Hedge Fund Operational Due Diligence: What Managers Need to Know
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Transcript of Hedge Fund Operational Due Diligence: What Managers Need to Know
Hedge Fund Operational Due Diligence:What Managers Need to Know
December 9, 2010
Our Speakers
Jason Scharfman, Managing Partner
Corgentum Consulting
Vinod Paul, Managing Director
Eze Castle Integration
Paul Chain, President
AIS Fund Administration
Agenda
The Investor Perspective– Impact of Dodd-Frank Reform on Due Diligence
Technology Considerations for Due Diligence– Top 5 Technology Best Practices
Recommendations for Fund Managers
Q&A
Hedge Fund Operational Due Diligence
Confidential – Not for distribution
© 2010 Corgentum Consulting, LLC
Presented by: Jason Scharfman, Managing Partner
www.Corgentum.com
What Topics Are Investors Focused On?
5
Confidential – Not for distribution
Technology and Systems
Business continuity and Disaster recovery
Legal/Compliance
Regulatory
Assets and investor concentration
Quality and length of relationship with tier-one service providers
Reputation of employees (including senior mgmt.) and firm
Valuation techniques and pricing sources
Compensation and employee turnover
Firm stability including expense analysis
Operations connectivity
Trade lifecycle
Fund terms Transparency and reporting
Counterparty oversight
Cash controls and management
What Topics Are Investors Focused On? – part 2
6
Confidential – Not for distribution
Insurance Independence and oversight of the board of directors
Quality and length of relationship with tier-two service providers
Tax practices
What Investors Are Looking for During Operational Due Diligence
Documentation: Accurate description of practices in place
Absence of overly broad or conflicting documentation
Manager understanding of documentation
Process transparency Forthcoming attitude to assist investor in
understanding the operational practices in place
Reasoned understanding of why certain operational choices were made
7
Confidential – Not for distribution
The Impact of Dodd-Frank on Due Diligence
Dodd-Frank is an artificial operational floor
Institutional investors perform due diligence at a much high standard than minimum SEC requirements
There will be heightened scrutiny of legal/compliance: Has a hedge fund appropriately budgeted for the increased costs
of compliance associated with Dodd-Frank?
With the increased focus on compliance has a hedge fund spoken to the appropriate service providers to ensure that quality individuals and adequate services are dedicated to the hedge fund's account?
What changes in compliance policies and procedures has a hedge fund undertaken? How have these changes been communicated to staff?
Has a hedge fund developed an reporting and technology infrastructure to meet new requirements?
8
Confidential – Not for distribution
Hedge fund preparation for operational due diligence?
Understand your investors goals
Do not mistake operational due diligence for merely discussing traditional “back-office” type issues
Be prepared to demonstrate your strengths
Be pro-active in highlighting any operational weaknesses
Ensure you can discuss reasons for your operational choices
Do not be afraid to respond that you will follow up with certain type of information
Ask for and listen to investor feedback
Mock operational due diligence walkthrough
9
Confidential – Not for distribution
On-going Investor Operational Activism
In the post-Madoff environment investors are more likely to make their voice heard in regards to operational issues
Many hedge funds have been forced to implement operational changes due to shifting market perceptions (i.e. – third-party administration)
Investors will likely perform on-going operational due diligence to, in part, monitor how a hedge fund responded to feedback
Investors appreciate hedge fund which develop a dialogue with them regarding operational issues
10
Confidential – Not for distribution
Why this all matters? : Less Operational Risk = More Allocations
A shifting allocation perspective
Traditional allocation models would not differentiate between hedge fund A and B (as long as a hedge fund was above the minimum threshold it was acceptable)
Modern fund of hedge funds and other institutional hedge fund allocation models would allocate more to hedge fund B (less operational risk for a higher expected return)
11
Why this all matters? : Case Study - Multiple “Small” Issues:
NegativeMedia
NegativeMedia
Inefficient Legacy
AdministratorStill Utilized
Inefficient Legacy
AdministratorStill Utilized
ExtendedDelay inGeneva
Implementation
ExtendedDelay inGeneva
Implementation
No OffsiteBCP/DR
Site
No OffsiteBCP/DR
Site
No InternalValuation
Committee
No InternalValuation
Committee
“Affiliated”Board
Members
“Affiliated”Board
Members
CCO Unawareof OutsideBusiness
Directorships
CCO Unawareof OutsideBusiness
Directorships
PersonnelTurnoverPersonnelTurnover
Not being reported? or Policy
not enforced?
Culture of compliance? /
Policy revisions?
Compensation issues?
Lack of independent oversight?
Lack of internal operational planning?
Reputational risks?
Level of pre-employment screening?
Service provider
oversight?
Retention scheme issues?
Code of Ethics Violations?
Input of IT into organizational
planning?
Information security issues?
Reduced InvestmentNo Investment
Elongated Due Diligence ProcessElongated Due Diligence Process
Sufficient internalchecks and balances?
Sufficient internalchecks and balances?
Are different parts of theorganization connecting?Are different parts of theorganization connecting?
Is the businessscalable?
Is the businessscalable?
Appropriate oversightfrom senior management?
Appropriate oversightfrom senior management?
Financial stabilityquestions?
Financial stabilityquestions?
Top 5 Technology Best Practices for Hedge Fund Operational Due Diligence
Vinod Paul, Managing Director, Eze Castle Integration
Eze Castle Integration OverviewEze Castle is a firm’s partner to eliminate enterprise infrastructure risk and enhance operations. We provide a foundation for investment firms at any stage of their lifecycle.
Hedge Fund
Technology
Managed Services
Compliance
Comms
Founded 1995
Mission To be the leading provider of IT services and technology solutions to the investment community worldwide
Offices Boston, Chicago, Dallas, Geneva, London, Los Angeles, Minneapolis, New York City, San Francisco, Singapore and Stamford
Clients Over 550 hedge fund clients, managing $300B+ of assets
83 firms with $1B+ AUM
# 1 Educate your investors.
Explain the designs and processes of your operations, particularly when it comes to your technology.– Technology matters today
Anticipate questions your investors may have– Be prepared with clear and concise answers– Ask your service providers for supporting info
Dedicate 20% of your presentation to educational content
Investors want to know where management fees are being allocated
Identify costs around:– Staffing: payroll, taxes, health and benefit costs, etc.– Building and facilities: consider office expenses and
lease obligation– Technology: If you don’t have an in-house IT staff, ask
your IT service provider to do this– Legal and Administrator fees– One time versus recurring
#2 Outline your budget.
Sample Technology BudgetEnterprise Infrastructure - Data + Networking Year 1 Year 2Hardware and Software Email, IM & Bloomberg Archival Project Labor Total Enterprise Infrastructure - Hardware Enterprise Infrastructure - Voice Year 1 Year 2Avaya Voice Hardware & Labor Total Enterprise Infrastructure - Voice Enterprise Infrastructure - 3rd Party Services Year 1 Year 2Central Copier - Multifunctional Copier Blackberry Voice & Data Service Bloomberg Users Verizon PRI Usage Including Taxes Total Enterprise Infrastructure - Services Enterprise Infrastructure - Circuits Year 1 Year 2ISP A ISP B ISP 1 - PRI ISP 2 - POTS Bloomberg Circuit Total Enterprise Infrastructure - Circuits Additional Services Year 1 Year 2Disaster Recovery Monthly Service Total Enterprise Infrastructure - Misc. TOTAL EXPENDITURE
#3 Communicate with your service providers.
Don’t be afraid to call them if you need clarification on their systems, processes, documentation, etc. – For example, ask your technology provider to create a
“technology blueprint” for you.
Technology BlueprintFirewall Client Site
RouterISP Edge Router
Desktop Server LAN
Define your technology requirements– High-speed, high resiliency, secure– Communications of the firm
• Voice, Data, Market Vendor, Disaster recovery replication
– Applications– Disaster Recovery & Business Continuity– Compliance
#4 Test, test, test.
Test your systems.– Especially your disaster recovery system (at least
quarterly) and show the results to investors
Regular test instills confidence and opens lines of communications with investors
Demonstrates your operational excellence
Disaster Recovery vs. Business Continuity
#5 Make operational excellence a priority.
Investors want to see that funds are serious and that they value operations and technology as vital aspects to their businesses.
Advanced planning is essential; Anticipate and prepare for change– Use operational benchmarking to assess areas for
improvement– Proactively prepare operations for upcoming
regulations– Document everything– Be committed to transparency
The Authority on Hedge Fund Operations
Hedge Fund Operational Due Diligence What Managers Need to Know
Due Diligence: What Manager’s Need to Know 24
AIS Fund Administration
The AIS daily model combined with our team approach results in ahigh level of responsiveness and exceptional service to our clients
Paul Chain, PresidentGlobal Sales & Marketing | Trading
Quality provider ● Fixed Income ● Derivatives ● Daily Model
Due Diligence: What Manager’s Need to Know
What is the Driving Force Behind Operational Due Diligence Procedures?
Due Diligence: What Manager’s Need to Know 26
Impetus for changeBayou Group - $450M
Lipper Convertible - $350M
KL Financial - $81M
Petters Group Worldwide - $3.5M
Beacon Hill Asset Management – $400M
Stanford Financial Group - $8B
Amaranth Advisors – $6.4B
Madoff – $64.8B
Due Diligence: What Manager’s Need to Know 27
Evolution of Due Diligence
Investors need to be educated
• Due Diligence Officer is no longer a Junior Person
• Industry standard, not a hobby• Process is still evolving, not where it should be
Due Diligence: What Manager’s Need to Know 28
Changing Position of Investor
• Paradigm shift• Managers and Administrators can help
– Big vs. small allocators– Tick the box vs. sophisticated investor– Education and advice– Watch lists
Know Your Customer
Due Diligence: What Manager’s Need to Know 29
Actionable Due Diligence Recommendations• Process is evolving, need to adapt with it• Ask questions
– What is their view of due diligence process– What is important to them– What is their background
• Don’t make assumptions on what they know/don’t know about process
• You’ll be in a position to learn or educate – which is it?– If they want to tick the box, help tick the box– If they want to understand the process, help them understand
• Before meeting ends, make sure you’ve communicated your views on
process
Meet the needs of your customer
Eze Castle Integration OverviewFounded 1995
Mission To be the leading provider of IT services and technology solutions to the investment community worldwide
Headquarters
Additional Offices
Boston
New York City, Chicago, Dallas, Geneva, Minneapolis, Los Angeles, San Francisco, Singapore, Stamford and London.
Phone 1.800.752.1382
Website & Blog www.eci.comwww.eci.com/blog
Core Services • Strategic IT Consulting
• Outsourced IT & Help Desk
• Professional Services
• Managed Services
• Startup & Relocation
• Communications Solutions
• Network Design & Management
• Business Continuity Planning
• Disaster Recovery
• Compliance Solutions
• Storage Solutions
• Cloud & Colocation Services
• Internet Service
• E-Mail & IM Archiving
Tel: 800.752.1382 www.eci.com