The Necessity Of Hedge Fund Due Diligence Investigations

In view of recent hedge fund scandals and the state of the economy, hedge fund operational due diligence may and should be done to verify that the fund is doing what they say they are doing and to ensure that the fund is following industry regulations and best practices.

As the words themselves imply, an ODD (operational due diligence) exercise is an investigation into operational factors, relating to a specific alternative investment entity such as a hedge fund (or private equity fund, or infrastructure fund, etc.), which may impact future results of the target alternative investment entity.

The field of ODD has gained prominence over the past years due to the failure of hedge funds such as Amaranth Advisors and the Bayou Hedge Fund Group . Also contributing to the increase of interest in this field were the actions of alleged rogue traders such as Brian Hunter and alleged Ponzi schemers such as Arthur Nadel and Bernard Madoff .

Operational risks , put simply, are the risks arising from execution of the business functions of any entity, for example an alternative investment fund, and these are distinct from its investment functions.

Richard Wilson, of http://richard-wilson.blogspot.com/2009/03/hedge-fund-operational-due-diligence.html has created a brilliant list of hedge fund due diligence questions.  Here is his list from A to aa:

a) Verify the business location is as stated in the legal documents.
b) Meet all of the principals, PMs, analyst, operational staff, etc.
c) Verify all internal groups operate accordingly. (technology, accounting, operations, trading, risk, research etc.). Walk through the entire trade process: Trade generation, execution and processing, reconciliation, accounting, database and systems administration etc.
d) Verify the Disaster Recovery site is operational and working. (When was it last tested? How often does the manager use it? Does the manager have a DR plan? If so get a copy of it, how was the manager affected by key events, such as 9/11 and the 8/14/2003 blackout, other business continuity planning, etc.)
f) Does the manager have a non-investment group that provides control oversight in an open and transparent manner?
g) Verify that the working relationships with service providers are fluid and work under stress.
h) Verify that other investors are also sophisticated investors. (you will certainly feel more comfortable if other investors have preformed their OPDD)
i) Develop an overall assessment of the team and infrastructure
j) Does the compliance environment include documented policies and procedures for all relevant areas (soft dollar, personal trading, trade allocations, etc)? (Ask for a copy of the compliance manual.)
k) Verify cash controls and movements.
l) Develop a list of likes and dislikes.
m) Portfolio administration: Does the manager use Advent, Advisorware or some other recognized software application, or are they using Excel? The software used is critical because robust software can reduce fail points and errors.
n) Does the manager rely on service providers for NAV accounting?
o) Does the manager have an independent set of books and records reconciled to the prime broker?
You should ask to see redacted key trades – let’s say the fund discusses a drawdown of 7% in February and a 21% peak in March you want to verify those trades actually occurred internally and with the Prime broker and the fund administrator.
p) Does the manager plan on trading new instruments?
q) Is the manager experiencing employee turnover?
r) Is the manager planning on making any material changes to management, administration, the strategy or key personnel?
s) Is the manager or any key personnel the subject of any governmental or regulatory investigation?
t) Does the manager have an experienced non-investment leadership providing oversight of internal processes and service providers?
u) Does the manager have a consistent and well – documented valuation and pricing process, if so ask for a copy.
v) Does the manager have an external administrator providing full service support including daily trade capture and reconciliation to prime broker?
w) Does the manager have a dedicated operational team with well defined procedures and processes?
x) Are cash movements and account openings authorized by a single signature?
y) Is the back office subject to key man risk due to being understaffed?
z) Verify the accuracy of the historical data (compare it to cleansed data – I’ve seen a PM show a profitable trade but when I took a closer look at the data it was not remotely close to what the market actually traded on the date in question.)
aa) Verify that the firm has followed its Business Plan.
bb) Does the manager provide annually audited finical statements for the considered funds?