A framework for HF operational due diligence

Here is another in a series by guest blogger Cox Owen on hedge fund operational due diligence (see part 1 and part 2 here). Please direct any comments to him directly at coxowen1 at yahoo.com.

A framework for OPDD
We have been jumping around a bit to try to show a broad picture of OPDD. I will try to use this post as a framework for start-up funds so that these first- timers will get a glimpse at the hoops the institutional investors will expect them to jump through from an OPDD perspective. Also, please understand that this is only a small portion of what institutional investors are looking for. As a start up you should be prepared to provide biographies of key staff, references, a list or service providers, a list a fund expenses and much more. Remember you are asking these institutions to trust you with their money. (not all start-ups are first-timers)

We must first discuss the hedge fund landscape. 10 years ago you could launch a single strategy fund (for the sake of this conversation we will assume that the strategy will be successful ) without having to jump through all of the hoops that HF’s must jump through today. This occurrence can be attributed to two primary factors. 1st – because OPDD has evolved tremendously since 1999. Every time there is a financial catastrophe, scandal, scheme, implosion, etc., our natural response is to say “How do we make sure that this does not happen to us again?”, and then we reactively add this new mechanism to our OPDD format. Second, because there were far fewer funds in 1999 than in 2009, the institutional investors did not have the luxury of saying. “Why should we put money with you when we can put our money with manager ABC who has a similar strategy and an enormous operational infrastructure.” Let me see if I can be a little more clear, in 1999 it was not an industry standard to have a robust operational infrastructure, in 2009 it is a standard ( a very expensive one). This does not mean the institutional investors will not invest in start-ups if the fund does not have all of the OPDD infrastructure listed below. Once again, this is only a small portion of OPDD that a fund should expect from an institutional investor.

Frameworks

1. Valuation
2. Trading
3. Operations and Accounting
4. Ethics
5. Compliance
6. Disclosure
7. The risk profile
8. Disaster Recovery & Business Continuity

I could write over 100 pages discussing the frameworks for these sections. Rather than bore you, I will try to condense a few topics that can be applied to each. Much of what I discuss can be found in the report Best Practices for the Hedge Fund Industry by the asset managers’ committee to the President’s Working Group on Financial Markets.

A) Is there a person or committee responsible for oversight of the framework? (In some instances a person would be better than a committee and vice versa . A good example of this would be to compare risk to valuation. Generally speaking, you would definitely want a valuation committee because valuation decisions are not difficult and it is easy to build consensus. Whereas in a risk profile you would much rather have a single person because the decisions are more complex , risk methodologies can be argued from many different perspectives, it would most likely be difficult to build consensus, and it would also be very expensive to have a team risk professionals debating methodologies for the profile. However this is not always the case.

B) Is there a documented procedure that describes how the framework is applied to the fund? (A good example of the would-be ethics. How does the firm ensure that all of its employees are following a code of ethics)

C) Who is responsible for monitoring the framework? (The best example here is probably compliance or DR/BC. Who is monitoring all of the evolving compliance matters are being met by the fund? Business interruptions from black-outs, terrorist attacks, hurricanes, floods, snow storms, earthquakes and many other reasons do occur. Who is monitoring and all of the operational and investment enhancements for DR/BC?)

D) Who is responsible for executing the framework? (Now I know this sounds a lot like monitoring but there is a big difference. Let’s use risk as an example. You can certainly have a lower level employee monitoring, let’s say position limits, and he notices that 8 separate traders each decided to take a long position in crude. Each decides to put on 1500 contracts in the front month, a total of 12000. Two big problems have occurred here. First, the position limits for exchange (NYMEX) is 10000 contracts in any one month. So this would certainly lead to some type of warning and possibly a fine by the exchange. Second is that the internal position limits of the fund have more than likely been breached (assuming the fund has internal position limits). Funds with sound risk profiles don’t want to find that they are holding 25% of the open interest in a commodity, so they instill an internal position limit. If a fund does hold such a large percentage of the open interest and the trade begins to move against them they will more than likely find themselves moving the market into limit up or limit down scenarios. So a senior officer of the fund should be responsible for executing (telling traders they have limits) the framework.

Where does the buck stop?
We could certainly dive further into OPDD framework, however let’s migrate a little bit and discuss accountability. As investors, we are always trying to protect our investments as best we can. We conduct thorough due diligence, we develop relationships with managers, we make every effort to ensure our investments. All of this, to find out that a rogue trader circumvented the risk teams at SocGen, or Amaranth or whereever. Let’s says for a minute that I actually believe the manager's story, if that’s the case, the manager seems to be negligent. After all, they verified in our DDQs that they have preventative measures in place to prevent these types of situation. The point here is that we need claw back provisions that allow investors to recover losses from poorly managed funds. Just my $.02 .

I certainly appreciate all of your e-mails and posts. I apologize if I have not been able to reply to all of you as the response has been much greater than I have expected. However, please continue to send e-mails and posts and I will do my best to reply.

I hope the read was beneficial. Thanks again for all of your kind e-mails and posts.