How To Perform Due Diligence On Alternative Investments and Provide Transparency To Your Clients

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How To Perform Due Diligence On Alternative Investments and How To Perform Due Diligence On Alternative Investments and How To Perform Due Diligence On Alternative Investments and How To Perform Due Diligence On Alternative Investments and

Provide Transparency To Your ClientsProvide Transparency To Your ClientsProvide Transparency To Your ClientsProvide Transparency To Your Clients

Presented by: Jason Scharfman, Managing Partner, Corgentum Consulting

March 13, 2009

© 2009 Corgentum Consulting, LLC www.corgentum.com

What Exactly is Due Diligence?

� Vetting investment capabilitiesinvestment capabilitiesinvestment capabilitiesinvestment capabilities?

� Verifying performanceperformanceperformanceperformance and/or other claims made by a manager?

� Reviewing a manager’s compliancecompliancecompliancecompliance with the law/regulatory schemes?


� Reviewing a manager’s compliancecompliancecompliancecompliance with the law/regulatory schemes?

� Confirming someone’s academic/professional academic/professional academic/professional academic/professional credentials?

� Evaluating someone’s reputationreputationreputationreputation in the market?

� Collecting documentationdocumentationdocumentationdocumentation?

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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)


� 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

� 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 Technology and Technology and Technology and

systemssystemssystemssystems

Business continuity Business continuity Business continuity Business continuity

and disaster and disaster and disaster and disaster

recoveryrecoveryrecoveryrecovery

Legal/complianceLegal/complianceLegal/complianceLegal/compliance RegulatoryRegulatoryRegulatoryRegulatory

Assets and investor

concentration

Quality and length

of relationship with

tier-one service

Reputation of

employees

(including senior

Valuation

techniques and

pricing sources

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tier-one service

providers

(including senior

mgmt.) and firm

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

Secondary Operational Risk Factors


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:

� 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


What data to gather?

Data gathering process?

Data analysis

Investors PerspectiveInvestors PerspectiveInvestors PerspectiveInvestors Perspective Hedge Fund’s PerspectiveHedge Fund’s PerspectiveHedge Fund’s PerspectiveHedge Fund’s Perspective

Respond to

data requests

Provide

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Data analysis

Operational Decision

On-going monitoring (if

investment made)

Provide

clarification

regarding data

analysis process

Assist with on-

going monitoring

(if investment

made)

Anatomy Of An Operational Risk Review

� Typical operation due diligence analyst time allocation:

On-site meeting, 3%

Final review, 7%

Meeting preparation, 3%


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*Based on an average 150 hour

operational due diligence review

Meeting preparation, 3%

Document collection, 17%

Document review, 70Document review, 70Document review, 70Document review, 70%

Data Gathering: Documentation – what to ask for?

For each Hedge Fund Vehicle(s) Under Consideration:

� Core fund legal documents:Core fund legal documents:Core fund legal documents:Core fund legal documents:

� Offering memoranda

� Subscription documents

� Articles of association (if applicable)

Limited partnership agreement (if applicable)


� Limited partnership agreement (if applicable)

� Other core fund documents:Other core fund documents:Other core fund documents: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:

� Compliance manual, including:Compliance manual, including:Compliance manual, including:Compliance manual, including:

� Personal trading procedures

� Anti-money-laundering policies and procedures

� Electronic communication policy

Organizational chart


� 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…

� For US SEC Registered funds:For US SEC Registered funds:For US SEC Registered funds: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


� 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


� 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 Trend in industry moving away from asking a hedge fund to complete a Trend in industry moving away from asking a hedge fund to complete a Trend in industry moving away from asking a hedge fund to complete a

unique due diligence questionnaireunique due diligence questionnaireunique due diligence questionnaireunique 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.


� 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?

� 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:


� 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 check the “as of” date check the “as of” date 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 receivereferenced but you did not receivereferenced but you did not receivereferenced but you did not receive

� If a manager says they will provide something – follow upfollow upfollow upfollow up

� Ask for a table of contents a table of contents a table of contents a table of contents if a manager won’t provide the whole thing

� Take the time to review documents onreview documents onreview documents onreview documents on----site site site site if a manager won’t release it

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Data Gathering: On-site Reviews

� Confirm the operational story Confirm the operational story Confirm the operational story 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


� 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


� 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.”


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Code of Ethics

Violation?

Code of Ethics

Violation?

Reputational

Risk?

Reputational

Risk?

“Culture of

Compliance”

Questions?

“Culture of

Compliance”

Questions?

Potential

ADV

Disclosures?

Potential

ADV

Disclosures?

Policy

Revisions?

Policy

Revisions?

Personnel

Turnover?

Personnel

Turnover?

Existing/New

Investor

Notification?

Existing/New

Investor

Notification?

Reduced InvestmentNo Investment

Elongated Due Diligence ProcessElongated Due Diligence Process

Case Study: Multiple “Small” Operational Issues

NegativeMediaNegativeMedia

Inefficient Legacy

AdministratorStill Utilized

Inefficient Legacy

AdministratorStill Utilized

ExtendedDelay inGeneva

Implementation

ExtendedDelay inGeneva

Implementation

No OffsiteBCP/DRSite

No OffsiteBCP/DRSite

No InternalValuationCommittee

No InternalValuationCommittee

“Affiliated”Board

Members

“Affiliated”Board

Members

CCO Unawareof OutsideBusiness

Directorships

CCO Unawareof OutsideBusiness

Directorships

PersonnelTurnoverPersonnelTurnover

Not being reported? or Policy

not enforced?

Culture of

Compensation issues?

Lack of independent oversight?

Lack of internal operational planning?

Reputational risks?

Level of pre-employment screening?

Service provider oversight?

Retention scheme issues?

Code of Ethics Violations?

Input of IT into organizational planning?

Information


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Culture of compliance? / Policy revisions?

Information security issues?

Reduced InvestmentNo Investment

Elongated Due Diligence ProcessElongated Due Diligence Process

Sufficient internal

checks and balances?

Sufficient internal

checks and balances?

Are different parts of the

organization connecting?

Are different parts of the

organization connecting?

Is the business

scalable?

Is the business

scalable?

Appropriate oversight

from senior management?

Appropriate oversight

from senior management?

Financial stability

questions?

Financial stability

questions?

Third-party due diligence vendors: Caveat Emptor

� The term “Due Diligence” means different things to different people “Due Diligence” means different things to different people “Due Diligence” means different things to different people “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”


“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


� 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


� 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


� Myriad of services including:

� Full outsourced operational due diligence

� On-going monitoring etc.

� Benefits:

Cost-effective

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� 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

The challenge of on-going monitoring

� Remote monitoring

� Requires an on-going effort

� How often to perform on-site visits?


� 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 manuaprocess manuaprocess manuaprocess manual which outlines your due diligence process

� Provide investors with example due diligence reportsexample due diligence reportsexample due diligence reportsexample due diligence reports you have created

� If outsourcing:


� If outsourcing:

� Be able to explain your providers processexplain your providers processexplain your providers processexplain your providers process

� Explain what you do with the information your provider gives youwhat you do with the information your provider gives youwhat you do with the information your provider gives youwhat you do with the information your provider gives you

� A detailed due diligence process can justify higher fees and serve as an A detailed due diligence process can justify higher fees and serve as an A detailed due diligence process can justify higher fees and serve as an A detailed due diligence process can justify higher fees and serve as an

important differentiatorimportant differentiatorimportant differentiatorimportant differentiator

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Questions


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For more information contact:

Jason Scharfman, Managing Partner

[email protected]

corgentum.com

Main: 201-360-2430

Direct: 201-918-5201

How To Perform Due Diligence On Alternative Investments and Provide Transparency To Your Clients

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