Hedge Fund Due Diligence

How Hedge Funds Use Different Internal Controls

There was a recent study conducted on hedge fund auditing and oversight practices, specifically, why do hedge funds use different internal controls? The study showed funds use greater internal controls to comfort their investors. Conversely, some funds use less internal controls because they do not want to expose their investing positions to outside oversight. The level of internal controls also translates into higher fees. How hedge funds use internal controls is a critical issue today as more hedge funds incorporate more sophisticated auditing and oversight practices. In the following video, one of the study’s authors, Wharton Professor Gavin Cassar, shares some of the most surprising findings.

Professor Cassar cites a number of examples of internal controls in the hedge fund industry. He finds that offshore hedge funds have better internal controls than U.S. onshore hedge funds. Another conclusion is that hedge funds with better internal controls charge a higher fee. Those hedge funds using a short-selling strategy will also use less auditing and oversight practices. This may be because hedge funds holding a short position want to limit the chances of an outsider taking advantage of this knowledge with a “short squeeze.” Contrary to popular belief, younger hedge funds employ greater internal controls than experienced hedge funds. This may be a way of compensating for the lack of experience and better oversight may entice wary investors.

A family office may have to choose hedge funds with increased internal controls which could protect against fraud and risky exposure even if it means a younger fund or paying higher management fees.

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Due Diligence Questions

Hedge Fund Due Diligence Questions

Below please find a list of of questions which may be asked during an on site due diligence visit by a consultant or fund of fund. We have just added this list to our Hedge Fund Due Diligence Tool.

a) Verify the business location is as stated in the legal documents.
b) Meet all of the principals, PMs, analyst, operational staff, etc.
c) Verify all internal groups operate accordingly. (technology, accounting, operations, trading, risk, research etc.). Walk through the entire trade process: Trade generation, execution and processing, reconciliation, accounting, database and systems administration etc.
d) Verify the Disaster Recovery site is operational and working. (When was it last tested? How often does the manager use it? Does the manager have a DR plan? If so get a copy of it, how was the manager affected by key events, such as 9/11 and the 8/14/2003 blackout, other business continuity planning, etc.)
f) Does the manager have a non-investment group that provides control oversight in an open and transparent manner?
g) Verify that the working relationships with service providers are fluid and work under stress.
h) Verify that other investors are also sophisticated investors. (you will certainly feel more comfortable if other investors have preformed their OPDD)
i) Develop an overall assessment of the team and infrastructure
j) Does the compliance environment include documented policies and procedures for all relevant areas (soft dollar, personal trading, trade allocations, etc)? (Ask for a copy of the compliance manual.)
k) Verify cash controls and movements.
l) Develop a list of likes and dislikes.
m) Portfolio administration: Does the manager use Advent, Advisorware or some other recognized software application, or are they using Excel? The software used is critical because robust software can reduce fail points and errors.
n) Does the manager rely on service providers for NAV accounting?
o) Does the manager have an independent set of books and records reconciled to the prime broker?
You should ask to see redacted key trades – let’s say the fund discusses a drawdown of 7% in February and a 21% peak in March you want to verify those trades actually occurred internally and with the Prime broker and the fund administrator.
p) Does the manager plan on trading new instruments?
q) Is the manager experiencing employee turnover?
r) Is the manager planning on making any material changes to management, administration, the strategy or key personnel?
s) Is the manager or any key personnel the subject of any governmental or regulatory investigation?
t) Does the manager have an experienced non-investment leadership providing oversight of internal processes and service providers?
u) Does the manager have a consistent and well – documented valuation and pricing process, if so ask for a copy.
v) Does the manager have an external administrator providing full service support including daily trade capture and reconciliation to prime broker?
w) Does the manager have a dedicated operational team with well defined procedures and processes?
x) Are cash movements and account openings authorized by a single signature?
y) Is the back office subject to key man risk due to being understaffed?
z) Verify the accuracy of the historical data (compare it to cleansed data – I’ve seen a PM show a profitable trade but when I took a closer look at the data it was not remotely close to what the market actually traded on the date in question.)
aa) Verify that the firm has followed its Business Plan.
bb) Does the manager provide annually audited finical statements for the considered funds?
Source

Review other resources related to hedge fund operational due diligence here: Hedge Fund Due Diligence Tool.

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Hedge Fund Due Diligence

Hedge Fund Due Diligence Resource

Last month someone sent me this resource on due diligence. Fortis offers this guide to investment due diligence which goes beyond the initial selection process. The article focuses primarily on identifying potential problems by maintaining contact with hedge fund managers and thoroughly looking into the operations.

Although much can be learned from traditional due diligence, Fortis suggests simply talking with the staff and manager. They suggest that a practical understanding of psychology helps detect the underlying factors that could effect a manager’s performance. This article advocates a close relationship with the manager, adding a level of transparency for the investor and includes helpful tips for building this relationship.

Here is the full resource: Fortis Due Diligence Article

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Cash Management

Cash Management Due Diligence Check

I recently found an article on conducting a cash management based hedge fund due diligence check. The relatively few major scandals involving hedge funds have led many investors to call for greater transparency and impose stronger due diligence. Investors hoping to reduce the chance of fraud or theft view cash management as a critical aspect of due diligence. They want to know where the money is going, how it is protected and ensure accountability for their investment. The focus on cash management has created a push for accountability and separation of duties so that one entity does not have too much responsibility.

This article believes that hedge fund managers can expect to answer more rigorous cash management questions involving the basics, how the money is invested, reporting and reconciliation, and subscription and redemptions. After numerous hedge fund frauds and thefts, how the fund manages an investor’s money has become a priority in due diligence. Managers can view this article as a method for assessing weaknesses and investors can use this to improve due diligence and protect their investment from poor cash management.

Resource: Due Diligence Check – Cash Holdings

- Richard

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Fund of Fund

Fund of Fund Due Diligence

I recently found this fund of fund due diligence article which you might have seen a link to within my hedge fund due diligence guide. Within this article Jim Tomeo, Chief Operating officer and Senior Portfolio Manager of SSARIS Advisors, presents some interesting information regarding hedge funds asset allocation process. He talks a lot about building a portfolio using a bottom up / top down approach and the due diligence that requires. This approach includes taking into consideration two different investment philosophies:

1. Convergent Strategy – The value of an equity is based on the company’s future expected earnings, future growth rate of these earnings, and uncertainty of these predictions.
2. Divergent Strategy – Past patterns in security prices can forecast future price patterns.

His process calls for 50% of returns coming from the convergent strategy and 50% coming from the divergent strategy. It also emphasizes the importance of proper pricing on hedge fund success. Another point that Jim stresses within this article is the importance of constantly evaluating hedge fund managers. This means frequent hedge fund manager due diligence:

• Reviewing internal structure / procedure
• Background checking
• Review of hedge fund documentation including memorandums

Jim believes that taking cautions in terms of pricing, manager selections, in addition to sticking with a bottom up and top down approach can help hedge funds endure through tough times and succeed.

Read more articles like this within the Hedge Fund Due Diligence Guide.

- Richard

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Hedge Fund Due Diligence

Hedge Fund Due Diligence Guide

New hedge funds are launched daily, which is constantly increasing the importance of conducting formal hedge fund due diligence and determining which hedge funds are appropriate for you or your firm to invest in becomes increasingly important. Every person or company is going to have different investment horizons, risk tolerances, strategy preferences, etc. so it is usually more valuable to know the basics of how to evaluate a hedge fund then it is to hear someone say which hedge funds are “the best.” I think giving hedge fund recommendations even to the degree of suggesting exactly how to evaluate a hedge fund is too close to finance advice to put online but the SEC website does provide this advice in conducting a minimum level of hedge fund due diligence before investing:

1. Read a fund’s prospectus or offering memorandum and related materials
2. Understand how a fund’s assets are valued
3. Ask questions about fees
4. Understand any limitations on your right to redeem your shares
5. Research the backgrounds of hedge fund managers
6. Don’t be afraid to ask questions

Hedge Funds Due Diligence Articles, Guides & Tools

I have been collecting the hedge fund due diligence resources below over the past 18 months and I’m posting them here in hopes that they will a few people construct a relatively holistic view of what hedge fund due diligence is about along with provide a few example RFPs and tools to use while conducting due diligence on hedge fund managers. This is not an exhaustive list and the information anywhere on this blog or within the linked sites should not be treated as investment advice or a substitute for financial advice of any type. This is simply an aggregation of online hedge fund due diligence resources. I have only listed 21 resources here so far, I hope to make this more robust, if you have something you think should be added here please email me at Richard@RichardCWilson.com.

Hedge Fund Due Diligence Articles

1. Hedge Fund Regulation Corner | Compliance & Law Notes
2. SEC on Hedge Fund Regulation
3. Hedge Fund Risk Analysis
4. Hedge Fund Fraud | SEC & Hedge Funds Fraud Case
5. Hedge Fund Due Diligence Tips
6. The Importance of RFPs in conducting hedge fund due diligence
7. Hedge Fund Manager Due Diligence
8. Due Diligence for High Net Worth Clients
9. Investment Due Diligence
10. Risks of hedge fund investing & portfolio management
11. How long should hedge fund due diligence take?
12. Institutional Hedge Fund Risk Controls
    
13. Hedge Fund Due Diligence Questions
14. Importance of transparency and hedge fund due diligence

Hedge Fund Due Diligence Whitepapers & PowerPoints

1. Whitepaper on Hedge Fund Operational Risk & Transparency
2. Alpha through rigorous hedge fund due diligence
3. In-depth hedge fund risk & due diligence PowerPoint
4. White Paper on Mitigating Operational Risk During Hedge Fund Due Diligence

Hedge Fund Due Diligence Tools

1. Swiss Analystics Hedge Fund Due Diligence Reports
2. FINRA Broker Check
3. Hedge Fund of Fund RFP Example – Used in Institutional Due Diligence Processes
4. HFN’s Guide to Hedge Fund Due Diligence
5. Book on Hedge Fund Due Diligence
6. Fund of Fund Due Diligence

Additional Hedge Fund Guide Sections

1. Hedge Fund Strategy
2. Hedge Fund Marketing
3. Hedge Fund Terms

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