Hedge Fund Operational Due Diligence Understanding the Risks

by Scharfman, Jason A.

• ISBN13: 9780470372340
• ISBN10: 0470372346
• Edition: 1st
• Format: Hardcover
• Copyright: 2008-12-03
• Publisher: Wiley

Summary

How to diagnose and monitor key hedge fund operational risks With the various scandals taking place with hedge funds, now more than ever, both financial and operational risks must be examined. Revealing how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds, such as multi-jurisdictional regulatory coordination, organizational nesting, and vaporware, Hedge Fund Operational Due Diligence includes real-world examples drawn from the author's experiences dealing with the operational risks of a global platform of over 80 hedge funds, funds of hedge funds, private equity, and real estate managers. Jason A. Scharfman (Jersey City, NJ) is a Director of Operational Risk with Graystone Research, a unit of Morgan Stanley. His responsibilities include analyzing and reporting on the operational risks of alternative investments considered for investment by ultra-high-net-worth individuals.

Author Biography

Jason A. Scharfman is a Director with Graystone Research at Morgan Stanley.

Table of Contents

Preface	p. xiii
What Is Operational Risk?	p. 1
Brief History	p. 2
Modern Definition of Operational Risk in a Hedge Fund Context	p. 7
Operational Due Diligence versus Operational Risk	p. 8
Key Areas	p. 9
External Risks	p. 12
Internal Risks	p. 23
Blended Risks	p. 36
The Five Core Themes	p. 45
The Importance of Operational Due Diligence	p. 49
Why Should Investors Care about Operational Risk?	p. 49
Morton's Fork or a Hobson's Choice?	p. 50
Outright Fraud Still Exists	p. 51
Hedge Fund Fraud Cannot Be Modeled	p. 52
Small Discrepancies Add Up	p. 52
Lack of Standardized Regulation	p. 54
Each Hedge Fund Is Different	p. 55
Ability to Generate an Informational Edge	p. 56
Potential to Reduce Losses and Increase Returns	p. 57
Considering Operational Risk Factors Presents a Different View into a Firm	p. 57
Common Misconceptions	p. 58
Other Considerations: There Is Not Necessarily a Positive Correlation between Assets and Operational Quality	p. 60
A Study in Operational Failure: Bayou Hedge Fund Group	p. 60
Affiliated Broker-Dealer	p. 61
Large Discrepancies in the Performance of Onshore and Offshore Funds	p. 62
Declining Capital of Broker-Dealer	p. 63
Board of Directors: Members and Actions	p. 63
Lavish Expenses of Broker-Dealers	p. 63
Fake Audits Prepared by a Phony Auditor	p. 64
Background Questions	p. 64
Lack of Investor Communication	p. 64
Ties to People Barred from the Securities Industry	p. 65
Revision of Conflicted Marketing Materials	p. 66
Other Anomalies	p. 66
Who Is Qualified to Perform an Operational Due Diligence Review?	p. 69
Essential Skills	p. 73
Primary Skills	p. 74
Primary, Secondary, Blended, and Other Skills	p. 84
In-house versus Outsourcing	p. 85
Evolution of Independent Operational Rating Agencies	p. 86
Benefits of Third-Party Rating Agencies	p. 86
Criticisms of Third-Party Rating Agencies and Operational Due Diligence Providers	p. 87
Factors to Consider before Performing an Operational Review of a Hedge Fund	p. 90
Creating an Initial Operational Profile	p. 91
When Does an Operational Due Diligence Review Begin?	p. 91
Documentation	p. 92
The Pinata Problem	p. 93
Due Diligence Questionnaire: To Use or Not to Use?	p. 99
Background Investigations	p. 101
Other Considerations	p. 106
Importance of Onsite Visits	p. 107
Which Office to Visit	p. 108
Manager Interview Process	p. 109
What Topics Should Be Covered During an Onsite Review?	p. 111
Sample Topic Questions	p. 113
In What Order Should These Topics Be Covered?	p. 117
Service Provider Reviews	p. 117
Qualitative Operational Report: Documenting the Operational Data	p. 119
Evaluating the Gray Areas: Examples	p. 121
"It Was Not Me"-Hedge Fund Manager Claims Mistaken Identity	p. 121
"It Was Me, But Everyone Was Doing It"-Are Regulatory Witch Hunts Real?	p. 123
"It Was Me, But I Did Nothing Wrong"-Manager Proved Not Guilty	p. 127
The Low-Profile Hedge Fund Manager-Is No News Good News?	p. 129
The Infrastructure Outsourcer-Can One Administrator Do Everything?	p. 135
The Mountain Climber-Can Plans for Large, Fast Growth Trip You Along the Way?	p. 137
The Stumbling Giant-Can a Large Manager Lose Sight of Small Controls?	p. 140
The Apologetic Headmaster-Are Junior Staff as Informed as Senior Management?	p. 143
Ten Tips for Performing an Operational Due Diligence Review	p. 145
Avoid Meeting with the Wrong People or the Wrong Groups	p. 146
Get Out of the Conference Room	p. 147
Little White Lies Can Turn into Big Problems	p. 149
Be Wary of Phantomware	p. 151
Focus on Documentation and Negotiation	p. 153
Read the Fine Print (Financial Statement Notes, etc.)	p. 154
Reference Checking: Importance of In-Sample and Out-of-Sample References	p. 156
Credit Analysis: Are Funds Financially Viable?	p. 157
Long-Term Planning: Key Staff Retention, Succession Planning, and More	p. 157
Growth Planning: Is the Manager Proactive or Reactive?	p. 158
Ongoing Operational Profile Monitoring	p. 161
How Often Should Onsite Operational Reviews Be Conducted?	p. 163
Remote Operational Due Diligence Monitoring	p. 164
Media Monitoring	p. 164
Litigation and Regulatory Monitoring	p. 166
Hedge Fund Communication Reviews	p. 166
Assets Under Management and Performance Monitoring	p. 167
Operational Events	p. 168
Effect of Discovery on the Magnitude of an Operational Event	p. 169
Onsite Visit Frequency and Operational Events	p. 169
Developmental Operational Traps	p. 169
Techniques for Modeling Operational Risk	p. 179
Scoring Systems	p. 179
Building a Scoring System: Category Determination	p. 179
Category Definitions	p. 185
Combinations of Category Definition Approaches	p. 189
Category Weight Assignment	p. 193
Weighting Aggregation Model	p. 195
Weighting Disaggregation Model	p. 197
WAM versus WDM	p. 200
Category Weight Consistency and Reweighting Considerations	p. 201
Factor Marginalization	p. 202
Category Scale Determination and the Meaning of Scores	p. 203
Threshold Self-Assessment and Determination	p. 204
Score Assignment	p. 206
Discretionary Penalties and Bonuses	p. 212
Score Aggregation: Sum Totaling and Weighted Averages	p. 214
Criticisms of Scorecard Models	p. 215
Benefits of Scorecard Models	p. 217
Visualization Techniques	p. 217
Bridging the Gap: Incorporating Operational Risk Consideration into the Portfolio Construction and Asset Allocation Process	p. 225
Proactive Monitoring: Graphical Universe Creation	p. 227
Proactive Management of Operational Risks	p. 232
Protecting against Conglomeration Risks: Multivariate Commonality Analysis	p. 233
Operational Directional Views	p. 235
Example of Multivariate Commonality Analysis	p. 236
First Objective: Total Diversity Goal	p. 237
Second Objective: FSA Overweight Goal	p. 239
Third Objective: FSA Underweight Goal	p. 243
Conclusions of Scenario Analysis	p. 243
Considering Operational Reviews in the Hedge Fund Portfolio Rebalancing Process	p. 245
Operational Drag	p. 245
Meta Risks	p. 249
Operational Factor	p. 250
Operational Scenario Analysis	p. 253
Can Operational Risk Be Entirely Eliminated?	p. 254
Factoring Operational Risk into Total Risk Calculations	p. 256
Beyond Scorecard Approaches: Discounting Expected Return	p. 257
Discounted Expected Returns with the Operational Factor	p. 261
Operational Haircuts	p. 262
Expected Return and Operational Risk	p. 263
Shape of the Expected Return versus Operational Risk Curve	p. 264
Second Operational Threshold	p. 265
Final Thoughts	p. 267
Looking Ahead: Trends in the Space	p. 269
Increased Use of Consultants	p. 269
Commoditization of Background Investigations and Canned Operational Due Diligence Reports	p. 272
Increased Reliance on Service Provider Consulting Services	p. 277
Capture of Hedge Funds by Service Providers and Employees	p. 278
Hedge Fund Pursuit of Audit Certifications	p. 280
Operational Activism	p. 281
AU 332 and FAS 157	p. 283
Development of Hedges to Operational Risks	p. 286
Links between Operational Risk and Credit Analysis	p. 288
Proposed Reregulation of the Hedge Fund Industry	p. 289
Index	p. 293
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