ORANGE COUNTY EMPLOYEES RETIREMENT SYSTEM MEMORANDUM. DATE: August 11, Members of the Audit Committee. Recommendation:

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1 ORANGE COUNTY EMPLOYEES RETIREMENT SYSTEM MEMORANDUM DATE: August 11, 2015 TO: FROM: SUBJECT: Members of the Audit Committee David James, Director of Internal Audit Audit of OCERS Due Diligence Process Recommendation: Receive and file the report Audit of OCERS Due Diligence Process. Background: OCERS Internal Audit Division has completed an independent audit of OCERS due diligence process over investment activities to determine compliance with the Due Diligence Policy Manual, the Investment Policy Statement, and the Procurement and Contracting Policy. In general, we found that OCERS Investments due diligence process adequately complies with the above policies in the areas of biannual meeting with investment managers, review of due diligence questionnaires, organizational review, assessment of investment performance, expectations for investments, fees, on-site visits, use of investment consultants and external legal counsel. Although the following are not considered non-compliant with existing policies, we have made recommendations to enhance the due diligence process by Investments such as having written procedures for conducting due diligence, enhancing operational due diligence processes, having consistent due diligence reporting and due diligence questionnaires for Request For Proposal managers, and obtaining consultants due diligence reporting. The details of our findings and recommendations are discussed further in the attached report. Prepared by: David James Director of Internal Audit Audit of OCERS Due Diligence Process Page 1 of 1

2 Audit of OCERS Due Diligence Process Report Date: August 6, 2015 Internal Audit Department Director of Internal Audit: David James, CPA, MBA Internal Auditor: Mark Adviento, CPA

3 OCERS Internal Audit Audit of OCERS Due Diligence Process August 6, 2015 Table of Contents Conclusion.1 Objective, Scope, and Methodology..1 Background...2 Findings, Recommendations, and Management Responses.. 9 Page ii

4 Conclusion OCERS Internal Audit Division has completed an independent audit of OCERS due diligence process over investment activities to determine compliance with the Due Diligence Policy Manual, the Investment Policy Statement, and the Procurement and Contracting Policy. In general, we found that OCERS Investments due diligence process adequately complies with the above policies in the areas of biannual meetings with investment managers, review of due diligence questionnaires, organizational review, assessment of investment performance, expectations for investments, fees, onsite visits, use of investment consultants and external legal counsel. Although the following are not considered non-compliant with existing policies, we have made recommendations to enhance the due diligence process by Investments such as having written procedures for conducting due diligence, enhancing operational due diligence processes, having consistent due diligence reporting and due diligence questionnaires for Request For Proposal managers, and obtaining consultants due diligence reporting. The details of our findings and recommendations are discussed further in the Findings, Recommendations, and Management Responses section of the report. Objective, Scope, and Methodology The objective of the audit was to assess the adequacy of the process for complying with OCERS policies related to due diligence. The scope of the audit included the due diligence process conducted by OCERS Investments staff and OCERS outside investment consultants between January 2013 and January 2015 for higher risk asset managers of hedge funds, direct lenders, and private equity. The audit did not include reviewing due diligence for traditional money managers such as equity index managers and fixed income managers, which are considered lower risk. Among the audit procedures performed were: Review OCERS policies for the due diligence process: the Due Diligence Policy Manual, the Investment Policy Statement, and the Procurement and Contracting Policy (see Appendix A). Interview OCERS Investments Division staff and outside investment consultants to obtain an understanding of the processes in place. Review due diligence questionnaires used by OCERS Investment Division for adequacy. Review Investment Committee meeting materials and Manager Monitoring Subcommittee meeting materials prepared by OCERS Investment Division and outside consultants for adequacy. Audit of OCERS Due Diligence Process Page 1 August 6, 2015

5 Review manager contract legal review memorandums prepared by OCERS outside legal counsel for adequacy. Observe on-site due diligence meetings with OCERS Investments staff and investment consultants to gain an understanding of areas covered in due diligence. We planned and performed this audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe the evidence obtained provides a reasonable basis for our findings and conclusions. We would like to thank management, staff, and consultants for their cooperation. Background Due diligence is the care a reasonable investor should perform before investing with an investment manager and the ongoing monitoring of the manger after investment. It is an investigation of an investment to confirm material facts about the investment and investment manager. It seeks to prevent unnecessary harm or financial losses to OCERS. Through the due diligence process, OCERS seeks confirmation that its understanding of its investment is accurate and that risks of that investment are understood. The due diligence process is key for ensuring that all managers hired by OCERS are legitimate fund managers and that material facts about the manager have been vetted on an introductory and on-going basis. There are two categories of due diligence: Investment due diligence quantitatively and/or qualitatively identifying and assessing managers that have the potential to produce appropriate risk-adjusted returns for the portfolio s investment allocation model. Operational due diligence addressing the risk of financial losses due to inadequate infrastructure or internal controls over items such as cash custody, trading activity, valuation policies, reconciliation and custody of investments, counterparty risk, the use of third-party administrators, technology infrastructure, disaster recovery, compliance structure, and the segregation of front, middle, and back office functions. There are three policies that apply to OCERS due diligence process: the Due Diligence Policy Manual, the Investment Policy Statement, and the Procurement and Contracting Policy (see Appendix A). The Due Diligence Policy Manual states that to discharge the fiduciary responsibilities of the Investment Committee, the Manager Monitoring Subcommittee (Subcommittee) meets with each investment manager at least once every two years. The investment managers are expected to complete a due diligence questionnaire. The Manager Audit of OCERS Due Diligence Process Page 2 August 6, 2015

6 Monitoring Subcommittee, as part of the review, receives an organizational update including assets under management, team structure, and any significant changes to the organization. The investment manager provides a review of its investment strategy, an update on the investments that OCERS is invested in, including performance attribution, outlook for investment returns and the market outlook on the specific asset class. The investment manager reviews the target return expectations and whether the returns are achievable in light of current market conditions. Additionally, each manager s fee structure is reviewed. The Chief Investment Officer (CIO) reviews staff s on-site due diligence schedule with the board during the annual budget approval process. Internal Audit found these guidelines are being followed. The OCERS Investment Policy Statement mostly covers the selection of managers. The policy states that the Investment Committee authorizes staff and consultants to initiate a search for a manager either to replace a manager or to fill a new mandate approved by the Investment Committee. The investment consultant and staff conduct the search in accordance with criteria established for the search. The search criteria include the scope of the mandate, the investment style, benchmark, and the minimum qualifications for candidates. The minimum qualifications includes a successful and generally consistent performance track record relative to benchmark, disciplined investment process, size of assets managed, experience of staff, and organizational stability. Staff may perform on-site due diligence of final candidates before the Investment Committee interview for selection. The investment staff works with the investment consultants and legal counsel to ensure that investment contracts include an industry-accepted standard of care to which the manager is held and a fiduciary relationship between the manager and the manager s client, which may be established by contract or by operation of law (e.g., by registration of the manager as an investment adviser with the U.S. Securities and Exchange Commission). Internal Audit found these guidelines are being followed. According to the Procurement and Contracting Policy, using the Request for Proposal (RFP) process includes technical and price competition between vendors and service providers. The proposal that best meets OCERS needs, with consideration for price, qualifications and other relevant and objective factors set forth in the RFP, is selected. Internal Audit found these guidelines are being followed. However, see Finding #4 for application of this policy to due diligence for RFP managers. Since late 2011, OCERS Investment Committee has approved shifts in the portfolio allocated to alternative investment and absolute return managers such as hedge funds, private equity, and direct lenders. Until recently, all managers added to OCERS portfolio were sourced from NEPC, Aksia, or RVK, who were all hired in In the past two years, OCERS Investments used the RFP process, rather than consultants, to Audit of OCERS Due Diligence Process Page 3 August 6, 2015

7 find and select three investment managers. Since 2011, OCERS has added 53 managers to the portfolio, which is valued at $12.6 billion as of March OCERS Investments Division Although managers recommended by the consultants go through the consultants due diligence process, OCERS Investments Division conducts its own due diligence process. Historically, OCERS Investment Division has focused more on investment due diligence than operational due diligence. However, in early 2015, OCERS CIO directed Investments staff to ask additional operational due diligence questions during on-site meetings to enhance due diligence questionnaires with operational inquiries. Internal Audit noted that OCERS Investment Division adequately performs standard industry due diligence practices, using consulting services, using due diligence questionnaires, reviewing manager materials (e.g., pitch book, Form ADV, partnership agreement, internal policies), and conducting on-site visits to perform investment due diligence on new and existing managers as described below. New Managers OCERS Investments Division sends due diligence questionnaires to potential new managers recommended by its investment consultants or for managers competing in a public RFP. Questionnaires vary by investment category and are built to gain an understanding of the manager s organization; key leaders; investment research process; past and potential investment performance; risk management process; and fee structure. Internal Audit noted an inconsistency in questionnaires Audit of OCERS Due Diligence Process Page 4 August 6, 2015

8 used for recent RFP requests (see Finding #4). Second, Investments staff reviews the investment manager s responses and various documents and exhibits from the manager. Documents include marketing materials, Form ADV (SEC required disclosures about the firm), offering materials, manager biographies, sample investor reports, valuation policies, and other background materials like organizational charts or ethics policy. Third, Investments Division staff conducts on-site visits with potential managers, often with its investment consultants. Also, in early 2015 the CIO increased the number of managers visited over an 18 month period covering all managers. Finally, Investments Division staff obtains external legal counsel s (Foley & Lardner, LLP) review and approval of the investment manager s contract agreement. After reviewing due diligence questionnaire responses, completing on-site visits, and obtaining external legal counsel review, an OCERS Investments staff officer writes a summary narrative of the investment manager s organization, investment philosophy, risk management process, and fee structure. Internal Audit found these narratives were not prepared for recent managers hired via an RFP (see Finding #3). Finally, this narrative, along with an analysis memo prepared by the CIO and a recommendation memo from the consultant, is presented to the Investment Committee when the investment manager appears before the Committee. In the past two years, OCERS has used the RFP process, not the external consultants, to hire three managers in two separate asset classes. With the RFP process, OCERS Investments Division relies on its own due diligence, since the manager may not be on the consultant s recommended list of managers subject to the consultants full due diligence process. Existing Managers For continuing due diligence of OCERS current investment managers, OCERS Due Diligence Policy Manual requires managers to appear before the Investment Manager Monitoring Subcommittee (subcommittee) once every two years. However, the investment manager can appear more frequently depending on significant changes with the manager. Investment managers are required to present the subcommittee with relevant organizational or personnel updates; current portfolio composition, strategy, and outlook; recent investment performance; and a review of its fee structure. OCERS outside investment consultants also provide the subcommittee with a written update of any recent and significant changes (i.e. personnel, investment philosophy, market outlook, performance, or client base) to the investment manager. Finally, the investment manager must provide OCERS Investment Division with an updated response to OCERS due diligence questionnaire. Audit of OCERS Due Diligence Process Page 5 August 6, 2015

9 Investment Consultants OCERS external investment consultants NEPC, Aksia, and RVK represented that they perform due diligence activities as described in detail below. Internal Audit did not audit that these activities are done, but this is provided for informational purposes only. NEPC NEPC is the general consultant used to monitor OCERS portfolio of 57 managers with a current market value of $10.8 billion (direct real estate and direct hedge fund managers are monitored by separate consultants as described below). NEPC recommends and monitors the majority of OCERS investment managers. NEPC s due diligence efforts primarily focus on investment due diligence rather than operational due diligence. Investment due diligence involves on-site meetings with the investment manager to review the manager s five P s : personnel, philosophy, process, performance, and price. In 2014, 77 investment managers were reviewed by NEPC s internal Due Diligence Committee with 22 failing to obtain approval for recommendation to clients. Of the approved managers, NEPC typically recommends only its highest conviction managers, or Focused Placement List (FPL) managers, to OCERS. For the managers it recommends to OCERS, NEPC creates an investment due diligence report, but it does not consistently provide a copy of this report to OCERS Investment Division for its review (see Finding #5). NEPC s two due diligence committees for traditional managers and alternative asset managers also meet biweekly to discuss changes in managers key investment personnel, changes in ownership structure, and changes in investment strategy that NEPC becomes aware of through client contacts, manager contacts, and investment related news services. In 2012, NEPC created a dedicated a team of three staff who conduct operational due diligence only on hedge funds. The operational due diligence team conducts deep dives of hedge fund managers by conducting documentation review, operational questionnaires, multiple on-site visits with the manager s various operational departments, and reference checks. Internal Audit noted that for several OCERS investments recommended by NEPC, operational due diligence is not performed by their dedicated team because the investments are not hedge funds. Another consultant should be used to perform more thorough operational due diligence for non-hedge fund managers recommended by NEPC (see Finding #2). Aksia Aksia is the consultant used to source and monitor OCERS portfolio of 15 hedge fund managers with a current market value of $800 million. Aksia focuses on hedge fund managers only, in contrast with the generalist approach of NEPC. Aksia s investment due diligence staff and its CEO must provide a passing investment due diligence rating for any hedge fund manager that is presented to its clients. Audit of OCERS Due Diligence Process Page 6 August 6, 2015

10 Furthermore, a separate team conducts operational due diligence. The head of Aksia s operational due diligence team has over-ride authority to prevent any manager from being presented to a client depending on the result of operational due diligence. Aksia s operational due diligence process attempts to identify the potential for fraud risk, business risk, and conflicts of interest within the manager firm. It is carried out by a team with backgrounds in audit, operations, legal, risk management, and fraud investigations. Aksia s operational due diligence includes questionnaires, documentation review, background checks, on-site due diligence, and third-party administrator due diligence. Aksia gives numerical rankings in the following operational areas: overall operations, business complexity, infrastructure, regulatory compliance, and independence of the net asset value calculation. A final operational due diligence report is written, updated annually, and made available online to OCERS Investment Division. Aksia also monitors investment managers for potential deterioration of funds for reasons such as key personnel changes, regulatory violations, investment style drift, or excessive use of leverage. Aksia updates its clients on the status of these managers. RVK RVK is the consultant used by OCERS to source and monitor a portfolio of 16 real estate fund managers with a current market value of $1.1 billion. Annually, RVK receives 200 to 300 solicitations from real estate managers to be recommended to its clients. RVK reviews these proposals, and 20 to 30 managers are selected for RVK s detailed due diligence process. The managers must provide written responses to RVK s due diligence questionnaire. The manager must also provide documentation illustrating their process for acquisitions, underwriting, financing, asset management, and asset disposition. Numerous other documents describing manager personnel and internal policies and audited financials are also reviewed by RVK. RVK typically eliminates 50% of these managers after reviewing the manager s questionnaire responses and other documents. RVK then performs additional on-site visits with the remaining managers to interview more junior and operational personnel, tour sample properties, review the track record of properties held by the manager, and corroborate or discuss any potential red flags noted by RVK. On an on-going basis, RVK reviews the manager s audited financials and capital call notices, and looks for key changes in the manager s personnel, performance, or market. Investments Legal Counsel Internal Audit also noted that OCERS external legal counsel reviews investment manager agreements and contracts prior to execution as described below. Audit of OCERS Due Diligence Process Page 7 August 6, 2015

11 Foley & Lardner In accordance with the Investment Policy Statement, OCERS hired Foley & Lardner (the firm) in 2010 to perform a legal review of potential investment managers contracts or agreements to ensure that OCERS interests are protected. The firm reviews all offering materials provided by the manager private placement memorandum, limited partnership agreements, or subscription agreements for any items that need to be brought to the attention of OCERS Investment Division. These are mostly clarifications of items such as fee structure or further information requests to the manager for items such as valuation policies. The firm also reviews the manager s responses to the firm s legal due diligence questionnaire and searches online legal databases for any evidence of past or current litigation. The firm summarizes its review by preparing for OCERS Investments Division a legal briefing memorandum. Major sections of the briefing memorandum discuss the investment fund s structure, management and performance fees, fund and manager expenses, investment objectives, and investment risk factors. The firm also prepares a side letter agreement with the manager to offer additional legal protections to OCERS. These protections include a most favored nation status which ensures no other investors get a more advantageous fee structure, the right to audit the fund s financial records, compliance with OCERS placement agent policy, establishing California as the jurisdiction for any possible lawsuits, key person event notifications, confidentiality clauses, confirmation of a fiduciary standard, and prohibition of soft dollar arrangements, among other protections. Internal Audit Memo on Documentation of Due Diligence In a memo presented to the Audit Committee on August 1, 2012, Internal Audit recommended that the CIO set up procedures, criteria, and templates to assist with documenting due diligence, the selection of investment consultants, fund managers, or specific investments (see Appendix B). During our current audit, Internal Audit noted that memos documenting the selection of investment consultants, fund managers, and specific investments are adequately prepared and presented to the Investment Committee. Internal Audit also noted that in January 2015, the CIO revised due diligence questionnaires to include operational and compliance areas, and the CIO also increased the number of on-site manager visits. However, we noted that there are no written procedures describing how to conduct due diligence (see Finding #1). Audit of OCERS Due Diligence Process Page 8 August 6, 2015

12 Findings, Recommendations and Management Responses Finding #1 Lack of Written Procedures for Due Diligence Although OCERS Investment Division has due diligence policies, it does not have written procedures that describe the specific steps necessary for staff to perform due diligence on an investment manager in order to comply with the policies. The OCERS Investments staff members have extensive experience performing due diligence. In order to facilitate smooth transitions and consistency during staff changes, there should be written procedures. Recommendation The CIO and his staff should create written procedures that specifically document the steps necessary to conduct adequate due diligence. Examples of such steps include: 1) Send out due diligence questionnaires (DDQ) appropriate for the investment manager s asset class, 2) review the manager s responses to the DDQ for reasonability, 3) conduct reference checks on the manager, 4) conduct on-site visits or teleconferences, 5) conduct queries regarding the manager s operational infrastructure, 6) review outside legal counsel s review of the manager, 7) review the investment consultant s due diligence reports, 8) review the investment manager s Form ADV, 9) review the manager s pitch book and marketing materials, 10) create a manager summary for the Investment Committee, 11) create a final summary evaluation of all due diligence materials reviewed and discussions held with the consultants and manager, and 12) conduct a peer review by other Investment staff or a supervisor. An important step in the recommended procedure should include a brief summary memo or checklist with a review signoff off by the CIO or Director of Investment Operations to evidence that the steps of due diligence were performed by staff and reviewed by management. OCERS Investments Division already uses a similar document with the CIO s review signoff in regards to the manager s investment agreements. Management Response We concur with the recommendation that written procedures are desirable, and staff is working on the development of a document that would fulfill this objective. Several of your suggestions are quite helpful and appropriate. The Director of Investment Operations has been tasked with development of this document, and will confer with Internal Audit regarding its contents to assure that the suggestions presented in this report are addressed responsibly and pragmatically. Audit of OCERS Due Diligence Process Page 9 August 6, 2015

13 Finding #2 Operational Due Diligence NEPC and Aksia conduct operational due diligence activities for hedge fund managers recommended to its clients. However, this is not performed for other non-traditional asset class managers such as private equity, direct lending, or diversified credit. These asset classes at OCERS currently comprise $1.5 billion allocated to 16 managers. Operational due diligence addresses the risk of financial losses due to inadequate infrastructure or internal controls over items such as cash custody, trading activity, valuation policies, reconciliation and custody of investments, counterparty risk, use of third-party administrators, technology infrastructure, disaster recovery, compliance structure, and proper segregation of front, middle, and back office functions. According to NEPC, it is not standard industry practice for generalist investment consultants to perform deep dive operational due diligence for non-hedge fund managers recommended to clients. Thus, there is risk that representations about operational controls made by money managers are not complete or accurate. Recommendation For non-traditional pension fund managers that have not undergone an operational due diligence review from the OCERS investment consultants, OCERS should consider the following on a case-by-case basis or at the CIO s discretion. A criteria or threshold (e.g., a dollar amount of an investment) should be set by the CIO to trigger when such a review will occur. OCERS should consider contracting with a public accounting firm experienced with performance of agreed upon procedures on-site with an investment manager to vet the manager s key operational controls, as is done by other public pension funds. Key operational controls include controls over cash movements, collateral margin, trading, investment holding valuation, risk management, investor reporting, computer systems, and disaster recovery. The agreed upon procedures should be tailored by OCERS Investments to address the particular operational risks associated with any given potential manager or asset class. Management Response Management agrees that a deeper dive could be appropriate for certain non-traditional managers, but only if a majority of the Board considers such measures to be necessary, cost-beneficial or justifiable on a risk-vs-cost basis. Cost-sharing strategies and outsourcing-versus-internal capacity should be explored and considered, along with a prioritization protocol. For the hedge funds overseen by our specialized consultant Aksia, their routine process generally seems adequate for our purposes. The most fruitful opportunity for improvement appears to be hedge funds and other alternatives managers that are Audit of OCERS Due Diligence Process Page 10 August 6, 2015

14 sourced or vetted by our general consultants at NEPC, where the general consultant admittedly does not perform the same level of diligence. In this regard, we believe the following considerations will be worthy of a family discussion that needs to include some serious cost-benefit dialogue at the Audit Committee, Investment Committee and full Board level -- most likely continuing into the 2016 budgeting process, and perhaps even carrying on into the 2016 investment consultant RFP reviews. a. Regulatory oversight of investment advisors including hedge funds has been tightened significantly since the notorious Bernie Madoff scandal. Although heightened regulatory oversight is hardly sufficient to eliminate fraud risks, we do believe that it is important to retain perspective on what constitutes a real versus imagined or historical risk ( fighting the last war ). b. Not all alternatives managers are likely to pose the same risks. We believe that investment managers and fund managers that are organized as public-traded companies with directors accountable to public shareholders and whistleblower laws are far less prone to the kinds of abuses that a privately held manager such as Bernie Madoff s firm practiced. For example, the levels of oversight and control at BlackRock s private equity and alternative asset teams are many times deeper and more robust than OCERS and its consultants will ever achieve on our own. NYSE-listed BlackRock, with a $55 billion market capitalization, arguably poses inherently less operational and default risk to OCERS than a small hedge fund owned by one principal with a tiny staff, or a small partnership operating in a market niche. Recovery from a publicly held firm is also likely to be far greater in most cases (with Lehman and Bear Stearns the obvious exceptions to that premise, for any advisors that are subsidiaries or affiliates of major brokerdealers or leveraged financial institutions). It may also be helpful and cost-effective to differentiate between funds and managers that employ (i) well-established, top-tier independent third party administrators/custodians that assure the reliability of data and veracity of assets, and (ii) no-name or affiliated administrators that may have a family or personal connection or loyalty to the money manager. The latter would be the firms that the Investments Team would probably identify as top candidates for extraordinary or heightened operational due diligence. To this end, the Director of Investment Operations has been tasked to develop a comprehensive schedule of the third-party administrators for all alternatives fund managers, in order that we can identify any that are not administered by prominent national or international third party administrators known to possess industrial strength in their back offices. One approach could be to require independent third party reviews of those funds whose administrators and auditors are not on an approved list vetted Audit of OCERS Due Diligence Process Page 11 August 6, 2015

15 with both the Audit Committee and the Investment Committee. Just who would pay for that outlier review is the subject of paragraph (e) below. c. The August 26 meeting of the Investment Committee will include an educational presentation by the forensic accounting experts at Kreisher Miller. Hopefully that session will provide useful perspectives on the cost-benefit aspects and industry economics of independent professional operational due diligence practices and the experience of other comparable public pension plans. Trustees will also need to consider the free rider benefit that OCERS would be providing to other public pension plans that would benefit from the work we do, without contributing the cost, if OCERS adopts this approach unilaterally. d. NEPC s contract to provide general consulting services to OCERS expires in One option worth considering is the insertion of tighter language to require the next selected contractor, whether or not it is NEPC, to provide more comprehensive operational due diligence. e. The CIO will confer with our consultants, industry experts and other CIOs to determine whether it is practical to require an independent audit of internal controls and procedures at the manager s expense -- as a pre-condition of engagement by OCERS or even prior to becoming a finalist after the initial staff screening. This approach would shift the direct cost of the independent engagement to the investment manager, who would arguably gain some marketing benefit from having satisfactorily achieved a good housekeeping seal. However it is still likely that some of the cost of such a certification would ultimately return to OCERS indirectly through incremental management fees or reduced discounts. There could also be a concern as to whether such a review is truly independent, if paid by the manager (although such an arrangement would be analogous to independent municipal bond ratings paid from bond proceeds to firms selected by the issuer). f. We should recognize that some firms may decide that an OCERS requirement for such an intrusive internal review is too burdensome regardless of who pays, and thereby drop out of consideration. If we ever begin investing directly in private equity firms, this outcome would be highly likely with some of the most successful firms that already consider public pensions too invasive with respect to their proprietary information. g. Before engaging an external firm, a cost-benefit analysis should be conducted to determine whether this function would better be performed by an OCERS staff member -- most likely supervised by the Internal Auditor to assure independence and competency for skill sets that are not ordinarily associated with investment portfolio work performed by the Investments staff. (We are aware of only one remotely comparable case, the $30 billion South Carolina state plan -- over twice Audit of OCERS Due Diligence Process Page 12 August 6, 2015

16 our size -- in which a qualified operational diligence officer is to be hired and would report to the CIO.) If fewer than 4-5 such reviews are to be completed annually, however, it is doubtful that insourcing would be cost-effective unless capacity and cost is shared with another public plan; hence: h. Capacity-sharing arrangements should be explored -- by which OCERS would share the expenses of deep dive independent verification of managers internal processes with other investors, especially public pension funds. Thus far, we have not found any takers for this strategy, but the concept warrants further consideration if OCERS trustees are keen to amplify this function either internally or externally. Finding #3 - RFP Reporting OCERS Investment Division typically provides the Investment Committee with an investment due diligence narrative of a potential manager. However, such a narrative was not provided to the Investment Committee with the selection of Pantheon Ventures in the 2013 RFP for the Private Equity Fund of Funds program and for the selections of Tennenbaum Capital Partners and Brigade Capital Management in the 2015 RFP for energy markets dislocation opportunities. OCERS Investments staff reviews numerous, lengthy documents and due diligence questionnaire responses provided by the investment manager as part of its due diligence process. To summarize this research process, Investments staff provides the Investment Committee with a succinct narrative describing a manager s organization, investment team, investment philosophy, research methods, investment process, target strategy allocation, risk management process, and fee structure. Thus, the Investment Committee has approved recent RFP managers without the benefit of the Investment team s standard written narrative of the manager in the Investment Committee meeting materials. Recommendation For RFP-sourced managers, there should be consistent narrative due diligence reporting provided to the Investment Committee. Investments should consider using a checklist to make sure all documents are included for the Investment Committee to consider. Audit of OCERS Due Diligence Process Page 13 August 6, 2015

17 Management Response We agree that our written procedures and future practices should include routine reporting of internal due diligence when the RFP channel is deployed for manager selection. The Director of Investment Operations has already included this step in the working draft of written procedures we are formulating and refining. Finding #4 Inconsistent RFP Questionnaire Information According to OCERS Procurement and Contracting Policy, The proposal that best meets OCERS needs, with consideration for price, qualifications and other relevant and objective factors set forth in the RFP, will be selected. The 2013 RFP questionnaire for private equity fund of funds required a candidate manager to provide documentation about operational internal controls over cash, valuation policies, risk management, capital calls, management fees, and fraud. It also requires the candidate manager to disclose the audit findings from its external auditor and from regulatory audits. However, the 2015 RFP questionnaire for energy market dislocation opportunities did not contain similar requirements in regards to operational infrastructure. Adequate operational infrastructure is a qualification for an institutional money manager competing for OCERS funds. Recommendation Future RFP questionnaires should include interrogatories regarding a manager s operational infrastructure and negative findings disclosed from their annual external audit. Management Response We agree that future RFPs should include standard (first-stage or second stage) provisions and questions that are relatively uniform regarding due diligence, operations, and related legal, regulatory and compliance risks. The cited incident was an oversight that need not recur. Written procedures and a process to review those routinely will be helpful to assure consistency. Finding #5 NEPC s Investment Due Diligence Report According to OCERS Investments staff, NEPC does not consistently provide OCERS with copies of its investment due diligence report. NEPC s investment due diligence report details a manager s description; investment strategy and process; internal policies; litigation and compliance history; infrastructure; performance track record; and Audit of OCERS Due Diligence Process Page 14 August 6, 2015

18 biographies of key personnel. If OCERS Investments Division does not obtain and review NEPC s due diligence analysis, there is risk for not identifying potential issues with a manager. Recommendation As part of its due diligence process, OCERS Investments staff should obtain and review NEPC s Investment Due Diligence Research Report for all managers NEPC recommends to OCERS. Management Response We agree that consultant documentation or pertinent summaries of their due diligence should routinely and consistently be included in Committee materials when managers are presented, or subsequently as a validating consent agenda item if their work follows a provisional approval. Audit of OCERS Due Diligence Process Page 15 August 6, 2015

19 Appendix A: Due Diligence Policy Manual, Investment Policy Statement, and Procurement and Contracting Policy Audit of OCERS Due Diligence Process Page 16 August 6, 2015

20 ORANGE COUNTY EMPLOYEES RETIREMENT SYSTEM DUE DILIGENCE POLICY MANUAL

21 GENERAL POLICY STATEMENT To discharge the fiduciary responsibilities of the Investment Committee, the Manager Monitoring Subcommittee (Subcommittee) will meet with each investment manager at least once every 2 years. The investment managers are also expected to complete a due diligence questionnaire for staff in advance of the Subcommittee presentation. The Manager Monitoring Subcommittee will annually review the template for the due diligence questionnaire and report its findings to the Investment Committee EVALUATION AND EDUCATION The Manager Monitoring Subcommittee, as part of the review, will receive an organizational update including assets under management, team structure, and any significant changes to the organization. The investment manager will provide a review of its investment strategy, an update on the investments that OCERS is invested in, including performance attribution, outlook for investment returns and the market outlook on the specific asset class. The investment manager will review the target return expectations and whether the returns are achievable in light of current market conditions. Additionally, each manager s fee structure will be reviewed ASSET CATEGORIES The Subcommittee meetings may be grouped by asset categories, but this will not be mandatory. Grouping asset categories enables the Subcommittee, staff and consultants to readily compare and contrast investment approaches, systems, and controls utilized by an investment manager and its peers. Grouping will also allow for a better evaluation of the existing asset allocation and diversification ON-SITE DUE DILIGENCE In addition to the Manager Monitoring Subcommittee meetings, investment staff will conduct conference calls, meet with investment managers at OCERS offices and/or conduct on-site meetings on an as needed basis. The Chief Investment Officer will review staff s on-site due diligence schedule with the board during the annual budget approval process. Staff due diligence on new service providers will be conducted according to the provisions set forth in the OCERS Service Provider Selection Policy. The Investment Committee will not directly participate in any due diligence being conducted on any new service provider, investment manager, or others as specified in that policy and will only focus on manager oversight. Due Diligence Policy Manual Page 2 of 3 Adopted November 20, 2002 Last Amended September 24, 2014

22 POLICY REVIEW The Due Diligence Policy Manual shall be reviewed every three years and updated as necessary POLICY HISTORY Adopted by the Board of Retirement on Monday, November 20, It was amended on June 21, 2004, June 18, 2007, March 22, 2010, and further amended by the Investment Committee on September 24, Steve Delaney, Secretary of the Board 09/24/2014 Date Due Diligence Policy Manual Page 3 of 3 Adopted November 20, 2002 Last Amended September 24, 2014

23 ORANGE COUNTY EMPLOYEES RETIREMENT SYSTEM INVESTMENT POLICY STATEMENT The Orange County Employees Retirement System was established in 1945 under the County Employees Retirement Law of The retirement system exists to provide retirement, disability, and death benefits for qualified employees of Orange County and participating special districts. As provided by its charter, the Investment Committee governs the investment program. The Investment Committee has the sole authority over the investment portfolio and may delegate responsibilities to the investment staff and external advisors. I. Purpose of Investment Policy Statement The purpose of the Investment Policy Statement is to assist the Investment Committee in effectively supervising, monitoring, and evaluating the investment of the system s assets by: Stating the Investment Committee s views, expectations, objectives, and risk tolerance for the investment of all assets of the system. Formulating an investment structure for managing all assets. This structure includes (1) diversified asset allocation with acceptable ranges and (2) a combination of investment management styles, to produce a sufficient level of overall diversification, and (3) prudent diversification of individual securities positions. Setting procedures for policy implementation. Providing guidelines for each investment portfolio to control the overall risk. Establishing criteria to monitor and evaluate the performance of the fund and investment managers. II. Statement of Objectives 1. The overall objective is to invest the assets of the system solely for the benefit of plan participants and beneficiaries while attempting to minimize employer contributions and investment and administration costs. 2. The long-term performance objective for the portfolio is to exceed the actuarially assumed rate of return net of fees and expenses, with a secondary objective of exceeding the return on an appropriate designated balanced index mutual fund over a complete economic cycle and relevant longer periods, also net of fees and expenses. INVESTMENT POLICY STATEMENT Page 1 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

24 III. Investment Policy and Guidelines 1. Time Horizon The Investment Committee will periodically review the portfolio s alignment with the fund s pension liabilities. The investment policy and guidelines are based on a time horizon of greater than five years. The Investment Committee will consider both intermediate-term and longer-term investment return horizons in formulating expected returns and assessing portfolio risk parameters. The system s strategic asset allocation is based on this longer-term perspective. Fluctuations of investment results in the interim should be viewed with an appropriate perspective. 2. Risk Tolerance Investment opportunities in various asset classes have differing risk and return expectations. In general, investments with higher expected returns involve a higher level of risk. The Investment Committee recognizes that some level of risk must be assumed to achieve the system s long-term investment objectives. The Committee shall establish risk tolerance parameters for the overall portfolio and its major asset classes. The Committee will attempt to achieve its investment return objective with an appropriate level of risk using an efficient combination of investable assets. 3. Liquidity Needs Sufficient liquidity must be maintained to pay benefits and expenses. Investment income and contributions are expected to exceed projected benefit payments and expenses on an annual basis for the foreseeable future, making it possible to invest a reasonable portion of the portfolio in illiquid investments. The liquidity horizon shall be reviewed each time asset allocations and expected return projections are revised. 4. Performance Objectives The expected and actual investment returns of the total fund will depend on the asset allocation targets, the mix of investment styles within asset classes, and individual manager performance. Therefore, performance objectives have been set at three levels: total fund, asset class, and individual portfolios. a) Total Fund i. Meet or exceed the actuarial rate of interest which has taken into account expected composite portfolio returns. Annualized investment returns (net of fees) should exceed the actuarial interest rate over most five-year periods and over complete economic cycles. ii. Meet or exceed the policy benchmark. Annualized investment returns (net of fees) to exceed the policy benchmark over five-year periods. The policy benchmark is a composite of the benchmarks of the asset classes in the asset allocation policy. INVESTMENT POLICY STATEMENT Page 2 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

25 Composition of the policy benchmark is detailed in Appendix 1. Returns in excess of the policy benchmark should indicate that the investment program as a whole is successfully adding value. iii. Comparison with peer group of funds with comparable metrics. No specific objective is set in terms of ranking because asset allocation, which primarily determines total fund returns, often varies widely between funds. However, the Investment Committee will review rankings of the fund and its asset class components in a peer group for informational purposes. b) Asset Class Level Annualized returns (net of fees) for the asset classes should exceed their respective benchmarks over a five-year period. The asset class benchmarks will be broad market indices that are representative of the investment structure for that asset class. For example the Frank Russell 3000 index of U. S. stocks, is chosen as a benchmark for U.S. equities since it represents about 98% of the capitalization of the U.S. equity market, is composed of diversified investment styles, and is an investable index. Current benchmarks for the asset classes are shown in Appendix 1. c) Individual Portfolios Performance objectives for manager portfolios are stated in the respective investmentmanager-agreements. Returns (net of fees) are expected to exceed the respective benchmarks over three to five-year periods and rank above the median in a peer group. Manager benchmarks will be determined based upon the investment style of the portfolio for which the manager is hired. 5. Asset Allocation The Investment Committee has adopted a strategic asset allocation plan based upon the fund s projected actuarial liabilities and, liquidity needs, the Investment Committee s risk tolerances and the risk/return expectations for various asset classes. This asset allocation plan seeks to optimize long-term returns for the level of risk that the Investment Committee considers appropriate. The current strategic asset allocation targets and ranges are detailed in Appendix 2. Since projected liability and risk/return expectations will change over time, the Investment Committee will conduct a periodic review of the asset allocation plan to maintain an optimal allocation, and may also revise the asset allocation in response to significantly changing market conditions that have affected valuations and forward-looking expected returns of asset classes. 5.1 Investment Structure and Style a) Domestic Equity The Investment Committee may from time to time adopt a style-diversified structure that is designed to reflect aggregate domestic equity portfolio characteristics similar to those of the broad market. Where active management is used this structure will be reviewed periodically to ensure neutrality relative to risk characteristics including: no material INVESTMENT POLICY STATEMENT Page 3 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

26 differences in beta (market exposure) and characteristics such as growth/value, yield, price to earnings, capitalization of companies, etc. The Investment Committee will periodically review the use of passive management and adjust targets based on the then-current evidence of the benefits of active vs. passive management. b) Global Equity The global equity portfolio allows investment managers to add value and take advantage of global opportunities in equities without the constraints of country allocation or currency controls. For such portfolios, the retained investment managers will have the authority to invest in both US and non-us based equities, including emerging markets. Hedging of currency exposure to control risk will be permitted. c) International Equity The international equity portfolio shall be broadly diversified across countries outside of the U.S. identified as developed and emerging markets. The portfolio shall also be diversified across industry sectors. Hedging of currency exposure to control risk will be permitted. d) Emerging Market Equity Emerging equity markets are included and constrained in the asset allocation to provide appropriate diversification to international equity. The portfolio shall be broadly diversified across various emerging markets and frontier markets, as defined by MSCI emerging markets criteria. e) Domestic Fixed Income The domestic fixed income structure is designed to provide diversification across sectors (government, corporate, mortgage, asset backed etc.) maturity/duration segments, and quality. The structure uses a combination of passive and active management. In order to control risk, managers have specific guidelines on duration, quality, and single-issue exposure. Hedging may be permitted for unconstrained fixed income managers. f) Global Fixed Income Global fixed income is included in the asset allocation to provide diversification. This portfolio will be invested primarily in developed countries and be broadly diversified across such countries. Hedging of currency exposure to control risk is permitted. g) Emerging Market Debt Emerging market debt securities represent investments in both hard currency and local currency debt issues of emerging market countries or entities domiciled or traded in emerging market countries. These securities have been included in the asset allocation to INVESTMENT POLICY STATEMENT Page 4 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

27 provide higher yields combined with diversification benefits including currency diversification. Hedging of currency may be permitted. h) Diversified Credit Diversified Credit is a global allocation that includes a number of diverse fixed incomerelated strategies. It represents an allocation that is diversified by region, by credit quality, and by sources of risk. The general shared characteristics of these strategies are a degree of illiquidity, and a focus on current yield as a principal source of expected return. Hedging of market and individual security risks and diversified risk-controlled tactical trading may be permitted. i) Absolute Return (Hedge Funds/GTAA (Global Tactical Asset Allocation) The allocation to absolute return strategies (Hedge funds/gtaa) includes investments in equities, bonds, currencies, inflation-linked bonds and emerging markets. Absolute return (Hedge Funds/GTAA) is included in the asset allocation to provide risk diversification, as most of these strategies are expected to have lower correlation to public equities and fixed income. (Some forms of GTAA may be expected to correlate with public markets.) Derivatives may be used as substitutes for natural positions, for diversified tactical trading, and for hedging, provided that risk controls are reviewed periodically by the Chief Investment Officer (CIO), the investment staff and the consultant engaged in the manager s selection and monitoring. j) Real Return Real return strategies have been added to the asset allocation mix to provide an inflation hedge. The allocation is represented by Treasury Inflation Protection Securities, timber, commodities, energy, agriculture, and may include other strategies. Derivatives may be used as substitutes for natural positions but not for speculative leverage. k) Real Estate Real estate is included in the asset allocation to provide diversification from equities and fixed income and to provide income. Real estate investments consist of both private holdings and public securities. Private real estate investments are accessed through direct investments and commingled funds. It is the intention of the Investment Committee to transition fully to commingled funds. Private real estate is illiquid and valuation is based on annual appraisals. Public real estate securities, on the other hand, are publicly traded and marked to market daily. An allocation to public real estate securities can be made in domestic and global markets. Private real estate is allocated among different strategies. Investments in core real estate are made through a separate account structure or through commingled funds. The investment structure for the core separate account program will consist of allocation ranges for property types and geographic regions to provide broad program diversification. Non-core strategies are accessed through commingled fund structures only. INVESTMENT POLICY STATEMENT Page 5 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

28 l) Private Equity Private equity includes investments in venture capital, buyouts, secondaries and special situations including distressed debt. Private equity is included in the asset allocation to provide further diversification and enhance expected return. This asset class has significant risk but also opportunities for high return. These assets are illiquid and valuations are not marked to market on a daily basis. Valuations for private equity investments are based on estimates of fair value in accordance with industry standards. These investments are currently made in a fund of funds structure, with the investment staff directed to advise the Investment Committee if and when more-efficient configurations are feasible and prudent. m) Use of Derivatives A derivative is defined as a security whose price is dependent upon or derived from one or more underlying instruments or assets. The most common underlying instruments include stocks, bonds, commodities, currencies, interest rates and market indexes. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. Derivatives are to be used for substitution, overlay, portfolio completion, risk control, diversified appreciation within specified position limits, and arbitrage but are prohibited for speculation. For this purpose, speculation does not inherently include diversified price appreciation strategies using derivatives under approved mandates by a fiduciary portfolio manager. The derivative instruments permitted include futures contracts, options, currency forward contracts, swaps, structured notes, warrants and credit default swaps. IV. Investment Committee Implementation 1. The Investment Committee will establish procedures for the Chief Investment Officer, the investment staff and the investment consultants to implement Investment Committee decisions and ensure compliance with Investment Committee policies and guidelines. 2. Periodic Review of Asset Allocation Policy a) The Investment Committee will conduct periodic review of the asset allocation policy with the input of the Investment Consultant, Actuary, and staff. These reviews will be conducted at least every year, with a comprehensive analysis, report, and Committee review in conjunction with actuarial-assumption cycles, typically, every three years. b) The Chief Investment Officer will review with the Investment Committee the portfolio values and actual versus target asset allocation each month. 3. Rebalancing the Asset Allocation The Chief Investment Officer will monitor the asset allocation and rebalance to the approved ranges as and when necessary. Any such rebalancing will be reviewed with the Investment INVESTMENT POLICY STATEMENT Page 6 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

29 Committee in the subsequent monthly report. Whenever practicable, major shifts in funds will be discussed in advance with the Investment Committee. The Chief Investment Officer may also recommend and implement dynamic or tactical rebalancing strategies as appropriate under various market conditions, if appropriate and prudent. OCERS normal strategic policy for rebalancing is to periodically migrate assets under management toward targets set by the Investment Policy Statement. Within the ranges established by the Committee for asset class allocation, the CIO may reallocate capital on a tactical or discretionary basis to overweight or underweight a particular manager or strategy in light of market valuations, extraordinary risks or manager underperformance, provided that these variations are consistent with previously documented House Views and/or the CIO s latest Manager Surveillance report. The CIO will report adjustments at the next meeting of the Investment Committee. Material dynamic or tactical tilts and their rationale will be well communicated, and performed after discussion with the relevant consultant(s), the CEO and, if available, the Committee Chair and Vice Chair. Unless approved by the Committee, the allocation to any given investment manager shall not be decreased or increased by more than 50% in any 12-month period as a result of such discretionary rebalancing. The CIO will present a quarterly written report to the Committee of the discretionary overweights and underweights. 4. Cash Requirements The Chief Investment Officer will ensure that sufficient cash is available to provide funds for benefits, expenses, and fund capital calls. The cash overlay program will allow the total plan allocation to be closer to policy unless modified or suspended by the Committee or through special actions of the CIO as provided in section 10. Manager Watch List and Termination subsection f) i. (c) Extraordinary risk-reduction and liquidation protocols. 5. Manager Monitoring and Compliance The Chief Investment Officer will monitor investment manager portfolios monthly to ensure compliance with the investment guidelines. The compliance report will be reviewed with the Investment Committee on a quarterly basis. The Manager Monitoring Subcommittee will systematically review managers on a periodic basis. 6. Derivatives Monitoring and Compliance The Chief Investment Officer will monitor the use of derivatives in the manager portfolios to ensure compliance with the investment guidelines. The compliance report for separate account managers will be reviewed with the Investment Committee on a quarterly basis. The CIO shall report to the Committee annually on the staff and consultants surveillance of diversification and risk controls associated with these instruments. The Chief Investment Officer shall provide reports periodically (not less than quarterly) of approved currency hedge positions, and discuss their rationale and changes in strategy as appropriate. INVESTMENT POLICY STATEMENT Page 7 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

30 7. Investment Cost Control The Chief Investment Officer will review the investment costs with the Investment Committee annually and identify opportunities for cost control or mitigation where appropriate. The Investment Committee will ensure that the investment management costs are reasonable. The use of passive management where appropriate and optimal portfolio size to minimize sliding scale fees are some of the measures used to reduce fees, while the use of performance based fees allows for better alignment of interest. 8. Performance Review The Investment Committee will review investment performance on a quarterly basis. The performance report will be prepared and presented by the Investment Consultant or staff using performance data calculated independently by the custodian bank. The performance review will consist of: a) Total fund performance relative to long-term investment performance objectives, the policy benchmark and appropriate peer groups. b) Asset class returns relative to benchmarks. c) Individual manager performance and portfolio characteristics relative to benchmarks and peer group rankings. d) A quarterly attribution analysis of the sources of returns for the portfolio, and the asset classes, with attribution analysis for the individual managers to be provided at least semiannually (on a rotational basis to provide periodic focus on portfolio segments). e) Investment staff will review monthly performance report prepared by the custodian to ensure accuracy. 9. Manager Selection The Investment Committee, with the assistance of the appropriate investment consultant and investment staff will select investment managers to manage the assets of the system. The Investment Committee will authorize staff and consultant to initiate a search for a manager either to replace a manager or to fill a new mandate approved by the Investment Committee. The investment consultant and staff will conduct the search in accordance with criteria established for the search. Managers may be sourced through consultants, a CIO-prepared request for information (RFI), or an Investment Committee approved request for proposal (RFP). The search criteria will include the scope of the mandate, the investment style, benchmark, and the minimum qualifications for candidates. The minimum qualifications will include successful and generally consistent performance track record relative to benchmark, disciplined investment process, size of assets managed, experience of staff, and organizational stability. Staff may perform on-site due diligence at appropriate premises of final candidates before the Investment Committee interview for selection. The investment staff shall work with the investment consultants and legal counsel to ensure that investment INVESTMENT POLICY STATEMENT Page 8 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

31 contracts include an industry-accepted standard of care to which the manager is held and a fiduciary relationship between the manager and the manager s client, which may be established by contract or by operation of law (e.g., by registration of the manager as an investment adviser with the U.S. Securities and Exchange Commission). 10. Manager Watch List and Termination a) Watch List and Termination Procedures for Publicly traded Equities, Fixed Income and Commodities, Individually managed Real Estate and Timberland, Real Estate Securities and Open-End Real Estate Commingled Funds. Investment staff and the Investment Consultant will recommend placing an investment manager on watch status when (1) the manager has materially underperformed its benchmarks and peers, (2) confidence is lost in the management of a strategy; or (3) the characteristics of the portfolio no longer satisfy the desired or expected elements of the mandate. The following are a list of scenarios that would lead to a loss of confidence in a Manager: i. Performance Continued performance shortfalls versus a peer group of managers with a similar style and market index. Absent a compelling justification, a manager that does not remain in the upper half of the universe and lags the pre-specified benchmark over a rolling three years for three consecutive quarters will be placed on watch status. ii. Changes in strategy or style If the manager departs from the strategy and/or style it was originally hired to implement, such as a switch from a quantitative process to a fundamental one and/or the strategy deviates from the universe and benchmark dramatically in a manner that would not have been expected given the tracking error expectations of the particular strategy. iii. Change in organizational structure or personnel A significant change in culture through a merger, or acquisition or reorganization that is likely to distort incentives and promote turnover, or if there are significant departures from the investment team. iv. Compliance Any gross negligence, willful misconduct, investment policy violation or breach of federal and state securities laws. v. Other INVESTMENT POLICY STATEMENT Page 9 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

32 Any other reason the Investment Staff and Investment Consultant may deem necessary for a heightened review of the manager. b) Procedures Following the Initiation of Watch Status i. The watch period will be established for a one-year total watch duration. During this period, the manager may be removed or asked to resign if confidence or performance deteriorates materially. ii. iii. iv. Within one quarter from the time a manager is placed on watch, the Investment staff and/or Investment consultant will interview the manager to determine if performance is explainable, and will continue to watch performance over the remainder of the three-quarter watch period. If at the end of the watch period, performance has improved to above-benchmark and/or above the manager median over a market cycle, the manager will be removed from the watch list. If, at the end of the watch period, the manager is underperforming either of the objectives, (in effect, four consecutive rolling time periods of non-compliance) the Investment Staff, with the assistance of the Investment consultant, will prepare a written recommendation to either: 1.) continue the manager on watch status for a specific period of time or 2.) terminate the manager. v. An underperforming manager on watch list status shall be given the opportunity to resign with acceptable advance notice in order to avoid termination action. c) Institute a manager termination or replacement process, this may include one or more of the following measures: i. Temporary or permanent reduction of the allocation to the manager with the amount determined by the Investment Committee; ii. iii. iv. Commencement of a search for a replacement manager; Intensive surveillance by the staff and consultant; Such other strategies and measures as the Investment Committee shall approve; d) Watch List and Termination Procedures for Closed-End commingled funds (private equity, real estate, energy and diversified credit) i. Unlike open-end funds and separate accounts which are more easily liquidated, closed-end commingled funds may be exited through the secondary market, but often marketability and liquidity is constrained to relatively few buyers. For these reasons, the watch list and terminating procedures used for traditional vehicles are not INVESTMENT POLICY STATEMENT Page 10 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

33 applicable for closed-end funds so the Chief Investment Officer and the Investment Consultant will make appropriate recommendations for exiting such positions. e) Termination Procedures for Direct Hedge Funds, Global Asset Allocation Managers, Diversified Credit (Multi-Strategies), and other Investment Managers legally structured as hedge funds i. Staff and consultant will monitor the managers. With the concurrence of the investment consultant, managers may be terminated by action of the Chief Investment Officer for conflicts of interests, unethical behavior or violation of investment management agreement, poor performance, style drift, operational deficiencies or turnover in personnel. Terminations and redemptions will be reviewed with the Investment Committee in the subsequent monthly report. 11. Risk Reduction Policies and Strategies a) Cyclical liquidity reserve and portfolio risk management strategies i. At the Committee s formal request, or when both market metrics and business cycle indicators appear to warrant a defensive cyclical approach to portfolio management, the CIO may recommend to the Committee a strategy to implement a liquidity reserve on either (1) a dynamic and systematic basis or (2) a tactical, ad hoc basis. The purpose of such a designated cyclical reserve should be to prudently establish sufficient liquidity as necessary and appropriate during fully priced and cresting equity markets in what appear to be late-cycle periods, to assure that cash can be timely mobilized to capitalize on potential subsequent depressed market conditions or severe market corrections when the reserve could be gainfully deployed with a long-term investment focus. In making such a recommendation, the CIO shall also present alternative or corollary strategies regarding the cash overlay program including liquid absolute-return strategies. ii. When presenting late-cycle investment options and any specific recommendations for a liquidity reserve, the CIO shall also present to the Committee one or more alternative cyclical risk management strategies and discuss their rationale, viability and comparable advantages or disadvantages, including (a) tactical tilts of asset allocation commitments within the Policy s target bands (b) a macro portfolio overlay for specific asset classes or categories (c) use of a liquid alternative asset class such as absolute-return funds in lieu of a cash reserve and (d) any alternative strategies specifically recommended by our risk advisor or general consultant. Before approving any of these strategies, the Committee shall be informed how these various alternatives would have performed in relevant prior market cycles, how the most robust strategies would be expected to perform under various conceivable future scenarios, and the appropriate circumstances to modify, discontinue or conclude the recommended strategy. INVESTMENT POLICY STATEMENT Page 11 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

34 iii. Adoption of such a strategy remains the prerogative and responsibility of the Committee after also conferring with its independent advisors, with the CIO responsible for implementation. b) Extraordinary risk-reduction and liquidation protocols i. When developing market events or trends present a cogent reason to exit or modify a strategy to de-risk the portfolio, the CIO, in consultation with staff, the responsible consultant, and the CEO, is authorized take the following tactical actions: (a) Currency hedges The CIO is authorized to liquidate or reduce currency hedges when developing market events or trends present an imminent risk or reason to exit or modify a strategy. (b) Hedge funds The CIO may liquidate, redeem or reduce a hedge fund position between meetings of the Committee if timely action is deemed to be in OCERS' best interest. A full redemption shall require the concurring opinion of the responsible consultant. (c) Cash overlay The CIO may liquidate all or an at-risk component of the cash overlay if extraordinary market conditions would favor higher cash exposure to protect capital. ii. iii. Before taking such extraordinary tactical actions, the CIO is expected to confer with staff, relevant consultants, the CEO, the risk advisor and, to the extent they are reasonably accessible and such consultation can be completed on a timely basis without jeopardizing the portfolio, the Committee Chair and Vice Chair. Such actions by the CIO shall be reported as soon as reasonably practicable to the Committee Chair and Vice Chair (if prior consultation does not take place) and at the next scheduled meeting of the Investment Committee. The CIO and CEO may jointly request a special meeting of the Investment Committee if extreme market conditions or extraordinary circumstances arise that compel an inter-sessional decision, deliberation, or guidance by the Committee. POLICY REVIEW The Board will review this policy at least every three years to ensure that it remains relevant and appropriate. INVESTMENT POLICY STATEMENT Page 12 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

35 POLICY HISTORY The Board adopted this policy on May 11, It was revised on the following dates: February 22, 2000, November 21, 2005, November 19, 2007, February 17, 2009, November 23, 2009, September 26, 2012, October 24, 2012, April 1, 2013, August 28, 2013, June 25, 2014, October 29, 2014, February 25, 2015, and June 24, SECRETARY S CERTIFICATE I, the undersigned, the duly appointed Secretary of the Orange County Employees Retirement System, hereby certify the adoption of this Policy. Steve Delaney, Secretary of the Board Date INVESTMENT POLICY STATEMENT Page 13 of 24 Adopted May 11, 1992 Last Revised June 24, 2015

36 ORANGE COUNTY EMPLOYEES RETIREMENT SYSTEM PROCUREMENT AND CONTRACTING POLICY PURPOSE AND BACKGROUND 1. The Procurement and Contracting Policy is intended to establish guidelines by which OCERS will procure goods and services. OBJECTIVES 2. The objectives of this policy are to ensure that: a) Contractual arrangements and the purchase of goods are made in the best interests of the members and beneficiaries of the OCERS; b) The procurement of goods and services is efficient, diligent, transparent, economical and fair; c) A system of internal controls related to the procurement of goods and services is supported by a requirement to contract for or purchase goods and services being developed by the user Department, authorized by appropriate OCERS staff, and paid for by the Finance Department; d) All contracting activities are performed by qualified individuals specifically delegated the authority, responsibility and accountability for said activities using sound business practices in an ethical manner, taking into consideration applicable law and regulations; and e) Contracts for the provision of goods and services are procured from qualified sources that provide maximum value for each expenditure, taking into consideration the nature of the goods and services and, as appropriate, quality and reliability, competitive price and delivery schedule. POLICY GUIDELINES 3. The CEO or his designee will be responsible for authorizing the purchase of goods and the execution of contracts for OCERS and for keeping the Board of Retirement apprised of such actions, where they are material. 4. Only the CEO or his delegate may bind or commit the Agency for the purchase of goods or services based upon the provisions of this policy, except in emergencies and as may be otherwise authorized by the Board of Retirement. 5. OCERS staff and Members of the Board shall not be directly or indirectly involved in a governmental decision if the decision will have a material financial effect on an economic Procurement and Contracting Policy Page 1 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

37 interest of the staff person, Board Member, or the immediate family of a staff person or Board Member. Material financial effect and economic interest are defined in the California Code of Regulations, 2 Cal. Code Regs. Sections through The role of the Board of Retirement is to: a) Establish appropriate policies to ensure selection decisions are prudent and sound; b) To monitor compliance with such policies; and c) To approve, upon the recommendation of the CEO, the appointment of Named Service Providers, where such providers are retained primarily to fulfill an independent audit or advisory role for the Board of Retirement. Named Service Providers include: i. Consulting actuary; ii. Actuarial auditor; iii. General investment consultant; iv. Alternative investments consultant; v. Real estate investment consultant; vi. Fiduciary counsel; vii. Custodian; viii. Securities lending manager; and ix. Financial auditor. THE SEARCH PROCESS General Guidelines 7. The selection of all service providers and vendors will be made in the best interests of the members and beneficiaries of OCERS, in keeping with the fiduciary responsibilities of the Board of Retirement and staff. Procurement and Contracting Policy Page 2 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

38 8. The selection of service providers and vendors will reflect a level of rigor that is commensurate with the importance and materiality of the service or purchase of goods in question. Procurements will be performed with one of the following methods: a) Invitation for Bid (IFB): i. This method will be used when multiple bidders are available and willing to bid, and procurement needs can be stated in detail, with precision, or where services or products are standardized, ii. Competitive bidding will be used to procure these goods and services with the lowest responsive and responsible bidder being selected. b) Request for Proposal (RFP): i. This method will be used where the product or service to be acquired cannot be stated with specificity, such as consulting services. ii. The RFP process includes technical and price competition between vendors and service providers. The proposal that best meets OCERS needs, with consideration for price, qualifications and other relevant and objective factors set forth in the RFP, will be selected. c) Small Purchase Procedures: i. The procurement of goods and services requiring an expenditure of less than $50,000 can qualify for a simplified acquisition process that is informal. ii. The simplified process must include documentation that the procurement was fair, ethical and transparent. iii. A minimum of three oral or written price or rate quotes from qualified sources must be obtained. Documentation of all quotes received will be retained. d) Sole Source: i. In cases when the CEO believes that a competitive alternative to a particular service provider does not exist, the CEO will provide the Board of Retirement with a report describing the unique characteristics of the service provider and supporting the need for a sole source approach. 9. The CEO or his designee will consider as broad a universe of qualified service providers and vendors that is practical and reasonable given budgetary, staffing, time and other relevant constraints. Procurement and Contracting Policy Page 3 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

39 10. The Board of Retirement authorizes the CEO to take advantage of available tools, technology or other resources that will allow for efficient screening of the universe of potential service providers and/or vendors so as to arrive at a qualified pool of candidates that warrant detailed examination, provided such tools, technology, or resources are consistent with sound and prudent industry practice. Named Service Providers 11. For Named Service Providers, the CEO, or his or her designee, will conduct an RFP at the expiration of a six year term from the effective date of the contract, or more often as necessary. 12. Prior to conducting a search for a Named Service Provider, the CEO or his designee will present a written summary information to the Board, which shall include: a) The type of service provider being sought and the supporting rationale; b) The objectives and selection criteria to be met and their relative importance; c) An estimated timeline for completion of the search process; and d) A description of the search methodology that is deemed most appropriate and cost effective in the particular circumstances, and that addresses such issues as: i. Whether a consultant is to be used in the search process; ii. The due diligence efforts to be undertaken, including such efforts as site visits, and reference checks. A copy of any criteria and weights to be used will be attached for information purposes; iii. Whether a Request for Proposal (RFP), or a variation thereof, is to be used with supporting rationale, and if so; a copy of the proposed RFP will be attached for information purposes; iv. The screening or selection criteria expected to be employed; and v. Such other information that the CEO believes may assist the Board of Retirement in better understanding the search process. 13. The Board of Retirement, or a committee of the Board, will interview the candidate or candidates recommended for appointment as Named Service Providers. Procurement and Contracting Policy Page 4 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

40 14. The CEO will provide the Board of Retirement or a designated committee of the Board of Retirement with periodic reports on the status of all search processes involving Named Service Providers. 15. Upon completion of the analysis and due diligence involved in a search process for a Named Service Provider, the CEO will provide the Board of Retirement or a designated committee of the Board of Retirement with a report containing, at a minimum: a) A description of the due diligence activities undertaken; b) The recommended finalist or a list of finalist candidates and analysis concerning the candidates; c) Confirmation of compliance with the objectives, selection criteria and search methodology presented to the Board of Retirement prior to the commencement of the search, or an explanation of any deviations that occurred; d) A description of performance expectations and the proper time horizon for evaluation of results; e) A Bid (pricing) summary with annotations regarding differentiality features; and f) A description of the expected performance monitoring and reporting efforts to be carried out with respect to the service provider throughout the term of the contract, including the reporting to be provided to the Board of Retirement. CONTRACTS 16. The CEO or his designee will, with the assistance of legal counsel as appropriate, negotiate and execute all agreements, contracts, and purchase orders with service providers and vendors. 17. All contracts with Named Service Providers will include a provision that the contract is subject to renewal at least every three years, for a total term of no more than six years, at which time the CEO and pertinent committees of the Board will assess the continued appropriateness and cost-effectiveness of the Named Service Provider in question. At the expiration of a six year term, the CEO, or his or her designee, will conduct a RFP. 18. Annually, the CEO will provide the Board of Retirement a schedule of the contracts with Named Service Providers due for renewal in the coming year. Procurement and Contracting Policy Page 5 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

41 MONITORING AND REPORTING 19. The following Named Service Providers will be subject to regular monitoring and also undergo performance reviews by the full Board or a committee of the Board at least biennially: consulting actuary; investment-related consultants; fiduciary counsel; and the financial auditor. Criteria for review may include, without limitation, performance, staff satisfaction, competitiveness of fees, quality of reporting, and accuracy of assumptions and forecasts. 20. The CEO will report regularly and in a timely fashion to the Board of Retirement on all monitoring efforts involving Named Service Providers, identifying any material issues or actions taken. 21. All monitoring and reporting provisions contained in this policy serve as minimum requirements. If more stringent requirements are established within other policies of the OCERS, such other policies will control. 22. The CEO will report promptly to the Board any failures by Named Service Providers (other than investment managers which are covered under the Monitoring and Reporting Policy) to comply with the terms of their contract. AUTHORITY TO EXECUTE CONTRACTS FOR GOODS AND SERVICES 23. The authority to execute contracts for goods or services, change orders and amendments to such contracts and purchase requisitions on behalf of OCERS shall be as follows: a) Named Service Provider Contracts: i. Board approval required prior to execution. ii. Must have available funds in the current year approved budget, including any Board approved amendments to the budget, to fund the current year s expense/cost. iii. Valued at less than $100,000 can be executed by the Executive responsible for the budget in which the contract is to be paid from. iv. Valued at $100,000 or more must be executed by the CEO. Procurement and Contracting Policy Page 6 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

42 b) Contracts and Agreements: i. Must have available funds in the current year s approved budget, including any Board approved amendments to the budget, to fund the current year s expense/cost. ii. Valued at less than $100,000 can be executed by the Executive responsible for the budget in which the contract/agreement is to be paid from. iii. Valued at $100,000 or more must be executed by the CEO. iv. Valued at more than $100,000 require Board approval prior to execution. c) Purchase of Goods: i. Must have available funds in the approved budget, including any Board approved amendments to the budget. ii. Non-routine expenses or items valued at less than $100,000 can be purchased with the approval of the Executive responsible for the budget in which the goods are to be paid from. iii. Non-routine expenses or items valued at $100,000 or more must be approved by the CEO. iv. Non-routine expenses or items valued at more than $100,000 must be approved by the Board either as part of their approval of the annual budget by it being identified specifically in the annual budget or by a separate item approved by the Board at a Regular or Special Board of Retirement meeting. d) Routine Operating Expenses (see definition in Section 24. below): i. Must have available funds in the approved budget, including any Board approved amendments to the budget. ii. Can be approved by the Executive responsible for the budget in which the items or services will be provided from. 24. Routine Operating Expenses a) Include items such as: i. Office supplies, postage, furniture, and office equipment, Procurement and Contracting Policy Page 7 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

43 ii. General services contracts and agreements such as hearing officers, medical panel reviewers, property management, maintenance and repair of landscaping, building and equipment, printing, board of retirement member elections, computer consulting, software licenses, messenger services, catering etc., and iii. Temporary services, professional and consulting services engaged to supplement or support staff in the continued efforts of administering the pension plan to OCERS members. b) Suppliers of Routine Operating Expenses will be reviewed routinely, not less than every three years, to ensure that prices remain competitive. 25. The CEO may delegate his authority to execute documents to an Executive. The Executive may delegate his/her authority to approve check requests and/or purchase requisitions. All such delegations will be documented in writing, identifying the individual to whom the authority is delegated and any dollar restriction or budget account restrictions associated therewith. POLICY REVIEW 26. The Board of Retirement will review this policy at least every three (3) years to ensure that it remains relevant and appropriate. POLICY HISTORY 27. The Board of Retirement adopted this policy on Monday, November 18, The policy was revised May 19, 2008, March 22, 2010, May 20, 2013, and January 20, Steve Delaney, Secretary to the Board 1/20/15 Date Procurement and Contracting Policy Page 8 of 8 Adopted November 18, 2002 Last Revised January 20, 2015

44 Appendix B: Memo to Audit Committee: Documentation of Due Diligence for Investments dated July 23, 2012 Audit of OCERS Due Diligence Process Page 17 August 6, 2015

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46 Audit of OCERS' Due Diligence Process August 21, 2015

47 Audit Objective Assess the adequacy of the process for complying with OCERS policies related to due diligence Policies: Due Diligence Policy Manual Investment Policy Statement Procurement and Contracting Policy

48 Audit Scope Included the due diligence process conducted by OCERS Investments from January 2013 to January 2015 Higher risk asset managers: Hedge funds Direct lenders Private equity Excluded traditional money managers such as equity index managers and fixed income managers, which are considered lower risk

49 Audit Conclusion OCERS Investments due diligence process adequately complies with policy Biannual meetings with investment managers Review of due diligence questionnaires Organizational review Assessment of investment performance Expectations for investments Fees Onsite visits Use of investment consultants External legal counsel

50 Finding #1: Written Procedures Lack of written procedures that describe steps for staff to perform due diligence on investment managers Recommendation: Investments should create written procedures that specifically document steps necessary to conduct adequate due diligence Management Response: Concur. The Director of Investment Operations is developing this document, and conferring with Internal Audit regarding its contents to assure that the suggestions presented in this report are addressed responsibly and pragmatically

51 Finding #2: Operational DD OCERS consultants conduct operational due diligence for hedge fund managers, but not for other nontraditional asset class managers Recommendation: Consider contracting with a firm experienced with performance of agreed upon procedures on investment manager s key operational controls. A criteria should be set by the CIO to trigger a review. Management Response: Agrees that a deeper dive could be appropriate for certain non-traditional managers, but only if a majority of the Board considers such measures to be necessary, costbeneficial or justifiable on a risk-vs-cost basis

52 Finding #3: RFP Reporting Investments provides the IC with a due diligence narrative of a potential manager, but this was not provided with the selection of Pantheon in a 2013 RFP, or for Tennenbaum and Brigade in a 2015 RFP Recommendation: For RFP-sourced managers, there should be consistent narrative due diligence reporting provided to the IC. Consider using a checklist to make sure all documents are included. Management Response: We agree that our written procedures and future practices should include routine reporting of internal due diligence when the RFP channel is deployed for manager selection