PRISM INSIGHTS 2015

PRISM LLCA l t e r n a t i v e I n v e s t m e n t s

LAURI MARTIN HAAS212 223 [email protected]://WWW.PRISMALTERNATIVES.COM

HEDGE FUND OPERATIONAL DUE DILIGENCE INSIGHTS 2015

KNOWLEDGE SHARING HELPING TO IMPROVE STABILITY & FACILITATE BUSINESS IN THE HEDGE FUND MARKET PLACE

HEDGE FUND OPERATIONAL DUE DILIGENCE

THE INSTITUTIONAL SOLUTIONTOP 50 PLATFORM & ASSURANCE ADVISORY SERVICES

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LAURI MARTIN HAAS TEL: 212-223-2288 E: [email protected]

OPERATIONAL DUE DILIGENCE VIEWPOINTS

THIS ARTICLE IS PROPRIETARY AND IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. PRISM LLC IS NOT A REGISTERED INVESTMENT ADVISOR OR BROKER DEALER, AND PRISM LLC DOES NOT MAKE INVESTMENT RECOMMENDA-TIONS. PRISM LLC CONDUCTS OPERATIONAL DUE DILIGENCE AND RELATED CONSULTING SERVICES ON HEDGE FUNDS. PRISM LLC STRONGLY RECOMMENDS CONDUCTING EXTENSIVE OPERATIONAL DUE DILIGENCE PRIOR TO MAKING

AN INVESTMENT IN A FUND AND ANNUALLY THEREAFTER ON AN ONGOING BASIS.

HEDGE FUND WIRE TRANSFER CONTROLS AND THE REGIONAL DIFFERENCES

Registered investment advisors with the US Securities and Exchange Commission generally have custody of client assets, either directly or indirectly. Why is this ac-ceptable practice in the United States and not in other countries around the world?

Most hedge fund fraud cases i.e. Ponzi schemes, misuse of assets, and expense manipulations, have occurred in the United States by US based investment managers. Research has shown that far fewer cases have occurred in the United Kingdom, Con-tinental Europe, Hong Kong, and Singa-pore. Local customs, parochial standards, and regulations have contributed to the US hedge fund industry’s higher than global operational risk. Having personally evalu-ated over 2,000 hedge funds in my career, I can attest to the fact that “access to cli-ent assets” is at the center of most frauds.

What is done differently by US based hedge fund managers?

While a private fund manager generally does not directly hold client assets, as they usually rely on prime brokers, banks, or other custodians, a US fund manager is often “deemed to have custody” be-cause it is party to an arrangement (such as an investment management agree-ment) under which it has the authority to withdraw funds or securities from a client account. This is typically done via a “pow-er of attorney” in order to pay manage-ment and performance fees to the fund’s manager/general partner and to have check writing authority to pay expenses.Having said this, United States hedge fund managers are permitted to have “custo-dy” of client assets subject to having cer-tain “controls” in place, according to SEC Custody Rule 206(4)-2. These controls

include having a financial statement au-dit completed within 120 days from fiscal year end, or undergoing an annual sur-prise custody examination by an indepen-dent public accountant. As such, most US hedge fund managers have the ability to withdraw cash from the fund, and not sole-ly the ability to process trade settlements. Instead of prohibiting the custody i.e. pos-session of client assets by registered investment advisors, the United States regulates the custody of client assets by registered investment advisors. This poses a conflict of interest, as the advi-sor both chooses the investments and has access and possession of client cash.

Why should an investment manager, which often is a privately owned and some-times closely controlled boutique, have access and control to client funds? The answer is that they probably shouldn’t.

If US investment advisors were subject to different guidelines, some of which are practiced overseas, for example were i) prohibited from having custody of client assets, ii) prohibited from having custody of client assets unless they were subject to a SSAE 16 Type II (which would likely only occur with asset managers with over $10 billion in AUM), or iii) prohibited from making non-trading payments whereby these payments were made only by a third party (e.g. an independent admin-istrator); I believe that the risk of fraud in the US hedge fund and private equity industry would decrease dramatically. While in reality there are very few cases of large scale frauds in our industry, we do need to work to eliminate the window of opportunity for financial loss resulting from fraud and mis-use of client assets.

Custody Norms

The global norm is for a hedge fund to en-gage independent qualified custodians to custody 100% of its assets, and institution-al banking relationships to process operat-ing transactions for the fund (i.e. investor subscriptions and withdrawals, and ex-penses in certain cases). However, the US norm is for hedge fund manager employ-ees to process and pay a fund’s expenses through the prime brokerage account which they have control over, while the non-US norm is for independent fund administra-tors to process and pay fund expenses through a bank account that they control.

Having said this, perhaps the process by which fund expenses are paid could be re-visited in America, as an ideal situation for a sound internal control structure is for the fund administrator to review, approve, and process all payments to vendors out of an administrator controlled bank account. In summary, it is not ideal for a manager’s employees to process expenses out of a fund’s prime brokerage account, and it is not ideal for a manager to pay expenses and later be reimbursed by the fund. While both of these scenarios are currently nor-mal, standard, and acceptable practice in the United States, they do expose funds to a higher risk of operational errors or worse, mis-appropriation of assets. In Europe and Asia, expenses are normally paid directly by the fund administrator.

MAY 2015

LAURI MARTIN HAAS TEL: 212-223-2288 E: [email protected] WWW.PRISMALTERNATIVES.COM




AVOIDING PONZI SCHEMES & HEDGE FUND FRAUDS

The single most important reason to conduct hedge fund operational due diligence is to avoid losing your capital. The most frightening way to lose your capital is through a fraud or Ponzi scheme. The largest Ponzi Scheme in the history of hedge funds is Bernard Madoff.

There are clear guidelines that an investor should follow in order to protect themselves from investing in a financial fraud. Hedge fund frauds, often structured in the form of a Ponzi Scheme, can result in a complete loss of investor capital. This loss typically leads to years of ongoing legal fees, which often negatively impacts the investor’s life or franchise long term. Ponzi Schemes often start out as legitimate investment strategies, and fraud ensues in an effort to cover up losses once performance or business targets are not met.

The following steps are critical to meeting the goal of avoiding fraud:

1. Hire an unbiased third party to assess the fraud risk of the hedge fund. The independence of this opinion is critical to removing the inherent conflict of interest between choos-ing performance or relationships over operational risk. This is especially important if you are a fiduciary.

2. Ensure that the fund’s financial statements are audited by an internationally recognized CPA firm. Obtain the audits from the administrator and inspect them for tampering.

3. Confirm that the fund uses an independent administrator that provides daily oversight of the fund’s cash flows.

4. Confirm that 100% of the fund’s assets are custodied by a qualified custodian, and confirm the account balances directly with the custodian.

5. Conduct at least three reference checks, including clients, former employers, and counterparties.

6. Conduct background checks, including verification of edu-cation, employment, registrations, and other public records.

7. Take an audit based, academic approach to conducting ODD. Do not place heavy importance on “positive industry talk”,“highly sellable stories”, or “old relationships”.

8. Ensure that every hedge fund allocation is protected by a third party custodian and a known fund administrator, even allocations to single traders running single investor funds.

9. Lastly but most importantly, maintain an unwavering atten-tion to institutional standards, and never “look for a reason to invest” or try to “qualify” the operational risk flags. Con-ducting extensive due diligence can prove wasteful if the investment decisions are undefendable when it comes to fraud and operational risk.

The following flags have been seen in actual Ponzi Schemes:

• Lack of transparency.• Nepotism.• Lack of a well known or independent custodian.• Lack of an institutional fund administrator.• Decentralized accounting i.e. use of several vendors.• Unusual investment strategy.• Unconventional and unprofessional behavior.• Unqualified back office personnel. • Affiliated broker dealer.• Use of feeder funds.• Use of unaudited SPVs (special purpose vehicles).• Use of several SPVs (a tactic used to confuse auditors).• Lack of audited GAAP financials (i.e. tax basis financials).• Inconsistent due diligence information (e.g. headcount).• Unexplained differences in custody account balances.• Unusual discussions regarding liquidity.• Past litigation with investors.• Unusual related party transactions in the audit.• Single signature wire transfer controls on fund accounts.• Lack of industry standard marketing material.• Highly paid fund directors.• Denied access to the back office team.• Service providers based in non financial centers, which are

not as well versed in hedge funds (DE, FLA, Netherlands).

One of the more important factors listed above is “unconventional behavior”. This is a gray area, and often will be a deciding factor on whether or not to place professional trust in a hedge fund manager. Some examples of unconventional behavior are dance music playing on the firm’s voicemail, black card stock with silver font used for audited financials, dogs onsite playing ball in the trading room, portfolio manager out on a run when you show up for a meeting, CFO looking for reasons to end a meeting early, unusual or lack of updates on SEC Form ADV. These are real life examples of hedge fund fraud flags, and are provided here as a frame of reference.

Over the last 20 years, most hedge fund frauds have operated via the manager’s use of fictitious client account statements. This was the case not only with Madoff, but it was the case with the large majority of historical fraud related blowups. There are ways to avoid the risk of relying on doctored statements. In short, requiring the use of an institutional SSAE SOC 1 daily fund administrator, the use of large custodians, and the use of a globally recognized financial statement auditor with a large financial services practice will limit your fraud risk substantially.

MAY 2015

OPERATIONAL DUE DILIGENCE VIEWPOINTS MAY 2015

VALUATION

Must Haves• IndepthGPwrittenvaluationpolicies&procedures• ACFOorcontroller• AfrontofficeP&L,abackofficep&l,and100%monthendadministratoroversight• GAAPaudits(if>1yearinoperation)• Acleardefendableunderstandingthatthevaluationmeetsindustrystandards

Valuation is at the center of hedge fund risk. Whether it is valuation on trades or val-uation on the books, having a clear and explainable understanding of how and who is generating valuation is a “Must Have” in the operational due diligence process.

Because we pay management and performance fees and subscribe and redeem on a GP generated valu-ation, which includes unrealized paper gains, transparency and vetting of valuation is critical to investment return. Do you want to pay performance fees at year end on an inflated or potentially manipulated valuation?

A hedge fund manager trading in level 2 or level 3 assets, should have a “live” pricing document, stipulating pricing sources, methods of obtaining the pricing sources, and accountability internally for obtaining and applying the pricing to the books and records of the fund. This “live” document should be dated and updated, as needed, but at least annually at the time of the financial audit. The pricing document of the most sophisticated hedge funds are thoughtful, academic, and practical.The pricing document is often 20-30 pages in length, and it should be an in depth analysis

An executive CFO is required for companies with shareholders, and definitely for companies with millions or hundreds of millions of dollars in revenue. Every hedge fund should have a senior financial person in house, with an extensive background in hedge fund accounting, operations, and finance.

Today, most hedge funds use an administrator that independently verifies month end pricing for 100% of the portfolio. Why then is extensive valuation due diligence necessary? Most administrators are indemnified from valuation liability and some administrators rely on the manager for level 2 or level 3 assets.

Having a clear understanding of a fund’s valuation process is necessary to fulfill one’s fiduciary duty. Any qualifications to the above “Must Haves” can greatly increase the risk of an unexpected mis-valuation.

Real Life Valuation Risk Signals:• ValuationpolicyinOMonly• Custodyreconciliation/assetconfirmationdoesnottieout• Strangebutconceivableexplanationsondiscrepancies• Administratorstatesthattheyobtainpricingquotesfrommanager• Auditqualificationonvaluation(currentorseveralyearsprior)• Administratorwithlimitedexperienceinlevel2andlevel3assets• Custodianorauditteambasedinanon-financialcenternottrainedinfinancialmarkets





LAURI MARTIN HAAS TEL: 212-223-2288 E: [email protected] http://www.prismalternatives.com


HEDGE FUND ADMINISTRATION

THE DIFFERENT LEVELS OF OVERSIGHT

Hedge fund administration has moved from an individually tailored back office and offshore statement distribution center, to an institutional trustee type role. Today, fund administration is a key factor in providing investor assurance, and an important part of the hedge fund due diligence process.

Check box “Must Haves” for institutional investors:

• Dailyinstitutionalqualityprofessionaloversightfromtrainedfundaccountingandoperationsprofessionals.• FullserviceadministrationincludingmaintenanceofGAAPfinancials,dailycashandpositionreconciliations,full

monthendindependentpriceverification,andindependentmonthlyclientstatementdistribution.• Technologysolutions,automation,SSAE16andassociatedqualitycontrolprocedures,andglobaloperations.• Strongattentiontotreasurycontrols,expensepayments,andanti-moneylaunderingchecks.• Transparency,investoraccesstoduediligencequeries,industryleadingclientservice,andrepeatableprocess.•







MAY 2015

JUNE 2015

Today’s Typical Add On Services:

• Middle office services• Transparency reporting• FATCA reporting• PF reporting• Tax preparation• Risk analytics• Financial statement preparation• General consulting

Today’s Standard Services:

• Maintenance of financial statements• Daily cash, position, and trade recs• Three-way reconciliations• Banking & treasury• Daily AML• Monthly client statement generation• Client statement distribution• Access to technology

Preferable Characteristics:

• SSAE 16 Soc 1• Notable market share• Standardized business model• Expertise in securities traded• Robust AML• Treasury services• Transparency• Access

PRISM provides a research service covering the due diligence of hedge fund administrators. Please email [email protected] for more information.

How to handle funds that do not have these fund administration credentials:

• Conductextensiveduediligenceontheadministratorandthemanager.• Determinewhetherthereare“otheralternativecontrols”whichmitigateoperationalrisk.• Discussavenuesthatmaytightenthefund’soversight.

Taking on additional operational risk with emerging managers:• Manyemergingmanagersengagewithsmallerserviceprovidersgiventheirsizeandbudgetconstraints.• Expertiseinadministratorselectioniscriticaltotheoperationalrisksuccessofyourhedgefundinvestment.• Makinginvestmentsinfundswithlimitedfundadministrationoversightorlessfundadministratorinfrastructure,mayincreaseoperationalrisk.Assuch,carefulsubjectivedecisionmakingonpartoftheallocatorisacriticalsuccessfactor.

HEDGE FUND BOARDS OF DIRECTORS

Hedge fund boards primarily exist with offshore funds, as funds

domiciled in the Cayman Islands are structured as corporations,

and local corporate law dictates that the company must have a

board. US private funds; however, are typically structured as

Delaware partnerships, requiring no board. As such, offshore

jurisdictions have set the standard for private pooled vehicles.

US registered investment company (RIC) boards (aka

“Liquid Alts”); however, function in a more traditional

way. Nonetheless, both governing bodies are in

place to ensure that investors’ interests are put first.

Today’s offshore hedge fund boards (>10,000 funds):

• Offshorehedgefundboardsareinplacetomeetlocalcorporategovernancelaws.Additionaloversightmayincludereviewofserviceproviders,annualauditedfinancials,andconflictsofinterest.

• Theboardstypicallyhave2independentdirectorsand1insider.• Thedirectorsaretypicallyprofessional“directorsforhire”.• Theboardstypicallymeet2-4timesperyear,with1or2meetingsin

person,andtheremainderofmeetingsaretelephonicorbyvideo.• Feesrangefrom$12,000-$25,000p.a.perdirector.

Today’s 1940 Act hedge fund boards (>400 funds):

• Fundstypicallyhave3independentdirectors.• Thefundsmustalsohaveanauditcommittee.• ThedirectorsaretypicallyknowledgeableUSfinancialexecutives.• Theboardsmeetformallyonaquarterlybasis.• Theboardsfunctioninthecapacityofapubliccompanyandmaypro-

videadditionaladvicei.e.approvalofinvestmentsandriskguidelines.



THIS ARTICLE IS PROPRIETARY AND IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. PRISM

LLC IS NOT A REGISTERED INVESTMENT ADVISOR OR BROKER DEALER, AND PRISM LLC DOES NOT

MAKE INVESTMENT RECOMMENDATIONS. PRISM LLC CONDUCTS OPERATIONAL DUE DILIGENCE

AND RELATED CONSULTING SERVICES ON HEDGE FUNDS. PRISM LLC STRONGLY RECOMMENDS CONDUCTING EXTENSIVE OPERATIONAL DUE

DILIGENCE PRIOR TO MAKING AN INVESTMENT IN A FUND AND ANNUALLY THEREAFTER ON AN

ONGOING BASIS.



JUNE 2015

Cayman Islands Requirements:The large majority of offshore hedge funds are domiciled in the Cayman Islands.

• Directors must be suitable.• Directors must register with CIMA.• A local Cayman license is required if an

individual sits on 20 or more boards.• Directors take on personal liability.• Directors need not be Cayman residents.

Cayman Islands Standards:

• Most Cayman funds use a corporate services firm to provide two individual local directors. Maples Finance is one industry leader in the space

http://www.maplesfs.com.• Certain offshore funds utilize a more

traditional approach with well known senior financial executive as directors.

Due diligence considerations for hedge fund boards:

• Thedirectorsshouldbeconductingregularmonitoringofthefund.• Theboardismostimportantwhenandifthereisawinddownoradistressedsituation.• LackofamajorityofindependentdirectorscoulddisadvantageLPs.• Directorsfees>industrynormof$15,000p.a.shouldbeconsidered.• Lackofformalfacetofaceboardmeetingsand/orformalminutesincreasesrisk.• Useofnonqualifiedindividualsonafundboardcouldimpairdecisionmaking.

BOARD OVERSIGHT, AND WHAT LEVEL OF ASSURANCE YOU SHOULD TAKE

HEDGE FUND EXPENSES

WHAT IS INDUSTRY STANDARD AND WHAT IS “EXTRA”

Hedge fund operating expenses should include costs necessary to operate the fund, and in some cases do include charges that are meant to add to the performance of the fund. Certain older and larger hedge funds charge through their own overhead in addition to, or sometimes in lieu of a standard 2% management fee. Nonetheless, a standard expense ratio is 30-40 BPS.

Operational Controls over Fund Expenses:

• Anin-houseCFOandbackoffice.• Anindustrystandardofferingmemorandumthatclearlystipulatesallowablefundexpenses.• Afullservicehedgefundadministratorreviewingeachjournalentryandcashpayment.• Aregulatedinvestmentmanagersubjecttoroutineexaminations.• GAAPauditswhichincludetransparencyaroundoperatingcosts.







MAY 2015

JUNE 2015

Additional Charges:

• D&O• Marketing• Research related travel• Accounting and risk software• Disaster recovery• Market data • Regulatory consultants• Research consultants

Standard Fund Expenses:

• Fund formation• Preparation of OM, articles, LP docs• Legal• Fund administration• Audit• Printing and mailing• Brokerage and custody• Indemnificationexnegligence

Unusual Charges:

• Manager overhead including rent and salaries

• Excessive travel costs (i.e. private jet, extended stays)

• Related party fees and services• Indemnificationforactspotentially

including gross negligence

Hedge fund expenses should be reviewed, or preferably processed by an institutional independent fund adminis-trator. This is the key to en-suring each cost is allowable, and there is reduced risk for erroneous charges.

Manager pass throughs are rare, but in place at some of the world’s larger, and most prestigious hedge funds.

Additional charges may or may not be industry stan-dard. The important thing is to ensure that each charge is “allowable”, and as an inves-tor your are comfortable with paying for these charges.

Additional or unusual charg-es increase the complexity of fund operations, and could signal higher structural risk.

REGULATORY COMPLIANCE

TODAY’S HEDGE FUND LANDSCAPE

SOUND REGULATORY COMPLIANCE PRACTICES FOR PRIVATE HEDGE FUNDS IS CRITICAL IN TODAY’S MARKET. WHETHER THE REGULATOR IS THE US SECURITIES AND EXCHANGE COMMISSION OR THE UK FINANCIAL CONDUCT AUTHORITY, HEDGE FUND MANAGERS NEED TO ABIDE BY BASELINE GUIDELINES, WHICH ARE FOCUSED ON PUTTING THE INVESTORS’ INTERESTS FIRST.

Operational Controls over Regulatory Compliance:

• Uptodateregistrationwiththemanager’sandfund’slocalregulators.• Adedicatedandqualifiedin-houseCCO,ortheuseofarecognizedregulatory

consultantifthefirm’ssizeandcomplexitydoesnotallowforanin-houseCCO.• Atailoredcompliancemanual,whichisupdatedasneeded,andatleastannually.• Sufficientdocumentretentiononpolicies,regulatorexams,andstafftraining.• Clearstaffpoliciesthatstipulateemployeecodeofconduct,andprotocolaround

complianceissuessuchaspossessionofmaterialnonpublicinformation,conflictsofinterest,outsidebusinessactivities,andpersonaltrading.

• Useoftechnologytostreamlinecompliancechecksi.e.GlobalRelay(emailreten-tion),Worldcheck(AML),AlphaPipe(FormADVUpdates),ACA(personaltrading).

New Frontier of Compliance under US Investment Advisors’ Act:

• IncreasedneedforcompliancestaffandoutsidecounseltriggeringarequirementforhigherAUMandfeestooperateanadequateandstablecomplianceregime.

• Increasedoversightfromregulators.







JUNE 2015

Key Global Compliance Issues:

◊ Prevention of insider trading◊ Cyber security ◊ Expert networks◊ PF Reporting◊ AIFMD◊ FATCA◊ Anti-money laundering◊ Personal trading◊ Best execution◊ Trade errors◊ Conflicts of interest◊ Employee training◊ Document retention◊ Email retention◊ Third party marketers◊ Confidentiality

Use of Compliance Consultants:

Today, there are numerous regulatory consulting groups that help hedge fund managers stay ahead of the curve, and on point with the regulators and the marketplace. Some market leaders are ACA, Kinetic, and Counselworks.

Hot Topics:

◊ Fraud◊ Use of feeders into 3rd party funds◊ Trading in public and private securities of the same issuer◊ Trading in unregistered securities◊ Expenses and passthroughs◊ Cyber security◊ Conflicts of interest

Due Diligence Flags:

◊ Old or brief compliance manual◊ Lack of dedicated CCO or regulatory consultant (reliance on a CFO or PM )◊ Unusual FORM ADV updates





INTERNAL CONTROLS

HEDGE FUND OPERATIONAL RISK & SEGREGATION OF DUTIES

Operational risk analysis was born in 1995, after the $1.3 billion blowup of Barings Bank. The blowup was due to unauthorized and concealed derivatives trading in an Asia based satellite office, due to one single trader who was also the head of the back office and a perceived significant profit generator for the British bank. This unfortunate incident awoke the marketplace, and created a field of practice that today focuses on internal controls and operational risk of trading firms. For the last 20 years, operational risk has been used as the foundation for conducting due diligence on hedge funds.







JUNE 2015

Adequate segregation of duties between front office and back office personnel is critical to reducing errors and concealing fraud. Analyzing a hedge fund’s organizational structure, its actual procedures, roles and responsibilities, and its qualifications of staff will tell an investor a lot about the quality of the firm and the structural risks of investing in their funds. Operational risk analysis is best conducted by qualified parties, who are those with extensive experience in 1) financial statement audit, 2) internal control reviews of asset managers, and 3) manager evaluation.

Following academic rules on segregation of duties is the hard part. Many investors make exceptions, only finding out later that the hedge fund exposed them to high financial risk.

Front Office

» Investment Research » Trading » Deal negotiation » Investment risk » Market risk » Hedging » Brokerage » Risk taking » Spending » Firm strategy

Back Office

» Confirmations » Reconciliations » Counterparty risk » Financing » Settlements » Valuation » Accounting » Cash transfers » Regulatory » Legal

Segregation of duties and adequate

internal controls improve operational

risk.

PMs should not reconcile trades, value

the portfolio, or handle regulatory

compliance.

CFO/COO should

not act as backup trader, participate in trade analysis, or be

compensated on p&l.

Operations should be

centralized, especially with multiple trading

teams and locations.

The key to successful ODD is following these

academic guidelines in evaluating managers.

Segregation of Duties=Reduced

Conflicts of Interest





HEDGE FUND ACCOUNTING

THE IMPORTANCE OF ACCURACY AND ACCOUNTING RISKPRISM LLCA l t e r n a t i v e I n v e s t m e n t s






JULY 2015

In fact, in numbers, most hedge fund operational risk issues are associated with smaller NAV errors, which are ultimately mistakes made by the in-house accounting team or the fund administrator. As such, it is important to critically evaluate how the NAV is being calculated, not just “if” the NAV is being calculated. Small errors can multiply, and ultimately create a material re-statement.

Institutional investors should require that the NAV is being calculated independently by a qualified fund administrator. They should also look to see if the manager is producing their own books and records in-house. A majority of “institutional hedge funds” also maintain a set of portfolio accounting records in-house on a vendor supported fund accounting system, such as Advent or SS&C. A majority of smaller funds and funds with no institutional client money, do not have their own accounting system in-house. Making the point that institutional investors require tighter controls around fund accounting risk.

Historically, many hedge funds have been forced into liquidation after redemptions mounted as a result of an NAV re-statement or rumors of accounting errors. Once accounting mis-statements materialize, it is difficult to calm investors, and as such funds that do not invest in “parallel accounting records” and “parallel portfolio accounting systems” are putting their business at higher operational risk.

In conducting due diligence on hedge funds, some people overlook the details of fund accounting. Why? Because accounting seems “straight forward” or perhaps “low risk” to the typical due diligence officer, and they rely on the administrator to have it under control. In reality, this is not always the case.

» Qualified CFO with a CPA/CA and several years of experience with fund accounting.

» Internal double sided accounting records in-house at the hedge fund, on a system such as Advent or SS&C.

» Institutional fund administrator with qualified accountants, and SOC 1 oversight.

» Adequate oversight around series accounting and partnership allocations.

» Close attention to outside journal entries such as fund expenses.

» System capability to handle exotic financial instruments such as over the counter derivatives and loans, if applicable.

» Accurate recording of fund expenses and accruals.

» Proper attention to allocations of costs across different funds.

» Accurate foreign exchange hedging.

» Globally recognized auditor.

» Lack of qualified or late audit opinions.





HEDGE FUND FINANCIAL DUE DILIGENCETHE IMPORTANCE OF A CPA WITH A SPECIALTY IN HEDGE FUNDS







JULY 2015

Due diligence on any investment should have a schematic approach, including elements of each type of risk: market, operational, financial, regulatory, franchise, fraud, accounting, valuation; to name a few. Financial due diligence should not be overlooked, and in fact should be conducted by CPAs with GAAP audit and/or CFO experience. An in depth review of historical and current financials will tell a lot about a hedge fund.

A systematic checklist approach to reviewing each financial statement (i.e. balance sheet, statement of income, statement of cash flows, and schedule of investments) is critical to understanding the operational activity of a hedge fund. Applying a detailed analysis, combined with experience and skilled unbiased judgment can mean the difference between investing in a Grade A fund and a Grade D fund.

The details in the financial statements, if read correctly, will bring to light a fund’s expense ratio, investment return, elements of the investment return, capital flows, general partner’s investment, fees paid to the investment manager, legal exposure, and related party transactions. The notes to the financial statements may provide further detail on unusual transactions, subsequent events, and structuring of the fund itself.

Assessing the manager’s financials is also an important, but typically a less transparent component to financial due diligence. Often, estimates need to be made based on current and historical AUM, headcount, and fees earned. In some cases, the GP may be willing to provide financials, but it is not the industry norm in today’s current marketplace.

Financial due diligence is critical to the success of your hedge fund portfolio. The dissection of audited financial statements by CPAs with extensive hedge fund industry audit experience is a key component to the due diligence process. Knowing what to look for, and how to look for it, could mean the difference between a profit and a loss.

» In depth analysis of historical audited fund financial statements.

» Detailed review of historical monthly performance.

» Dissection of types of income earned.

» Critical analysis of fund expenses and related party transactions.

» Assessment of GP financial condition and its history of investing in its business and infrastructure.





ANTI-MONEY LAUNDERING

MONEY LAUNDERING RISK IN HEDGE FUNDSPRISM LLCA l t e r n a t i v e I n v e s t m e n t s






JULY 2015

Anti Money Laundering (“AML”): A set of procedures, laws, or regulations designed to stop the practice of generating income through illegal actions. The purpose of AML is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing. While the various sources of AML processes, laws, and flags have significantly increased in the last 15 years, depth, independence, and daily frequency are the guidelines for best practice.

Today’s industry standard is for hedge fund managers to outsource AML procedures to the fund’s administrator. Most administrators now have honed their AML process, with most firms utilizing Reuters’ popular World-Check service as their primary source of AML. World-Check is the market share leader in AML, and was bought by Reuters in 2011. World-Check has hundreds of analysts covering technological and manual access to hundreds of lists around the world, which help the financial community vet counterparties and monitor cash flows. The firm’s tagline is: “Human networks hide many risks. We expose them”. This is a good methodology to follow for all types of due diligence.

Since AML is ultimately the responsibility of the investment manager, and not the fund administrator, some larger hedge funds have chosen to duplicate the process performed at the fund administrator and run investor names through World-Check in-house a second time. The costs are reasonable, and this helps ensure that their fiduciary responsibility is being met.

In short, AML should be conducted daily, and World-Check is used at almost every hedge fund administrator today. The financial and reputational loss that a hedge fund would incur if found with illegal funds could be significant.

Recent history has shown that the global financial system has weaknesses in its money laundering prevention infrastructure. Some of the largest, most well regarded financial institutions have been caught in the middle of money laundering schemes that have cost them reputation damage and financial loss. What is preventing the same from happening with well regarded hedge funds? The risk is real.





DUE DILIGENCE DOCUMENTATION

THE IMPORTANCE OF DOCUMENTATION IN THE HEDGE FUND DUE DILIGENCE PROCESS







AUGUST 2015

The Hedge Fund Investor

Conducting due diligence on any type of investment is only useful if the information is used wisely. Investors should only be putting money with managers whom they see have acceptable levels of operational risk. Therefore, documenting due diligence findings in accordance with industry and regulator standards is worth its weight in gold.

Hedge fund investors should have completed initial and ongoing due diligence on each investment, and they should maintain industry acceptable levels of due diligence documentation on file for every investment. Operational and structural risks should be identified, documented, and explained in order to demonstrate diligence. Every hedge fund has operational risks, weaknesses, and considerations. The important issue is whether the operational risks are reasonable and acceptable.

The Hedge Fund Manager

Drafting and maintaining a “constitution” of policies, procedures, and protocol; sets the standard from the top of the organization. Following the “constitution” is up to management, and can mean the difference between longevity and profitability, and the failure of a business.

Hedge fund managers that do not have written policies and procedures, should now be investing in the initiative of having such documents drafted. This is part of the evolution of any investment management business, and 2 and 20 is meant to provide not only alpha, but a certain level of investor protection against losses or complete failure resulting from operational risk. The largest hedge funds may have the capital to engage Big 4 consultants, while small and mid size firms will take on this initiative in-house, or with smaller consultants.

Whether evaluating an investor’s due diligence documentation or a hedge fund manager’s operational documentation; the important factor is whether or not the documentation is clear and has integrity.

Documentation is about taking accountability. Whether it is a manager documenting roles, responsibilities, process, and policies; or an investor documenting their findings in a due diligence review: documentation feeds transparency.





TRANSPARENCY REPORTING

“THE KEY MONTHLY REPORT YOU NEED FROM THE FUND’S ADMINISTRATOR”







AUGUST 2015

Fund administrators are the closest thing investors have to a trustee. Fund administratorR “Transparency Reports” are an effective due diligence tool that should not be overlooked. .

Transparency Reports are typically generated by the fund administrator, either on a monthly or quarterly basis. Investors often need to opt in on the distribution, and the fee is paid for by the fund, or is offered complimentary by certain administrators.Transparency Reports provide investors with metrics around portfolio valuation and counterparty exposure that were vetted independently by the administrator. Most institutional administrators offer this service, although not all funds choose to use the service. Investors should request and obtain these reports, and ensure that a qualified due diligence staffer is reviewing them in detail. Early adopters of this service included Citco, GlobeOp, and State Street/IFS.

Valuation Exposure

Counterparty Exposure





PRISM INSIGHTS 2015

Documents

Transcript of PRISM INSIGHTS 2015