Operational Due Diligence Insights

May 2012 Edition

Regulatory Focus - New Transparency and Registration Requirements Place Increased Information Burden on Investors

The area of fund compliance has been in flux over the past few months. Spurred in part a number of factors including the continuing financial crisis and the passage of new laws such as Dodd-Frank, the US financial regulatory system has seen the enactment of new registration requirements for many fund managers, including hedge funds and private equity funds. As more and more funds have added their names to the regulatory registration rolls, so too have funds now been required to release more information than ever before. Outside of the US, similar demands for increased fund registration are being echoed in Europe via initiatives such as MiFiD, and in Asia via increased regulatory oversight in countries such as Singapore.

Fund managers and their lobbying groups originally resisted against such additional registration and disclosure requirements. The unfortunate result for investors seems to be a regulatory compromise which relies seems to rely more on the volume of actual disclosures rather than how meaningful they are. This all show and less substance regulatory format runs the risk of fueling an already vulnerable investor base which may be increasingly seeking to cut corners on unwisely operational due diligence.

A good example of how this works in practice relates to enhanced ADV disclosures which US SEC registered fund managers must now make. Specifically, in the US, fund managers registered with the SEC are now required to disclose several pieces of information which were not previously mandatory. Currently, for SEC registered funds, many of these disclosures come on Form ADV and potentially in the future via additional forms such as the new Form PF.

There is really nothing that new about the additional Form ADV disclosures, as they have been in place for awhile. However, as many managers which were previously unregistered now register, many recent articles in the media have focused on the information revealed in this form about traditionally very secretive managers. The types of additional information disclosed which were not necessarily mandated a few years ago includes additional biographical information about the firm and key personnel as well as details about fund service providers.

While the general consensus among the investment community, at least in a due diligence context, is that additional disclosures and government oversight is a good thing, the hedge fund industry has seemed to pull the wool over investor's eyes. The nature and types of disclosures allow hedge funds and private equity managers to seemingly be more transparent and perhaps indicate a sense of capitulating to investor and government demands for additional transparency. The problem for investors seeking to perform due diligence however, is that the transparency levels are set so artificially low as to make these additional disclosures almost moot in nature.

The bulk of the "additional" Form ADV disclosures provide information which is so basic in nature that any investor performing operational due diligence on a fund manager would be reckless as to not request it to begin with. For example, in Part B of Section 7.B.1(1) of Schedule D, the current Form ADV disclosures require fund managers to provide service provider information concerning five types of service providers (auditors, prime brokers, custodians, administrators and marketers) which the SEC views as being important so-called "gatekeepers" for private funds. Generally, the requirements are that the fund manager provide the "gatekeepers": 1) identity, 2) location and 3) state whether they are related (i.e. - affiliated) with the fund manager.

An investor performing operational due diligence, who did not inquire as to the identity of a fund's auditor would not really be conducting much operational due diligence at all. Forcing a manager to put these disclosures in writing to the SEC is a positive development, but why did the SEC stop so short, when they had the ability to force managers to make meaningful disclosures. These limited scope disclosures runs the dangerous risk of allowing certain investors to believe that they either (by requiring the enhanced Form ADV disclosures the government) will actually be responsible for policing fund managers better or even worse, that investors can solely rely on the government to perform due diligence on fund manager’s operational aspects.

With a belief that the more information managers disclose is necessarily better, investors may lose sight of the importance of what information is actually disclosed. Phrased another way, is it better to know 100 pieces of information which may hold little value from an operational risk perspective or five pieces of information of higher value?

With more information comes more responsibility. The onus is on investors, or their advisors, to ensure that effective operational due diligence is performed on fund managers. Collecting and reviewing regulatory filings, be it in the US or in other jurisdictions, such as Form ADV (replete with additional disclosures and all) is certainly something investors should do, but they should be cautious not to become overly reliant on regulators to put together a complete operational due diligence review - that is still the job of the investor.

Business Continuity Corner - Plan Testing: Can Funds Put Increasingly Complex Plan Into Action?

Evaluating a fund manager's business continuity and disaster recovery ("BCP/DR") planning is a critical part of the operational due diligence process. As investors have continued to place increase focus on BCP/DR planning, funds have responded by developing increasingly detailed plans. These plans can often run the gamut from data backup and alternative backup power generation plans to phone notification trees and alternative gathering locations.

The best laid plans however, can be useless if they are not properly implemented during a business disruption or disaster event. This is where the role of plan testing comes into play. Funds that test their BCP/DR plans more frequently are better prepared to deal with disaster events. A major risk related to evaluating a fund's BCP/DR planning is whether or not the plan can be carried out once activated.

Testing can come in many different forms. There are technology based tests which solely focus on restoring the firm's systems and hardware after a business disruption or disaster event. Other types of tests can be more focused on the role played by the firm's personnel in the event of a disaster event. If a fund's BCP/DR plans call for the ability for the firm's employees to access the firm's systems remotely should the firm's primary office become inaccessible, then, one type of test could have employees attempt to connect to the firm's network from outside of the office.

Other types of tests can include more realistic simulations where employees stay home for the day and try to continue operations or instead continue working from a remote location. Investors should take steps during the operational due diligence process to evaluate both the frequency and scope of a fund manager's BCP/DR testing. Some key questions investors should ask include:

Have BCP/DR plans ever been tested?
If so, when was the most recent test?
What kind of test was it?
How was the test carried out?
Who at the firm was responsible for evaluating whether the test was a success?
How have your firm's BCP/DR plans changed as a result of test feedback?
How frequently do you plan to perform such tests going forward?

Another key consideration, related to BCP/DR testing is whether or not employees have the necessary information and tools to remain in contact after a business disruption or disaster event. Some funds for example, provide employees with remote mobile devices. As part of BCP/DR planning and testing, a fund may load each employees contact details onto these devices so employees can utilize this information to contact others in an emergency.

Investors that invest with fund managers that have solid BCP/DR plans and test them frequently will be less exposed to the operational risks associated with the inability of funds to continue operations should a disaster ever strike.

Accounting Spotlight - Limited Disclosures May Hamper Investor's Diligence Efforts: Transparency versus US GAAP

During the operational due diligence process, one of the core documents investors commonly collect and review is fund audited financial statements. Reviewing these statements can often provide valuable insights into the operational risks associated with funds under review. Investors that conduct such reviews may however become frustrated when attempting to dig below the surface of such disclosures due in part to the limited nature of information required to be contained in the audited financial statements of funds such as hedge funds and private equity funds.

A good example of this relates to fund expenses. Generally, details of fund expenses can be found in multiple areas of a fund's audited financials including the Statement of Operations, which is also sometimes called the Income Statement, and the financial statement notes, including the financial highlights. In reviewing the information contained on the Statement of Operations of most fund managers investors may often come across an expense category referred to as Other Expenses. These catch-all categories are perfectly acceptable under US GAAP, however, the notion of such catch-all categories is in direct odds with the goals of an investor seeking to perform operational due diligence.

Operational due diligence seeks to diagnose, analyze and mitigate investor's exposure to towards operational risk. Transparency is a key element in gathering the data to perform this analysis. Catch-all categories in financial statements do not facilitate this transparency. The goal of US GAAP, as well as other accounting standards, is not necessarily to assist investors in performing an operational assessment of a fund manager. Instead, standards like GAAP seek, in part, to create a uniform method for presenting financial statements. It is up to investors to utilize the tools afforded to them and execute their own operational assessment.

Employing financial statement analysis techniques can facilitate an investor's analysis of audits and can in some instances help investors garner more information than was seemingly available at first glance. However, as our example illustrates, financial statements should not be viewed in isolation. When presented with such catch-call categories, particularly in the area of fund expenses, investors should conduct further due diligence. This can be accomplished in part through discussions with the fund manager themselves in regards to what expenses are charged to the funds and an analysis of other fund documents such as the offering memoranda which may provide further details on fund expenses. Furthermore, comparing the ratios of fund expenses on a year-over-year basis can also provide useful guidance in this regard.

Investors tend to gravitate towards certain accounting standards such as US GAAP when reviewing audited financial statements of funds. Such standards should be viewed as merely a standard to facilitate a further analysis. While embracing the benefits of standards such as GAAP, investors should also be conscious of the weaknesses present in different account standards and not let the standard itself limit the operational due diligence process.

Private Equity - Hedge Fund and Private Equity Operational Due Diligence - Tailoring Investor Approaches

Once an investor begins developing an operational due diligence program, there is a likely tendency over time for the nature of fund manager reviews to change over time. This could be in part due to changes in the market environment in which fund managers operate. An example of this would be regulatory changes such as changes in SEC registration requirements. Such changes would affect the nature of a fund manager's operational risk environment and therefore, investors would need to tailor their operational due diligence programs accordingly.

The nature of operational due diligence reviews can also change among different fund managers within the same asset class. For example, an investor might be required to perform a different type of operational due diligence review on the valuation practices of a long/short equity fund manager as compared to a distressed manager. Similarly, operational due diligence techniques may also vary among asset classes. This is particularly true in comparing operational due diligence approaches to hedge fund and private equity funds.

When investors begin the operational due diligence process, they may develop a core process around a certain asset class. In recent years, many investors developed their operational due diligence programs around hedge funds. The logic behind this may have been that many investors may have viewed hedge funds to be the riskiest parts of their overall investments, at least from an operational risk perspective. Over time, more and more investors have begun to realize the benefits of a well-developed operational due diligence program which reviews operational risk across fund managers from all asset types including hedge funds, private equity and long only managers.

Focusing on private equity in particular, there are a number of different operational due diligence approach commonalities and differences between hedge funds and private equity. Some common similarities between hedge fund and private equity operational due diligence include the shared process goals of evaluating operational risk. Additionally, among hedge funds and private equity operational due diligence approaches for most investors, there will also likely be an overlap in core operational risk areas reviewed such as valuation, technology, regulatory and compliance

It is also worth considering the ways in which the underlying fund managers themselves are different from an operations perspective. As compared to their hedge fund counterparts traditionally, private equity managers trade less frequently than hedge funds. Investors may dangerously equate less trading frequency with less operational risk.

While increased trading frequency may increase the time span over which a trading problem may occur, this does not necessarily decrease the magnitude of potential losses. Operational problems in private equity firms may result in trading losses which are more consolidated and may still lead to equal or greater losses, as compared to more frequently traded hedge funds. As such investors which initially developed an operational due diligence program centered around hedge fund investments, one must not ignore operational risks relating to trade operations when applying this core program to private equity.Other key traditional differences between hedge fund and private equity funds that investors might want to consider in tailoring their operational due diligence programs include:

Private equity portfolios may be more concentrated as compared to hedge funds
After initial fund raising, many private equity funds generally do not have as actively traded portfolios as hedge funds
Beyond certain core documents, hedge funds and private equity funds will generally have different series of documents which an investor will need to collect and review during the operational due diligence process
Investors may need more asset specific knowledge to effectively perform operational due diligence on certain private equity funds

Due to these differences, investors should consider the benefits of not employing one single approach towards operational due diligence which lumps together all asset classes and fund managers. Instead, investors should take measures to adapt their hedge fund operational due diligence programs appropriate so as to ensure the key operational risks associated with private equity funds are appropriately vetted. The results will be better tailored operational risk reviews which afford investors with the opportunity to drill down on operational risks specific to each asset class.

IT HUB - Software Upgrade Cycles - An Operational Due Diligence Quality Indicator?

During the operational due diligence process, investors often come across a number of technology related issues that touch either tangentially or directly, a number of different segments of a fund manager's operations. For example, most funds typically employ some sort of order management system, commonly referred to as an OMS, which facilitates the entry, processing and general organization of fund trades. An OMS is a piece of software and therefore, falls within the realm of a fund's larger information technology architecture.

Technology which is involved in other areas of the firm's operations is not simply limited to software concerns - hardware also typically plays a role as well. To take a basic example, consider the fact that most portfolio managers execute or log at least a portion of their trades electronically. These electronic executions typically take place via a desktop computer of some sort. This piece of hardware also falls within the arena of the fund's information technology infrastructure. In addition to understanding the role technology plays in each respective area of the firm's operations, during the operational due diligence process, investors should conduct a review of the information technology function itself within a firm. Investors who may not be as familiar with information technology may run the risk of being overwhelmed by system names and technological jargon in this area.

Another point of consideration, which may make fund information technology analysis a challenging area is the speed at which information technology evolves. The rate of this change is an area which also presents a number of challenges for fund manager's information technology departments as well.

Many funds rely on third-party software applications to perform various functions within their organizations. When a fund manager purchases these third-party applications they are typically purchasing the most recent release version of the application. In order to keep applications fresh and add different, system upgrades third-party vendors often go through series of ongoing software upgrades. These upgrades are typically not automatically pushed out to users of the systems (i.e. - fund managers) but instead the fund manager has to actively install such an upgrade. This makes sense because if it is a major upgrade the third-party vendor does not want to force a disruption on a fund manager.

The versions of software used by fund managers, is an area which runs the risk of being overlooked during the operational due diligence process. This process becomes even more complex because fund managers typically do not utilize just one software application within their organizations. No, rather fund managers may use dozens of different third-party software applications. Investors may feel inquiring about software versioning across all of these multiple applications is either too cumbersome or they may feel unsure what to do with this information. Furthermore, some fund managers themselves may either not have this software version information readily available or simply not want to share this information with investors.

In these cases, there are a number of strategies and techniques that can be employed during the operational due diligence process by which an investor can come to a compromise with a fund manager, in terms of information required and burden on the manager. A key caveat to the previous statement is that just because a fund manager eventually may object to a certain request and an investor then accepts less information then they originally asked for, does not mean that an investor should draw this conclusion on their own. That is to say, an investor should ask for software versioning information from a manager and if the manager objects that is where the negotiation and compromise may begin. In some instances, an investor may also choose to draw a line in the sand and state that this is a "dealbreaker" issue such that if the manager does not provide this information, the investor will walk away.

But returning to the issues of fund manager software versions, beyond the actual data itself (i.e. - what version of a particular software application a fund manager is utilizing), an investor can often garner valuable meta data about the nature and quality of a fund manager's operations by inquiring as to software versions employed. Perhaps it is best to illustrate this point by example.

Let us consider two fund managers: A and B. Fund manager A began using a fund accounting system, which we will call System1 in June 2008. When fund manager A purchased the system, the most recent version available was version 2.0. Fund manager B also utilizes System1. B began utilizing the system in September 2010. At that time, System1 was on version 2.5. Fast forward to today. The most recent version of System1 is version 4.0. This version contains many upgrades which were not available in the older versions. Today fund manager A utilizes version 3.5 of the system, while fund manager B utilizes version 4.0. A logical conclusion may be that fund manager A is behind the times and perhaps not on top of latest operational developments as fund manager B.

These conclusions may not necessarily be correct. For example, perhaps version 4.0 was recently released and fund manager A just completed an expensive upgrade from to version 3.9 last year. Fund manager A may be waiting for version 4.1 to come out before completing the next upgrade. Similarly, perhaps fund manager B never conducted any other previous upgrades in between version 2.5 and the current version 4.0. An argument could perhaps be made that fund manager B had poor operational planning during this period as compared to fund manager A because some of the interim system upgrades (i.e.- between version 2.5 and 4.0) during this period may have helped fund manager B.

When an investor begins to delve into the issues and circumstances concerning system versions and upgrades, often times they can begin to get a sense of the larger operational planning going on within the organization. Additionally, as outlined above, an investor can often develop a dialogue with a manager about why certain upgrades may or may not have been conducted at certain time periods. During the operational due diligence process, such discussions can often provide useful perspective in evaluating software versions rather than simply conducting an exclusively quantitative comparison among managers of software versions.

When evaluating the versions of software employed by a fund manager some considerations include:

How many versions behind the most recent version are they?
Is this version delay limited to only one software application or multiple applications?
Will the fund be able to complete the upgrades themselves or will they need to work with a third-party consultant?
If the upgrade will involve more than clicking a few buttons or downloading a new upgraded version of the software, how has the fund planned to handle any software disruptions?
Has the fund taken appropriate steps to ensure data loss will not occur during any system migrations?
If any changes were required to be made to users or access points for the new upgraded system, has the fund checked to ensure any unauthorized security holes have been properly closed?

Investors that inquire about such seemingly minor issues like what versions of software are being used by a fund manager, may be surprised about how this information can yield valuable insight into the larger operational quality of a fund manager.

Fund Terms - Understanding Fund Terms: Soft Lock-up

Operational due diligence is a multidisciplinary subject. An investor beginning the operational due diligence process for the first time may encounter subjects with which they have little to no familiarity. As the scope of operational due diligence has become broadened in recent years, even seasoned operational due diligence professionals may encounter terms which they may be unfamiliar. The purpose of this section of Operational Due Diligence Insights, is to cast a spotlight on some of the words and terms, investors may have not previously encountered, or that tend to get overlooked during an operational due diligence review.

This issue's word: Soft lockup

Defined: A soft lockup refers to the ability of the fund to charge a penalty for investors redeeming capital prior to the expiration of a pre-defined time period. Soft lockup penalties are not universal and may vary among fund managers. Additionally, some fund managers may offer soft lockup penalties which vary on a sliding scale based on the amount of time an investor remains invested in a fund. So for example, consider a fund with a three year soft lockup. Under a sliding scale structure a penalty of 2% may be applied for investors which redeem capital anytime during the first 12-24 months of investment. This penalty could decrease to 1% for redemptions anytime during the last 12 months (i.e.- months 25 through 36) of the entire three year period. Investors should take measures to understand soft lockup penalties and terms. Additionally, soft lockups may interact with other fund terms such as gates, which investors should also consider during the operational due diligence process.

What investors should know: Soft lockups can be contrasted with hard lockups, which are sometimes just referred to as lockups. By comparison, under a hard lockup an investor cannot redeem capital prior to the the expiration of a pre-defined time period

Talking Service Providers - Value Proposition - A Deep Dive into Fund Administration

Although administrative work may never be as glamorous as the shimmering halls of hedge fund offices, the additional comfort and added services offered should not be overlooked by Investors and Asset Managers alike. Today, as regulations tighten and the aftermath of 2008 settles, the hedge fund industry is overwhelmed with the demands of operational due diligence and increases in transparency, the control environment, liquidity, and independent oversight. Whereas to successfully fulfill such demands, Hedge Fund Managers must choose to outsource internal functions and partner with independent Fund Administration firms. Firms that not only have a proven track record but that will also be proactive in adapting their service model to the ever increasing demands of its clients and their stakeholders.

To provide some further insight, Scott Price, Vice President and Managing Director of Custom House Fund Services (Chicago) LLC, a global fund administration firm establish in 1989, has provided some brief responses to questions regarding the changes and valued added services within the fund administration industry and how Custom House aims to be at the forefront of that change.

What are some of the more major trends you are seeing within the industry?

Consolidation. Similarly to 2011, I believe a major trend in 2012 and onwards will be the consolidation and acquisition of the smaller boutique or specialist fund administrator firms. This will most likely result in many independent firms being acquired by larger and longer established service providers. I also expect that the remaining independent administrators will invest heavily into their technology and infrastructure.

Fund administrators are now being required to supply more comprehensive and more frequent reports that are more transparent in nature and focused towards the investors. The days of simply producing a valuation and communicating the NAV to the funds investors are somewhat past and we must have an adequate strategy and resources to cope with both the onslaught of investor transparency demands as well as any regulatory changes. Those that can not adapt and provide a saleable solution will become obsolete.

Will this consolidation have any significant operational impact and if so, what is important for managers to know in this regard?

Typically, we are seeing firms offer what they present as a “one-stop shop” to fund managers. So it can be quite attractive for a hedge fund to partner with a firm that can provide a full suite of different services, whether that be custody, brokerage, administration, compliance support, etc.

However, investment managers should be aware that such simple solutions do not always equate to the best choice. Of course, many companies can provide superior services to a wide range of offerings but a common problem is that a one-stop shop service provider may offer poor or limited services in areas that are not their core competency. Therefore, it is important to investigate each service individually and ensure that you will not only receive the necessary reports but also the necessary customer service and on-going support for each service offering.

Is there value in onsite visits to the Fund Administrator and what are the typical questions you experience from investors during those visits?

Yes, every investor accepts and appreciates the importance of comprehensive due diligence on a potential manager. However, this is only one component, as all service providers within the wheelhouse of the Fund should be assessed, especially the chosen fund administrator. Overall, managers will do the necessary deep dive before choosing their administrator, so it is really up to the investor to ensure this was done to a high standard and ensure a strong control environment exists in order to produce truly independent valuations. They should also assess the provider within the framework of business risk, as well as ensuring that they work with an administrator who offers a true scalable and customized offering.

Initially, an investor must simply verify that each manager has an administrator appointed and most importantly that they are separate from the manager. You can do this by merely verifying given addresses. Also, an investor can ask each administrator for a completed DDQ (and read it!), references from current clients and the SAS 70 document. This will highlight the valuation procedures, cash controls, segregations of duties (to name a few). It would also be recommended to ask for specific contacts of senior management at the administrator and request a call, if not on-site visit was scheduled.

Lastly, where do you see the industry heading in the short and long term?

In the short and long term I would suspect that regulation will be an absolute challenge for the fund administration sector. With the JOBS Act expecting to pass and FATCA requirements being rolled out in the near future, this will undoubtedly have an effect on Fund Administrators and their potential role. For example, FATCA, with administrators having access to the majority of all the relevant investor information it seems appropriate for us to play a critical role with the compliance of such new regulations.

Custom House is being proactive to identify exactly who this will affect so that when the requirements are made known we will be prepared to act. This may cause major data maintenance problems for other firms that do not have the necessary infrastructure to handle this demand and report.

Scott Price can be reached via email at scott.price@us.customhousegroup.com

On the Calendar

Please see below for a list of upcoming operational risk items of note and events:

Emerging Managers Summit - (Chicago, IL) May 30 - June 1, 2012. Jason Scharfman to moderate Private Equity Outlook: Do Emerging Managers have an Edge? Presented by Opal Financial Group.
Surviving a Hedge Fund Operational Due Diligence Audit- (New York, NY) June 12, 2012. Jason Scharfman to teach a class on preparing hedge fund managers for an operational due diligence review. Presented by Financial Technologies Forum.
Hedge Fund Operation Risk and Due Diligence class at New York University June 6, 2012.Jason Scharfman to teach eight session class on hedge fund operational risk and due diligence at New York University. Class sponsored by New York University.
Family Office and Private Wealth Management Forum - (Newport, RI)
July 23 - 25, 2012. Jason Scharfman to speak on real estate panel. Presented by Opal Financial Group.

About Corgentum Consulting

Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers.

We work with investors including fund of funds, pensions, endowments, banks and family offices to conduct the industry's most comprehensive operational due diligence reviews. Our work covers all fund managers and strategies globally including hedge funds, private equity, real estate funds, and traditional funds. Our sole focus on operational due diligence, veteran experience , innovative original research and fundamental bottom up approach to due diligence allows us to ensure that our client's avoid unnecessary operational risks.

More information is available at www.Corgentum.com , via email at info@Corgentum.com , or via telephone at 201-918-5201.