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How To Perform Due Diligence On Alternative Investments and Provide Transparency To Your Clients Presented by: Jason Scharfman, Managing Partner, Corgentum Consulting March 13, 2009
Š 2009 Corgentum Consulting, LLC
www.corgentum.com
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What Exactly is Due Diligence?
Vetting investment capabilities? capabilities
Verifying performance and/or other claims made by a manager?
Reviewing a manager’s compliance with the law/regulatory schemes?
Confirming someone’s academic/professional credentials?
Evaluating someone’s reputation in the market?
Collecting documentation? documentation
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The Due Diligence Equation
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The Alternatives Due Diligence Challenge
Lack of transparency
“Complex” structures and investment strategies
Minimal regulatory oversight - (but this may change soon)
Tendency towards being geographically global in scope
Too little or too much infrastructure
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Alternatives Due Diligence - More Bang For The Buck
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Increased up-front due diligence on alternatives can often add more value than due diligence on “traditional” investments:
Alternatives generally have longer lock-ups
Illiquid investments may incentivize investors to stick-around longer to realize returns
Redemption fees
“Small tickets” may not have a better opportunity for due diligence
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What is Operational Risk?
“A time bomb for investors.” David Aldrich, Hedge Fund Operational Risk: Meeting the Demand for Higher Transparency and Best Practice (June 2006)
“A fear category with a problematic reality status.” Michael Power, The Invention of Operational Risk (June 2003)
“The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.” Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework (June 2004)
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Primary Operational Risk Factors
Technology and systems
Business continuity and disaster recovery
Legal/compliance
Regulatory
Assets and investor concentration
Quality and length of relationship with tier-one service providers
Reputation of employees (including senior mgmt.) and firm
Valuation techniques and pricing sources
Compensation and employee turnover
Firm stability including expense analysis
Operations connectivity
Trade life cycle
Fund terms
Transparency and reporting
Counterparty oversight
Cash controls and management
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Secondary Operational Risk Factors
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Insurance
Independence and oversight of the board of directors
Quality and length of relationship with tier-two service providers
Tax practices
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The Effect of Re-regulation On Due Diligence
New “publicly available” standard - formalizing and requiring essentially same disclosures as current SEC form’s ADV
Re-regulation creates a minimum floor – it does not remove the requirements of both investment and operational due diligence
Non-US funds may not have to provide any information to the SEC
New SEC documents provide a good starting point for due diligence but:
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Unclear if the bill will pass
How long it will take to register every hedge fund?
How often this information will be updated?
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Beginning the due diligence process: Self-assessment
Do you have a current due diligence process? Is it documented or informal?
What is your goal in performing due diligence?
Is your due diligence process consistent across all investments?
How much time do you have to dedicate to due diligence?
What resources can you dedicate to due diligence?
Do you have the requisite skills to perform both investment and operational alternatives due diligence?
Can you explain and demonstrate your due diligence process to your clients?
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The Stages In A Due Diligence Program Investors Perspective What data to gather?
Hedge Fund’s Perspective
Respond to data requests
Data gathering process?
Data analysis
Provide clarification regarding data analysis process
Operational Decision On-going monitoring (if investment made)
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Assist with ongoing monitoring (if investment made)
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Anatomy Of An Operational Risk Review
Typical operation due diligence analyst time allocation:
On-site meeting, 3% Final review, 7% Meeting preparation, 3% Document collection, 17% Document review, 70% 70
*Based on an average 150 hour operational due diligence review
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Data Gathering: Documentation – what to ask for?
For each Hedge Fund Vehicle(s) Under Consideration:
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Core fund legal documents:
Offering memoranda
Subscription documents
Articles of association (if applicable)
Limited partnership agreement (if applicable)
Other core fund documents:
Audited financials
Hedge fund manager provided due diligence questionnaire
Samples of recent marketing materials (pitchbook, etc.)
Recent investor letters
Performance track record
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Data Gathering: Documentation continued‌
For the Hedge Fund Management Company:
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Compliance manual, including:
Personal trading procedures
Anti-money-laundering policies and procedures
Electronic communication policy
Organizational chart
Business continuity and disaster recovery plan
Valuation procedures
Certificate of incorporation and/or certificate of good standing
Details of insurance coverage (including copies of insurance certificates)
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Data Gathering: Documentation continued…
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For US SEC Registered funds:
Form ADV Part 1
Form ADV Part 2
Schedule F
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Data Gathering: Documentation – how to ask for it?
Do not submit self-limiting documents requests
Ask the manager if there is anything else you should have
Do not be afraid to ask a manager to create a basic document (i.e. – org chart) if they don’t have
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Data Gathering: Background investigation component
Costs considerations – reports can be in excess of $1,500 per person
Whom to order investigation on?
On-going monitoring components
International capabilities?
Very important to understand the scope what is being covered
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Data Gathering: Documentation – DDQ’s
Some advisors prepare their own due diligence questionnaires – others do not
Trend in industry moving away from asking a hedge fund to complete a unique due diligence questionnaire
Creates a large burden on the manager – often copied from their own ddq
Element of surprise
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Data Gathering: Documentation – what to do with it?
All documentation should be read in detail
Notes system should facilitate document review
Silo approach – break the review up by function and document type (i.e. – legal documents reviewed by a lawyer)
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Data Gathering: Documentation – Common Issues?
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The Piñata Problem:
Too many documents become overwhelming
No one tells you what is “important” and what isn’t
No one tells you “where” to look in “important” documents
Fat-file syndrome:
Documents are collected to check-a-box and thrown in a drawer
Can create more liability issues than if you never collected them at all
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Data Gathering: Documentation – General Tips
Always check the “as of” date for stale documents:
Inaccurate or irrelevant information
May state service provider relationships that no longer exist
Can be a sign of laziness/poor oversight on fund’s part
If a new version of a document is released compare the old with the new
Look for documents that are referenced but you did not receive
If a manager says they will provide something – follow up
Ask for a table of contents if a manager won’t provide the whole thing
Take the time to review documents onon-site if a manager won’t release it
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Data Gathering: On-site Reviews
Confirm the operational story you pieced together from a hedge fund’s documentation
Follow up on /clarify any specific issues that documents were either vague about or not discussed in enough detail
Other factors to review confirm when on-site: office space, scalability, security etc.
Be prepared! – don’t learn the subject while taking the test
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Data Gathering: Service Provider Reviews
Common service providers examined:
Administrator
Auditor
Custodian
Legal Counsel
IT providers
At a minimum attempt to confirm the relationship with all providers
Attempt to collect documentation from providers such as DDQ’s and SAS 70
Common to perform a call with administrator to confirm what the hedge fund has told you
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Free/Low cost due diligence resources
Web-searches (Google etc.)
Real and virtual social networks (i.e. – Linked in)
Regulatory websites: www.sec.gov; www.fsa.go.uk; www.nfa.future.org
Database services: LexisNexis, Factiva etc.
“Library model” background investigation canned reports
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Case Study: The Snowball Effect
Due diligence uncovers misdemeanor criminal activity in department head’s background (not caught by the company’s pre-employment screening because occurred after initial date of hire); hedge fund organization was unaware of this…
Hedge fund maintains a code of ethics which states, “Employees shall advise compliance immediately if they become involved in or threatened with litigation or an administrative investigation or proceeding of any kind, or is subject to any judgment, order or arrest.”
Code of Ethics Violation?
Reputational Risk?
“Culture of Compliance” Questions?
Potential ADV Disclosures?
Policy Revisions?
Personnel Turnover?
Existing/New Investor Notification?
Elongated Due Diligence Process
No Investment 25
Reduced Investment
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Case Study: Multiple “Small” Operational Issues Negative Media
Inefficient Legacy Administrator Still Utilized
Extended Delay in Geneva Implementation
No Offsite BCP/DR Site
Level of preemployment screening?
Service provider oversight?
Lack of internal operational planning?
Input of IT into organizational planning?
No Internal Valuation Committee
Lack of independent oversight?
Reputational risks?
Financial stability questions?
Is the business scalable?
“Affiliated” Board Members
Sufficient internal checks and balances?
CCO Unaware of Outside Business Directorships
Personnel Turnover
Not being reported? or Policy not enforced?
Compensation issues?
Code of Ethics Violations?
Retention scheme issues?
Culture of compliance? / Policy revisions?
Information security issues?
Appropriate oversight from senior management?
Are different parts of the organization connecting?
Elongated Due Diligence Process
No Investment 26
Reduced Investment
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Third-party due diligence vendors: Caveat Emptor
The term “Due Diligence” means different things to different people – it is important to understand exactly what kind of due diligence you are buying
Background investigation firm’s sell their services under the heading “due diligence”
Compliance consultants will perform compliance-heavy reviews calling it “due diligence”
Some companies sell investment only reports as “due diligence”
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Third-party due diligence resources: Rating Agencies
Operational Risk Ratings (NOT RECOMMENDED!) :
Offer a “seal of good housekeeping” for operational risk
Several problems associated with operational risk rating firms: Franchise Risk
Conflict of Interest
Cookie-Cutter Approach
Poor Market Perception
Information Decay
No On-going Monitoring
No On-going Support
Limited Scope
Few Actionable Recommendations
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Third-party resources: Traditional Consultants
Provide advice/guidance on alternatives selection
Some perform only investment due diligence
Movement towards incorporating operational due diligence too
Cumbersome process often discourages hedge funds from participating
Database services offered as well
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Third-party resources: Operational Risk Consultants
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Myriad of services including:
Full outsourced operational due diligence
On-going monitoring etc.
Benefits:
Cost-effective
Access to specialized skill sets required for comprehensive review
Potential pitfalls:
Firm’s focusing too heavily on one area (i.e. – compliance, accounting etc,)
Canned reports
Perception that you can outsource the process completely
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The challenge of on-going monitoring
Remote monitoring
Requires an on-going effort
How often to perform on-site visits?
Do not expect the hedge fund to be pro-active
Clippings services
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Providing transparency into your process
Create a process manual manua which outlines your due diligence process
Provide investors with example due diligence reports you have created
If outsourcing:
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Be able to explain your providers process
Explain what you do with the information your provider gives you
A detailed due diligence process can justify higher fees and serve as an important differentiator
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Questions
For more information contact:
Jason Scharfman, Managing Partner scharfman@corgentum.com corgentum.com Main: 201-360-2430 Direct: 201-918-5201 33