A hedge fund and private equity fund operational due diligence publication.

Transcription

1 2018 A hedge fund and private equity fund operational due diligence publication. A hedge fund and private equity fund operational due diligence publication.

2 ABOUT PRISM LLC Founded in 2009 by industry veteran Lauri Martin Haas. 100% dedicated to operational due diligence services on hedge funds and P/E funds. PRISM LLC is in its 10th year in operation. PRISM Insights is celebrating its 3rd year anniversary, publishing over 85 ODD white paper briefs since May of PRISM LLC brings experience conducting 2,400 extensive ODD reviews for institutional investors. Procedures oriented boutique ODD consultant. Specializes in providing institutional quality operational due diligence services. In depth, structured, and systematic due diligence process with 30 day turn-around times. Based in Los Angeles with a footprint in New York.

3 TABLE OF CONTENTS OPERATIONAL DUE DILIGENCE ( ODD ) OUTLOOK 2. EXPENSE ALLOCATIONS 3. BEST PRACTICES FOR LARGE MANAGERS 4. BEST PRACTICES FOR SMALL MANAGERS 5. HUMAN RESOURCES, ADMINISTRATION, CODE OF ETHICS 6. ODD PROCESS 7. FUND ACCOUNTING 8. STANDARDIZATION ODD PROCEDURES 9. TRADE SURVEILLANCE AUTOMATION 10. ODD FOR PE AND VC FUNDS 11. VALUATION DUE DILIGENCE TRENDS 12. MATERIAL NON PUBLIC INFORMATION 13. INTRA-YEAR ODD MONITORING PROCEDURES 14. THE IMPORTANCE OF VERIFYING FIRMWIDE AUM 15. EVALUATING LEGAL RISK AND INSURANCE 16. REVIEWING PUBLIC INFORMATION (MEDIA, SOCIAL MEDIA, OTHER PUBLIC WEBSITES) 17. QUANTITATIVE RISK MANAGEMENT AND ODD 18. COUNTERPARTY RISK MANAGEMENT AND ODD

4 2018 OUTLOOK OPERATIONAL DUE DILIGENCE ( ODD ) OUTLOOK 2018 starts off strong with a continuing focus on honing the science of operational due diligence. Institutional investors and fiduciaries continue to outsource ODD or build out their ODD teams, to develop a tighter approach to completing diligence on hedge fund and private equity fund managers. Surprisingly, even as recently as 2017, it seems that a sizeable number of asset managers and allocators were conducting their ODD in-house using accounting, compliance, or investment staff, without the use of ODD specialists, but as businesses grow with the help of tax breaks and a booming stock market, these gaps will continue to close in Moreover, this specialist field of diligence has proven its merit over the years. The question remains, however, when or will the US move to a fund pay model? FUND PAY MODEL VERSUS INVESTOR PAY MODEL WHY HASN T THIS HAPPENED YET? Around the world, ODD is paid for and mandated by the institutional investor, and not the fund, like the case is for GAAP audits. Why would this be, when this creates a significant cost burden for the manager and for the investors? Why should each pension, endowment, wealth management platform, or FOF have different levels of ODD information, expertise, and take on different levels of fraud risk and operational costs? The answer seems to be three fold: a) FOFs continue to market their ODD as one of their edges, b) converting from an investor pay model to a manager pay model would theoretically put many internal ODD analysts out of work, c) and lastly the managers do not want to put all of their eggs in one basket betting their business on the operational risk assessment generated by one firm. So, today managers sometimes host hundreds of ODD meetings a year, and investors do varying levels of ODD work, resulting in tens of millions of dollars in duplicative costs. Some spending 100 hours on ODD using non experts, and some spending 30 hours a year using ODD specialists. Simply put, it is not an efficient frontier. Australia is one of the first countries to make the move and treat each investor equally by recently putting out regulatory guidelines recommending that managers/funds obtain a periodic ODD opinion from a reputable ODD firm. The process is in motion, but not yet fully up and running. When or will the rest of the world follow? TRENDING OPERATIONAL AREAS Current operational areas being studied by practitioners and regulators are expense allocations, HR and corporate culture, cyber security, and interaction with management and consultants as it relates to exposure to MNPI (material non public information). Specifically on expense allocations: are expenses charged to the fund actually explicitly permitted on the OM, are they accurately allocated to the proper funds (e.g. how are SMAs handled), and does the administrator review these calculations? Specifically on HR and corporate culture: how is hiring and code of ethics training handled, are background checks done annually or at all, have there been any employee HR claims? On cyber security, has there actually been a professional diagnostic performed on the firm, and what types of formal ongoing monitoring and testing is performed? For MNPI, the use of consultants and expert networks continues to be monitored, and controls around these processes are critical to a successful ODD assessment. Access to company management and long term relationships with company management also increases awareness especially with sector focused funds.

5 EXPENSE ALLOCATIONS Hedge fund expense allocations is a topic that has received more attention, and maybe even pressure over the past couple of years due to the SEC s attention to the matter. PRISM too has placed higher attention to the dollars spent by each fund under review, in order to better understand the financials of the fund and the financial budget and approach of the investment manager. Many investors and managers alike still focus on expense ratios, which average around 35 BPS for a long shore equity fund or a bit higher for credit funds due to deal associated legal fees, but PRISM believes it is important to go a few steps deeper into the analysis. For example, what are the fees paid to each vendor, and can we gain comfort that the manager is negotiating market rates, or further is there any operational reason why a fund is paying much higher or much lower fees to a vendor than industry average. Another important area where PRISM seems to find omissions or violations is in the disclosure in the OM on what the fund can pay for. From time to time, PRISM finds that managers may be charging through insurance or software without explicitly disclosing these charges in the offering memorandum. Industry leaders say that investors and regulators could raise issue with the lack of disclosure, or if they find other flags in the infrastructure may find issue with the lack of explicit disclosure (e.g. research travel should state business class or private airfare, if economy airfare is not being used). Investors should also list out in their minds what the OM allows the fund to pay for, and look for unusual language that may, for example, signal the use of unregulated activity. Most managers are meticulous about their costs, but the responsibility of the investor and its diligence efforts is to clearly understand the financials and operations of the fund, and to do this, granular work needs to be done to meet today s regulatory and market expectations. Last, but not least, who is calculating the expense allocations, and who is checking the allocations? Many fund costs are spread across all of the managers clients, and as such the costs for software or market data need to be allocated pro rata across funds based on current AUM, like trade allocations. Further, when a manager has managed accounts where operational charges are not shared with SMA, does the manager cover those costs, or did they exclude the SMA from the expense allocation calculation?

6 BEST PRACTICES FOR LARGE MANAGERS The bar for hedge fund operational best practices changes often, but here are a few best practices seen globally for large >$10 billion private fund managers. The idea with best practices is to retain and build AUM through accessing institutional capital that has set a high bar for hedge fund operational risk. Staffing and Organization Commercial hiring practices with a focus on experience, education, and merit Institutional level staffing including a full management team across verticals Use of committees (i.e. management, compliance, risk, valuation, etc.) Initial and then annual ongoing staff background checks Transparent staff biographies ie names and dates of education and employment Ongoing firm culture, technical, and ethics training Operations Written operations manuals across middle and back office Industry leading systems in-house around risk, data, trade order management, investment compliance, fund accounting, general ledger, client management Use of automation in trade flow, operations, and accounting Daily cash, trade, and position reconciliations conducted in-house Daily cash, trade, and position reconciliations conducted by the fund administrator Use of vendors for level 2 assets (instead of manually collecting broker quotes) Use of third party valuation agents for level 3 assets (at least semi-annually) Full service daily oversight from a qualified fund administrator Accounting Qualified CFO and Controller in-house with investment management experience In-house portfolio accounting system and shareholder allocation records Monthly NAV issued by BD Monthly audits and K1s issued by March 31 Cash Treasury Existence of a separate segregated treasury team Dual signatures and authorizations required on all fund accounts Formalized processes around vendor approval Formalized multi level review process around expense allocations Fund expenses processed independently by the fund administrator Adequate portfolio risk systems to re-calculate collateral calls Regulatory Up to date registrations Current compliance manual updated at least annually Clean regulatory history (no violations for staff or firm) Qualified chief compliance officer on staff who is also independent of the front office Regulatory consultant on retainer continuously advising managers on regulatory matters Clean regulatory exams (reasonable or no findings in SEC exams) Limited or prohibited personal trading in individual securities Legal Clean legal history (no corporate or staff litigation) Existence of E&O and D&O insurance Experienced in-house and external legal counsel Corporate Governance Quarterly fund board meetings with a majority independent experienced directors Offering memorandums reviewed and updated at least annually Investor Relations Existence of qualified IR or marketing staff to be available to answer investor questions Up to date marketing material and DDQ/FAQs (updated at least quarterly) Licensed marketing personnel

7 BEST PRACTICES FOR SMALL MANAGERS The bar for private fund operational best practices changes often, but there are a few best practices seen globally for smaller <$250 million private fund managers. Small managers can and often attract institutional capital and meet institutional guidelines. Here is how: Capital: New managers need a baseline level of capital to start their business. Even if you do have initial launch capital for your fund, you need to sign an office lease, hire at least a few staff, buy furniture and computer equipment, produce marketing material with a graphic designer or marketing firm, and buy insurance. You also need working capital to buy time until you meet your break-even AUM. Capital can be brought in by the managing partner, or a seed investor. New or small managers should not under estimate the value of representing themselves as a business and a professional money manager. Outsourcing: The main key to strengthening a small fund manager s infrastructure is to outsource operational functions to strong service providers that can provide the fund with the same level of expertise as hiring senior, more expensive full time operational staff in-house. This practice is very acceptable to institutional investors, and provides them with access to smaller nimble alpha generating traders. Common operational areas for small managers to outsource include: regulatory compliance, CFO and back office, marketing, legal, and IT. In order to be successful at passing institutional ODD exams, outsourcing must be done with recognizable firms in the industry, and the persons doing the work should have relevant qualified backgrounds in the respective operational area. Outsourcing to a firm that does not service the private funds industry, will likely not provide the necessary level of comfort for an approval. Daily Fund Administration: Fund administrators are a major part of the fund infrastructure. Another way that small managers should lower their operational risk is to hire a fund administrator that provides daily oversight, has a full scope SOC 1 with no testing exceptions, and is seen servicing funds in the institutional market. Audit and Tax: Auditors and tax preparers are key gate keepers for funds, so it is critical to chose a provider for the funds that institutions trust, and that has a collection of other hedge fund or private equity fund clients servicing the assets your fund holds. The same holds true for your management company. Investors will be worried about your stability and your break-even AUM, and the integrity of your financials and also your tax returns. A reputable auditor servicing the private funds industry will provide institutional investors with comfort around the stability of your firm and its accounting practices. Higher Costs for Credit Managers: Managers and investors should remain aware that credit managers generally require more technology and staffing to support their over the counter trading complexity compared with long short equity hedge fund managers. Having said this, more capital is needed to add technology around portfolio management, risk, and collateral management.

8 BEST PRACTICES FOR HUMAN RESOURCES Long gone are the days when hedge funds hired their nephew, cousin, and college roommate to staff their new hedge fund. Today s hedge fund is the serious, often boutique in size, money manager who is focused on merit, experience, and transparency when it comes to building a team. They are focused on what their institutional clients are looking for in terms of human capital, human resource practices, and code of ethics. The goals today are credentials, longevity, and results. Hiring: Hiring has become a complex process over the years in all industries. Today, there are sophisicated sociologists and psychologists around the world who have mapped out various approaches to interviewing professional candidates for jobs in order to ensure that that person is qualified for the role and will fit in with the corporate culture. The same is true for the private funds industry. Current hiring practices in the industry include multiple interviews, producing case studies, generating writing samples, conducting background checks, and drug screening. Background checks are often now conducted annually, especially for key staff or persons handling client money. Organizational Structure: Does the hedge fund have an org chart, reporting lines, committees? Are the employees all full time staff compensated with a W2? Do people work remotely or part time? Is there any window dressing with senior people on the org chart who are not full time with the business? How do staff in smaller satellite offices integrate into the firm s culture and code of ethics? Is the team collaborative? Do they value input and ideas from less experienced staff, or is the firm truly key man dependent? HR Administration: Who handles the day to day HR function? Hiring, terminations, outsourcing, complaints, payroll, benefits? Does the firm outsource their payroll or do they handle this complex tax oriented process by themselves in-house? Do they provide formal training to their staff? What are the benefits of working at each firm that will make each particular hedge fund competitive in recruiting their human capital? Code of Ethics: A culture of compliance and ethics is critical to the success of any money management fiduciary organization, especially in today s times. Having said this, clear lines of communication between staff and the person(s) in charge of the business is important to avoid legal and regulatory problems. Investors should check for negative media and/or corporate litigation between the investment manager and its current and prior staff. On the culture side, one should ask: Has the firm added senior staff to bring in new insight and give assurance that the firm is evolving with best practices?

9 ODD UNDERWRITING BEST PRACTICES An investment fund operational due diligence review is simply defined as manager due diligence. The manager selection process and the portion of the work performed by a CIO or a manager research team is typically qualitative, quantitative, investment style oriented, and serves as the initial filter. The due diligence however on each fund and manager is typically handled by the group of specialists often referred to as the operational due diligence team, but in reality this team is the group conducting the formal diligence, or almost all of the scrubbing and checks and balances. The scope of an Operational Due Diligence ( ODD ) review has broadened dramatically in today s modern world. Underwriting Methodology: A due diligence review should be transparent and the team should be asking for permission to review the relevant documents, to meet and interview the relevant people, and to contact the relevant service providers. In today s world, there are no real behind the scenes secret investigations. Background checks are typically requested of the investment manager, and permission to conduct a background check is also typically done in writing. So, when the term underwriting is used, it can be translated into the type of financial underwriting one might see with an IPO, or more simply a complex mortgage application. Transparency: The comparison of a manager ODD review to a mortgage underwriting is used to set the stage for transparency. Information for a manager due diligence review is requested of the manager, then obtained, reviewed, vetted, and analyzed by the ODD provider. The documents are typically similar or maybe the same from one ODD provider to the next ODD provider, but the value added real difference comes down to the tailored data requests that one ODD provider might ask that another ODD provider might not; and then more importantly what the ODD provider s overall opinion is. It should also be noted that information includes any information provided directly by service providers (e.g. banks, fund administrators) and public information that may be freely presented on the internet (media, social media, regulatory websites, and manager websites). In the end, ODD encompasses a broad section of the overall due diligence process for investment funds, and not just middle and back office processes anymore.

10 FUND ACCOUNTING BEST PRACTICES Hedge fund and private equity fund accounting is a focal point of every operational due diligence review. The costs of accounting systems have gone down due to increased competition in the software space, and more and more private fund managers are now maintaining parallel portfolio accounting records and financial statements in-house. This is a great step to reducing operational risk, especially when coupled with an independent fund administrator that is SOC compliant and has institutional controls around fund accounting and producing shareholder allocations and client statements. Here is a quick list of best practices for fund accounting: Institutional fund administrator Fund administrator producing monthly statements timely (quarterly for most PE funds) Lack of historical NAV restatements Reputable audit firm Annual GAAP audits released timely without any historical qualifications In-house CPA/CFO/Controller In-house portfolio accounting system including the maintenance of fee and expense accruals In-house shareholder allocations, either maintained in spreadsheets, or better in shareholder allocation software Physical or automated checks and balances over each client statement prior to release each month Straight through trade processing Daily three way reconciliations Documented middle and back office policies and procedures

11 GENERALLY ACCEPTED ODD PROCEDURES Hedge fund ODD (Operational Due Diligence) has been around since around the year 2000, but at that time it was more of a concept, most allocators were not doing it, and there was only a small handful of people with any ODD experience. Today, almost 10 years post Madoff, most firms are having initial ODD performed on their hedge fund and private equity fund investments, but to wide varying degrees and at unsteady frequencies or at no frequencies at all. The investment funds industry has not codified an industry approved set of Generally Accepted ODD Procedures. The is primarily due to competition. While today there is a solid sharing of information on ODD practices through conferences, round tables, and white papers; there is no requirement for independent opinions, certifications, or a set of procedures or standards to follow and adhere by. ODD professionals have a specialized skillset that is typically obtained through several years of training as a hedge fund financial statement auditor or a hedge fund lawyer, combined with manager selection and due diligence experience. Independent ODD providers offer a specialized and relevant service that helps to secure the markets, and their independence, experience, and credentials create a critical piece of the fiduciary due diligence process.

12 TRADE SURVEILLANCE DEVELOPMENTS The evolution of policing market manipulation and abuse is speeding up with the wider use of trade surveillance systems. These systems are coded to monitor real time market events, as well as a hedge funds real time trades and/or past behavior and patterns in order to flag transactions that may signal illicit activity. The wider use of these applications is just the next step to the automation of regulatory compliance, and these apps are also built to help compliance teams manage data and manage cases that need further investigation. Some trade surveillance system providers include Smarts, NICE Actimize, Trillium, and ACA Decryptex. Combine this with an independent regulatory consultant and an experienced CCO with a law degree setting the tone at the top, and insider trading activity will continue to decrease. Additionally, these tools can help ensure trade suitability, help manage best execution, and discourage front running. Installing trade surveillance systems in both small and large hedge funds is a trending best practice. Hedge funds are needing to go further down the road of automating their trading compliance because eliminating or detecting market abuse and insider trading is still not a perfect science. Faster detection should lead to fewer incidents, and perhaps more importantly the sheer knowledge of knowing you are under automated trade surveillance, could stop a trader from taking action that turns him or herself into a bad actor.

13 ODD IN P/E, R/E, VC, AND PRIVATE DEBT Investors often ask, Why do I need to do Operational Due Diligence ( ODD ) on my private equity or drawdown vehicle if the investments are fair valued and I don t pay carried interest until there are distributions? Why should I have ongoing ODD performed on these investments if I cannot redeem even if I wanted to? The answers are clear: It is your fiduciary duty to diligence your investments before funding and know what your risks are in order to gather assurance around the manager s and fund s operational risk. Two, you do not want to learn about the manager s problems, or your exposure, in the Financial Times. Private equity, private debt, real estate, and venture capital managers have the same level and types of operational risk as hedge funds, except in many cases they are smaller managers with less infrastructure, and in all cases, you are paying management fees on valuations of illiquid private investments. Having said this, having professional ODD conducted on these managers is worth its time and resources, to give you and your investors peace of mind. These managers should be reviewed at the same frequency as hedge funds, with a full scope review done at least every months.

14 BEST PRACTICES IN PORTFOLIO VALUATION Over the last few years, applying independent valuations for hedge and P/E funds has become easier due to market data service provider advancements, liquidity of markets, and the growth and expertise of the auditors, administrators, and pricing providers. Nonetheless, valuation risk still remains one of the largest operational risks of a private investment fund. When conducting operational due diligence, one should think about valuation risk in several ways. Here are a few: First, in understanding the investment strategy and the liquidity of the portfolio, then in understanding the manager s depth of valuation expertise in-house and its segregation of duties, then in evaluating the work that the independent fund administrator and/or third party valuation agents provide to the fund. On a positive note, many more level 2 assets can now be priced at month end using vendors that have recently advanced their platforms. There still however remains many less liquid credit markets which require the manual application of broker quote(s) to estimate fair value, or where the prime broker may not be providing prices at all. For assets with no secondary market, the frequency of level 3 valuation opinions, the percentage coverage of the portfolio, and the valuation firm s independence are key to assessing the reliability of a valuation agent s assurance opinions. Hedge funds should seek assurance reports for each level 3 position at least semi-annually, although best practice is quarterly and some funds obtain these opinions monthly. Private equity or debt funds should seek assurance reports for each level 3 position at least annually, although best practice is semi-annually or quarterly. Financial statement auditors continue to conduct their GAAS audits, but one should research the audit firm s and the auditor s expertise in the asset class and dissect the financial statements to ensure that the notes to the financial statements reconcile to the manager s assertions.

15 MATERIAL NON PUBLIC INFORMATION Exposure to Material Non-Public Information How to reduce it. A hedge fund s exposure to material nonpublic information ( MNPI ) can come in many forms, and a hedge fund s investment strategy and corporate culture can affect the firm s exposure. First, firms can be asked to go private with an NDA to participate in a private offering within the capital structure. This is a normal point of exposure for funds in the practice of holding structured credit, private debt, and other restricted securities. These firms typically maintain a long restricted list and cannot trade in the names of which they purposely went private in. This is normal for these types of strategies, and their compliance department handles these restrictions, which are typically shared across the firm and coded into any trading systems. Then, there are other less intentional ways of becoming privy to MNPI. Hedge fund staff may hear information in and around industry conferences, organized dinners, professional events, and social gatherings. Often the unstructured time at these locales is where bad actors tend to test the waters (bad actors can be at a fund or at a portfolio company). Another area of focus on MNPI is equity long short sector funds. Sector specialists are paid to know everything about a particular sector, its market players, its C-Level executives, and its vendors and customers. This inherently increases the risk that they become privy to MNPI, if they are not careful. Hedge funds should coach their PMs, analysts, and other access staff to document all conversations with third parties that may relate to a company in their investment universe. Hedge fund staff should avoid isolated one on one portfolio conversations with third parties especially in a social setting where peoples guard may be down. A hedge fund s management should know their staff, review their s and messages, and conduct trade surveillance including back testing to ensure they are not trading on inside information. Automation in trade surveillance, meeting calendars, and personal trading is a good way to streamline these processes. In the end, anyone trading on inside information is a bad actor, and an analyst may be doing so to earn a higher bonus or a promotion at their firm. It may be difficult to grasp, but bad actors are typically both on the inside of a portfolio company and at a hedge fund, and they typically exchange cash or they barter other information in exchange for the tip.

16 OPERATIONAL DUE DILIGENCE MONITORING Procedures an investor should perform in between annual Operational Risk Assessments : Daily Review media articles citing your hedge funds Follow your hedge funds on Linkedin Monthly Review Investor Statements for accuracy and timeliness Review Transparency Reports honing in on changes in valuation and custody coverage Review Fact Sheets Review Performance including estimates to actuals Review changes in FORM ADV Quarterly Review manager letters honing in on operational changes Send routine quarterly DDQs to your managers asking about staff turnover, litigation, service provider changes Annual Review annual K1s Review audited financial statements in an in depth and systematic fashion Conduct annual background checks on litigation Conduct full scope onsite operational risk assessments

17 DUE DILIGENCE & FIRMWIDE AUM VERIFICATION There are numerous instances, even current open cases, of hedge fund and P/E fund managers mis-representing firmwide AUM. This underlines the need for AUM verification across accounts, administrators, and clients. The independent fund administrator plays a crucial and growing role in the gate keeping of a private fund. Thorough due diligence needs to be completed on each fund administrator to prove that they are in a position, based on their expertise and their service agreement with each fund, to confirm fund AUM. AUM verification needs to be completed on each fund, and that happens by conducting a variety of audit and due diligence procedures, coupled with financial analysis. But, how does one confirm firm-wide AUM, and why should one bother to go through this tedious effort? With the growing number of institutional clients opting for tailored product arrangements (e.g. SMA, sub-advisory, co-investment) over a pooled investment vehicle (Cayman or Delaware private fund), investors are left diligencing unverifiable or difficult to verify firm-wide AUM. This is the case especially with fixed income managers and private equity managers. Applying decades of hedge fund due diligence experience, PRISM can help navigate these issues and seamlessly complete these due diligence objectives.

18 EVALUATING LEGAL RISK & INSURANCE There are several ways of looking at legal risk when evaluating a private fund manager. Alongside evaluating legal claims and the manager s appetite for litigation, one should look at their regulatory history and confirm and understand their insurance coverage. The harder part of evaluating legal risk is to have in depth experience looking at management teams and organizational structures; and utilizing effective interviewing techniques to collect relevant information. Then, taking a decision on whether investing in a higher risk manager is worth the value. First, it is critical to conduct a thorough background check and highlight historical and/or pending legal claims against the manager and its principals personally. Only a professional background check provider has the resources to do this, given the legal complexities of each jurisdiction, nationally and internationally. Second, one should look at the manager s choice in legal counsel, the language used in the fund s offering documents and investment management agreement, and then look at the overall organizational set up of the firm. Overall, fair and commercial terms and conditions and the existence a reputable legal counsel with no litigation history should reduce the number of blinking warning lights in a due diligence review. Third, does the manager hold errors and omissions and directors and officers insurance, since when, what level is the coverage, and have there been any claims? E&O and D&O policies provide a layer of assurance that in the event of a claim, the manager and their staff will be able to financially defend themselves effectively. Having insurance should also help attract C-level talent who want to know that in the event of a claim, they will trigger the insurance policy and be able to pay their legal fees immediately, versus having to wait for the investment manager to front their legal indemnification costs. E&O policy premium costs run around $10,000 annually per $1 million in coverage, scaled downward for each million.

19 CONDUCTING DUE DILIGENCE ALSO MEANS REVIEWING PUBLIC INFORMATION ON A FUND MANAGER Due Diligence using Public Information and Social Media: Conducting fund manager due diligence means that one should conduct relevant, reasonable, and often extensive diligence procedures, which include not only reviewing private documentation that is requested of a fund manager, but also reviewing publicly available information on a fund manager by conducting easily accessible media and public website searches. This is an important part of the due diligence process that sometimes gets over looked by due diligence teams, because these teams are labeled operational due diligence and are often solely hired to focus on middle and back office operations or perform a one time static operational risk review, instead of also including ongoing web and media monitoring into their program. The label Operational due diligence is a long way of saying Due Diligence, to differentiate the attention away from investment strategy assessments and portfolio management credentials, and towards overall business risk. The Operational Due Diligence portion of manager analysis should include vetting the numbers, reviewing the business, assessing the middle and back office operations including information technology and regulatory compliance. It is important not to miss the information available on the world wide web through media, social media, and regulatory websites.

20 RISK MANAGEMENT AT A HEDGE FUND MANAGER HOW DOES QUANTITATIVE RISK MANAGEMENT FIT INTO OPERATIONAL DUE DILIGENCE ( ODD )? Investment or quantitative risk management at a private fund manager is almost always handled by the CIO and COO. These firms are not large enough or institutional in size to include a dedicated risk manager or risk management team like one would see at a large money manager. Having said this, one generally cannot rely on risk management being an independent function with clear or any segregation of duties, putting more and more reliance on CIO and COO judgment and accountability, and overall corporate culture. Operational due diligence should cover risk limits, risk systems, and risk policies. Operational due diligence does cover segregation of duties, skillset and experience of human capital, and corporate culture. Operational due diligence can cover verification of adherence to certain risk parameters at any one point in time (e.g. audit date or other specialized alternative procedures), but this is not always, and not often possible. Operational due diligence does not include quantitative analysis such as recalculating position level or fund level risk metrics. Quantitative analytics should be performed by investment due diligence personnel, and this is generally done by persons with a specialized quantitative skillset. Lastly, it is key to have operational due diligence personnel with financial risk management experience, to see clearly certain flags that are shown in the numbers and in the infrastructure.

21 COUNTERPARTY AND FINANCING RISK AT A HEDGE FUND HOW FORMAL IS YOUR HEDGE FUND MANAGER S COUNTERPARTY RISK MANAGEMENT PROCESS? At a hedge fund or any boutique asset manager, counterparty risk management is typically handled by the PM and the CFO, in that the PM selects the custodians and trading counterparties, and the CFO typically negotiates the terms and executes the counterparty agreements. When the relationships are up and running, the PM typically selects which counterparty to add risk to. For larger hedge fund managers, in the multi billion dollar range, there is often a more formal counterparty risk management process, whereby an analyst tracks credit spreads, stock prices, and company news in order to help management assess the ongoing credit risk of each counterparty. They may also have a dedicated trader who adds another layer of insight and decision making into selecting who the fund will add custody, repo, or ISDA counterparty risk to. At large credit and/or multi strategy hedge fund managers, one sometimes may find a dedicated treasurer in-house. This person is a typically a senior credit executive level professional with sell side treasurer experience, and this person leads the process of managing counterparty risk decisions supported by their often detailed credit risk assumptions of each counterparty. The importance of counterparty risk management is real, and even heightened when financing, ISDA trading, and leverage is used by the fund. Terms and conditions should be assessed and compared to market in order to make a reasonable assessment of the counterparty and liquidity risk profile. PRISM believes that counterparty risk management is an area of the operational framework that could use some improvement across the industry.