Hedge Fund Development: Best Practices for Business, Operations and Portfolio Management

1. Hedge Fund Development
Implementing Best Practices For Business, Operations & Portfolio Management
2009
Joseph Gigliotti
Halogen Asset Management
667 Madison Avenue
Floor 25
New York, NY 10065
joe@jgigliotti.com
joe@jgigliotti.com

2. Table of Contents
What are “Best Practices”? ............................................................................................................. 1
What is Operational Risk? .............................................................................................................. 2
What is Analyzed During a Due-Diligence Assessment?............................................................... 3
Hedge Fund Best Practice Implementation..................................................................................... 4
Business Management ................................................................................................................. 4
Operations Management ............................................................................................................. 5
Portfolio Management ................................................................................................................. 7
JOSEPH GIGLIOTTI
joe@jgigliotti.com

3. What are “Best Practices”?
Despite the fact that a growing list of hedge funds over the past ten years had experienced teams
with excellent pedigrees, they nonetheless failed due to matters unrelated to performance. Many
lessons have been learned by investors and auditors from studying these failures, and many
business and operational practices are now demanded to be in place to help prevent their
recurrence. Simply put, “best practices” can be described as the culture, controls and processes
that should exist at a hedge fund to prevent the potential loss of capital from its business,
operations or portfolio management. The six areas that best practices address include (1)
Disclosure, (2) Valuation, (3) Risk Management, (4) Trading, (5) Business Management and (6)
Compliance.
In order to protect investors, managers must be able to explain how they have adopted,
implemented and updated best practices. Investor due-diligence teams are now required to do
more than have managers merely speak to their processes in a meeting, they must also be able to
validate and prove them in a tangible manner. Not validating that the processes are documented,
understood and internally practiced by the manager could be construed as a breach of an
allocator’s fiduciary duty to the investors that they represent, and arguably could be considered
negligence. Anyone with a cursory understanding of the most high profile hedge fund failures
over the past five years is aware of this fact, including most sophisticated family offices, FOF’s,
pensions funds, endowments and consultants.
Current hedge fund best practices call for the segregation of a hedge fund business into two areas
of management with clearly segregated duties: (1) activities related to alpha generation (the
investment team and trading), and (2) activities related to business, operations and portfolio risk
management. The following pages include a task list of actions, controls and processes that
address business, operations and portfolio management. This summary overview would be over
seventy pages if it explained every item on the task list in detail and included the historical
context of each item (certain deliverables on the task list range from ten to over thirty pages and
can be reviewed upon request). That said, the task list items include policies, controls and
governance that were designed to incorporate updated industry standard best practices and
specific concerns expressed by institutional investors through 2009. The task list items, controls
and processes have been validated as best in class over the course of four audits, have passed the
scrutiny of institutional due-diligence reviews, and have met the standards set forth by both the
President’s Working Group on Financial Markets and the AICPA (American Institute of Public
Accountants). It should be noted that the following pages include processes to both protect
capital and address building an organization for long term growth.
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JOSEPH GIGLIOTTI
joe@jgigliotti.com

4. What is Operational Risk?
…and why has it become the second most important investment criteria for investors after
performance?
• US Treasury Definition of operational risk: "the risk of loss resulting from inadequate or
failed internal processes, people and systems, or from external events".
• The Basel Committee has established seven areas of loss events that arise from
operational risks: (1) Internal Fraud, (2) External Fraud, (3) Employment Practices, (4)
Clients, Products & Business Practice, (5) Damage to Physical Assets, (6) Business
Disruption & Systems Failures, and (7) Execution, Delivery & Process Management.
• "In up or down markets, and even for strong investment managers using sound strategies,
operational risks can turn successful hedge funds into failed enterprises." (Rothstein
Kass)
• Over 56% of hedge fund failures were caused by business or operational deficiencies, not
performance. Family offices, FOF's, pension funds, endowments and consultants are
aware of these statistics - many from first-hand experience - and now require operational
best practices to be in place before making an investment.
• According to Deutsche Bank's 2009 Alternative Investment Survey, risk management is
the second most important factor when selecting a manager: "In the post-Madoff era, this
concentration on risk management is an expected development. Furthermore, with the
continued institutionalization of the industry, investors have become more risk aware,
needing to meet higher institutional standards with regard to their risk management
processes."
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JOSEPH GIGLIOTTI
joe@jgigliotti.com

5. What is Analyzed During a Due-Diligence Assessment?
Typical due-diligence reviews scrutinize an investment manager's controls, governance and
fund documents to determine:
1. Any deviations from industry standard best practices
2. Any gaps or deficiencies in portfolio or operational controls
3. The level of staff knowledge, capability and accountability
4. The quality of vendors and their capability
5. The segregation of duties between the investment and operations teams
6. The extent to which a manager can demonstrate an investment process that is
consistent, repeatable and documented, which is understood by the investor and
practiced by the investment team
7. The level of consistency between what the investment team does and what the
manager has represented in marketing materials and meetings
8. The risks that were taken to achieve returns (a quantitative examination of
performance, risk, exposures and attribution analysis)
9. The internal level of consistency regarding policy, governance and manager awareness
throughout the LLC agreements, LPA's, Offering Memorandums, Subscription
Agreements, Marketing Collateral, Investment Management Agreements, ISDA
Agreements, Administrator Agreements, PB Margin and Security Lending Contracts,
Compliance Manuals, Employee Manuals and Operational Controls.
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JOSEPH GIGLIOTTI
joe@jgigliotti.com

6. Hedge Fund Best Practice Implementation Tasks
Business Management
1. Five year benchmarks for AUM, scaling of professionals and infrastructure requirements
2. Three year operating budget; AUM for positive cash flow from management fee
3. Three year CAPEX budget for PP&E and IT systems
4. Quarterly review process to assess benchmark progress
5. Code of ethics and insider trading policy, agreements and governance system
6. Employee manual; define culture, create process for governance
7. IT topography, disaster recovery, and business continuity plans
8. Exchange server relay and audit system for e-mails and instant messages that is SEC
compliant
9. SEC registration, examination procedures, examination disclosure policy
10. AIMA DDQ or one with equivalent content
11. Human Resources: create effective communication and review process to manage
expectations, increase productivity, mediate conflict resolution, and create environment
that facilitates talent retention.
12. Create brand identity and incorporate into marketing collateral, including the following
list per product (fund): (1) monthly newsletter design with statistics feed (Pertrac link),
(2) quarterly newsletter design, (3) one page overview (4) long form fund overview for
distribution (4) short form fund overview for meetings.
13. Marketing narrative for investment process that is clearly articulated, easy to follow and
memorable. It should be concise and cover the following subjects to explain the life cycle
of an investment: Investment Universe, Idea Generation, Thesis Review, Research, Buy
Discipline, Position Monitoring and Sell Discipline. Define edge.
14. Marketing program with quarterly benchmarks; implement CRM system
15. Leverage personal networks and understanding of industry trends and investor demands
to market to FOF’'s, pensions and endowments, family offices, hnw individuals and
consultants.
16. Create schedule for PM speaking engagements within FO and conference network
17. List fund and maintain monthly data postings in HF data bases including, Bloomberg,
HFR, Hedgefund.net, Cambridge Associates
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JOSEPH GIGLIOTTI
joe@jgigliotti.com

7. Operations Management
1. Legal Review
Funds: Create system to manage compliance with CIMA, SEC, Reg D, Blue Sky, AML,
ISDA's, securities lending, margin agreements, pb agreements, offering memorandums,
LPA's, subscription and redemption procedures, and any MFN or side letters that may
arise
Business: Understanding and management of contracts with fund counterparties,
employees, data agreements, technology companies, operating contracts, landlords.
2. Transparent system redundant to administrator to validate fund accounting, NAV
valuation processes, individual investor performance reporting, onshore and offshore
partnership book allocations, and multiple share class/series accounting
3. Accurate, timely and consistently applied FASB 157 valuation policies
4. Internal position level pricing for daily verification (reconcile pb to
administrator using two pricing sources)
5. Document internal process of reconciling margin balances and accruals with
interest rates
6. Document trade processing, settlement and cash management controls
7. Trading and execution policy, EMS system, tax-lot and wash sale management and tax
efficiency reporting. Install trader audit system that is transparent, logs every trade by
user login, and tracks individual pnl of traders and their implementation shortfall (among
other measurements) including triangulated position, pricing and cash reconciliation
(PB’s, Admin and Internal).
8. Report package for distribution to Portfolio Managers, CFO and back office on a
daily basis which provides (1) delta adjusted and market value summary of exposures at
both the portfolio and position level (2) risk limit alerts, (3) position level detail of all
holdings and (4) the prime broker transaction journal from the prior day that lists all
trades, cash movements and trade breaks
9. Trade break and cash movement journal that is automatically e-mailed by the
administrator to both the CFO and the back office every morning
10. Document trade break mitigation process and audit system
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JOSEPH GIGLIOTTI
joe@jgigliotti.com

8. 11. Work flow of trading life cycle from ticket to general ledger as close to Straight-
Through-Processing as possible (include execution instruction limits reconciliation and
clearing)
12. Corporate actions management
13. Policy and methodology for managing separate accounts and performing related
allocations
14. Soft dollar policy, governance, reporting and accounting system
15. System to prepare and manage audit (must be transparent and efficient to (1) decrease
cost (2) reduce possibility of audit deficiencies or gap analysis findings (3) result
in timely distribution of audit to investors
16. System to manage taxes and K1 distributions (must be efficient and result in timely
distribution of K1 's)
17. Service provider and counterparty management system for defining and monitoring
counterparty risk. Create risk indicators for service provider. Legal document review and
trigger/default lists: understand custody agreements, re-hypothecation terms, CDS
monitoring. Dual prime planning, custody of cash and business continuity assessment.
18. Document internal interviews to validate employees’ understanding of work flow
processes, policies and mitigation of gap analysis findings. Documented training will
create and demonstrate a culture of accountability.
19. Implement and document portfolio risk systems for VaR, delta adjusted exposure and
“what if” scenario analysis, stress tests, back testing, correlation analysis, portfolio
holdings news items and alerts for mobile devices, pre and post trade analytics systems,
real time and remote consensus valuations and internal valuation overlays for positions
20. Position, performance and investor reporting
21. Third party NAV transparency reporting for investor distribution, including fund
asset/liability confirmation, pricing, FASB 157 classifications and third party exposure
22. Valuation, Risk, Softdollar, Investment and Approved Vendor List Committees
23. Design internal system to receive position and cash data from multiple prime brokers
into one CSV file that can be used for custom internal risk reporting, correlation work
product and integration with Bloomberg Portfolio Analytics and Risk systems
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JOSEPH GIGLIOTTI
joe@jgigliotti.com

9. Portfolio Management
I. Risk Policy (Establish Policies and Document Controls)
• Portfolio Exposure limits: Gross Long, Gross Short, Net, Gross
• Fund Limits
o Position Size
o Industry/Sector
o VaR
o Stop Loss (at position level)
o Stop Loss (at portfolio level)
• Draw Down Management
• Stress Tests and Equity Market Sensitivities
• Target Fund Volatility
• Target Fund Performance
• Number of Positions
• Anticipated maximum allocation per analyst
• Position sizing Long Short
At entry
Min/Max
• Market Capitalization
• Capital Structure Diversification
• Position Liquidity Constraints
• Days to liquidate 90 %
A. with price sensitivity
B. without price sensitivity
• Provision for any side pocket
II. Risk Monitoring and Governance
• Daily reporting and mediation of risk parameters and policies including exposures and
position, industry, VaR and stop loss limits
• Monthly reporting of performance, risk, and performance attribution including
standard deviation, alpha, beta, market correlations, delta-adjusted exposures, VaR,
Sharpe and Sortino Ratios, draw down, liquidity, turnover, commissions, stop loss, top
ten positions, pnl by position-sector- analyst, restricted and illiquids, expense ratios
and ERISA-exposure limits
III. Portfolio Level Risk Assessment
• Systematic assessments of market, credit, counterparty & liquidity risk
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JOSEPH GIGLIOTTI
joe@jgigliotti.com