider Reviews 117

Qualitative Operational Report: Documenting the Operational Data 119

Chapter 5 Evaluating the Gray Areas: Examples 121

Scenario 1: “It Was Not Me”—Hedge Fund Manager Claims Mistaken Identity 121

Scenario 2: “It Was Me, But Everyone Was Doing It”—Are Regulatory Witch Hunts Real? 123

Scenario 3: “It Was Me, But I Did Nothing Wrong”—Manager Proved Not Guilty 127

Scenario 4: The Low-Profile Hedge Fund Manager—Is No News Good News? 129

Scenario 5: The Infrastructure Outsourcer—Can One Administrator Do Everything? 135

Scenario 6: The Mountain Climber—Can Plans for Large, Fast Growth Trip You Along the Way? 137

Scenario 7: The Stumbling Giant—Can a Large Manager Lose Sight of Small Controls? 140

Scenario 8: The Apologetic Headmaster—Are Junior Staff as Informed as Senior Management? 143

Chapter 6 Ten Tips for Performing an Operational Due Diligence Review 145

Tip 1: Avoid Meeting with the Wrong People or the Wrong Groups 146

Tip 2: Get Out of the Conference Room 147

Tip 3: Little White Lies Can Turn into Big Problems 149

Tip 4: Be Wary of Phantomware 151

Tip 5: Focus on Documentation and Negotiation 153

Tip 6: Read the Fine Print (Financial Statement Notes, etc.) 154

Tip 7: Reference Checking: Importance of In-Sample and Out-of-Sample References 156

Tip 8: Credit Analysis: Are Funds Financially Viable? 157

Tip 9: Long-Term Planning: Key Staff Retention, Succession Planning, and More 157

Tip 10: Growth Planning: Is the Manager Proactive or Reactive? 158

Chapter 7 Ongoing Operational Profile Monitoring 161

How Often Should Onsite Operational Reviews Be Conducted? 163

Remote Operational Due Diligence Monitoring 164

Media Monitoring 164

Litigation and Regulatory Monitoring 166

Hedge Fund Communication Reviews 166

Assets Under Management and Performance Monitoring 167

Operational Events 168

Effect of Discovery on the Magnitude of an Operational Event 169

Onsite Visit Frequency and Operational Events 169

Developmental Operational Traps 169

Chapter 8 Techniques for Modeling Operational Risk 179

Scoring Systems 179

Building a Scoring System: Category Determination 179

Category Definitions 185

Combinations of Category Definition Approaches 189

Category Weight Assignment 193

Weighting Aggregation Model 195

Weighting Disaggregation Model 197

WAM versus WDM 200

Category Weight Consistency and Reweighting Considerations 201

Factor Marginalization 202

Category Scale Determination and the Meaning of Scores 203

Threshold Self-Assessment and Determination 204

Score Assignment 206

Discretionary Penalties and Bonuses 212

Score Aggregation: Sum Totaling and Weighted Averages 214

Criticisms of Scorecard Models 215

Benefits of Scorecard Models 217

Visualization Techniques 217

Chapter 9 Bridging the Gap: Incorporating Operational Risk Consideration into the Portfolio Construction and Asset Allocation Process 225

Proactive Monitoring: Graphical Universe Creation 227

Proactive Management of Operational Risks 232

Protecting against Conglomeration Risks: Multivariate Commonality Analysis 233

Operational Directional Views 235

Example of Multivariate Commonality Analysis 236

First Objective: Total Diversity Goal 237

Second Objective: FSA Overweight Goal 239

Third Objective: FSA Underweight Goal 243

Conclusions of Scenario Analysis 243

Considering Operational Reviews in the Hedge Fund Portfolio Rebalancing Process 245

Operational Drag 245

Meta Risks 249

Operational Factor 250

Operational Scenario Analysis 253

Can Operational Risk Be Entirely Eliminated? 254

Factoring Operational Risk into Total Risk Calculations 256

Beyond Scorecard Approaches: Discounting Expected Return 257

Discounted Expected Returns with the Operational Factor 261

Operational Haircuts 262

Expected Return and Operational Risk 263

Shape of the Expected Return versus Operational Risk Curve 264

Second Operational Threshold 265

Final Thoughts 267

Chapter 10 Looking Ahead: Trends in the Space 269

Increased Use of Consultants 269

Commoditization of Background Investigations and Canned Operational Due Diligence Reports 272

Increased Reliance on Service Provider Consulting Services 277

Capture of Hedge Funds by Service Providers and Employees 278

Hedge Fund Pursuit of Audit Certifications 280

Operational Activism 281

AU 332 and FAS 157 283

Development of Hedges to Operational Risks 286

Links between Operational Risk and Credit Analysis 288

Proposed Reregulation of the Hedge Fund Industry 289

Index 293

"Informative book by Jason Scharfman, on, well, pretty much everything you need to run a hedge fund…Scharfman also explains the reliance on technology that is becoming ever more apparent in hedge funds, the dangers of phantomware, and questions that should be asked before committing to any new technology." (hedgeco.net, January 26th, 2009)

"In his book, Jason Scharfman identifies these operational risks and recommends a strong and innovative "operational" due diligence review program as the best defense against them. His book outlines a step-by-step guide that shows investors how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds and other investments in order to provide hedge funds and their investors with the skills to understand and hopefully mitigate these risks." (The Hedge Fund Law Report, January 8, 2009)

JASON A. SCHARFMAN is a Director with Graystone Research at Morgan Stanley. His responsibilities include analyzing and reporting on the operational risks of alternative investments such as hedge funds, funds of hedge funds, and private equity considered for investment. He also makes recommendations to the firm's investment committee based on that analysis. He has written on the subject of operational due diligence and travels and speaks worldwide on hedge fund operational risks.

Hedge Fund Operational Due Diligence

Understanding the Risks

One need only glance at the cover of the Wall Street Journal or turn on CNBC to learn about the latest debacle befalling hedge funds, due to poor operational oversight and controls. Long viewed by many hedge fund investment professionals as one of life's necessary evils and a distraction from the "real" business of investing, the field of operational due diligence has finally caught on today as an essential area of hedge fund risk management.

Filled with real-world examples drawn from the author's experiences dealing with the operational risks of a global hedge fund platform, Hedge Fund Operational Due Diligence: Understanding the Risks clearly outlines a flexible framework to enable you to diagnose a hedge fund's operational risks. This user-friendly, step-by-step guide shows you how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds, such as multijurisdictional regulatory coordination, silo creation, operational drag, organizational nesting, and vaporware, to equip you with a complete understanding of the importance and benefits of a comprehensive operational due diligence program.

Designed to enable hedge fund personnel to perform self-diagnostic health checks and determine areas in which operational improvements are needed using the techniques described, this timely book:

• Features an analysis of the failed Bayou Hedge Fund Group, highlighting how operational risks can bring down an organization

• Explains how to diagnose and analyze the operational risks that may be present in a hedge fund

• Covers the primary, secondary, and blended operational risk factors present in the vast majority of modern hedge fund organizations

• Offers techniques for the modeling of operational risk

• Explores how to factor the results of operational risk analysis into the overall hedge fund asset allocation process

A strong operational infrastructure serves as a crucial backbone to the modern hedge fund, without which even the smartest money managers in the world could not thrive. Hedge Fund Operational Due Diligence: Understanding the Risks provides you with the necessary tools to effectively consider operational reviews in conjunction with investment reviews.

Praise for Hedge Fund Operational Due Diligence: Understanding the Risks

"This book should be required reading for anyone who wants to successfully invest in hedge funds. As operational problems are reputed to cause over 50% of all hedge fund failures, it is essential that hedge fund analysts understand how to conduct proper operational due diligence—many firms are only now starting to understand the importance of this skill set. Mr. Scharfman's book will go a long way towards educating analysts in this critical area."
—Ed Rogers, CEO, Rogers Investment Advisors, LLC

"Scharfman has written an excellent book! Highly accessible . . . covers crucial topics! This book should be read by all analysts who cover the hedge funds space. It also furnishes a very valuable and necessary addition to the MBA finance curriculum. Solid operational infrastructure is exactly what the smart institutional investors are demanding, and rightly so. Scharfman's book is going to help make a lot of good decisions—that is, for those who are prudent enough to read it."
—Dr. Ranjan Bhaduri, Managing DirectorAlphaMetrix, LLC

A straightforward how-to guide for conductingeffective hedge fund operational due diligence

Providing a hands-on, step-by-step guide to the operational due diligence process involving hedge funds, Hedge Fund Operational Due Diligence: Understanding the Risks addresses essential issues including:

• Why you should care about operational risk

• Who is qualified to perform an operational risk review

• How you can easily create an initial operational profile

• The gray areas of operational due diligence

• Ten tips when performing an operational due diligence review

• Techniques for modeling operational risk

Packed with insight and tips to help you diagnose and monitor key hedge fund operational risks, Hedge Fund Operational Due Diligence: Understanding the Risks is required reading for every hedge fund analyst and investor.