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Hedge Fund Operational Due Diligence: Understanding the Risks
BY Jason A. Scharfman
BUSINESS & MANAGEMENT / FINANCE & INVESTMENTS / SPECIAL TOPICS /
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.
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.
TABLE OF CONTENTS:
Chapter 1. What is Operational Risk?
Modern Definition of Operational Risk in a Hedge Fund Context.
Operational Due Diligence versus Operational Risk.
Transparency and Reporting.
The Five Themes.
Chapter 2. The Importance of Operational Due Diligence.
Why Should Investors Care About Operational Risk?
Morton's Fork Or A Hobson's Choice?
Outright Fraud Still Exists.
Hedge Fund Fraud Cannot Be Modeled.
Small Discrepancies Add Up.
Lack Of Standardized Regulation.
Each Hedge Fund Is Different.
Ability To Generate An Informational Edge.
Potential To Reduce Losses And Increase Returns.
Considering Operational Risk Factors Presents A Different View Into A Firm.
Other Considerations: There Is Not Necessarily A Positive Correlation Between Assets And Operational Quality.
A Study In Operational Failure: Bayou Hedge Fund Group.
Affiliated Broker Dealer.
Large Discrepancies Between The Performance Of Onshore And Offshore Funds.
Declining Capital Of Broker Dealer.
Board Of Directors: Members And Actions.
Lavish Expenses Of Broker-Dealers.
Fake Audits Prepared By A Phony Auditor.
Lack Of Investor Communication.
Ties To People Barred From The Securities Industry.
Revision Of Conflicted Marketing Materials.
Chapter 3. Who Is Qualified To Perform An Operational Due Diligence Review?
Primary, Secondary, Blended, And Other Skills.
In-House Versus Outsourcing.
Evolution Of Independent Operational Rating Agencies.
Benefits Of Third-Party Rating Agencies.
Criticisms Of Third-Party Rating Agencies.
Factors To Consider Before Performing An Operational Review Of A Hedge Fund.
Chapter 4. Creating An Initial Operational Profile.
When Does An Operational Due Diligence Review Begin.
The Piñata Problem.
Due Diligence Questionnaire: To Use Or Not To Use?
Importance Of On-Site Visits.
Which Office To Visit?
Manager Interview Process.
What Topics Should I Cover During An On-Site Review?
Sample Topic Questions.
In What Order Should These Topics Be Covered?
Service Provider Reviews.
Qualitative Operational Report: Documenting The Operational Data.
Chapter 5. Evaluating the Gray Areas: Examples.
Scenario 1: It Was Not Me每Hedge Fund Manager Claims It Is Mistaken Identity.
Scenario 2: It Was Me But, Everyone Was Doing It每Are Regulatory Witch Hunts Real?
Scenario 3: It Was Me But, I Did Nothing Wrong--Manager Proved Not Guilty.
Scenario 4: The Low Profile Hedge Fund Manager每Is No News Good News?
Scenario 5: The Infrastructure Outsourcer每Can An Administrator Do Everything?
Scenario 6: The Mountain Climber 每 Can Plans For Large Fast Growth Trip You Along The Way?
Scenario 7: The Stumbling Giant每Can A Large Manager Lose Sight Of Small Controls?
Scenario 8: The Apologetic Headmaster每Are Junior Staff As Informed As Senior Management?
Chapter 6. Ten Tips When Performing an Operational Due Diligence Review.
Tip 1. Meeting With The Wrong People Or The Wrong Groups.
Tip 2. Get Out Of The Conference Room.
Tip 3. Little White Lies Can Turn Into Big Problems.
Tip 4. Be Wary Of Phantomware.
Tip 5. Focus On Documentation And Negotiation.
Tip 6. Read The Fine Print (Financial Statement Notes Etc.).
Tip 7. Reference Checking: The Importance Of In-Sample And Out Of Sample References.
Tip 8. Credit Analysis: Are Funds Financially Viable?
Tip 9. Long-Term Planning: Key Staff Retention, Succession Planning, And More.
Tip 10. Growth Planning: Is The Manager Pro-Active Or Reactive??
Chapter 7. On-going Operational Profile Monitoring.
How Often Should Background Investigations Be Renewed?
Remote Operational Due Diligence Monitoring.
Litigation And Regulatory Monitoring.
Hedge Fund Communication Reviews.
Assets Under Management And Performance Monitoring.
Effect Of Discovery On The Magnitude Of An Operational Event.
On-Site Visit Frequent And Operational Events.
Developmental Operational Traps.
Multi-Jurisdictional And Intra-Jurisdictional Regulatory Coordination.
Chapter 8. Techniques For Modeling Operational Risk.
Building a Scoring System: Category Determination.
Category Definitions: Combinations of Approaches.
Category Weight Assignment.
Weighting Aggregation Model.
Weighting Disaggregation Model.
WAM versus WDM.
Category Weight Consistency and Re-weighting Considerations.
Category Scale Determination and The Meaning of Scores.
Threshold Self-Assessment and Determination.
Discretionary Penalties and Bonuses.
Score Aggregation: Sum Totaling and Weighted Averages.
Criticisms of scorecard models.
Benefits of scorecard models.
Chapter 9. Bridging the Gap: Incorporating Operational Risk Consideration Into the Portfolio Construction and Asset Allocation Process.
Pro-Active Monitoring: Graphical Universe Creation.
Pro-Active Management Of Operational Risks.
Protecting Against Conglomeration Risks: Multivariate Commonality Analysis.
Operational Directional Views.
Example Of Multivariate Commonality Analysis.
First Objective: Total Diversity Goal.
Second Objective: FSA Overweight Goal.
Third Objective: FSA Underweight Goal.
Conclusions Of Scenario Analysis.
Considering Operational Reviews In The Hedge Fund Portfolio Rebalancing Process.
Operational Scenario Analysis.
Can Operational Risk Be Entirely Eliminated?
Factoring Operational Risk Into Total Risk Calculations.
Beyond Scorecard Approaches: Discounting Expected Return.
Discounted Expected Returns With The Operational Factor.
Expected Return And Operational Risk.
Shape Of The Expected Return Versus Operational Risk Curve.
Second Operational Threshold.
Chapter 10. Looking Ahead: Trends in the Space.
Increased Use Of Consultants.
Commoditization Of Background Investigations And Canned Operational Due Diligence Reports.
Increased Reliance On Service Provider Consulting Services.
Capturing Of Hedge Funds By Service Providers And Employees.
Hedge Fund Pursuit Of Audit Certifications.
AU 332 And FAS 157.
Development Of Hedges To Operational Risks.
Links Between Operational Risk And Credit Analysis.
Proposed Re-Regulation Of The Hedge Fund Industry.