Sunday, January 4, 2009

Hedge fund due diligence: the visit

Further to the last post on Hedge fund operational due diligence, here is another by Cox Owen on the site visit.

I just have one addition to his comments. If I were to do a site visit of an investment manager, hedge fund or otherwise, I would ask the portfolio managers, traders and other staff questions about the investment and operating philosophy of the firm to see if there are any significant differences between the operational view and the marketing spin. In times of market stress, these differences in philosophy and approach can make the difference between successful control and catastrophic failure.

You can respond to him directly at coxowen1 at

On-site visit
We are going to fast forward quite a bit so we can jump into the “On-Site Visit”. In proper OPDD we would have discussed numerous other items prior to the on-site visit such as extensive phone conversations, verifications, background checks, reviewing the DDQ and much more. The on-site visit is not an overwhelming task if it is done correctly. Depending on the depth of your experience and the complexity of the fund, the visit should take a minimal amount of time. (usually only a day of two but can take up to a week if necessary). I will try to keep this very high level and extremely general in discussion, there is certainly more to the “On-Site Visit” than what is listed below.

A checklist for the visit
The on-site visit is a critical component of the due diligence process. Make sure the manager is aware that you are coming for a scheduled visit. You want to make sure that all key personnel are informed of your visit and are there to answer any questions you might have.

This is where the rubber meets the road. You have had the opportunity to review the offering documents, understand the managers fund structure and investment philosophy as well as answer almost any question you have about the manager via prior phone conversations. Now you starting the on site visit. This is how you will verify that the manager is operating according to what the offering documentation and DDQ have revealed.

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?

The on-site visit is much broader than the few areas mentioned above. Obviously the operational due diligence criteria will differ from manager to manager and is quite extensive. After all relevant information is collected it should be turned over to the investment committee for review. OPDD does have a black and white science behind it. But there is also the art of connecting all of the procedures and practices that lead to understanding the workflows that actually occur. Anyone new grad student can go down a check list, but to truly understand all of the operational fund complexities can only be done through experience.


Unknown said...

Oh man do you have it wrong! Checklists? That's so pre-Madoff. It's checklists like your that got us in this mess.

Unknown said...

Wow, I rarely say this but the other poster is correct! Cam you are du egg head d'jure with this stuff - normally spot on but a bit snarky and way off here!!! It's about proper methodologies not your bloddy lists sir - I am surprised you don't get this.

Institutional investor said...

Another on point post Cox. One of the risk managers that reports to my office pointed out your articles. A couple of questions. 1. What do you think of third party valuation groups? Can you recommend any? 2. We are looking into upgrading our OMS, do you have any opinions on the latest applications? By the way, some of the folks at GS recommended you to us today.

Scott said...

Spot on post. We ask almost the same sensible questions and have never had a problem with our manager selection.

Cox Owen said...

institutional investor - Thank you for the comments. As far as 3rd party valuation groups go, they play a vital role to the independent valuation process. Check out Navigant Capital Advisors. For your OMS take a look at Quod Financial, this is a very robust OMS/EMS in one application. Feel free to e-mail me at the above address if you would like to continue this discussion in more depth.

Cox Owen said...

Author/ Bernard – There are two options here, you can either ask these questions or not. Are you suggesting that we as investors do not ask these questions? ????????? I’m not sure if you have read the other post but this list of questions does come from a methodology. Feel free to e-mail me at the above address if you would like to continue this discussion in more depth or if I can help in any way.

Cox Owen said...

Scott – Thank you for your comments. Your correct, asking sensible and investigative questions is what OPDD is all about, assuming you understand the underling complexities of hedge funds. Anyone suggesting otherwise is just foolish.