Service Providers: The Importance of Prime Broker Due Diligence A recent Corgentum study has demonstrated that in the post-Lehman environment investors have increasingly and somewhat dangerously downgraded the roles of prime brokers. The majority of those surveyed ranked fund administrators and auditors as being more important than prime brokers. Specifically, only 17% of those investors surveyed indicated that they felt that prime brokers were the most important hedge fund service provider. When investors perform operational due diligence on fund managers, such as hedge funds, evaluating the fund and firm service providers is a critical element of the process. Included in this list of service providers should be a fund's prime brokerage relationships. This survey data suggests a trend whereby investors are increasingly minimizing the roles of prime brokers. As a result of this minimized importance, resource limited investors run the very real risk of focusing their due diligence efforts away from prime brokers, and instead on other service providers which they view as being more important. As the failure of Lehman brothers has demonstrated, investors can not solely rely on the fact that a prime broker is a big name bank or a leader in the industry. Additionally, different fund managers may be receiving different levels of services from prime brokers. Without delving into the specifics of such relationships, during the due diligence process investors may not have the information they need to make an effective determination as to the service provider risks to the hedge funds. Operational due diligence on prime brokers also provides investors with a useful avenue for independent fund manager asset verification. Investors who do not even attempt to contact prime brokers, or who are only confirming a fund manager’s relationships with a prime broker and doing nothing more, are missing this valuable opportunity. For those investors that wisely perform evaluations of fund manager prime brokerage relationships during the operational due diligence process, a word of caution is necessary. Perhaps taking a cue from the audit industry and on the advice of their legal departments, prime brokers have become increasingly difficult to deal with. So for example, if an investor reaches out to a prime broker to ask certain questions regarding the nature of their relationship with a fund manager, many times prime brokers will send back generic responses that do not address the investor’s questions in detail. Furthermore, such responses are often rife with legal disclaimer language making them difficult to evaluate in certain circumstances. The onus is then put back on investors to follow up with the prime brokers to attempt to have their specific questions answered. In many cases, prime brokers may be unresponsive or slow to respond which can
elongate the due diligence process and make it more difficult. However, just because it may be difficult does not mean that investors are not up to the challenge. By acknowledging the importance played by prime brokers, and constructing a detailed service provider review program which encompasses the specifics of prime brokerage relationships, investors will develop more comprehensive operational due diligence solutions, and perhaps avoid indirect exposure to the next Lehman. Originally posted in the August 2012 edition of Corgentum Consulting's Operational Due Diligence Insights. For More Information
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Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers. The firm works with investors including fund of funds, pensions, endowments, banks ultra-high networth individuals, and family offices to conduct the industry's most comprehensive operational due diligence reviews. Corgentum's work covers all fund strategies globally including hedge funds, private equity, real estate funds, and traditional funds. The firm's sole focus on operational due diligence, veteran experience, innovative original research and fundamental bottom up approach to due diligence allows Corgentum to ensure that the firm's clients avoid unnecessary operational risks.
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