Operational Due Diligence

Increased demands for hedge fund managers and investors

Originally published in the June 2010 issue

Hedge fund investors have become increasingly aware of operational risk and the need to include operational due diligence within their fund selection process. In recent years, hedge fund failures have cost investors billions of dollars, and the industry has experienced a steady stream of other losses attributed to Ponzi schemes, theft, deliberate mis-pricing and other operational failures. Madoff’s spectacular fraud highlighted, in the most dramatic way, the importance of operational risk.

Investors have also come to appreciate, however, that the impact of operational risk on a hedge fund portfolio extends beyond the risk of a catastrophic “blow up”. There is an increasing awareness that hedge funds need to be managed by well controlled and resourced firms, if they are to generate attractive returns over the long term. Hedge fund managers who build a robust business infrastructure will suffer fewer errors and less disruption. A hedge fund that fails to invest in people, systems and service providers will be operationally weak, and may suffer a drag on performance due to poor processes, procedures, controls and internal information. Above all, unlike investment risk, exposure to operational risk does not provide potential for greater returns.

Recent hedge fund failures have highlighted the extent to which the industry had moved towards strategies which trade more illiquid securities. The credit crisis also highlighted clear mismatches between the liquidity terms offered to investors and the liquidity of the underlying portfolios. Furthermore, the credit crisis itself created liquidity and pricing issues in previously liquid markets. The debt markets, for example, suffered exceptional illiquidity and pricing uncertainty during 2008. Finally, the collapse of Lehman Brothers and Bear Stearns exposed the extent to which funds and investors may be subjected to the credit risks of their counterparties.

Ongoing operational due diligence, therefore, may not only act to prevent direct financial losses, but also help investors to make more informed and timely decisions.

Investor’s perspective
Many hedge fund investors are facing a greater requirement to collect and monitor more information about the operational risks of hedge funds. They are under pressure to dedicate more resources to operational due diligence and to increase the scope, depth and frequency of reviews. This is happening at a time when many allocators must make do with fewer, rather than additional, resources.

Faced with this issue, investors are seeking to realise ‘efficiencies’ in their operational due diligence review processes through the use of standardised checklists, scorecards and other quantitative measures. Unfortunately, due to the scale, heterogeneity, and degree of change within the hedge fund industry, it is not possible to effectively assess operational risk using such techniques.

The diversity of the hedge fund industry provides significant challenges for all investors. These challenges are equally applicable to the assessment of operational risk. The size of the industry means that one approach does not suit all. Funds may follow a straightforward or complex investment strategy, have significant assets under management or have raised only seed capital. While the largest hedge fund managers may have in excess of 150 employees, many managers remain very small.

The lack of a standard business model within the hedge fund industry means that it is not meaningful to apply a “scorecard” approach to the evaluation of operational risk. Amber’s experience strongly suggests that a rigid, quantitative approach is unhelpful as a finite list of criteria will fail to take into account unique features within a particular hedge fund or management company which may work to increase, or mitigate against, operational risk.

Given this environment, a sufficient, sophisticated and flexible operational due diligence methodology is essential. Ideally, an operational due diligence methodology should also consider current global sound practice standards, such as those set out by Alternative Investment Management Association (AIMA), the Managed Funds Association (MFA) and the Hedge Fund Standards Board (HFSB).

Significant expertise is required to conduct operational due diligence effectively. The range of non-investment activities requiring assessment is considerable and includes, amongst many other things, the manager’s staff and their experience, qualifications, conflicts of interest and incentives; the role of management, committees and directors, as well as processes for authorisation and oversight; IT infrastructure and security as well as business continuity and disaster recovery; legal issues, compliance policies and procedures and regulatory oversight; and, the role of the administrator, level of service provided, assessment of the specific administrative team and its interactions with the hedge fund manager.

The sheer range of operational related activities to be assessed and their interactions requires subjective judgments from industry experts with considerable experience. In addition, these experts need to be able to devote sufficient time to research and analysis, and confer with similarly qualified colleagues, in order to reach a calibrated conclusion. A balance is required between a consistent and objective process to gather relevant information, with professional judgment to qualitatively assess the unique strengths and weaknesses of each hedge fund’s operations.

Many investors find they do not have such resources available in house and look to external operational due diligence service providers to act on their behalf. The choice of service provider is, however, not a straightforward matter with many factors to be taken into account. Prior to selecting a service provider, investors must consider the following:

1. How many individuals within the firm have operational expertise? Are they full time or part time staff? What makes them an expert in this field? Amber’s experience has shown that a group that has diverse operational expertise is critical to identify operational risks adequately.

2. How many individuals participate in the onsite review? A minimum of two qualified staff is required to facilitate an effective internal review process and to calibrate issues appropriately. For larger and more complex strategies, it may be appropriate to have three or four staff on site.

3. Is the firm conducting investment and operational due diligence? If so, how can you be assured that investment performance does not override the assessment of operational risk?

4. What internal process does the service provider have to check the factual accuracy of its reports?

5. Is the firm adequately capitalised? There are many small, boutique firms that are solely reliant on their current revenues to sustain their business, and do not have sufficient capital to operate beyond one year without these revenues. In such cases, it is difficult to recruit senior talent as well as to implement appropriate training programmes.

Hedge fund manager’s perspective

In the ‘post Madoff’ environment, investors expect hedge fund managers to allow them access to all operational information, and indeed prefer those that are prepared to respond efficiently and effectively to such requests. There is also an increasing acceptance within the industry that hedge fund managers require some form of external operational review.

As the scope and frequency of investors’ operational due diligence demands have escalated, the time and resources dedicated by hedge fund managers to operational reviews has risen correspondingly. Hedge fund managers can no longer rely on generic operational due diligence questionnaires and brief, infrequent meetings. Investors are now requesting more detailed information, more frequently, and on a wider range of operational issues. These increased operational due diligence requirements mean hedge fund managers are required to dedicate more resources to investors’ reviews, including time spent preparing documents, completing questionnaires and attending on-site meetings.

Whilst hedge fund managers clearly want to ensure that investors have the information they need to gain sufficient comfort, the cost of investor operational due diligence reviews to hedge fund managers has increased sharply. Increased staff resources to address this issue mean higher overheads, reducing the hedge fund manager’s profit margins and most importantly, focus on the business. Consequently, hedge fund managers are seeking ways to deal with the on-going requirements of operational due diligence in an efficient and cost-effective manner. They are also concerned that certain investors fail to fully understand the hedge fund’s complex operational environment, risks and controls. This means investors may make decisions based on factual inaccuracies, effectively wasting the resources the hedge fund manager devoted to the review process.

Finally, administrators are also experiencing sharply increased workloads and are incurring higher expenses as a result of the increased burden of investor requests for more information and to speak to various departments providing mid/back office and fund administration services. This will have an impact on profit margins and will, all things being equal, mean higher fees for hedge funds and, therefore, for investors.

Alternative approaches
The hedge fund industry has sought alternative ways to address these issues and to improve the effectiveness and efficiency of the operational due diligence process by engaging firms such as Amber Partners to provide a certification review and/or hire an audit firm to perform a SAS 70 or AAF 01/06 review.

There are two types of SAS 70 reports. A Type I report describes the organisation’s internal controls and is written by the client’s management. The auditors offer their opinion on the fairness of management’s description and the suitability of the controls to achievetheir objectives. No testing is involved. A Type II report is similar to Type I, but in addition, the auditors test key controls over a specified period and deliver their opinion on the effectiveness of those controls.

SAS 70 was originally drafted to provide guidance to auditors assessing the internal controls of service organisations. Service organisations are firms that provide outsourcing services which impact their customers’ control environments. The statement was intended to apply to a wide range of service providers from medical claims processors to credit card processing organisations. A SAS 70 Type II report undoubtedly gives additional comfort that the internal control environment is operating as described for large organisations with high volumes of trading.

The Amber operational certification report was created for the hedge fund industry. Engaged by the hedge fund and the hedge fund manager in the same manner as auditors and administrators, Amber’s main objective is to provide operational risk information which corresponds to the level of information sophisticated investors should reasonably expect to gather as part of their operational due diligence process on a hedge fund. All Amber operational certification reports are comparable in scope and format, and are written in a way that is concise and digestible for investors. Amber certified funds have, amongst other things, appropriate policies and procedures in place to reduce the risk of fraud and a material misstatement in the NAV calculation. Necessarily, this means that Amber’s operational review process must consider the quality of staff, utilisation of systems, policies and procedures within both the hedge fund manager and fund administrator’s organisations on a fund specific basis. For instance, it is important to consider the qualifications of the specific fund administration team assigned to the fund based on the complexity of the hedge fund’s strategy, the specific procedures it performs for that fund (such as verification of existence of assets, independent pricing or verification of manager pricing, etc.) and details of the team’s interactions with the hedge fund manager, especially for issues such as margin movements, pricing and reconciliations.

Whilst Amber’s Certification review does not incorporate testing, the review process does seek evidence that the key policies and procedures described by management are, in fact, in place through documentation review, corroboration of information with different employees and with external service providers, and walk through procedures that cover the trade flow process. Amber’s Certification methodology also recognises that there are key operational risk areas that cannot be tested. For instance, the adequacy of segregation of duties, suitability of key compliance policies, corporate governance practices, business continuity plans and the appropriateness of staff qualifications, to name a few, are all important to the assessment of operational risk yet cannot be objectively tested.

Amber’s Certification methodology has been designed in light of current industry practices whilst also considering the recommendations of industry trade associations. In particular, Amber’s methodology considers the operational recommendations of the 2009 edition of MFA’s Sound Practices for Hedge Fund Managers, AIMA and the UK HFSB Standards. The methodology creates a consistent framework for each Amber Certification, and provides guidelines for the performance of an operational due diligence investigation that can be applied to any fund.

Hedge fund investors have become increasingly aware of operational risk and the need for thorough due diligence. This increased focus has in turn highlighted resource constraints within the hedge fund industry. Allocators are under pressure to dedicate more resources to operational due diligence, and many investors, who do not have sufficient resources in house, are looking to external service providersand third party reports to provide additional information and comfort.

There is also an increasing recognition within the fund management community that hedge fund managers can benefit significantly from an external operational review. As the scope and frequency of investors’ operational due diligence demands have escalated, the time and resources dedicated by hedge funds to operational reviews has risen correspondingly. Hedge fund managers are looking for ways to deal with the on-going requirements of operational due diligence in an efficient and cost-effective manner as well as looking for ways to differentiate themselves from their peers.

The hedge fund industry has sought to address these issues, in particular through engaging firms such as Amber Partners to provide a certification review and/or hiring an audit firm to perform a SAS 70 or AAF 01/06 review. Whilst such reviews differ in purpose and scope, they play an increasingly important role in making the operational due diligence process more cost efficient and effective for both investors and hedge fund managers.

Amber Partners is a leading independent operational risk certification firm to the hedge fund industry and is one of the foremost experts in the field of hedge fund operational due diligence. Engaged by hedge funds, Amber Partners provides advice on hedge fund operational risk and a credential for hedge funds: Amber Certification. Amber certified funds have a commitment to operational best practice, provide operational transparency, and meet a benchmark of global operational standards. Amber’s operational certification reports are widely recognised and accessed by approximately 2500 registered users globally, including institutions, pension funds, endowments, family offices, banks and funds of funds.