Hedge Fund Operational Due Diligence : Understanding the Risks

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  • Edition: 1st
  • Format: Hardcover
  • Copyright: 2008-12-03
  • Publisher: Wiley
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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

Prefacep. xiii
What Is Operational Risk?p. 1
Brief Historyp. 2
Modern Definition of Operational Risk in a Hedge Fund Contextp. 7
Operational Due Diligence versus Operational Riskp. 8
Key Areasp. 9
External Risksp. 12
Internal Risksp. 23
Blended Risksp. 36
The Five Core Themesp. 45
The Importance of Operational Due Diligencep. 49
Why Should Investors Care about Operational Risk?p. 49
Morton's Fork or a Hobson's Choice?p. 50
Outright Fraud Still Existsp. 51
Hedge Fund Fraud Cannot Be Modeledp. 52
Small Discrepancies Add Upp. 52
Lack of Standardized Regulationp. 54
Each Hedge Fund Is Differentp. 55
Ability to Generate an Informational Edgep. 56
Potential to Reduce Losses and Increase Returnsp. 57
Considering Operational Risk Factors Presents a Different View into a Firmp. 57
Common Misconceptionsp. 58
Other Considerations: There Is Not Necessarily a Positive Correlation between Assets and Operational Qualityp. 60
A Study in Operational Failure: Bayou Hedge Fund Groupp. 60
Affiliated Broker-Dealerp. 61
Large Discrepancies in the Performance of Onshore and Offshore Fundsp. 62
Declining Capital of Broker-Dealerp. 63
Board of Directors: Members and Actionsp. 63
Lavish Expenses of Broker-Dealersp. 63
Fake Audits Prepared by a Phony Auditorp. 64
Background Questionsp. 64
Lack of Investor Communicationp. 64
Ties to People Barred from the Securities Industryp. 65
Revision of Conflicted Marketing Materialsp. 66
Other Anomaliesp. 66
Who Is Qualified to Perform an Operational Due Diligence Review?p. 69
Essential Skillsp. 73
Primary Skillsp. 74
Primary, Secondary, Blended, and Other Skillsp. 84
In-house versus Outsourcingp. 85
Evolution of Independent Operational Rating Agenciesp. 86
Benefits of Third-Party Rating Agenciesp. 86
Criticisms of Third-Party Rating Agencies and Operational Due Diligence Providersp. 87
Factors to Consider before Performing an Operational Review of a Hedge Fundp. 90
Creating an Initial Operational Profilep. 91
When Does an Operational Due Diligence Review Begin?p. 91
Documentationp. 92
The Pinata Problemp. 93
Due Diligence Questionnaire: To Use or Not to Use?p. 99
Background Investigationsp. 101
Other Considerationsp. 106
Importance of Onsite Visitsp. 107
Which Office to Visitp. 108
Manager Interview Processp. 109
What Topics Should Be Covered During an Onsite Review?p. 111
Sample Topic Questionsp. 113
In What Order Should These Topics Be Covered?p. 117
Service Provider Reviewsp. 117
Qualitative Operational Report: Documenting the Operational Datap. 119
Evaluating the Gray Areas: Examplesp. 121
"It Was Not Me"-Hedge Fund Manager Claims Mistaken Identityp. 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 Guiltyp. 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 Reviewp. 145
Avoid Meeting with the Wrong People or the Wrong Groupsp. 146
Get Out of the Conference Roomp. 147
Little White Lies Can Turn into Big Problemsp. 149
Be Wary of Phantomwarep. 151
Focus on Documentation and Negotiationp. 153
Read the Fine Print (Financial Statement Notes, etc.)p. 154
Reference Checking: Importance of In-Sample and Out-of-Sample Referencesp. 156
Credit Analysis: Are Funds Financially Viable?p. 157
Long-Term Planning: Key Staff Retention, Succession Planning, and Morep. 157
Growth Planning: Is the Manager Proactive or Reactive?p. 158
Ongoing Operational Profile Monitoringp. 161
How Often Should Onsite Operational Reviews Be Conducted?p. 163
Remote Operational Due Diligence Monitoringp. 164
Media Monitoringp. 164
Litigation and Regulatory Monitoringp. 166
Hedge Fund Communication Reviewsp. 166
Assets Under Management and Performance Monitoringp. 167
Operational Eventsp. 168
Effect of Discovery on the Magnitude of an Operational Eventp. 169
Onsite Visit Frequency and Operational Eventsp. 169
Developmental Operational Trapsp. 169
Techniques for Modeling Operational Riskp. 179
Scoring Systemsp. 179
Building a Scoring System: Category Determinationp. 179
Category Definitionsp. 185
Combinations of Category Definition Approachesp. 189
Category Weight Assignmentp. 193
Weighting Aggregation Modelp. 195
Weighting Disaggregation Modelp. 197
WAM versus WDMp. 200
Category Weight Consistency and Reweighting Considerationsp. 201
Factor Marginalizationp. 202
Category Scale Determination and the Meaning of Scoresp. 203
Threshold Self-Assessment and Determinationp. 204
Score Assignmentp. 206
Discretionary Penalties and Bonusesp. 212
Score Aggregation: Sum Totaling and Weighted Averagesp. 214
Criticisms of Scorecard Modelsp. 215
Benefits of Scorecard Modelsp. 217
Visualization Techniquesp. 217
Bridging the Gap: Incorporating Operational Risk Consideration into the Portfolio Construction and Asset Allocation Processp. 225
Proactive Monitoring: Graphical Universe Creationp. 227
Proactive Management of Operational Risksp. 232
Protecting against Conglomeration Risks: Multivariate Commonality Analysisp. 233
Operational Directional Viewsp. 235
Example of Multivariate Commonality Analysisp. 236
First Objective: Total Diversity Goalp. 237
Second Objective: FSA Overweight Goalp. 239
Third Objective: FSA Underweight Goalp. 243
Conclusions of Scenario Analysisp. 243
Considering Operational Reviews in the Hedge Fund Portfolio Rebalancing Processp. 245
Operational Dragp. 245
Meta Risksp. 249
Operational Factorp. 250
Operational Scenario Analysisp. 253
Can Operational Risk Be Entirely Eliminated?p. 254
Factoring Operational Risk into Total Risk Calculationsp. 256
Beyond Scorecard Approaches: Discounting Expected Returnp. 257
Discounted Expected Returns with the Operational Factorp. 261
Operational Haircutsp. 262
Expected Return and Operational Riskp. 263
Shape of the Expected Return versus Operational Risk Curvep. 264
Second Operational Thresholdp. 265
Final Thoughtsp. 267
Looking Ahead: Trends in the Spacep. 269
Increased Use of Consultantsp. 269
Commoditization of Background Investigations and Canned Operational Due Diligence Reportsp. 272
Increased Reliance on Service Provider Consulting Servicesp. 277
Capture of Hedge Funds by Service Providers and Employeesp. 278
Hedge Fund Pursuit of Audit Certificationsp. 280
Operational Activismp. 281
AU 332 and FAS 157p. 283
Development of Hedges to Operational Risksp. 286
Links between Operational Risk and Credit Analysisp. 288
Proposed Reregulation of the Hedge Fund Industryp. 289
Indexp. 293
Table of Contents provided by Ingram. All Rights Reserved.

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