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Hedge fund operational_due_diligence_insights_corgentum_january_2013
1. January 2013
Operational Due Diligence Insights
In This Issue
Welcome to Our January
- Regulatory Focus: Can Operational
Due Diligence Prevent Exposure to 2013 Edition
Hedge Fund Insider Trading?
Welcome to the January 2013 issue of Corgentum Consulting's Operational
- Business Continuity Corner: A Post- Due Diligence Insights. This newsletter serves as a resource for news,
Sandy Analysis of Hedge Fund BCP/DR opinions and insights focused on issues related to operational risk and
Planning? operational due diligence on fund managers including hedge funds, private
equity funds, real estate and traditional managers.
- Private Equity: Will the Coming
Private Equity Data Storm Influence LP
Operational Due Diligence? Can Operational Due Diligence
- IT Hub: Evaluating Hedge Fund
Technology Consultants
Prevent Exposure to Hedge
- Service Providers: Analyzing Fund Fund Insider Trading?
Legal Counsel - Does It Matter As
Long As It's Legal? There has been much news recently with regards to high profile hedge fund
insider trading cases such as Raj Rajaratnam's Galleon. As there seems to be a
-Term of the Month: Audit Holdback continuing strong interest from the government in prosecuting insider trading,
investors may be increasingly asking themselves what they can do to minimize,
- Fraud Spotlight: The Preposterous or perhaps even completely reduce, their exposure to hedge funds that either
Fraud of Andrey C. Hicks and Locust may be accused of insider trading, or even worse guilty of it.
Offshore Management
Before we can answer this question however, it is first useful to make sure we
- Accounting Spotlight: Interpreting understand what is meant by insider trading. To boil it down to its most simple
Fund Expense Disclosures form, insider trading relates to people utilizing so-called "insider" information
- On the Calendar ...continued on next page
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3. January 2013 | 3
Insider Trading - Continued from page 2...
Are there sufficient prohibitions or limits on the
way gifts are given, and received, in order to
different questions to make an assessment as whether
prevent any potential conflicts or bribery with
or not the compliance function is actively policing the
regards to information sharing?
analyst research process or not. Examples of the types
of questions investors can ask in this regard include:
Step 3: Evaluate trading oversight
Third-party expert networks:
It is worth noting at this point that just because a hedge
Has the compliance function vetted a firm's
fund may come into possession of so-called material
relationship with third-party expert networks?
nonpublic information, they are not necessarily guilty of
If so, what did this assessment entail?
anything if they do not act on it.
Has the hedge fund communicated its policies This is where an analysis of the oversight of a hedge
with regards to material nonpublic information
fund trading procedures comes into play. After a hedge
and insider trading to the third-party network?
fund has done its research and makes a determination
that it would like to trade in a certain security, investors
If so, has the network agreed in writing to must determine what oversight is in place. One
comply with these policies? common way hedge funds seek to prevent trading on
securities on which they may possess material
If hedge fund research personnel would like to nonpublic information about is via a so-called restricted
utilize such a network, must pre-approval be list. In general, securities on the restricted list cannot be
obtained from the compliance function first? traded by the firm. However, not all restricted lists are
created equal, and not all hedge funds maintain
What research does the compliance function restricted lists. In addition to determining whether or
perform before granting pre-approval? not such a restricted list is actually in place, investors
can ask a number of questions to determine the
Once approved, has compliance taken any oversight and effectiveness of such lists including:
additional measures to ensure compliance with
the hedge fund's policies? (i.e. - such as reading How are securities put on the list? Is there set
a disclaimer before the call begins) criteria or does one person make the
determination in their discretion?
Additionally, do compliance personnel listen in
on calls? If a security is placed on the restricted list, is
trading activity suspended for a certain pre-
Is a log kept of the use of such third-party defined period? (i.e. - 30 days)
networks?
How do securities come off of the restricted
Research sources in general: list?
Does the hedge fund have any bans on speaking
to individuals who either work at public Who maintains the restricted list?
companies or have recently worked at such
companies? If so, what are the details of this How often is it updated?
ban? How is it monitored and implemented?
How is the list shared throughout the firm?
Are any conflict checks performed to make sure
that a hedge fund analyst is not discussing a
company with someone with whom the hedge
fund may have already been conflicted out of …continued on next page
(i.e.- passing along tips)?
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5. January 2013 | 5
Business Continuity- Continued from page 4... well as with prospective firm's they may evaluate in the
future. Digging into the details of real-world activations
of BCP/DR plans can provide investors with valuable
According to a recent Corgentum survey, 74% of
insights of how effectively a hedge fund’s best laid plans
investors felt that their hedge fund was adequately
may hold up in a storm.
prepared to continue operational during hurricane
Sandy. In order to confirm these beliefs when a wide
scale storm or other BCP/DR event which may affect a
hedge fund occurs, investors should seize the
Will the Coming
Private Equity Data
opportunity to vet the real-world effectiveness of their
hedge funds plans during the storm.
Some questions investors may want to ask regarding a
hedge funds reaction to the storm included: Storm Influence LP
At what point was the decision made to activate
the firm's business continuity and disaster
Operational Due
recovery plans? - If the plan was activated too
late perhaps it was either diminished in Diligence?
effectiveness, or represented a failing of the
firm's judgment in having qualified personnel
making the decision whether or not to activate Private equity General Partners ("GPs") are under
BCP/DR plan increasing pressure to provide more transparency than
ever before. This transparency is not limited to any one
Were employees able to communicate with area (i.e. - investment performance or fund accounting
each other during the storm? procedures).
If alternative off-site third-party locations were Further complicating the problem is that these
part of a hedge fund's plans, did they perform requests, or in some cases demands, for additional data
as expected? come from multiple sources, the two primary ones
being Limited Partners ("LPs") and regulators.
If equipment was destroyed during the storm, Turning to regulators first, there have been a number of
will it be covered by the hedge fund's insurance recent regulatory changes that will require most private
policies? Is backup equipment available in the equity GPs to report to regulators more detailed
interim? information than ever before. A recent example of this
is Form PF filings required by the US Securities and
What parts of the BCP/DR plan worked correctly Exchange Commission. Under these rules, which
during the storm? targeted not only private equity firms but also a wide
variety of fund managers including hedge funds, GPs
were required to make a number of disclosures
What plan problems or weaknesses came about
including:
during the storm?
Reporting data related to the indebtedness of
Is the hedge fund implementing any changes to portfolio companies a private equity fund may
the plan based on lessons learned from the control. This data includes revealing the identity
storm? of the lenders of any bridge loans as well as
debt -to-equity ratios.
Investors should ask such questions both of the hedge
funds with which they maintain existing investments as …continued on next page
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7. January 2013 | 7
Private Equity - Continued from page 6... external resources. Additionally, many hedge funds may
utilize certain consultants on an ad-hoc or as needed
basis and therefore, perhaps don't feel highlighting such
increased data analysis and resource management
relationships matters much to investors performing
challenges which should be planned for. Without such
operational due diligence.
preparation them find themselves awash in a sea of
data that they are unsure how to navigate.
Investors should not be discouraged however, and
should take measures to evaluate the role of
Evaluating Hedge information technology consultants. A good starting
point is speaking directly with the hedge fund managers
Fund Technology
about the use of such consultants.
Learning what consultants do:
Consultants There are diagnostic benefits to such third-party
provider due diligence. By inquiring about these third-
party firms, investors will likely learn about the duties
It is common for many hedge fund managers, especially performed by different information technology
smaller ones, to leverage off of external information consultants. The answers to these questions can
technology consultants. These consultants come in provide valuable insights into a number of different
many different forms and can provide a wide array of areas including:
services for fund managers. In general, common Where a hedge fund may be weaker internally
services provided by information from a technology perspective and feels the
technology consultants can need to augment these deficiencies
include: with external resources?
Help desk support Has there been turnover
among information technology
Software development and consultants in a particular function? If
support so, why?
Hardware maintenance If the hedge fund utilizes a
consulting firm, as opposed to an
New software or hardware vendor and package individual freelancer, what personnel from the
selection IT consultant are actually doing the work?
Implementation of new systems or hardware How often are the IT consultants in the offices
of the hedge fund manager? If not frequently,
Business continuity and disaster recovery do they access the firm's systems remotely?
program design, testing and maintenance
Does the hedge fund control information access?
During the operational due diligence process, investors
may sometimes find it difficult to obtain a straight After an investor has obtained a detailed understanding
answer from their hedge fund managers with regards to of what a third-party information technology consultant
the work of these information technology consultants. may actually do for a hedge fund, investors should next
Perhaps it is because certain fund managers want to inquire as to how the hedge fund controls the third-
emphasize the arguably more important role played by party's access to, and use of fund data. Some questions
dedicated in-house information technology personnel
(be they dedicated or shared) while minimizing the …continued on next page
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9. January 2013 | 9
Legal Counsel - Continued from page 8... Are flat fees charged for any projects?
Does the law firm have any particular expertise
Often this service provider clustering effect also
that may be applicable to the hedge fund? (i.e. -
influences the ways in which certain investors overlook
jurisdictional expertise, or experience in
the role played by a hedge fund's legal counsel. During
performing legal work related to certain
the operational due diligence process, some investors
investment products)
may simply check to see if a hedge fund is working with
a large, well-known law firm. Other investors may go
This above list is of course not comprehensive, but is
further and attempt to confirm the relationship with
intended as a guide with which an investor could start a
the legal counselors, but may be unsure what other
conversation with a law firm in order to gauge certain
items they should evaluate.
basic issues regarding its relationship with the hedge
fund. Beyond the basics, an investor could inquire
The role played by a law firm working for a hedge fund
further into a number of different topics in an attempt
is not cookie cutter in nature. As could be said with all
to understand the extent of the law firm's work with the
service providers - they are
hedge fund. Examples of some items
not created equal. This is
an investor could cover may include:
particularly true when it
comes to fund legal counsel.
A number of differences may Does the law firm provide
any compliance related services to
exist with regards to not only
the hedge fund?
the quality of work they
perform for the hedge fund,
but the type of areas they If the hedge fund works with
cover. As with all hedge fund a separate compliance consultant,
service providers, investors does the law firm interact with them?
would be well served to
capitalize on the opportunity to vet the role played by a Has there been any personnel turnover among
hedge fund's legal counsel during the initial due the key individuals servicing the hedge fund's
diligence process. account?
For starters, investors should endeavor to cover what Can the law firm provide an example of a recent
could be considered the nuts and bolts of the matter on which it has worked for the funds?
relationship with a law firm by attempting to
understanding answers to questions including: If the funds or hedge fund management
What is the hourly billing rate charged to the company was (or currently is) involved in any
hedge fund? litigation, can the law firm walk the investor
through the litigation (and any outcomes)?
Is a blended rate charged or instead does the
rate vary by the experience of the law firm Does the law firm interact with any other law
employee (including non-attorneys) performing firm's used by the hedge fund?
the work?
Can the law firm provide a summary of the
Are any hourly billing rate or fee caps in place? routine legal tasks performed for the firm?
Is the hedge fund notified if fee caps are being Additionally, other more broad questions could be
approached? asked of the law firm to gain an understanding of how
much they interact with, and understand, the hedge
…continued on next page
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11. January 2013 | 11
with high alpha. The firm's quantitative strategies are
Fraud
based on mathematical models developed by the fund's
manager, Andrey C. Hicks, during his tenure at Harvard
University and are executed by computer software.
Spotlight: Human involvement in the strategy life cycle is limited to
model and code development and refactoring. The firm
The is primarily engaged in the U.S. equity markets and
adheres to a market-neutral, risk-averse trading
Preposterous Fraud of philosophy.
Andrey C. Hicks and
Some of the more interesting things alleged by the SEC
include that Mr. Hicks:
Locust Offshore Lied about his education - he claimed to have
obtained undergraduate in biochemistry (for
Management with a 4.0 grade point average) as well as a
graduate degree from Harvard. Mr. Hicks wasn't
satisfied claiming just any graduate degree such
as an MBA. Instead, he claimed to have
A man claiming to run a high profile hedge fund recently obtained a PhD in Applied Math in just two
pleaded guilty to stealing approximately $2.3 million years. According to the SEC, Mr. Hicks was
from investors. The plea came at the end of 2012 and indeed enrolled at Harvard as an undergraduate
slipped off many people's radar, however, the but was forced by the university to withdraw on
preposterousness of the case is worth revisiting. two separate occasions and he never
In October 2012, the SEC charged Andrey C. Hicks and graduated.
his firm Locust Offshore Management with employing a
fraudulent scheme to dupe investors into investing in a
Lied about his employment background - he
purported British Virgin Islands fund called the Locust
claimed to have not only worked at Barclay's
Offshore Fund, Ltd. The problem, the SEC alleged, was
Capital (which was a lie) but that, "he grew his
that there was never any such fund. Furthermore, the
book nearly two-fold and expanded his group’s
SEC complaint alleged that, "Hicks has transferred
assets under management to roughly $16
substantially all of the investors' funds to bank accounts
[billion]" (which was also a lie)
in his personal name and, on information and belief, for
his personal use."
Lied about the fund's auditor - he claimed Ernst
Mr. Hicks claims about his firm were so outlandish that & Young served as the fund's auditor, they
it was reported he stated to prospective investors to didn't (besides there was never any fund to
have grown "assets under management from $100M audit)
USD to nearly $1B USD in six (6) months through capital
raising and high returns." Lied about the fund's prime broker and
custodian - he claimed that the fund had a
To provide some additional perspective on the relationship with Credit Suisse - it didn't
outlandishness of this case, here is partial description of Opened business a checking and savings
what Mr. Hicks claimed his firm was doing: accounts for the firm and funds with the intent
to defraud investors
Locust Offshore Management, L.L.C. develops and
executes sophisticated quantitative strategies across
asset classes to produce absolute, risk-adjusted returns
…continued on next page
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13. January 2013 | 13
Fund Expenses - Continued from page 12... (i.e. - legitimate versus illegitimate) but also the way in
which they will be allocated.
manager’s standard operating procedure. Where
It is worth noting here the importance of incorporating
investors may differ in their opinions is whether the
documents other than the audited financial statements
expense of such research trips should be charged
into the overall expense analysis process. Although, it
directly to the funds themselves, or rather if the
could be classified as a legal document, as compared to
expense for such trips should sit at the management
a purely accounting related document such as the
company level.
audits, investors should not be hesitant to seek out
information from other sources to guide their analysis.
There are many other examples of areas where
This produces a more comprehensive well rounded
investors, and fund managers, may disagree as the
review, which runs less of a risk of ignoring key risk
appropriateness of allocating all or a portion of an
areas simply because they may be interdisciplinary in
expense to the funds versus the management company.
nature.
Additional examples of these types of expenses may
include the allocation of a hedge fund's office rent
Returning to our discussion of expense allocation rules,
expense and expenses related to acquiring and
in addition to the offering memorandum, another
maintaining the information technology function
source of good source of information may be the
including hardware which may be used to execute the
audited financial statements themselves. Often times
funds trading strategies.
the Statement of Operations, also known as the Income
Statement, will provide valuable
Regardless of which side
information about the detail of
of the argument a
total fund level expenses. The
particular investor lands
problem however, is that the
on, from a due diligence
figures presented in these
perspective it is
statements are often in summary
important that that
format. For example, the
investors have
statements may indicate that
transparency with
interest and dividends expense
regards to such
was $100. It would arguably be
expenses. Additionally,
more useful for investors to know
investors should seek to
more detail. So something like, the
evaluate the consistency
interest expense was $30 and the
of a hedge fund
dividend expense was $70.
manager’s approach in allocating such expenses. Said
another way, it is up to investors to understand what a
Another problem investors often encounter relates to
particular hedge funds rules of the expense allocation
so-called rollup categories of expenses. These are
game are before they can evaluate if a manager is
groups of expenses that are bundled together into a
following them.
single line-item. An example of such an expense
category would be "Professional fees and other." Under
Figuring Out The Expense Allocation Rules
US GAAP there is no universal rule as to what exactly
should be lumped into such a category. Furthermore,
Where is an investors supposed to figure out what the
there is not even a general agreement among hedge
hedge fund's policy is with regards to allocating such
funds or investors as to what exactly may go into such a
expenses? Well, a hedge fund's offering memorandum
category. Typically, an expense category such as this
might be a good start. The offering memorandum often
would contain items such as Board of Director’s fees
contains valuable information about not only what
and legal fees, however, investors should
expenses are anticipated to be charged to the fund,
…continued on next page
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15. January 2013 | 15
On the Calendar
Please see below for a list of upcoming operational risk items of note and events:
Investment Education Symposium (New Orleans, LA)
February 6-8, 2013. Corgentum to moderate Investing in Alternatives panel
Presented by Opal Financial Group
Investment Consultants Forum (New York, NY)
March 4, 2013. Corgentum to moderate Manager Selection Process panel
Presented by Opal Financial Group
GAIM Ops Cayman (Grand Cayman, Cayman Islands)
April 21-24, 2013. Corgentum 's Jason Scharfman to conduct pre-conference Private Equity Operational Due
Diligence workshop
Presented by IIR USA.
About Corgentum Consulting
Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of
fund managers.
We work with investors including fund of funds, pensions, endowments, banks and family offices to
conduct the industry's most comprehensive operational due diligence reviews. Our work covers all fund
managers and strategies globally including hedge funds, private equity, real estate funds and traditional
funds. Our sole focus on operational due diligence, veteran experience, innovative original research and
fundamental bottom up approach to due diligence allows us to ensure that our clients avoid
unnecessary operational risks. More information is available at www.Corgentum.com or follow us on
Twitter @Corgentum.
Email: Info@Corgentum.com
Main Tel. 201-918-520
www.Corgentum.com