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A Global Perspectives White Paper




                        The Rise & Rise of
                       Operational Due
                         Diligence
                         “Who to meet & what to ask”.




                                                      By Shane Brett,
                                                      Founder
                                                  Global Perspectives

                                          www.globalperspective.co.uk
       Date 28th July 2012
Contents

Introduction              2   "Sunlight is the best disinfectant"
Who should be visited?    2   US Supreme Court Justice Louis Brandeis
Investment Manager        3
Administrators            3   Introduction
Auditors                  4
Software Vendors          5   The Madoff scandal exposed the Alternative
                              Investment Industry to widespread allegations of
Ongoing ODD               5   substantial neglect, in terms of its Due Diligence
DIY versus Bought in      6   processes. Understandably since then,
                              Operational Due Diligence (ODD) has moved
Conclusion                6   from a neglected, peripheral activity to centre
Next Steps…               6   stage within the industry.

                              The main aim of Hedge Fund Operational Due
                              Diligence is to ensure that the fund is being
                              managed in accordance with best practice
                              operationally and that all aspects of its operation
                              are above board.

                              This White Paper will consider what a Hedge
                              Fund Investor or Fund of Hedge Fund Manager
                              needs to do, who they should visit and what they
                              should ask?

                              At Global Perspectives our Senior Staff have
                              experience running the global ODD programmes
                              for some of Europe’s largest Fund of Hedge
                              Fund Managers. We have asked the hard
                              questions and seen it all before.

                              Who should be visited?

                              A substantial part of successful Hedge Fund
                              ODD is a judgement call. You know the facts,
                              but how do you really make yourself comfortable
                              that your investment will be managed properly?

                              Our view is that you cannot accurately
                              determine this with a phone call. To gain comfort
                              with the people who will be directly and indirectly
                              managing your investment, you must go on-site.

                              For an investor to evaluate whether to proceed
                              with an investment, they need to meet with all of
                              the parties associated with the fund (outlined
                              below). It is not enough to meet with the
                              Investment Manager.
Ignore consultants or hedge funds that        In this case the Hedge Fund Manager had
try and tell you a phone call is good         difficulties understanding why we would not
enough. It is not.                            approve an investment until this policy was
                                              changed - but changed it was. Thankfully this
As any experienced ODD practitioner           level of amateurism is in the past and will
will tell you - you need to see the whites    disappear completely as the industry matures
of people’s eyes.                             and becomes dominated by large Institutional
                                              Investors.

                                              Another area to focus on is around access. Will
                                              the Fund Manager give you free, independent
Investment Manager                            and unrestricted access to the Fund’s Service
                                              Providers?
The Investment Manager will likely send
you their standard AIMA questionnaire         If not, then this is a major problem.
in advance of your meeting. While this is
a useful starting point it is imperative to
see beyond this.                              We have had successful, well-known Hedge
                                              Fund Managers try and stop us speaking to their
                                              administrators (“you would only be distracting
You are interested in understanding the       them from their work on the Fund”). This is not
detailed operational processes of the         good enough and should be a red flag to any
Fund Manager – from initial subscription      savvy investor.
to the fund, right through to the
portfolio’s investments and the process
of eventual redemption.                       Thankfully this sort of active prevention is
                                              becoming rarer and rarer, as Hedge Fund
                                              Managers chase allocations and Investors stand
In asking your questions (and seeing          their ground.
beyond that questionnaire) It is
important to follow the flow of cash into
the fund and understand operationally         Lastly, remember when you plan your visit to the
what will happen as the money is              Investment Manager it should be built around
invested, valued and finally returned to      the following core tenet –
you as an investor.
                                              “Don’t tell me, show me”.
One area to pay particular attention to is
the Fund Manager’s protocol                   Everything the Fund Manager (and
surrounding the movements of cash             Administrator) tells you must be backed up with
from the fund. Although this sounds           clear, verifiable evidence. You need to see their
obvious, it is scandalous the level of        systems, see their processes and see their
standards that existed in parts of the        controls.
industry before the global financial
crisis, regarding how & when money            If all of this sounds cumbersome, that’s because
could be moved from a Fund.                   it is. It could also save you from being a victim of
                                              the next Madoff.
In one memorable instance the Founder
& Manager of a $4 billion dollar hedge
fund we spoke to was allowed to move
up to $5 million dollars of the Fund’s        Administrators
money to any account worldwide - with
just his signature (“but sure he would
only be stealing from himself” was their      As the role of the Administrator increases in
outrageous excuse).                           importance in our industry, a large part of ODD
                                              is now focused on the Administrator’s processes

Global Perspectives
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +44 20 3239 2843
Mobile: +353 (0) 87 115 2173
and how they manage (which is after           One final point to remember is around asset
all), the Fund’s official books and           segregation. The endless, legal black hole
records.                                      which confronted many Hedge Funds after
                                              Lehman’s collapsed could have been prevented
Now that the US self-administered fund        if assets had of been properly segregated. It is
model has (thankfully) gone the way of        vital you ensure that there is no co-mingling of
the Dodo, Institutional Investors want to     assets at your administrator. You must see clear
see a robust, efficient and responsible       evidence that your assets will be segregated in
third party administrator in place for        an account in the name of the Fund.
every potential Hedge Fund to review.

Some Administrators boast about their
internal propriety systems, others            Auditors
promote their “best of breed” industry
software. What is important to each
                                              Even today many Investors complete their ODD
investor is different and this will largely
                                              process by speaking to the Fund Manager and
dependent on your individual risk
                                              the Administrator only. That is not enough.
appetite.
                                              Hedge Funds (particularly in the US) are often
Most Administrators in the Hedge Fund
                                              audited by small (and very well regarded)
industry report being inundated with
                                              specialist audit firms, which are well outside the
ODD requests in the last few years.
                                              Big 4 in terms of scale and coverage.
Many of the larger shops have set up
specialist internal teams to facilitate
these visits and co-ordinate the              The driver here is of course the Madoff debacle
responses.                                    and his infamous unknown 3 person audit firm in
                                              Florida (complete with an 88 year old lady and
                                              only one practising accountant).
This is great, but it’s important to look
beyond the standard responses and
actually see how their controls work and      As a potential investor you need to be
their processes take place (just like at      comfortable that your auditor can perform their
the Investment Managers).                     function in accordance with industry best
                                              practise. They are your main layer of protection
                                              as to the correct operational execution of the
One trend we have noted recently is the
                                              fund.
attraction of Administrators with large
parent banks. Investors want to know
there are very deep pockets behind their      Auditors are peer reviewed every couple of
Administrator (ironically as more and         years. You should be able to see the results of
more administrators seek to limit their       this process and make yourself familiar with the
liability in their administration             findings. Ignore attempts at obfuscation and
agreements).                                  insist to see the report (or at least the Executive
                                              Summary). This will not make you any friends,
                                              but now that all the large Audit firms are Limited
Given the demands from Institutional
                                              Liability Companies, it is up to you to ensure you
Investors identified, above it is
                                              are happy that have your investment is
unsurprising that a wave of
                                              protected. Your financial comeback in court is
consolidation has enveloped the
                                              limited.
Administration industry. Large
Administrators are buying smaller outfits
and many independent shops are                The Auditor should be able to flag any past
quietly up for sale.                          issues that have arisen with the Investment
                                              Manager (or generally within the industry). You
                                              should feel comfortable that the fund’s audit firm
                                              fully understands all aspects of the industry and
                                              the assets and instruments being traded.
Global Perspectives
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +44 20 3239 2843
Mobile: +353 (0) 87 115 2173
Just like at the Administrator, the           Finally, all Investment Managers and
important question here is -                  Administrators will have a Business Continuity
                                              Plan in place (if not then you shouldn’t be
“Who is watching the watcher”?                considering an investment). Nowadays many of
                                              these disaster recovery programmes are
The short answer is – you are.                outsourced to third parties at specific off-site
                                              locations.
That is why detailed ODD is so
important.                                    You need to familiarise yourself with their plans
                                              and speak to their providers. How often is their
                                              plan tested (it should be at least annually)?
                                              Have they had any emergencies in the past?
                                              How did they cope? What did they learn?
Software Vendors
                                              One US Fund Manager we spoke to had to
The Asset Management industry is              move their business to the BCP location for 3
becoming more and more dependent on           days after a murder was committed elsewhere in
its software. Our suggestion is that you      their business park and the police closed the
speak to the vendors of the main              whole area for 72 hours, while forensics
software used to value and price your         gathered evidence.
potential hedge fund. Essentially this will
be the Administrators software.               The unthinkable can happen.

If it is proprietary then you will want to
know how it is supported. This includes
meeting the individual’s responsible for
keeping it running smoothly and secure.
                                              Ongoing ODD

If it is an off the shelf system then you     It is important to emphasise that ODD is not a
need to familiarise yourself with this        one-off exercise that is finished at the moment of
company and its background as well as         investment. Too many Fund of Hedge Funds /
ensuring it is well managed and solvent.      Investors make this mistake (despite claiming to
                                              the contrary).
For both types of software you will want
assurances that the vendor has a clear        ODD is an on-going and iterative process.
development plan to update their              We can’t repeat this point often enough to our
software so it encompasses all                clients.
forthcoming regulatory requirements.
These should be met quickly and               You should be visiting the Fund Manager,
efficiently and incorporated into the         Administrator and Auditor on at least an annual
software well in advance of legislative       basis, with calls/visits in between as required by
requirements becoming law.                    changes to their business (e.g. a major Partner
                                              resigns, a NAV is restated etc).
Understand the vendor’s testing
processes and its speed to market.            This way you establish a deep and on-going
There is so much regulatory change            relationship with the Fund Manager and their
taking place across the industry this is      service providers. It is then far easier to
crucial (e.g. FATCA, AIFMD, Dodd              ascertain when something is wrong.
Frank etc).




Global Perspectives
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +44 20 3239 2843
Mobile: +353 (0) 87 115 2173
DIY versus Bought in                       Conclusion

An important question for any potential    In summary, when embarking on Hedge Fund
investor to ask is whether to carry out    Operational Due Diligence you need to ensure
ODD by themselves or call in an            you speak to all parties that provide services to
external party?                            the Fund. You need to make yourself
                                           comfortable with those people, their story and
Many investors will try and do this work   their strategy. This includes getting past the
themselves. Some of the larger FoHF’s      basic questions to gain a thorough
have even set up specialist in-house       understanding of their operational processes
ODD teams.                                 and procedures.

One of the main problems for investors     If you don’t get the transparency and comfort
or fund managers trying to execute top     you require, you must walk away from the
class ODD is that they do not have the     investment.
required extensive operational
experience. They might understand          Next Steps…
investment strategy, but this does not
mean they will understand operational      Global Perspectives can assist you by
best practise - or more importantly -
                                           providing independent Operational Due
recognise when something is out of
place.                                     Diligence services for all your potential
                                           Alternative Investments.
A real difficulty for many investors is
trying to recognize a substantial          We have also partnered with the only
operational risk when they see it.         dedicated ODD software solution in the
                                           market. This outstanding database and
In addition, conducting the ODD yourself   reporting solution centralizes and manages
means you have a lack of independent       all your ODD data.
judgement. You already think the fund is
a good investment; otherwise you           Contact us for more information.
wouldn’t have reached this stage in the
allocation process. This can cloud your
judgement.                                 Sign up for our monthly White
                                           Papers at-
It is also far easier to recommend
holding up an investment if you are an     http://www.globalperspective.co.uk/#!white-
external party. It is much harder if you   papers
report to an internal manager keen to
invest.                                    Or email: - shane@globalperspective.co.uk

Finally, be aware that some investment
consultants now offer ODD as a service.
Why any self-respecting investor would
pay an investment consultant for this
service - when they stand to gain
handsomely if the investment goes
ahead - is beyond our understanding.
This is a blatant, screaming conflict of
interest. Don’t fall for it.




Global Perspectives
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +44 20 3239 2843
Mobile: +353 (0) 87 115 2173

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The Rise & Rise of Operational Due Diligence - A Global Perspectives White Paper - July 2012

  • 1. A Global Perspectives White Paper The Rise & Rise of Operational Due Diligence “Who to meet & what to ask”. By Shane Brett, Founder Global Perspectives www.globalperspective.co.uk Date 28th July 2012
  • 2. Contents Introduction 2 "Sunlight is the best disinfectant" Who should be visited? 2 US Supreme Court Justice Louis Brandeis Investment Manager 3 Administrators 3 Introduction Auditors 4 Software Vendors 5 The Madoff scandal exposed the Alternative Investment Industry to widespread allegations of Ongoing ODD 5 substantial neglect, in terms of its Due Diligence DIY versus Bought in 6 processes. Understandably since then, Operational Due Diligence (ODD) has moved Conclusion 6 from a neglected, peripheral activity to centre Next Steps… 6 stage within the industry. The main aim of Hedge Fund Operational Due Diligence is to ensure that the fund is being managed in accordance with best practice operationally and that all aspects of its operation are above board. This White Paper will consider what a Hedge Fund Investor or Fund of Hedge Fund Manager needs to do, who they should visit and what they should ask? At Global Perspectives our Senior Staff have experience running the global ODD programmes for some of Europe’s largest Fund of Hedge Fund Managers. We have asked the hard questions and seen it all before. Who should be visited? A substantial part of successful Hedge Fund ODD is a judgement call. You know the facts, but how do you really make yourself comfortable that your investment will be managed properly? Our view is that you cannot accurately determine this with a phone call. To gain comfort with the people who will be directly and indirectly managing your investment, you must go on-site. For an investor to evaluate whether to proceed with an investment, they need to meet with all of the parties associated with the fund (outlined below). It is not enough to meet with the Investment Manager.
  • 3. Ignore consultants or hedge funds that In this case the Hedge Fund Manager had try and tell you a phone call is good difficulties understanding why we would not enough. It is not. approve an investment until this policy was changed - but changed it was. Thankfully this As any experienced ODD practitioner level of amateurism is in the past and will will tell you - you need to see the whites disappear completely as the industry matures of people’s eyes. and becomes dominated by large Institutional Investors. Another area to focus on is around access. Will the Fund Manager give you free, independent Investment Manager and unrestricted access to the Fund’s Service Providers? The Investment Manager will likely send you their standard AIMA questionnaire If not, then this is a major problem. in advance of your meeting. While this is a useful starting point it is imperative to see beyond this. We have had successful, well-known Hedge Fund Managers try and stop us speaking to their administrators (“you would only be distracting You are interested in understanding the them from their work on the Fund”). This is not detailed operational processes of the good enough and should be a red flag to any Fund Manager – from initial subscription savvy investor. to the fund, right through to the portfolio’s investments and the process of eventual redemption. Thankfully this sort of active prevention is becoming rarer and rarer, as Hedge Fund Managers chase allocations and Investors stand In asking your questions (and seeing their ground. beyond that questionnaire) It is important to follow the flow of cash into the fund and understand operationally Lastly, remember when you plan your visit to the what will happen as the money is Investment Manager it should be built around invested, valued and finally returned to the following core tenet – you as an investor. “Don’t tell me, show me”. One area to pay particular attention to is the Fund Manager’s protocol Everything the Fund Manager (and surrounding the movements of cash Administrator) tells you must be backed up with from the fund. Although this sounds clear, verifiable evidence. You need to see their obvious, it is scandalous the level of systems, see their processes and see their standards that existed in parts of the controls. industry before the global financial crisis, regarding how & when money If all of this sounds cumbersome, that’s because could be moved from a Fund. it is. It could also save you from being a victim of the next Madoff. In one memorable instance the Founder & Manager of a $4 billion dollar hedge fund we spoke to was allowed to move up to $5 million dollars of the Fund’s Administrators money to any account worldwide - with just his signature (“but sure he would only be stealing from himself” was their As the role of the Administrator increases in outrageous excuse). importance in our industry, a large part of ODD is now focused on the Administrator’s processes Global Perspectives www.globalperspective.co.uk Email: Shane@globalperspective.co.uk Phone: +44 20 3239 2843 Mobile: +353 (0) 87 115 2173
  • 4. and how they manage (which is after One final point to remember is around asset all), the Fund’s official books and segregation. The endless, legal black hole records. which confronted many Hedge Funds after Lehman’s collapsed could have been prevented Now that the US self-administered fund if assets had of been properly segregated. It is model has (thankfully) gone the way of vital you ensure that there is no co-mingling of the Dodo, Institutional Investors want to assets at your administrator. You must see clear see a robust, efficient and responsible evidence that your assets will be segregated in third party administrator in place for an account in the name of the Fund. every potential Hedge Fund to review. Some Administrators boast about their internal propriety systems, others Auditors promote their “best of breed” industry software. What is important to each Even today many Investors complete their ODD investor is different and this will largely process by speaking to the Fund Manager and dependent on your individual risk the Administrator only. That is not enough. appetite. Hedge Funds (particularly in the US) are often Most Administrators in the Hedge Fund audited by small (and very well regarded) industry report being inundated with specialist audit firms, which are well outside the ODD requests in the last few years. Big 4 in terms of scale and coverage. Many of the larger shops have set up specialist internal teams to facilitate these visits and co-ordinate the The driver here is of course the Madoff debacle responses. and his infamous unknown 3 person audit firm in Florida (complete with an 88 year old lady and only one practising accountant). This is great, but it’s important to look beyond the standard responses and actually see how their controls work and As a potential investor you need to be their processes take place (just like at comfortable that your auditor can perform their the Investment Managers). function in accordance with industry best practise. They are your main layer of protection as to the correct operational execution of the One trend we have noted recently is the fund. attraction of Administrators with large parent banks. Investors want to know there are very deep pockets behind their Auditors are peer reviewed every couple of Administrator (ironically as more and years. You should be able to see the results of more administrators seek to limit their this process and make yourself familiar with the liability in their administration findings. Ignore attempts at obfuscation and agreements). insist to see the report (or at least the Executive Summary). This will not make you any friends, but now that all the large Audit firms are Limited Given the demands from Institutional Liability Companies, it is up to you to ensure you Investors identified, above it is are happy that have your investment is unsurprising that a wave of protected. Your financial comeback in court is consolidation has enveloped the limited. Administration industry. Large Administrators are buying smaller outfits and many independent shops are The Auditor should be able to flag any past quietly up for sale. issues that have arisen with the Investment Manager (or generally within the industry). You should feel comfortable that the fund’s audit firm fully understands all aspects of the industry and the assets and instruments being traded. Global Perspectives www.globalperspective.co.uk Email: Shane@globalperspective.co.uk Phone: +44 20 3239 2843 Mobile: +353 (0) 87 115 2173
  • 5. Just like at the Administrator, the Finally, all Investment Managers and important question here is - Administrators will have a Business Continuity Plan in place (if not then you shouldn’t be “Who is watching the watcher”? considering an investment). Nowadays many of these disaster recovery programmes are The short answer is – you are. outsourced to third parties at specific off-site locations. That is why detailed ODD is so important. You need to familiarise yourself with their plans and speak to their providers. How often is their plan tested (it should be at least annually)? Have they had any emergencies in the past? How did they cope? What did they learn? Software Vendors One US Fund Manager we spoke to had to The Asset Management industry is move their business to the BCP location for 3 becoming more and more dependent on days after a murder was committed elsewhere in its software. Our suggestion is that you their business park and the police closed the speak to the vendors of the main whole area for 72 hours, while forensics software used to value and price your gathered evidence. potential hedge fund. Essentially this will be the Administrators software. The unthinkable can happen. If it is proprietary then you will want to know how it is supported. This includes meeting the individual’s responsible for keeping it running smoothly and secure. Ongoing ODD If it is an off the shelf system then you It is important to emphasise that ODD is not a need to familiarise yourself with this one-off exercise that is finished at the moment of company and its background as well as investment. Too many Fund of Hedge Funds / ensuring it is well managed and solvent. Investors make this mistake (despite claiming to the contrary). For both types of software you will want assurances that the vendor has a clear ODD is an on-going and iterative process. development plan to update their We can’t repeat this point often enough to our software so it encompasses all clients. forthcoming regulatory requirements. These should be met quickly and You should be visiting the Fund Manager, efficiently and incorporated into the Administrator and Auditor on at least an annual software well in advance of legislative basis, with calls/visits in between as required by requirements becoming law. changes to their business (e.g. a major Partner resigns, a NAV is restated etc). Understand the vendor’s testing processes and its speed to market. This way you establish a deep and on-going There is so much regulatory change relationship with the Fund Manager and their taking place across the industry this is service providers. It is then far easier to crucial (e.g. FATCA, AIFMD, Dodd ascertain when something is wrong. Frank etc). Global Perspectives www.globalperspective.co.uk Email: Shane@globalperspective.co.uk Phone: +44 20 3239 2843 Mobile: +353 (0) 87 115 2173
  • 6. DIY versus Bought in Conclusion An important question for any potential In summary, when embarking on Hedge Fund investor to ask is whether to carry out Operational Due Diligence you need to ensure ODD by themselves or call in an you speak to all parties that provide services to external party? the Fund. You need to make yourself comfortable with those people, their story and Many investors will try and do this work their strategy. This includes getting past the themselves. Some of the larger FoHF’s basic questions to gain a thorough have even set up specialist in-house understanding of their operational processes ODD teams. and procedures. One of the main problems for investors If you don’t get the transparency and comfort or fund managers trying to execute top you require, you must walk away from the class ODD is that they do not have the investment. required extensive operational experience. They might understand Next Steps… investment strategy, but this does not mean they will understand operational Global Perspectives can assist you by best practise - or more importantly - providing independent Operational Due recognise when something is out of place. Diligence services for all your potential Alternative Investments. A real difficulty for many investors is trying to recognize a substantial We have also partnered with the only operational risk when they see it. dedicated ODD software solution in the market. This outstanding database and In addition, conducting the ODD yourself reporting solution centralizes and manages means you have a lack of independent all your ODD data. judgement. You already think the fund is a good investment; otherwise you Contact us for more information. wouldn’t have reached this stage in the allocation process. This can cloud your judgement. Sign up for our monthly White Papers at- It is also far easier to recommend holding up an investment if you are an http://www.globalperspective.co.uk/#!white- external party. It is much harder if you papers report to an internal manager keen to invest. Or email: - shane@globalperspective.co.uk Finally, be aware that some investment consultants now offer ODD as a service. Why any self-respecting investor would pay an investment consultant for this service - when they stand to gain handsomely if the investment goes ahead - is beyond our understanding. This is a blatant, screaming conflict of interest. Don’t fall for it. Global Perspectives www.globalperspective.co.uk Email: Shane@globalperspective.co.uk Phone: +44 20 3239 2843 Mobile: +353 (0) 87 115 2173