Friday, December 26, 2008

Hedge fund operational due diligence

In light of the Madoff scandal, I thought that rather than add my own snark I would ask Cox Owen to guest blog on the issue of operational diligence. Cox has worked with and consulted for hedge funds, prime brokers, fund administrators and others for almost eight years in numerous capacities. While in the hedge fund business he has worked as an operations manager, trader, project manager, consultant and more. Cox's experience of launching his own fund and consulting for other start up funds has allowed him to gain an in-depth understanding of the operational due diligence process.

You can respond to him directly at coxowen1 at

The Operational Due Diligence Process
Operational Due Diligence within the hedge fund world typically is 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 long as we continue to allow the financial executives to “creatively” spin their ideas of fraud into alpha generation we will continue to see crisis after crisis. Unfortunately our regulators come up with solutions like SOX and FAS 157 after the damage is done. The regulators in our industry need to be proactive and not reactive to these types of double dealings.

With that being said, let me first say how sorry I am to all of the people who have been affected by the actions of the executives in the financial firms that have put us in this hellish situation. It seems that in executive speak - marketing is synonymous with lying and retention payment is synonymous with bonus. Since or current regulatory environment allows the Madoffs of the world to make fools of the fund of funds, hedge funds and other asset managers it seems that this is a good time to discuss operational due diligence.

I am not blaming the regulatory agencies for the losses we have seen in this mess. I am saying they could have done a lot to help prevent to current situation if we had rigorous regulation in the certain markets, specifically the swaps market. Unfortunately since there is no accountability for the Wall Street executives we will continue to see these firms grossly mismanaged again and again with bailout after bailout until we hold the executives and board members are held accountable or until it drags our country into a depression. Given all of the financial events that have occurred since 9/15/2008 (the day Lehman filed bankruptcy) through today, we are going to have to rely on ourselves for longevity. We will achieve this only through extensive operational due diligence within our industry.

Let's first discuss Mr. Madoff. It is exceptionally difficult to find any sympathy for the financial institutions that invested with Mr. Madoff. These financial institutions are supposed to verify numerous operational components of any type of investment vehicle they invest in. No one is sure what due diligence was done by these firms, we are only sure that it was offensively inadequate. They only logical explanation that I can see is that these firms were impressed with his background as Chairman of the NASDAQ and other moving accolades. There is certainly a place in my heart for all of the non-sophisticated investors (even though they might be classified as sophisticated because of income or net worth) who did not have the staff or knowledge to look into this Ponzi scheme.

I was recently asked to draft an operational due diligence manual to show the complete depth of OPDD. As I pondered the task I quickly came to the conclusion that each manual would be different. Conducting OPDD on a trend following CTA would be entirely different from a distressed debt shop, convertible arbitrage, market neutral and every other type of strategy. Of course you would have plenty of similarity in the basic questions, number of employees, who are the principals, what sectors do you trade, etc. I clearly understand the reason for secrecy in the hedge fund world. OPDD is not about getting the recipe to the secret sauce used in McDonalds hamburgers, rather it is to verify that there is a sauce, a hamburger, customers, and all of the other components that make a successful transaction in today’s markets. After almost 40 pages into my 1st manual for one strategy it became clear that this project could grow to about 150 pages. So not to bore you with all of the details I will try to provide you with a very high level overview of OPDD. So here we go, Before examining the core aspects of any operational components of a hedge fund we should look at the fundamental characteristics that will give us a better feel for the overall evaluation of the fund in question. Due Diligence starts before the front door, understand the prospect and their strategy before having in-depth conversations. Request offering documents and marketing literature.
  1. Articles – There are many media circulations (Hedge Fund Alert, Infovest 21, MAR Hedge,,, etc) that can provide general information about the individuals and their backgrounds. These articles can be a great starting point, but the information found in them should not be taken as gospel. The characteristic to look for: If the hedge fund tabloids find a launch story to be news worthy there may be some credibility to given to the fund managers. The sword cuts both ways, often you can find articles that take a negative spin. Read as many articles as you can and ask questions about the article as you can. Often you will get valuable information that you were not even looking for.
  2. People – a) Who are they?
    b) Are they known among credible peers or unknown?
    c) What is their pedigree?
    d) What type of significant investment experience do they possess?
    e) What were the key elements in the inception of the fund?
    f) Education?
  3. The Story – tell us how you got started in finance and what has lead you to this point. (Take notes)
    a) You want to make sure the story makes sense.
    b) You are checking the story for consistency as you will discuss
    their story more detail later.
    c) The story gives you the opportunity to take your discussion in any direction.
  4. The Strategy – Generally speaking, strong managers can articulate a robust and compelling strategy. (Most successful managers will offer significant amounts of information about their strategy because they know how difficult it is to replicate and to find the people to do it, successful managers usually will leave out small amounts of key information that constitute trader secret information)
    a) Being vague is a red flag.
    b) Managers who are unwilling or unable to discuss the strategy,
    are often amateurs or hobbyists.
    c) The manager should be an expert in the strategy and should
    be able to answer any question. d) What is the capacity of the strategy?
  5. Performance History (absolute and relative)- Performance history is subjective since it is correlated with risk. Example: A fund with a 2 yr track record that shows a +10% return at the end of both years might not be a good fit if it was riding 40 % drawdowns during the return period. Generally speaking, a minimum of a 2 consecutive year double digit positive return would be acceptable to move forward. As we discussed, this area is subjective for numerous reasons. Is the performance audited or verifiable in any way?
  6. Risk Management – After the Amaranth Advisors debacle and other financial disasters, it is critical to insure that risk managers are reporting and explaining all risk exposure to fund managers and others.
    a) Does the Manager use Incremental Var?
    b) Does the Manager use Marginal Var?
    c) Does the Manager use stress tests?
    d) Does the Manager apply its risk management methodology into its back testing?
  7. Traded Instruments and Liquidity – Illiquid markets can be difficult to enter
    and exit.
    a) What is the trading ability of the manager to execute trades in the described markets?
  8. Service Providers – Weaker managers will often use unknown service
    providers to reduce cost whilst sacrificing on proper service. More well
    known service providers arrange an on boarding team that will help new
    managers with many of the launching pitfalls?
    a) What law firm represents the manager?
    b) Who is the Auditor?
    c) Who is the Fund Administrator?
    d) Who is the Prime Broker?
  9. Transparency – Transparency is critical to investors today so they can see a
    day by day actual P&L.
    a) What types of transparency does the manager offer?
    b) What internal controls is the manager willing to share with the investor?
    c) What is the policy on trading errors?
    d) Does the fund have an error account?
    e) Does the manager offer managed accounts?

The offering document
The offering documentation structure can be different for every hedge fund and is almost completely different in context. The legal documentation of a hedge fund defines how the business and the fund will operate. Since every hedge fund is different (generally) and there are many good law firms with many good lawyers (each have a different flair for creating documentation). The general structure(an LLC is the GP of the LPA) is the same. The list of documents below will provide you with a general description and how they apply to the organizational and operational structure of the fund.

  • Operating Agreement – The operating agreement of an LLC defines how the business will operate. They are usually contain dissolution strategies (in the event of partnership disputes), allocations, distributions, capital commitments, management, fiscal matters, transfer of interest and more.
  • Private Placement Memorandum (PPM) – also known as the private offering memorandum. This memorandum specifies that this is a private offering that contains information about the investment process, management, ERISA and other regulatory issues, subscriptions, tax considerations, and more.
  • Limited Partnership Agreement (LPA)– This agreement defines the responsibilities and liabilities of the limited partners and the general partner. The LPA will discuss issues about key man risk, liquidation of assets and will also contain much of the same information contained in the PPM and the operating agreement.
  • Subscription Agreement – The subscription agreement allows the subscriber to identify what type of investor they are. (HNW, QEP, Foundation, Family Office, Institutional Investor, etc.)
  • Risk Disclosure Document – Often called a “D-Doc”, this document is designed to talk about the types in investing and the risks associated.
  • Business Plan – The Business Plan is a guide that the business follows in order to grow it’s business. They often detail the expenses for the first 2 yrs, number of employees, at what stage with assets under management will more employees be hired and more.
  • Marketing Document – This document will define how the fund and the managers are different from others. This document will also explain the investment philosophy and the key personnel involved.

You should keep in mind that you will see redundant information in theses documents. You are looking for inconsistencies within these documents and the DDQ that you will review later. Compare the DDQ to the notes that you have gather from the onsite visit (done later) along with the notes you have taken during your phone conversations.

Other documents that you could find along with the listed offering documents:
Investment Management Agreement
Investment Management Fees
Acknowledgement of Receipt
Trading Authorization
Arbitration Agreement
Form of Notional Funds Letter
Give-Up Agreement
Payment Authorization

The few topic we discussed are the tip of the iceberg. If you are interested in reading more about OPDD please post a response or email me directly. Or fell free to tell me to keep my trap shut and my opinions to myself.

Thank you for reading.


Unknown said...

very informative post!...... in researching more about hedge funds I came across a few books that were fascinating ..honest, and informative…..Hedge Fund Trading Secrets Revealed by Robert Dorfman... and Confessions of a Street Addict by Jim Cramer....both these books take you on a great ride about hedge funds and how they make money. I learned about this secret society than I ever would have imagined.

Finetimeman said...

Very good post Cox. I've been on the recipient end of OPDD for 10 years and many FoFs have no clue what to look for. Many use 25 yr olds college grads as DD analysts for on-the-job training exercises. Most of the high level checks you mention need to be done by every large, professional investor. Madoff's scam is the epitome of what is wrong with reputational investing.

Cox Owen said...

Kimbo - you hit the nail on the head. I’ve seen too many 20 something’s try to masquerade as investment gurus.

Unknown said...

Hedge fund regulation is likely to increase as Congress passes more laws with the intent of regulating the capital markets. Starting a hedge fund will become much more difficult in this new regulatory environment. However, hedge fund investors will likely receive more information on hedge fund managers as a result.

Finetimeman said...

As we embark on the money trail hunt with the Madoff issue, I'm interested in US readers' views on the effectiveness of the SEC as an enforcement regulator as opposed to other regulators around the world which have a Principles based framework. Do you think a Principles based approach in the US would be better or worse in protecting US investors from outright frauds like Madoff ?

Cox Owen said...

hedge fund lawyer - I hope you are correct. Amending the 3c7 & 3c1 sections of the 40 Act would be a good place to start.

Cox Owen said...

Hi Kimbo – Any additional US regulation would certainly be a step closer in protecting investors. So I am all for principal based regulation (as the FSA has tested the water first ) however, I’m not convinced it is a standalone answer.

Unknown said...

Kimbo - not sure if you came across this new book called Hedge Fund Operational Due Diligence written by Jason Scharfman, but it provided me with a good guide for what to expect from the investor operational due diligence process. Definetly worth the read before I got investor visits!

Finetimeman said...

Thanks Cox & Jim for your comments. We are having some good discussions with the Oz regulator down here. Particularly as the upcoming IOSCO taskforces on SSing, unreg. markets, and unreg. products, are coming to an end. Madoff managed bro. accts. probably falls into latter category. I note he is wearing bullet proof vests for his court appearances these days.His Columbian and Russian customers must be making their post-investment feelings known.

Jim, I'll look out for the HF DD book.

Unknown said...

I found this website to a be a good resource on this subject of me

Unknown said...
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