The Ten Commandments of Operational Due Diligence Robert P. Swan III Chief Operating Officer and Director of Due Diligence Lighthouse Partners, LLC Palm Beach Gardens, Florida A well-defined operational due diligence process can help investors uncover risks and avoid the types of operational problems that can lead to a hedge fund blowup. Most issues begin with fundamental weaknesses of internal financial control, lack of separation of duties, and lack of support from top management for the firm s operational infrastructure. Investors should look for an independent and segregated function that values the books and supports the operational infrastructure. Additionally, the firm s management should be actively involved in the creation and monitoring of the firm s control systems. A fter 10 years of being involved in managing hedge fund products, overseeing hedge fund operations, and performing operational due diligence reviews, I am glad to see that due diligence of hedge fund operations is receiving some focus from organizations as well regarded as CFA Institute. In this presentation, I want to provide a peek behind the curtain and describe some of the key components of how we at Lighthouse Partners follow certain processes and procedures when conducting our operational due diligence reviews. I would like to stress that if you take nothing else away from this presentation, please recognize the need for a sense of responsibility. One thing we investment professionals should do is make it our responsibility to continue demanding the establishment of an environment of compliance and controls among the hedge fund advisors to whom we allocate our clients capital. If we can create an environment that has more compliance and control as a standard, everyone will benefit: analysts, investors, advisors, and investment managers. Most managers will probably agree that taking losses from a calculated investment risk may be acceptable, or at least explainable, but taking losses from unidentified and unevaluated operational risks is clearly unacceptable. Unfortunately, these types of losses are usually the ones that make news headlines. In guarding against operational problems, understanding the work of auditors, administrators, attorneys, and other consultants is important. But those of us working in this area must go well beyond that. If we wait for one of those groups to catch operational issues, it will usually be too late. That is, we will be at risk of losing some of our clients money if we have not done our job ahead of time. Thus, we must delve into the key components of operational due diligence the ten commandments of operational due diligence. One: Define the Role Of all the hedge fund risks, operational risk has historically been given the least attention. Ten years ago, I did not hear much about defining the role, hiring a chief financial officer (CFO), or developing an operational due diligence process. Fortunately, I had some partners that recognized business and operational risks and supported my efforts. For a variety of reasons, such as the growth of institutional investment among hedge funds, other groups are beginning to focus more on operational risks. Due diligence is a vague term. As interest in operational due diligence grows and funds put together a team to focus on operational risks, one of the important things to do is to educate personnel about the role and responsibility of the operational due diligence function and empower this team with a proper level of authority. At Lighthouse Partners, we go to the extent of providing veto power to the operational due diligence team, thus enabling the team to hold back an investment that does not meet minimum internal financial control standards. 2004, CFA Institute cfapubs.org CFA Institute Conference Proceedings 47
Challenges and Innovation in Hedge Fund Management Two: Define the Goal Safeguard the Assets What is the main goal of operational due diligence? It is to maintain the highest possible level of safeguarding client assets. First and foremost, in an absolute-return category, if we are not preserving client capital by reviewing and evaluating operational risk, we are simply not doing our job. Three: Define the Objective Integrate Controls Consistently and Effectively Regardless of the different sizes and levels of resources within hedge fund operations, at a minimum, there has to be a consistent and effective integration of five key elements: decision support, trade execution, risk management, compliance, and accounting systems. Internal controls begin at the trading desk and end at the accounting and operations area, trickling down to the most detailed elements of accounting and operational control in hedge funds, such as daily cash, position, and P&L (profit and loss) reconciliation. If these controls are not consistently and effectively integrated, problems may arise. Four: Segregate the Function The most significant weakness of internal control systems is their lack of segregation and independence. By some estimates, more than 50 percent of hedge fund failures relate to operational risks, with a primary contributor being a basic lack of segregation of accounting roles and responsibilities between the front office and back office. 1 This segregation does not have to be complicated. Proper segregation often involves independent bodies doing simple things, such as independently valuing the portfolio and reconciling the books. These basic functions can usually catch most trade errors and rogue trader type situations. Rogue traders are not going to show up in the trade room and tell everyone they are planning to steal. Obviously, rogue traders will work to conceal their actions. Putting basic policies and procedures in place and performing the appropriate walk-throughs can help identify these problems. 1 Data based on a March 2003 study by Christopher Kundro and Stuart Feffer with Capco (www.capco.com). The study is based on 100 hedge fund failures over the past 20 years. Five: Do the Work On-site review of the operations function is critical and warrants more than lip service. At Lighthouse Partners, we focus on performing a significant number of manager interviews every year. Our investment analysts carry the burden of reviewing and evaluating a majority of the investment opportunities we look at each year, but no investment gets into our portfolio without an operational due diligence review. We make sure that we understand the corporate structure and service providers used, the key people and their backgrounds, the accounting process and controls, and the technology. We perform our review with the CFO or head of operations. If the accounting function is outsourced, we make sure that we understand the administrator s role, frequency of involvement, process, and infrastructure because the administrators that have grown dramatically over the past four years represent as many potential problems as the hedge fund operations. Six: Document and Communicate Effective and well-documented operational due diligence is the only way to benchmark and support the verification of an operational infrastructure. Additionally, educating the investment analysts about where to find weaknesses is necessary. Finally, documentation and communication help facilitate ongoing evaluation. A firm simply cannot perform one due diligence review, make its investment or trade, and not perform ongoing analysis. Solid documentation also helps us identify changes that may be making the firm susceptible to different risks going forward. Seven: Work Efficiently with Investment Research Delivering a consistent philosophy to the investment team and educating them about business risks are important. Everyone must be the eyes and ears of the organization. Eight: Remember the Fundamentals Investment due diligence is essentially irrelevant without adequately supported operational due diligence. The best trader in the world is useless without adequate and timely financial reporting, verification, and support for his or her investment track record. Conducting operational due diligence 48 CFA Institute Conference Proceedings 2004, CFA Institute cfapubs.org
The Ten Commandments of Operational Due Diligence is the only way to ensure that the cash, position, and P&L reconciliations are occurring daily, going through the full cycle monthly, and being carried through properly to the financial reports that the firm gets monthly, quarterly, and annually from its auditors. If that information flow has problems or delays, then it is a serious red flag. Nine: Note the Tone at the Top The common thread among significant losses in investment firms is the lack of appropriate senior management involvement. With some of the more noteworthy failures of the past, a system of internal financial controls was in place but management did not review it or sign off on it. Senior management should be involved in ensuring that a welldocumented policy and control manual exists and that it is actually in place and functioning. Ten: Be Vigilant about Red Flags The red flags to look for are usually very basic, such as employee turnover, which often leads to the ability to circumvent controls. Other indications may include volatility of character and personality. Often, problems start with a lack of support for an independent operational infrastructure that is properly empowered. That situation can provide support for someone to potentially circumvent existing controls. Additionally, watch out for conflicts. An important step is to have the investment team interview the portfolio managers and document their story and then compare that story with the operational due diligence review. For example, as part of our reviews, we include a trading and risk management section that asks a variety of questions that get at the same basic things that our investment analysts ask. If we get different answers to those questions from the ones the investment analysts heard, it is a serious red flag. 2004, CFA Institute cfapubs.org CFA Institute Conference Proceedings 49
Challenges and Innovation in Hedge Fund Management Question and Answer Session Alain De Coster Robert P. Swan III Question: How do you feel about negotiating with hedge funds on fees? Are you believers in side agreements? Swan: It is a benefit to our clients to negotiate fees when we can. One of the reasons clients come to us is that we have generated the leverage in relationships over time and arrived at a position where we are often able to negotiate fees. The key is not to drive down fees to the point where we are not a partner with the manager. Rather, we strive to get to a point where we are in agreement as to what we are doing for each other. Some very successful firms will not negotiate fees. In those instances, a fund-of-funds manager just hopes to get capacity. So, without question, we take the opportunity when it arises to negotiate reduced-fee relationships because that directly benefits our clients. Question: Do you see capacity as a problem? De Coster: Capacity is definitely an issue. First, the number of analysts and the quality of their research are limited and can only be increased over time, so having managers with a clear understanding of what they can do with the current staff is important. Second, market liquidity comes and goes. And flexibility and liquidity tend to disappear at the precise time that managers need them most. The issue is further complicated by the fact that it is difficult to gauge exactly where capacity should be set. Managers obviously want to be prudent so that they will be in business five years from now. That said, there are always new people opening their doors with new strategies and new opportunities. Swan: Capacity often follows the 80/20 rule. That is, the best managers are in the top 20th percentile, and that is obviously where you hope to find opportunities. Capacity also tends to follow a moving scale in that it cycles up and down based on changes in the equity, credit, and fixed-income markets. Fortunately, we are presently pretty excited about the opportunities we are seeing in the current hedge fund cycle. Question: Does it worry you when you hear about soft closes versus hard closes? Swan: I think closes are an important thing to monitor with hedge fund allocations. It is a problem when managers do not understand their capacity constraints and how they affect their ability to continue extracting an edge with their strategy or investment philosophy. When I meet with managers, it is a high priority to get an understanding of whether capacity will dictate a soft close or a hard close. If the manager claims he or she will hard close at a certain point and the fund later blows through that level, I want to know about it immediately and find out why the manager is still raising assets and whether it is supported by the opportunity set presented to the manager. Question: How about liquidity? De Coster: It is paramount that fund-of-funds managers ensure there is not a breakdown between the liquidity provided to their investors and the liquidity provided by the underlying funds they invest in. Some fund-of-funds managers offer more liquidity to their investors than we do, but they are running a liquidity risk that can ultimately hurt their clients. We do not take that risk. Similarly, it is important to understand the liquidity of the underlying investments within the hedge funds in our fund-of-funds portfolios. The liquidity of those underlying investments should be in line with the liquidity that the hedge fund manager offers. Swan: Liquidity is certainly a key issue in hedge fund investing. We do our best to understand liquidity constraints and strive for a balance that makes sense. For example, if someone is operating in a distressed category and is offering monthly liquidity, that is a mismatch. We strive to understand the underlying asset class and combine those risks accordingly with the liquidity we offer our clients. Also keep in mind that liquidity varies in different stages of a hedge fund s business. When a manager is growing dramatically and has consistent inflows, the liquidity picture is a lot different from when money stops coming in or when the manager stops taking assets. We make sure that we understand where a hedge fund investment is along that life cycle and the subsequent impact on liquidity. Question: Is there a correlation between funds willing to provide transparency and subpar performance? De Coster: I think the first thing you have to do is define adequate transparency. For us, transparency is not about knowing every single position held by every manager in our portfolio. Full transparency is 50 CFA Institute Conference Proceedings 2004, CFA Institute cfapubs.org
Q&A: De Coster and Swan not the best use of time both for the manager and for us. Of course, we still do site visits to discuss large positions and concentrations in the portfolio. But we believe the key issue is to understand the portfolio structure, the risks, and how the portfolio changes over time. Question: How often do you require net asset values (NAVs) from your managers? Swan: Generally, it is difficult to get a full accounting close from hedge funds more frequently than once a month. At a minimum, we require monthly NAVs with independent documentation to support their valuations. We are fortunate to have good reporting relationships even with the fund managers that typically provide only quarterly reporting. Question: Do you have requirements for minimum track records or assets under management? De Coster: If you find a good manager but wait for a three-year track record, you are likely to discover that the manager is closed by the time you are ready to invest. Consequently, due diligence around issues other than the track record and assets under management becomes important so you can accurately gauge the quality, the valuation, and the future prospects. Swan: At one time, a three-year track record was our minimum requirement. But growth of the industry and competition for solid opportunities have pushed that requirement back. Consequently, vetting out other aspects of the manager s history, such as background and reference checks, is all the more important. So, to answer the question, we look for a track record but are willing to accept situations where other substantive due diligence work indicates a solid opportunity. Question: How do you assess offshore administrators? De Coster: It is the same process for offshore and onshore administrators, especially because a lot of offshore administration is actually done onshore. Swan: The offshore administrators have been slowly consolidating onshore. So, we simply conduct the same analysis. We make sure that we understand the infrastructure. You have to do good work on both the manager and the administrator. You cannot count on administrators and auditors to find problems because they will ultimately point their fingers at the expert manager who is providing valuations. Question: Does it worry you if administrators are not third parties? De Coster: Experience has taught us to avoid some administrators just based on the way they operate. Some of these people have multiple jobs and have their hands in multiple pockets. It is important to make sure they are doing fund administration and that they are not doing something else on the side. Question: What has been your experience with terminating managers? De Coster: When we at ABS Investment Management terminate a manager, we like to do it face to face so that we can explain why we are taking the money out of the fund. In a few cases, we took money out and came back a year or two later after we thought the fund had cleaned up the areas of concern. That is rare, but it does happen. An investment is not always redeemed simply so we can allocate the capital to a different manager. Also, performance is not always the main reason why we get out. We understand a manager can have a tough environment and can underperform. Sometimes, we see things we do not like, such as when managers run outside the boundaries of their stated investment strategies. In other instances, we might exit because the manager is having business issues or people issues. Finally, we tend to worry and may terminate a relationship if the manager s assets are growing too quickly. A lot of managers become very large almost to the extent that they become a new breed of mutual fund. It scares us to see a manager trying to run too much in assets or too many managed products. Swan: We believe it is very important to educate and create a partnership with our managers. It is about setting the appropriate expectation at the start of the relationship. We want them to have a good understanding of our expectations and why they are in the portfolio. That way, if we later decide to exit, it is easy to explain why. Question: Does there come a point where a plan or portfolio is large enough that the investor is better off building a hedge fund portfolio of its own rather than paying the additional fees involved with a fund of funds? De Coster: It is important to consider the resources necessary to do a good job; it is definitely a fulltime job. Moreover, if you are going to try and effectively build your own fund-of-funds portfolio, you must have good people running it and compensate them accordingly. Also, you have to be sure that there is a solid infrastructure in place. Having started a fund of funds 10 years ago, growing it to more than $3 billion, and starting a new one, I can say that the cost of running a fund of funds is about fourfold what it was a decade ago. Building infrastructure has become very expensive. For example, a decent hedge fund analyst with five or six years experience is very expensive. 2004, CFA Institute cfapubs.org CFA Institute Conference Proceedings 51
Challenges and Innovation in Hedge Fund Management If a plan is large enough to overcome these obstacles, that is great. But it must be prepared to devote significant resources to build the right infrastructure or it will hit a wall. Swan: The bar has definitely been raised over the past several years. Building a team with the right experience, tools, systems, and processes is a significant challenge. Institutional investors looking to go direct sometimes do not fully appreciate what is involved in evaluating, managing, and monitoring a significant fund-of-funds portfolio. Question: What is different about your job today versus five years ago? De Coster: What is different today is that hedge funds are in the limelight. When I started in the early 1990s, hedge funds were not mainstream. You could find hedge funds, co-invest your money with them, and build a great hands-on relationship. Now that hedge fund transaction fees generate the lion s share of the prime brokerage revenues, even though they represent only 10 percent of the total volume of transactions, it is a war out there. We are being bombarded by conferences, e-mails, and new managers that are lined up by the prime brokers. They throw a lot of names at us, and it is clear that their interests are different from ours. We want to get a great risk reward ratio from our investment; they want to get a commission. The issue is that they have made the situation more difficult to evaluate than in the past. Prime brokers have predesigned presentations by strategy. When somebody comes to them and says I want to launch a high-yield long short fund, they have the presentation for you. These guys have been taught the way to present to us, and often it is basically a prepackaged pitch. Consequently, people need more experience to evaluate hedge funds now than in the past because these guys have been much better prepared by the prime broker. Swan: It has certainly become more challenging to keep the infrastructure on par with the complexities of the business. Infrastructure must continually grow to keep pace. There is a higher emphasis today on managing human capital and improving technology. Also, many hedge funds have a much better understanding of what is necessary to get an allocation from an institutional-quality investor and have devoted the appropriate resources. Question: What about hedge funds keeps you up at night? De Coster: Worrying about doing the best that I can keeps me up at night. I want to deliver the quality, service, and return that my clients expect. I want to make sure that we have the best possible organization and the best group of people. Swan: The things that keep me up at night are related to what I talked about, which is operational risk. Not enough people focus on the operational side of the business, such as processes, systems, and limitations. Frankly, those are the risks that end up generating headlines in the newspapers. Thus far, I have not found myself in that situation, but avoiding it is always on my mind. 52 CFA Institute Conference Proceedings 2004, CFA Institute cfapubs.org