Hedge Fund Operational Due Diligence

JASON A. SCHARFMAN is a Director with Graystone Research at Morgan Stanley. His responsibilities include analyzing and reporting on the operational risks of alternative investments such as hedge funds, funds of hedge funds, and private equity considered for investment. He also makes recommendations to the firm's investment committee based on that analysis. He has written on the subject of operational due diligence and travels and speaks worldwide on hedge fund operational risks.

• Preface xiiiChapter 1 What Is Operational Risk? 1Brief History 2Modern Definition of Operational Risk in a Hedge Fund Context 7Operational Due Diligence versus Operational Risk 8Key Areas 9External Risks 12Internal Risks 23Blended Risks 36The Five Core Themes 45Chapter 2 The Importance of Operational Due Diligence 49Why Should Investors Care about Operational Risk? 49Morton’s Fork or a Hobson’s Choice? 50Outright Fraud Still Exists 51Hedge Fund Fraud Cannot Be Modeled 52Small Discrepancies Add Up 52Lack of Standardized Regulation 54Each Hedge Fund Is Different 55Ability to Generate an Informational Edge 56Potential to Reduce Losses and Increase Returns 57Considering Operational Risk Factors Presents a Different View into a Firm 57Common Misconceptions 58Other Considerations: There Is Not Necessarily a Positive Correlation between Assets and Operational Quality 60A Study in Operational Failure: Bayou Hedge Fund Group 60Affiliated Broker-Dealer 61Large Discrepancies in the Performance of Onshore and Offshore Funds 62Declining Capital of Broker-Dealer 63Board of Directors: Members and Actions 63Lavish Expenses of Broker-Dealers 63Fake Audits Prepared by a Phony Auditor 64Background Questions 64Lack of Investor Communication 64Ties to People Barred from the Securities Industry 65Revision of Conflicted Marketing Materials 66Other Anomalies 66Chapter 3 Who Is Qualified to Perform an Operational Due Diligence Review? 69Essential Skills 73Primary Skills 74Primary, Secondary, Blended, and Other Skills 84In-house versus Outsourcing 85Evolution of Independent Operational Rating Agencies 86Benefits of Third-Party Rating Agencies 86Criticisms of Third-Party Rating Agencies and Operational Due Diligence Providers 87Factors to Consider before Performing an Operational Review of a Hedge Fund 90Chapter 4 Creating an Initial Operational Profile 91When Does an Operational Due Diligence Review Begin? 91Documentation 92The Piñata Problem 93Due Diligence Questionnaire: To Use or Not to Use? 99Background Investigations 101Other Considerations 106Importance of Onsite Visits 107Which Office to Visit 108Manager Interview Process 109What Topics Should Be Covered During an Onsite Review? 111Sample Topic Questions 113In What Order Should These Topics Be Covered? 117Service Provider Reviews 117Qualitative Operational Report: Documenting the Operational Data 119Chapter 5 Evaluating the Gray Areas: Examples 121Scenario 1: “It Was Not Me”—Hedge Fund Manager Claims Mistaken Identity 121Scenario 2: “It Was Me, But Everyone Was Doing It”—Are Regulatory Witch Hunts Real? 123Scenario 3: “It Was Me, But I Did Nothing Wrong”—Manager Proved Not Guilty 127Scenario 4: The Low-Profile Hedge Fund Manager—Is No News Good News? 129Scenario 5: The Infrastructure Outsourcer—Can One Administrator Do Everything? 135Scenario 6: The Mountain Climber—Can Plans for Large, Fast Growth Trip You Along the Way? 137Scenario 7: The Stumbling Giant—Can a Large Manager Lose Sight of Small Controls? 140Scenario 8: The Apologetic Headmaster—Are Junior Staff as Informed as Senior Management? 143Chapter 6 Ten Tips for Performing an Operational Due Diligence Review 145Tip 1: Avoid Meeting with the Wrong People or the Wrong Groups 146Tip 2: Get Out of the Conference Room 147Tip 3: Little White Lies Can Turn into Big Problems 149Tip 4: Be Wary of Phantomware 151Tip 5: Focus on Documentation and Negotiation 153Tip 6: Read the Fine Print (Financial Statement Notes, etc.) 154Tip 7: Reference Checking: Importance of In-Sample and Out-of-Sample References 156Tip 8: Credit Analysis: Are Funds Financially Viable? 157Tip 9: Long-Term Planning: Key Staff Retention, Succession Planning, and More 157Tip 10: Growth Planning: Is the Manager Proactive or Reactive? 158Chapter 7 Ongoing Operational Profile Monitoring 161How Often Should Onsite Operational Reviews Be Conducted? 163Remote Operational Due Diligence Monitoring 164Media Monitoring 164Litigation and Regulatory Monitoring 166Hedge Fund Communication Reviews 166Assets Under Management and Performance Monitoring 167Operational Events 168Effect of Discovery on the Magnitude of an Operational Event 169Onsite Visit Frequency and Operational Events 169Developmental Operational Traps 169Chapter 8 Techniques for Modeling Operational Risk 179Scoring Systems 179Building a Scoring System: Category Determination 179Category Definitions 185Combinations of Category Definition Approaches 189Category Weight Assignment 193Weighting Aggregation Model 195Weighting Disaggregation Model 197WAM versus WDM 200Category Weight Consistency and Reweighting Considerations 201Factor Marginalization 202Category Scale Determination and the Meaning of Scores 203Threshold Self-Assessment and Determination 204Score Assignment 206Discretionary Penalties and Bonuses 212Score Aggregation: Sum Totaling and Weighted Averages 214Criticisms of Scorecard Models 215Benefits of Scorecard Models 217Visualization Techniques 217Chapter 9 Bridging the Gap: Incorporating Operational Risk Consideration into the Portfolio Construction and Asset Allocation Process 225Proactive Monitoring: Graphical Universe Creation 227Proactive Management of Operational Risks 232Protecting against Conglomeration Risks: Multivariate Commonality Analysis 233Operational Directional Views 235Example of Multivariate Commonality Analysis 236First Objective: Total Diversity Goal 237Second Objective: FSA Overweight Goal 239Third Objective: FSA Underweight Goal 243Conclusions of Scenario Analysis 243Considering Operational Reviews in the Hedge Fund Portfolio Rebalancing Process 245Operational Drag 245Meta Risks 249Operational Factor 250Operational Scenario Analysis 253Can Operational Risk Be Entirely Eliminated? 254Factoring Operational Risk into Total Risk Calculations 256Beyond Scorecard Approaches: Discounting Expected Return 257Discounted Expected Returns with the Operational Factor 261Operational Haircuts 262Expected Return and Operational Risk 263Shape of the Expected Return versus Operational Risk Curve 264Second Operational Threshold 265Final Thoughts 267Chapter 10 Looking Ahead: Trends in the Space 269Increased Use of Consultants 269Commoditization of Background Investigations and Canned Operational Due Diligence Reports 272Increased Reliance on Service Provider Consulting Services 277Capture of Hedge Funds by Service Providers and Employees 278Hedge Fund Pursuit of Audit Certifications 280Operational Activism 281AU 332 and FAS 157 283Development of Hedges to Operational Risks 286Links between Operational Risk and Credit Analysis 288Proposed Reregulation of the Hedge Fund Industry 289Index 293

"Informative book by Jason Scharfman, on, well, pretty much everything you need to run a hedge fund…Scharfman also explains the reliance on technology that is becoming ever more apparent in hedge funds, the dangers of phantomware, and questions that should be asked before committing to any new technology." (hedgeco.net, January 26th, 2009) "In his book, Jason Scharfman identifies these operational risks and recommends a strong and innovative "operational" due diligence review program as the best defense against them. His book outlines a step-by-step guide that shows investors how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds and other investments in order to provide hedge funds and their investors with the skills to understand and hopefully mitigate these risks." (The Hedge Fund Law Report, January 8, 2009)