PRISM LLC · PRISM LLC Alternative Investments ... Tier 1 hedge fund Fund Administration: ......

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

PRISM LLC New York and Los Angeles | Contact: Lauri Martin Haas | www.prismalternatives.com | E: [email protected]

Hedge Fund and Private Equity Fund Operational Due Diligence Services

Extensive operational risk analysis, internal control assessments, and manager evaluation.

Since 2009, bringing over 20 years of experience serving top tier financial institutions with operational risk analysis.

PRISM LLCNew York and Los AngelesContact: Lauri Haaswww.prismalternatives.com212-223-2288424-302-0165

2016 PRISM INSIGHTS

HEDGE FUND OPERATIONAL RISK WHITE PAPERS

1. Avoiding Hedge Fund Fraud2. Optimization of Hedge Fund Due Diligence3. The Perfect Hedge Fund4. The Top 100 Funds5. Service Provider Directory6. The Sociology Factor in Operational Due Diligence7. Fund Expenses8. US Fund Administration Regulation9. Fictitious Account Statements10. Asset Liability Management11. Assessing Counterparty Risk12. Evaluating Hybrid Funds13. Allocating Money to International Managers14. Why Operations is Not the Only Piece of Operational Due Diligence15. ODD Commoditization or Innovation?16. The Balancing Act of using Leverage17. The Hedge Fund Industry Contraction18. ODD Synergies19. Segregation of Duties20. Insider Trading21. Evaluating Someone’s ODD Process22. Daily Fund Administrator Reconciliations23. Contemplating Suitability of Cash Movements24. Private Equity Funds25. Regulatory Consultants26. Fund Management Teams27. Financial Budgets28. Operations Policies & Procedures29. The Imperfect Information Factor30. The Risks of Decentralized Operations


BUSINESS MINDED | IN DEPTH | ACCURATE ANALYSIS


THE CALL FOR US HEDGE FUND ADMINISTRATION REGULATIONJANUARY 2016

Having had the experience of successfully identifying the world’s largest hedge fund frauds, makes it easier to see them coming.

One should not invest their money into an unaudited investment limited partnership, a non-

administered investment fund, or an investment fund whereby the custodian is an affiliate

of the manager or the custodian is not a bulge bracket bank. PRISM recommends, and

will always strongly urge these rules, when allocating to third party hedge fund managers.

Sure, certain elements of operational due diligence can be performed by non-practitioners,

but a full hedge fund operational risk assessment should be performed by qualified

ODD specialists with a long standing successful track record; in the same way that an

audit of a public company should be performed by a reputable firm of licensed CPAs.

Fund administration, financial statement audit, regulators, related party transactions, and

transparency are some keys to identifying potential financial frauds. Managers not willing to provide

institutional levels of transparency should be avoided until they are ready to meet industry standards.

Passing on these managers could mean the difference between keeping and losing your capital.

PRISM has had unparalleled success in identifying large scale frauds before they were

uncovered, and for assessing the operational risk of thousands of hedge funds and hundreds

of financial institutions. Engaging a third party to conduct this detailed work provides a

professional arm’s length viewpoint that investors need in successfully avoiding fraud.


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

http://www.prismalternatives.com

PRISMALTERNATIVES.COMPRISM INSIGHTS


AVOIDING HEDGE FUND FRAUD


1


The consolidation and optimization of the operational due diligence space is inevitable, and critical to the continued institutionalization of the hedge fund industry.

Confidentiality, security of information, reduction of costs, and bringing things into focus. Today, thousands of investors around the world conduct their own proprietary operational due diligence reviews spending between $3,000 and $30,000 per year per hedge fund. Hedge funds with hundreds of investors spend close to $1 million a year managing the operational due diligence efforts of each allocator. Does each investor conduct its own GAAP financial statement audit? Of course not. That would be a poor use of resources on both the manager and client side. Why then are we still opting for manual, bespoke, overlap of operational due diligence? Wouldn’t it be better if funds had to undergo one ODD audit every 12 months by a reputable provider? Or semi-annually by two reputable providers? This would eliminate the investors’ direct costs and would reduce the manager’s costs significantly.

In terms of process optimization, this is critical to be able to focus on subjective analysis. The future of operational due diligence lies with a repeatable process, supporting IT applications, and qualified management to oversee both the process and the intangible “Structural Risk Factor”. The Structural Risk Factor will continue to be the reason why investors hire and fire specific individuals or firms to oversee their ODD. Proprietary information flow regarding trends across the industry is also a key component of coming up with the “best answer”. Understanding the marketplace, its players, and having an unparalleled historical knowledge of the playbook, the processes, and the frauds; will demonstrate one’s ability to obtain information that others cannot see, and ultimately enable them to make better decisions.

The world’s largest allocators know that to complete a thorough institutional operational due diligence review of a hedge fund, the costs run approximately $20,000 and the billable time is 60 hours. If you are paying less, then you likely do not have the right people employed on the file. PRISM’s Platform engages multiple investors to provide them with the same proprietary analysis, at an optimal fee structure.




PRISM INSIGHTS


THE OPTIMIZATION OF HEDGE FUND OPERATIONAL DUE DILIGENCE


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The perfect hedge fund has an annualized 15% + track record of generating superior uncorrelated performance, a pedigree background, a seasoned management team, a repeatable process, and an “A” on the Operational Risk Assessment. What are today’s institutional requirements for being a hedge fund leader in operational and structural risk?






THE PERFECT HEDGE FUND

Staffing: Experienced management team. Corporate hiring practices. Professional and commercial HR

policies. Competitive compensation. Low personnel turnover. Ongoing management rotation. Backup for

staff to avoid a breach in segregated duties. Regulatory: Regulatory oversight from relevant government

bodies. A dedicated in-house CCO that is not the CFO or the PM. Outside regulatory consultant on retainer.

Current and relevant compliance manual. Completed cyber security assessment and ongoing surveillance.

Prohibition of personal trading. No soft dollars. No historical regulatory violations. Systems: Vendor supported

IT platform including a portfolio management system, a trade order management system, a fully functional

portfolio accounting system, and a shareholder allocation system. Internal Controls: Distinct segregation of

duties between portfolio management and trading, and operations and accounting. In depth documented

operational policies and procedures. Valuation: Proprietary in depth valuation policies and procedures.

Formal minuted valuation committee. Back office generated valuation. 100% independent valuation

every month end. Big 4 auditor. Custody & Counterparty Risk: Multiple large prime brokers. Custodian for

cash and fully paid for securities. Daily bilateral collateral calls. Fund Administration: Tier 1 hedge fund

administration. Daily oversight from the Tier 1 hedge fund administrator. Monthly Transparency Reporting.


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A study of how a hedge fund’s success may be correlated to its selection of service providers. Cross referencing Barron’s Best 100 Hedge Funds List to the SEC’s FORM ADV, the following metrics were revealed:




PRISM INSIGHTS

THE TOP 100 FUNDS AND THEIR SERVICE PROVIDERS

53% are based in the New York area

22% are based in other parts of the US

21% are based in Europe

3% are based in Asia

1% is based in Canada

87% of US managers use Big 4 auditors

21% use IFS/State Street as administrator

15% use SS&C GlobeOp

12% use Citco

11% use Morgan Stanley Fund Services


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INSTITUTIONAL HEDGE FUND SERVICE PROVIDER DIRECTORY

Fund AdministrationCitco Fund ServicesInternational Fund Services (State Street)JP Morgan Alternative Investment ServicesMitsubishi Fund ServicesMorgan Stanley Fund ServicesNorthern TrustSEISS&C GlobeOp

Outsourced Back OfficeNorthern Trust Viteos Fund Services

Audit & TaxDeloitte & Touche LLPErnst & Young LLPKPMG LLPPricewaterhouseCoopers LLP

Valuation Agents (Level 3 assets)Duff & PhelpsHoulihan Lokey Sterling Valuations

Offshore Corporate Governancedms ManagementIMSMaples FS

Legal CounselsMaples & Calder OgierSchulte Roth & Zabel Seward & KisselSidley Austin


IT, DRAbacus Group LLCEze Castle Integration Richard Fleischman & AssociatesSunGard

Cyber Security ControlsACAAgioCypher Tech SolutionsDell SecureWorkseSentire Inc.Siemens

Accounting Software Advent GenevaSS&C Total Return

Trade Order Software AdventCharles River Eze Castle Trader ConsoleNorthpointSS&C

CRM SoftwareBackstopSales Force

Graphic DesignOvis CreativeSynergy Networx

FORM ADV ReviewsAlphapipe

Best PracticesAIMAMFA

Listed in alphabetical order. PRISM does not endorse any of these service providers, but acknowledges them as institutional market share leaders.

PRISM LLCNew York and Los AngelesContact: Lauri Haaswww.prismalternatives.com424-302-0165

Prime BrokersBofACredit SuisseDeutsche BankGoldman SachsJP Morgan SecuritiesMorgan Stanley

CustodyThe Bank of New York MellonNorthern Trust

BankingFirst RepublicNorthern TrustAffiliate of fund administrator

Regulatory Consultants ACA Compliance GroupKinetic (Duff & Phelps)Counselworks (Duff & Phelps)

Anti-Money LaunderingMcDonald Information Services Inc.Reuters World-Check

Background Check ProvidersBishops ServicesFADV/BacktracksKroll

Executive Hedge Fund RecruitersKorn FerryJSB PartnersDHR International

Hedge Fund CoverageAlbourne (IDD, ODD)Aksia (IDD, ODD)PRISM (ODD only)

5


THE SOCIOLOGY FACTOR IN HEDGE FUND DUE DILIGENCE


Sociology is the alpha of hedge fund operational due diligence.

Operational due diligence is made up of audit and analysis. Without the audit, the practitioner is being negligent. The subjective analysis sets apart each person or firm. This is the art of manager selection.

Integrity, transparency, and commercial business practices are a good indicator of a sound hedge fund manager. However, these characteristics need to be backed up by facts, benchmarking, and analysis. Understanding what the hedge fund is saying, and more importantly what they actually mean, could mean the difference between a good and a bad investment; or a total loss of capital. Checking facts and analyzing returns and operations are critical to gaining assurance over a hedge fund investment. However, clear communication with a clear understanding of how the fund performs and operates, is the end goal. Understanding the hedge fund business and its people are they key to operational risk assessments.

The first operational risk that an investor needs to rule out is fraud, which exists in various forms. Unless an allocator has the experience and expertise to detect fraud, they may overlook it. Moreover, human relationships, which are the bedrock of the hedge fund industry, can cloud judgment, which is why an independent opinion is paramount to a sound portfolio.


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HEDGE FUND EXPENSES

Investors pay their share of a fund’s operating expenses. What does this include?

Hedge funds are private investing vehicles that are not registered entities. When subscribing to

a hedge fund, or purchasing shares or partnership interests, an investor agrees to the terms and

conditions of a private and confidential offering memorandum. Amongst other things, this 50-

100 page document outlines what types of expenses the fund will pass through to investors in the

normal course of business. However, it will generally never outline expense ratios and it will only

provide general categories of allowable costs. It is up to the due diligence process to uncover what

an investor will pay for, and whether the manager is passing through any unallowable expenses.

» The average expense ratio of a hedge fund is 35 basis points. This excludes brokerage costs and management and performance fees. The expenses should include fund administration (typically 15 BPS), fund audit, fund tax, printing, mailing, fund domicile related regulatory filings, legal structuring costs, and ongoing maintenance of the offering documents.

» In addition, funds typically allow themselves to pay

for risk software costs, market data feeds, research costs, all or a portion of E&O/D&O insurance, and deal related legal fees (which could be significant).

» Some managers will also pass through ‘other’

charges, that could be perceived by some people as a cost that should be covered by the hedge

fund manager. These other charges may include employee salaries, overhead such as office rent, accounting software, outsourced back office services, research related travel, marketing, and regulatory compliance advice. In addition, there may be an allowance for ancillary fees, which may include related party commissions, deal fees, syndication fees, and other hidden costs that the manager earns in addition to its management and performance fee.

While many investors focus on the net return,

it is also critical to focus on what the manager is passing through to its limited partners, and what the controls are around expense approvals and

processing. This is a current focus of securities regulators.



7


There are a handful of areas of the market that could benefit from regulation, and US hedge

fund administration may be one of them. Many hedge fund administrators have done a

phenomenal job in institutionalizing themselves to serve fiduciaries. However, why wouldn’t a

US investor want a government regulating a fund’s internal control systems when other global

jurisdictions, including Ireland, Luxembourg, and the Cayman Islands have this requirement?

With $3 trillion in assets across hedge funds globally, why hasn’t the United States had the chance to regulate this activity?

Let’s put this into perspective. Regulating hedge fund administration in the United States could standardize processes across the globe, and help investors rely on the work being conducted by these firms. This additional layer of regulation should help grow the market. This concept goes hand in hand with the institutionalization of the hedge fund space, which investors and managers both embrace. After all, lower operational risk for investors results in increasing mandate size, and significantly higher revenue for managers.

The gaps that exist today in the hedge fund administration space include the lack of a required protocol around 1) expense payments, 2) AML, 3) valuation, and 4) reconciliations. Even at some of the largest fund administrators, all four areas have flexibility. For example, managers typically pay fund expenses, and not always do fund administrators obtain invoices for backup. Two, AML is not always checked daily. Three, valuation for level 2 and level 3 assets are not always vetted. Four, reconcilations are not always performed daily. In summary, oversight, a repeatable and reliable process, and judgment should streamline investor due diligence efforts.






US HEDGE FUND ADMINISTRATION REGULATION


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Fraud almost always involves the creation of false documents.

Studying back to the 1990s, almost all historical financial frauds have been concealed through

the use of fictitious statements: falsified investor statements, falsified brokerage statements,

falsified valuations, or falsified invoices. Investors can avoid these pitfalls by performing in depth

unbiased operational due diligence. Unbiased operational due diligence requires the party

conducting the diligence to be able to ignore the name on the door and ignore performance.

Several small hedge funds and high profile institutional hedge funds have been indicted for fraud, and in almost every case, the fraud was concealed by the actual creation of false documents. While the concept of creating fake client statements or fake invoices may seem far-fetched, this is how frauds are generally concealed. PRISM specializes in fraud detection and has unique expertise in performing analysis to prove that large scale fraud does not exist. While it is rare to find actual large scale hedge fund fraud, it is a real risk, and fraud exists in various forms including the passing through of unauthorized and sometimes fake expenses.

False investor statements are the most common form of concealing fraud, whereby the manager, not an independent administrator, provides monthly investor statements with account balances. While today most hedge funds do use an administrator, it is not a requirement. Moreover, private investment funds may sometimes have unique structures that are attractive to investors, or worse, legacy relationships cause an investor to turn a blind eye to reduced oversight. It is also very common for private equity and real estate funds not to use an administrator.

Valuation fraud can occur in many ways. One common way is through the use of doctored broker quotes, which are provided by the manager to the administrator, instead of the administrator independently obtaining pricing from their own selected third party sources. Valuation fraud has also been caught where a manager convinced employees at a broker dealer to fictitiously report prices on certain bonds.

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


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LIQUIDITY RISK SHOULD NOT BE OVERLOOKED

In a period of liquidity concerns and hedge fund liquidations, carefully

assessing asset and liability liquidity risk is critical now more than ever.

Evaluating hedge funds in today’s market is a science that involves in depth investment,

qualitative, quantitative, and operational analysis. Liquidity risk falls across all four areas, and if not

assessed correctly can leave you with locked up capital, poor returns, and potential litigation.

The first thing to remember is that portfolio liquidity should match investor liquidity. A long short equity

fund should generally not have annual liquidity. A distressed debt fund should generally not have

monthly liquidity. These are simple examples, but the details of the portfolio liqudity should be studied

and carefully cross referenced to the fund terms and conditions. The second thing to remember is that

you want your level 2 and level 3 assets locked up, at least for a reasonable time period, as you do not

want your manager giving back investor capital, forcing them to sell and lock in losses. The third thing to

remember is that your hedge fund manager needs a diversified client base to survive long term, and if

there is a client concentration, there needs to be proof and assurance that that investor is locked up. A

redemption from a large investor (defined as 15% or more) can cause a liquidity crunch for the manager

resulting in stress and a possible shut down. I hear all of the time about institutional investors putting money

in funds that have a 50% investor concentration. Valuation and liquidity go hand in hand. Your portfolio

valuation sources should match your understanding of the liquidity of the investment strategy. If you have

an ABS fund that the manager claims to be pricing with 5 or more quotes, then something is not adding

up. Or if your credit fund has a 3 year lockup, and is priced using multiple pricing vendors, perhaps the

portfolio is too liquid for a long lock up. Last but not least, portfolio management, risk management, and

investment concentration have a real impact on liquidation potential. For a concentrated portfolio,

a longer lockup will better protect investors. Many funds have recently shut down, and some did so

because they cannot make money without taking large bets. Today’s institutional investors want a

repeatable investing process with a trusted risk management and portfolio management methodology.

HEDGE FUND INVESTING: ASSET LIABILITY RISK MANAGEMENT



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Assessing Counterparty Risk in Hedge Funds

Counterparty risk is a subset of operational risk that is focused on the structural components of the NAV. Understanding credit, OTC trading, and treasury is critical to opining on a hedge fund’s counterparty risk. PRISM has 20 years of experience evaluating these factors in capital markets.

• Segregation of duties between treasury and trading

• Accuratelyassessingthecapabilitiesofstaffandmanagement

• IT capability to vet counterparty exposures and margin calls

• Diversificationofassetsacrossprimebrokers,custodians,andcounterparties

• Qualificationstoperformcreditanalysisoncustodiansandcounterparties

• Segregation of assets from counterparty assets, where practical

• Financing terms that put the fund in a strong position with the counterparty

• Collateral management capability

• Bilateral collateral calls

• Daily collateral calls

• ISDAterms(NAVtriggers,keymantriggers,floors)

• Evaluating the relationship factor



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THE RISKS OF INVESTING IN BOTH PUBLIC AND PRIVATE SECURITIES OF THE SAME NAME

The bottom line is regulatory risk. Why take on added regulatory exposure if you don’t need to?

Hybrid funds and hedge fund managers launching private equity or debt funds have been trending for

the past 10 years. The expertise available in a single sector, such as life sciences or distressed debt, can

be exponential when combining both public and private analyst teams. However, there is a higher risk

of trading on inside information, when a manager is in the routine business of signing NDAs and being

brought over the wall with material non public information. The most important operational control to

look for is infrastructure coupled with a strong regulatory and internal control framework. Larger firms

have the revenue stream to support this necessary infrastructure, as legal and regulatory staff are

expensive. Smaller funds may not be able to do the same job. Either way, the details must be analyzed.

• Physical and/or server walls (aka Chinese Walls) often separate a private investment team from a public investment team. In these cases, the firm allows each team to have their own restricted list, and as such may invest in the same names on both the private and public side. The internal control here is that the other side is not privy to the material non-public information. The risk is that this is sometimes not always controllable.

• Where there are no walls, there is a firm-wide restricted list, and either the firm’s accounts may not go both public and private in the same name, or their public trades will be

restricted during the non disclosure period. This is a more conservative approach.

Both options are acceptable by the regulators, but the latter provides lower regulatory risk, especially

if trading in the same name is not permitted. There is always a possibility of a rogue trader or a rogue

portfolio manager. Avoiding these situations is the hardest part, which is why unbiased and expert

operational due diligence should be performed to avoid decisions impacted from conflicts of interest.

HYBRID HEDGE FUNDS: INVESTING IN BOTH PUBLIC AND PRIVATE MARKETS


Choose a manager that employs a qualified in-house regulatory compliance team.

Have a preference to choose managers that prohibit investing in both the public and private securities of the same issuer.

If necessary, demand written policies around investing in both the private and public securities of the same company.



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The 3 Cs: Cost, Culture, and Compliance

The business of allocating capital to overseas hedge funds is expensive, and therefore is generally

set a side for larger hedge fund allocators. The added costs include overseas travel (which is almost

always a business class airline ticket in the world of finance), high caliber staff with international

experience who will be well received overseas, possible language translators, and local legal

and regulatory intelligence. Having said all of this, the $10,000-$15,000 operational due diligence

fee will often be less than the sum of the added costs, with travel being the most burdonsome.

PRISM cautions against investing in any hedge fund without conducting a full

operational due diligence site visit with management, which many small allocators

do in order to bypass the prohibitive travel costs. Investors should conduct thorough

operational due diligence on their allocators to ensure that this step is not being skipped.

Understanding the culture of those in other countries such as Asia, South America, or

the Middle East is key to building a trusting relationship with the manager and receiving

information that is necessary to build a proper due diligence file. Language barriers or

a lack of understanding of customs could hinder the overall integrity of the process.

Legal and regulatory risk is more complex when it comes to cross country borders. Each country has

different privacy laws, insider trading guidelines, money laundering considerations, and cyber security

and disaster recovery rules. This knowledge is critical to making an informed operational risk opinion.

PRISM has extensive international experience and an Approved List consisting of overseas managers,

enabling investors to save on ancillary expenses.




PRISMALTERNATIVES.COMPRISM INSIGHTSAVOIDING HEDGE FUND FRAUD

THE CHALLENGES OF ALLOCATING TO

INTERNATIONAL MANAGERS


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WHY OPERATIONS IS ONLY ONE PIECE TO THE PUZZLE

Trade authorization, brokerage, financing, systems, settlement, reconciliations, corporate actions, valuation,

wire transfers, and fund accounting. These are the primary underlying back and middle office operations

that support the process beginning with idea generation and ending with the recording of profit or loss. For

a fund to be approved, these operations must be sound, and must be governed by documented operational

policies and procedures; employed by qualified staff who operate with a proper segregation of duties from

the front office. Only operational risk practitioners have the insight into evaluating these evolving processes.

Operational risk analysis was born in 1995 after the blowup of London headquartered Barings

Bank due to unauthorized derivatives trades conducted in a satellite office in Singapore. These

unauthorized trades generated a $1.5 billion deficit in the bank’s balance sheet, which raised

awareness around the globe of the risk of de-centralized, undocumented, and untested operations.

All of these components are “must haves” and are critical to conducting operational due diligence. However, the

qualitative and structural components of operational due diligence are the add-ons which typically make the

difference between making a good and a bad hedge fund allocation. Hedge fund operational due diligence should

be conducted by experienced due diligence professionals who can utilize the fact based ODD assessment results and

form a sound and sophisticated recommendation. It is always the qualitative opinions that differentiate investors.






AVOIDING HEDGE FUND FRAUD

THE OPERATIONS FACTOR IN HEDGE FUND

OPERATIONAL DUE DILIGENCE


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Hedge fund operational due diligence is in transformation with great innovation, and not commoditization.

Today’s hedge fund operational due diligence is different from ODD 10 or even 5 years ago. The

parties are committed, cooperative, and now finally the market is looking for efficiency. There

is simply no need to duplicate hundreds of ODD reviews for the sake of claiming to “have the

better ODD information in-house”. The notable shift is that the ODD service providers today are

well informed and staffed with industry leaders with extensive experience and track records.

Innovation in ODD so far has meant leaning towards economies of scale, and utilizing platforms.

This trend is growing, and the concept of one single ODD audit by a reputable service provider

is becoming the new conversation, and potentially the industry solution as the regulators

and the institutional investors continue to direct the marketplace. Proprietary in-house

qualitative due diligence will continue to stay “as is” at the forefront of an allocator’s success.

Benefits of a Platform or a Single ODD Audit

• Significantlylowercostsforinvestors.

• Drasticallyloweringtimecommitmentsplacedonmanagers.

• Inevitablycreatinggenerallyacceptedhedgefundoperationalduediligencestandards.

• Slowlyshiftingthemarketplaceawayfromduplicity,excesscosts,andwastedresources.

• Surelyeliminatingconflictsofinterest,alwaysmaintaininganindependentODDopinion.






ODD COMMODITIZATION OR INNOVATION?


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Assessing leverage and liquidity risk requires a technical understanding of the mosaic of financing factors.

Leverage has proven itself to be a high operational and structural risk for companies,

governments, and people. We can use the widely studied examples of LTCM, Lehman Brothers,

or the US Government. While hedge funds have generally lowered their use of leverage and

financing since the 2008 crisis, many hedge fund strategies still utilize leverage as part of

their thesis, and some strategies continue to use high levels of leverage. Understanding the

sometimes complex mosaic of leverage sources, terms, changing regulations, and operations

is the key to avoiding performance and operational issues caused by using borrowed

money to invest. Each security has its own financing ability, and each financing source has

a maze of terms and conditions that will impact the fund under certain specific conditions.

Sources of Financing

• RegTmarginintheUS

• MargintradingoutsideoftheUS

• Futurestrading

• Repoandreverserepotrading

• ISDAorOTCtradinginderivatives

• Traditionallinesofcredit

• Embeddedleverage(ABS,directlending)





THE BALANCING ACT OF USING

LEVERAGE IN HEDGE FUNDS

Examples of Trigger Points

• Sourceofmargin

• Portfolioliquidity

• Grossexposure

• 10yearequivalent

• Lockupperiods

• OTCcontractclauses

• Financingcosts


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The hedge fund industry has peaked at $3 trillion, and is now trending in the opposite

direction. It is time to take a look at what was done well, and what isn’t working.

We are living in a crowded market, which is the typical scenario of what happens when a successful

trend peaks. The good news is that hedge funds, now falling under the alternative investment category of

“private funds”, are here to stay, and it is exciting to look at what the future will bring: efficiency and clarity.

Of the total hedge funds in existence today, 15% of the managers are institutional. Only about half of those managers

possess the qualities that made hedge funds the hot ticket in the 1990s and 2000s. Having said all of this, what is next?

We will likely see more closures in the next 24 months. Some of these closures will be failed funds, and some will be suffering

funds where the principals are ready to retire and enjoy their lives. New launches will be limited to those of a certain pedigree,

who have the credentials and relationships to launch and operate a private fund. This is a reversion back to the beginning.

Operational risk requirements will continue to expand, but will become standardized. In order for the industry to

operate efficiently, it will need to rely more and more experts, in order to drive down costs to a reasonable level.

Fee structures will move away from standardization, and like any other financial service, hedge fund fees will be determined based

on credentials, performance, and value added services. After all, 2 and 20 works, if and only if the hedge funds can provide superior

performance over their competitors over a period of time. 2 and 20 doesn’t work as a one size fits all fee structure. Lastly, hedge

funds will need to, and will want to partner with their GPs in order to get funding, business advice, and access to different markets.

In order to sort through the menu of hedge funds offered today, is critical to have a set of requirements when

selecting hedge funds. A good start is an unwavering attention to pedigree, track record, references, background

checks, regulatory record, institutional daily fund administrator, and a Big 4 or at least top 10 auditor. Once a fund is

vetted through these filters; qualitative, investment, and operational due diligence will detail the quality of the fund.





THE CONTRACTION IS HERE:

What does the hedge fund industry contraction mean?


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An honest guide to maximizing your hedge fund p&l.

1. Outsource operational due diligence on funds and service providers

2. Add technology (fund DD databases, ADV filings)

3. Routinely analyze regulatory history via automation

4. Use downloadable industry vendor performance and risk data

5. Hire experts with a track record of evaluating hedge funds

6. Find economies of scale with use of consultants (ODD, background checks)

7. Seek independent opinions on funds to eliminate costs of conflicts

8. Invest with hedge fund managers only (traders are for multi strategy

platforms)

9. Place real value on manager pedigree (education, resume, references)

10. Rely on SOC reports of fund administrators and prime brokers




PRISMALTERNATIVES.COM

ODD COST SYNERGIES

Finding synergies and cutting the costs of investing in hedge funds.

Outsourcing operational due diligence can cut an institutional investor’s costs in half compared to hiring in-house, by leveraging strong expertise, a tested process, and economies of scale.


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• Portfoliomanagersandtradersshouldnotconfirmtrades,settletrades,reconciletrades,

recordtrades,orvaluetrades.

• Portfoliomanagersandtradersshouldnothavewriteaccesstothefundaccountingsystem.

• PortfoliomanagersandtradersshouldnotactascomplianceofficerorsigntheADV.

• Portfoliomanagersandtradersshouldnotberesponsibleforvaluingorobtainingvaluesfor

securitiesorinvestmentsforreportingpurposes.

• COOs,CFOs,CCOs,andcontrollersshouldnotbeapprovedtoexecutetrades.

• COOs,CFOs,CCOs,andcontrollersshouldnotbeinvolvedintheanalysisoftrades.

• CCOsoranoutsourcedregulatoryfirmshouldpoliceregulatorycompliancepolicies.

• Dualsignaturesshouldberequiredonallfundwires,andsignatoriesshouldbefromseparate

departmentstoreducetheriskofcollusionandtheft.

• Athirdpartyadministratorshouldproducefinancialstatements,clientstatements,

transparencyreporting,andperformtransferagencyservicesi.e.anti-moneylaundering.





HEDGE FUND SEGREGATION OF DUTIES

Following the rules for segregating operational duties between trading and accounting for p&l. Unnecessaryoperationalriskiscausedbypoorinternalcontrolsincludingthelackofsegregationofduties.

The collapse of Barings Bank due to the lack of segregation of dutiescreatedoperationalriskanalysisin1995.


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The risk of insider trading is becoming increasingly higher, as the industry sees real life cases of well known hedge fund organizations in the news charged with insider trading crimes. Investor fear is rising, as some of these firms allegedly involved with trading on material non-public information are not small hedge funds with limited regulatory oversight. In fact, the funds may even be using the highest regarded service providers. If this is the case, how do we avoid these situations?

Like all operational risk areas, one must always adhere to a set of unwavering criterion. Sound diligence must be performed in a routine process oriented manner, bound by set policies. If then, your hedge fund is still indicted for insider trading, then likely it had happened under a different historical operational framework, or it illicitly happened without knowledge of management. This is where your background checks and your network may help.

Best practices for reducing insider trading risk include being registered with the appropriate regulatory bodies, having a qualified CCO in place with supporting staff, having a current compliance manual that is vetted annually by regulatory experts or legal counsel, and employing staff with clean regulatory backgrounds that demonstrate a mindset of compliance. Further, best practices today include prohibiting employee personal trading in single name securities, employing outside regulatory consultants, and avoiding investing in both public securities and unregistered securities of the same issuer.

The use of expert networks is a real risk for the market, and today has been limited to larger consultants, given their ability to vet their consultants and put some controls in place over releasing material non public information. Consultants should be contracted through known consulting firms and should not be individuals, and the number of meetings with any one consultant is typically limited to a few times per year. Sector funds present inherent operational exposure because these industry experts have organically developed more relationships than generalist managers.





INSIDER TRADING AT HEDGE FUNDS

Conducting the operational due diligence review with certainty, and driling down on the use of consultants and investing in both private and public securities of the same issuer.


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An important factor in investing in private funds is having a sound and reliable diligence process. Whether you are a direct investor or invest through funds of funds, here are key considerations.





ASSESSING THE DILIGENCE PROCESS IN PRIVATE FUNDS

How long is your private fund diligence process? How many hours are logged in, over what time period?

Who is conducting the diligence process, what are their qualifications, levels of experience, and track record? What are their conflicts of interest?

What does the diligence process entail? Is it a standardized step by step audit that was tested over time? Is it tailored to each fund review? Who makes subjective decisions or are there strict criterion?

How is the diligence documented? Is it in an institutional report or a memorandum? Do the write-ups demonstrate a clear understanding of the fund and its operations? Do the write-ups outline current and potential operational and structural risks?

How frequently is the diligence completed on an ongoing basis, and what scope is applied on the ongoing review?


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DAILY HEDGE FUND ADMINISTRATOR RECONCILIATIONS

BALANCING OUT ANY ERRORS

Daily reconciliation oversight from a hedge fund administrator has become the industry standard,

and is no longer just a “best practice”. In fact, less than daily oversight from an administrator

will expose your investment to unnecessary additional operational risks. In today’s hedge

fund market, it is critical to embrace the concept of daily oversight. While a large majority of

hedge funds do use a third party administrator that is contracted to perform daily cash, trade,

and position reconciliations; approximately 15-20% of the funds do not have this oversight.

However, the only reason not to have the administrator perform daily reconciliations is cost.

Today, most large administrators only offer a daily standard fund administration service.

However, many of the mid to small sized fund administrators offer a la carte or bespoke

services that are tailored to each client, a process which is typically driven by fees. In

addition, some of the largest players do have legacy contracts with older clients that limit their

oversight to month end reconciliations. And lastly, one-off relationships are being signed with

certain larger administrators for monthly reconciliations, and not the daily standard model.

PRISM spends extensive time evaluating fund administrators, their infrastructure,

business model, client base, and expertise. This in and of itself is a critical piece

to evaluating operational risk in a hedge fund. PRISM conducts research on the

market place, and on each company providing unique insight into their capabilities.


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PRIVATE FUND EXPENSES

CONTEMPLATING SUITABILITY AND CASH MOVEMENTS TO VENDORS

Private fund expenses typically include audit, legal, administration, printing, regulatory, deal fees, and brokerage

and financing. Other somewhat commonly seen expenses include E&O/D&O insurance, software licenses, research

travel, marketing costs, and market data fees. Operating costs exclude brokerage, deal fees, and financing; which

are investment related. Today, the average operating expense ratio of a hedge fund is 35 BPS, and will vary depending

on the size of the fund’s AUM. The two operational risk issues today are 1) What are investors actually paying in

expenses, and how much of these costs should actually be covered under the management fee, and 2) How are

these invoices are being paid. The first issue is food for thought, and the latter issue will be addressed in this brief.

Ideally, fund expenses should be paid by the independent administrator through the fund’s bank account controlled by the administrator. The administrator should have an annual budget for the fund, they should independently obtain vendor invoices, ensure that the fund is authorized to cover the cost per the OM, obtain authorization from the manager, and then send the wire to the vendor. However, while this best practice is almost always followed outside of the United States, inside of the US, most fund expenses are actually paid by the manager out of the prime brokerage account. Do you pay your phone bill from your brokerage account?

This US custom is driven by local practices that have been adopted due to the US Custody Rule, allowing managers to have custody and management of assets, including cash. The operational risk is that managers are controlling

investments and expenses.

The overall worry is that additional expenses could more easily be passed through the fund, as there is often less oversight and sometimes less scrutiny exercised by the administrator when they themselves are not moving the money to third parties. The second issue is that many managers actually pay fund expenses themselves, and then take a fund reimbursement. This method is typically used for the “extra” charges noted above, that could sometimes be viewed as manager overhead (e.g. software, market data, insurance). Managers choose this route of paying expenses, because it is operationally easier to send one wire to a vendor, rather than send multiple wires from multiple funds. The problem is that administrators are not always obtaining those invoices, tying out the numbers, and vetting their suitability. Moreover, this method creates a related party cash transaction between the manager and the fund.

PRISM looks closely at the appropriateness of fund expenses, and the operations surrounding expense

payments. It is important to consider that private fund operational customs differ around the world.


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PRIVATE EQUITY FUNDS

WHY YOU NEED OPERATIONAL DUE DILIGENCE, AND WHY NOT EVERYONE DOES IT

Historically, investors did not engage in traditional operational due diligence on

private equity funds. They performed investment due diligence, they conducted

back ground checks, but they bypassed ODD. Today, about 65% of institutional

investors conduct formal ODD on their private equity and real estate fund

investments, and the number is growing.

In the past, people did not conduct ODD on private equity funds because there is no “trading” at a

PE or RE fund, and the operations are therefore perceived not as complex as a hedge fund. After all,

many people still believe that ODD is looking at and focusing on middle and back office operations. In

reality, it covers these areas, but really it focuses on overall business and fraud risk. A PE /RE fund still

has a management team, staff, systems, fund accounting, valuation, cash movements, disaster recovery,

cyber security considerations, fraud risk, and the same business risks as a hedge fund. It also has higher

exposure to changing regulations, expense and fee allocations, and it faces the challenges of OTC

valuation and custody, which are actually more complex than a hedge fund; especially if the PE fund

has no independent fund administrator. More intensive work needs to be completed on a PE /RE fund,

as assets are not custodied at a traditional custodian, and investments are not valued using Bloomberg.

PRISM methodically conducts operational due diligence on hedge funds, private equity funds, and real

estate funds (aka private funds). PRISM has been in operation for 7 years, and its principal has over 20

years of capital markets operational due diligence experience, including exposure to over 2,000 private

funds and hundreds of financial services firms including banks, trading platforms, and fund administrators.


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HEDGE FUND REGULATORY CONSULTANTSWHY THEY ARE PLAYING A KEY ROLE IN THE SUCCESS OF LOWERING OPERATIONAL RISK

Today’s regulatory landscape is complex, and the exposures are high for

managers who are not in compliance with the law, or the institutional investor’s

operational due diligence requirements.

About 80% of US managers are now using regulatory compliance consultants, because they can provide

significant value to the operation and the growth of the business. It is not just the small managers who do

not have the budget for an internal experienced CCO, but it is also the largest managers who are finding

value in having help from experts. Consultants provide arm’s length oversight and assistance in many areas

including staff regulatory training, email surveillance, personal trading monitoring, regulatory filings (PF,

Blue Sky, 13F and G), general advice on areas such as conflicts of interest, and the update of compliance

policies and procedures. For smaller managers, consultants are generally more efficient and cost effective

than trying to tackle this activity with internal staff with the wrong backgrounds. For all managers, they

provide invaluable insight into what the market practices are, and how the regulators view certain activities.

ACADUFF & PHELPSASCENDANT CORDIUM


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FUND MANAGEMENT TEAMS

WHETHER YOU ARE HIRING INTERNAL EMPLOYEES OR AN EXTERNAL FUND MANAGER,

CREDENTIALS, EXPERIENCE, AND CULTURE ARE KEY IN DETERMINING SUCCESS.

Like one would do with evaluating a stock of a company, it is critical to evaluate

both management teams and staff when conducting due diligence on a hedge

fund or private equity manager.

After identifying investment strategy and performance, clearly understanding the hedge

fund or private equity fund manager’s management team is the first step in due diligence.

Evaluating and looking deeply into the backgrounds and credentials of their staff, as

well as their hiring practices will help an investor understand and predict the power and

potential success that fund will have in the market place. Management teams that do

not have prior executive experience, or prior experience in their current role (e.g. a CFO

that is not a CPA/CA and/or has no prior back office experience in investment funds)

could create growth challenges or worse, heightened operational risk for that manager.

PRISM is a highly specialized consultant that methodically conducts operational due diligence

on hedge funds, private equity funds, and real estate funds (aka “private funds”). PRISM

has been in operation for 7 years, and its principal has over 20 years of capital markets

operational due diligence experience, including exposure to over 2,000 private funds and

hundreds of financial services firms including banks, trading platforms, and fund administrators.


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WHAT IS YOUR BUDGET?

ANALYZING A FUND’S EXPENSE BUDGET, DOLLAR FOR DOLLAR.

The private funds industry is used to looking at expense ratios, but in many ways

the ratio is irrelevant when we look at fund size. PRISM looks at a fund’s annual

expense budget, and analyzes the finances of each fund.

Does your hedge fund CFO run the fund’s finances like it runs the investment manager’s

finances? Performing financial due diligence on a hedge fund, a private equity fund,

or a real estate fund will tell you a lot about the manager’s operational approach.

Evaluating each expense line by line will not only reveal if your manager is passing

through costs that are typically covered by the management fee, but it will also reveal

whether they are over-paying or under-paying for professional and other services.

Over-paying could indicate a poor attention to negotiation or a lack of awareness of

market rates, while under-paying could reveal limited oversight from those service

providers. Looking at expenses in absolute dollars, is important because the only

AUM driven cost should be fund administration. Other operational costs including

audit, insurance, legal, regulatory, and directors should be unaffected by fund size.







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POLICIES AND PROCEDURES

HEDGE FUND MIDDLE AND BACK OFFICE DOCUMENTATION: DOES IT EXIST?

It wasn’t until the blowup of Barings Bank in the mid 1990s until most large financial

institutions woke up to the value of thoroughly developed written policies and

procedures. Private funds are now in the same place.

PRISM evaluates both the existence and the effectiveness of a private fund’s operations, and notes that today

most firms have limited or no written policies and procedures manuals. An operations manual would address

not only policy, but step by step mechanical processes, systems and server and file location of required

documents, and roles and responsibilities across trade execution, trade confirmation, settlement, recording

of trades, interest and dividend accruals and receipts, corporate actions, valuation, money movements

and financial statement preparation. Written middle and back office procedures have not yet been an

institutional investor requirement, but the market is slowly arriving at this point. The industry standard today

includes some writeups on operations in the DDQ, maybe a trade flow diagram, perhaps some checklists,

maybe an old manual that was produced internally at one point in time, and managers like to point to the

administrator and their SOC 1 report. However, an internal “Operations Manual” updated at least annually,

and when needed, designed by internal control experts is just not what is in place at most funds today.

Operational risk has been signficantly lowered in the last 5-10 years, and this is one of the market’s next steps.







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IMPERFECT INFORMATION

CLOSING THE GAP ON IMPERFECT INFORMATION.

By definition, research and due diligence have an imperfect information factor.

Why can certain players close the gap on imperfect information?

Research, due diligence, and audit are all based on similiar principles: education,

skill, experience, judgment and information flow. Some market participants are

equipped to provide better information than others. Today, while there is no

widely accepted “ODD certification”, the track record, education, and level of

experience successfully working with market leaders will determine who you select

to provide you with independent operational due diligence opinions. As you would

with a hedge fund, chose the provider that has the strongest Wall Street quality

biographies. Chose the most intelligent research, coupled with the firm that has

a proven ability to produce a commercial audit oriented due diligence program.

Evaluate who can seemlessly handle each investment manager with professionalism,

while they successfully evaluate the exposure to operational risk and fraud.


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FINANCIAL LOSS AND THEFT RESULTING FROM DECENTRALIZED OPERATIONS

MANY THE HEDGE FUND INDUSTRY’S LARGEST PROBLEMS HAVE OCCURRED

IN REMOTE OFFICES AROUND THE GLOBE THAT HAD A LACK OF CENTRALIZED

OPERATIONS AND SENIOR MANAGEMENT OVERSIGHT.

The case studies are endless proving that unsupervised personnel in remote locations can cause financial blowups.

Ranging from unauthorized trading at banks and hedge funds, to the

numerous recent SEC enforcements on hedge fund administrators

whose satellite international offices have sent wires based on fraudulent

expense invoices. When it comes to creating a sound asset management

business, nothing is more important than centralized operations with

internal controls overseen by senior management. Operational risk in

hedge funds and private equity funds have hundreds of nuances that

should be evaluated in detail by internal control and audit specialists.


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• OperationalRiskAssuranceReportsforInvestors

• OperationalRiskConsultingforFundManagers

• OutsourcedHeadofOperationalDueDiligence

PRISM brings more than 20 years of institutional experience in capital markets and alternative

investments operational risk analysis. With more than 7 years in operation, and a footprint in New York

and Los Angeles, PRISM’s services help top tier fiduciaries navigate their operational risks with underlying

money managers. PRISM provides a clear and independent picture of operational and structural

risk, and specializes in facilitating enhancements to firm operations, where deemed necessary.

BUSINESSMINDED | INDEPTH | ACCURATEANALYSIS





OPERATIONAL DUE DILIGENCE

HEDGEFUNDS,PRIVATEEQUITYFUNDS,

ANDREALESTATEFUNDS


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