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Corgentum Consulting's Quarterly Hedge Fund Operational Due Diligence Newsletter. Available at www.Corgentum.com. January 2013 edition.
January 2013 Operational Due Diligence Insights In This Issue Welcome to Our January - Regulatory Focus: Can Operational Due Diligence Prevent Exposure to 2013 Edition Hedge Fund Insider Trading? Welcome to the January 2013 issue of Corgentum Consulting's Operational - Business Continuity Corner: A Post- Due Diligence Insights. This newsletter serves as a resource for news, Sandy Analysis of Hedge Fund BCP/DR opinions and insights focused on issues related to operational risk and Planning? operational due diligence on fund managers including hedge funds, private equity funds, real estate and traditional managers. - Private Equity: Will the Coming Private Equity Data Storm Influence LP Operational Due Diligence? Can Operational Due Diligence - IT Hub: Evaluating Hedge Fund Technology Consultants Prevent Exposure to Hedge - Service Providers: Analyzing Fund Fund Insider Trading? Legal Counsel - Does It Matter As Long As It's Legal? There has been much news recently with regards to high profile hedge fund insider trading cases such as Raj Rajaratnam's Galleon. As there seems to be a -Term of the Month: Audit Holdback continuing strong interest from the government in prosecuting insider trading, investors may be increasingly asking themselves what they can do to minimize, - Fraud Spotlight: The Preposterous or perhaps even completely reduce, their exposure to hedge funds that either Fraud of Andrey C. Hicks and Locust may be accused of insider trading, or even worse guilty of it. Offshore Management Before we can answer this question however, it is first useful to make sure we - Accounting Spotlight: Interpreting understand what is meant by insider trading. To boil it down to its most simple Fund Expense Disclosures form, insider trading relates to people utilizing so-called "insider" information - On the Calendar ...continued on next page www.Corgentum.com 2 | Operational Due Diligence Insights Insider Trading - Continued from page 1... Information, often referred to be the acronym MNPI, and how the analyst obtained this information. which they either: Following the Information Flow: a Four Step Process (i) misappropriated (i.e. - stole) This is all well and good, but investors generally do not (ii) obtained by legal means, or even by have the transparency or the ability to follow around accident, but: the analysts of the hedge funds to determine how they a) shouldn't have acted upon; or are obtaining research. Therefore, the question could b) had a duty to disclose it be posed, what are investors supposed to do? Of course there are a number of nuanced complexities The answer lies in understanding the nature of the when it comes to analyzing the actual insider trading control environment surrounding both the investment laws themselves. An example of this is whether the so- research process, as well as a fund's ability to act on called duty to disclose was pro-actively requested by research obtained. But, how should an investor go the person obtaining the information or instead was about assessing this environment? Detailed operational imposed upon them. However, such legal intricacies are due diligence can provide a number of valuable insights of little use to investors seeking to evaluate the overall in this regards. potential for insider trading to occur. Step 1: Determine research sources One of the big problems with insider trading prosecutions from an One area which an investor can investors and fund evaluate during the operational managers perspective, is due diligence process relates to that it is an area in which firstly understanding the ways in any bright line rules that which a hedge fund's analysts may have existed are now conduct research. In particular, seemingly in flux. Recent what research sources do they legal decisions have utilize? Do they primarily read seemingly increased the industry journals and go on scope of the type of Bloomberg? What about attending information that is now conferences? Do the analysts considered illegal to trade perhaps meet with the upon. management of any particular companies? Do they talk to analysts at other hedge funds? What about analysts Additionally, insider trading is inherently in particular sectors at other firms outside of the hedge counterintuitive in some regards to what hedge funds fund industry? Are third-party expert networks utilized? are paid to do - conduct research and utilize this research to make investments. Insider trading rules, it Step 2: Evaluate research oversight can be argued, stymie the efforts of analysts to collect this information. It stands to reason that a hedge fund After an investor makes a determination as to what analyst may be able to devote more time to collecting research sources a hedge fund utilizes, the next step is research, and be more skilled at it, then let us say a to determine what actions the fund is taking to monitor regular retail investor. Is this insider trading for the such relationships. This oversight can come in a number hedge fund analyst to act on this better information? of different forms, but is primarily driven by the compliance function. During the operational due Well the answer, the insider trading rules explain, diligence process an investor can ask a number of depends on a number of factors including whether the information is so-called Material Nonpublic …continued on next page Corgentum Consulting ©2013 Corgentum Consulting, LLC January 2013 | 3 Insider Trading - Continued from page 2... Are there sufficient prohibitions or limits on the way gifts are given, and received, in order to different questions to make an assessment as whether prevent any potential conflicts or bribery with or not the compliance function is actively policing the regards to information sharing? analyst research process or not. Examples of the types of questions investors can ask in this regard include: Step 3: Evaluate trading oversight Third-party expert networks: It is worth noting at this point that just because a hedge Has the compliance function vetted a firm's fund may come into possession of so-called material relationship with third-party expert networks? nonpublic information, they are not necessarily guilty of If so, what did this assessment entail? anything if they do not act on it. Has the hedge fund communicated its policies This is where an analysis of the oversight of a hedge with regards to material nonpublic information fund trading procedures comes into play. After a hedge and insider trading to the third-party network? fund has done its research and makes a determination that it would like to trade in a certain security, investors If so, has the network agreed in writing to must determine what oversight is in place. One comply with these policies? common way hedge funds seek to prevent trading on securities on which they may possess material If hedge fund research personnel would like to nonpublic information about is via a so-called restricted utilize such a network, must pre-approval be list. In general, securities on the restricted list cannot be obtained from the compliance function first? traded by the firm. However, not all restricted lists are created equal, and not all hedge funds maintain What research does the compliance function restricted lists. In addition to determining whether or perform before granting pre-approval? not such a restricted list is actually in place, investors can ask a number of questions to determine the Once approved, has compliance taken any oversight and effectiveness of such lists including: additional measures to ensure compliance with the hedge fund's policies? (i.e. - such as reading How are securities put on the list? Is there set a disclaimer before the call begins) criteria or does one person make the determination in their discretion? Additionally, do compliance personnel listen in on calls? If a security is placed on the restricted list, is trading activity suspended for a certain pre- Is a log kept of the use of such third-party defined period? (i.e. - 30 days) networks? How do securities come off of the restricted Research sources in general: list? Does the hedge fund have any bans on speaking to individuals who either work at public Who maintains the restricted list? companies or have recently worked at such companies? If so, what are the details of this How often is it updated? ban? How is it monitored and implemented? How is the list shared throughout the firm? Are any conflict checks performed to make sure that a hedge fund analyst is not discussing a company with someone with whom the hedge fund may have already been conflicted out of …continued on next page (i.e.- passing along tips)? www.Corgentum.com 4 | Operational Due Diligence Insights Insider Trading - Continued from page 3... operational or otherwise, can completely prevent exposure to hedge fund with insider trading issues. That being said, investors that conduct due diligence to Are names of securities contained in the understand the ways in which research is conducted, restricted list hard-coded into any trading how trades are executed, and the internal oversight of systems or instead is it up to employees to such processes will be more informed about the risks monitor the list? involved . As with all operational due diligence, investors that dive deeper will be making more Are employees allowed to trade in names of the informed investment decisions. Additionally, a hedge restricted list for their own personal securities fund with robust oversight of the research and trading accounts? process will likely have a much lower likelihood of being placed into situations where insider trading could be Step 4: Is oversight provable and tested? alleged. After taking measures to evaluate any internal hedge Conclusion: fund oversight on the way in which a hedge fund collects research and then trades on that data, are In conclusion, investors that take the time to ask investors finished? questions and evaluate research and trading oversight during the operational due diligence process are likely The best compliance policy in the world is meaningless to have more conviction that their hedge funds won't unless it is a living policy. Investors be accused of insider trading - that is as long as should take measures to ensure that the hedge funds continue to follow these not only does a hedge fund have policies. such research and trading oversight in place, but can demonstrate the oversight. For example, if pre- approvals are required before a A Post-Sandy hedge fund analyst speaks to a third- party expert network can the fund Analysis of Hedge Fund BCP/DR produce an example of such a pre- approval form? Similarly, it is important for hedge funds to back test such policies. So for example, assume that a hedge fund Planning maintains a restricted list. Does the hedge fund US based hedge funds recently faced a large scale real manager's compliance department perform random world test of their business continuity and disaster back test audits of fund trading to check that no trading recovery plans in the form of a super storm named in restricted names occurred? Sandy. Hurricane Sandy represented a large unprecedented weather event that caused flooding and So what does this all mean? devastation throughout the eastern coast of the United States including the major hedge fund centers of New Returning to our original question, "Can Operational York and Connecticut. Due Diligence Prevent Exposure to Hedge Fund Insider Trading?" the short answer is - no. Hedge funds, like all Some of the challenges faced by people and businesses, organizations are evolving entities. Employees come including hedge funds, affected by the storm included and go. New funds are launched and closed. Revised sustained power outages, inability to access office computer systems are put in place and old ones are buildings and office flooding. phased out. With these constant changes, it is impossible to unequivocally state that due diligence, …continued on next page Corgentum Consulting ©2013 Corgentum Consulting, LLC January 2013 | 5 Business Continuity- Continued from page 4... well as with prospective firm's they may evaluate in the future. Digging into the details of real-world activations of BCP/DR plans can provide investors with valuable According to a recent Corgentum survey, 74% of insights of how effectively a hedge fund’s best laid plans investors felt that their hedge fund was adequately may hold up in a storm. prepared to continue operational during hurricane Sandy. In order to confirm these beliefs when a wide scale storm or other BCP/DR event which may affect a hedge fund occurs, investors should seize the Will the Coming Private Equity Data opportunity to vet the real-world effectiveness of their hedge funds plans during the storm. Some questions investors may want to ask regarding a hedge funds reaction to the storm included: Storm Influence LP At what point was the decision made to activate the firm's business continuity and disaster Operational Due recovery plans? - If the plan was activated too late perhaps it was either diminished in Diligence? effectiveness, or represented a failing of the firm's judgment in having qualified personnel making the decision whether or not to activate Private equity General Partners ("GPs") are under BCP/DR plan increasing pressure to provide more transparency than ever before. This transparency is not limited to any one Were employees able to communicate with area (i.e. - investment performance or fund accounting each other during the storm? procedures). If alternative off-site third-party locations were Further complicating the problem is that these part of a hedge fund's plans, did they perform requests, or in some cases demands, for additional data as expected? come from multiple sources, the two primary ones being Limited Partners ("LPs") and regulators. If equipment was destroyed during the storm, Turning to regulators first, there have been a number of will it be covered by the hedge fund's insurance recent regulatory changes that will require most private policies? Is backup equipment available in the equity GPs to report to regulators more detailed interim? information than ever before. A recent example of this is Form PF filings required by the US Securities and What parts of the BCP/DR plan worked correctly Exchange Commission. Under these rules, which during the storm? targeted not only private equity firms but also a wide variety of fund managers including hedge funds, GPs were required to make a number of disclosures What plan problems or weaknesses came about including: during the storm? Reporting data related to the indebtedness of Is the hedge fund implementing any changes to portfolio companies a private equity fund may the plan based on lessons learned from the control. This data includes revealing the identity storm? of the lenders of any bridge loans as well as debt -to-equity ratios. Investors should ask such questions both of the hedge funds with which they maintain existing investments as …continued on next page www.Corgentum.com 6 | Operational Due Diligence Insights Private Equity - Continued from page 5... this lack of legal obligation to do so as a shield to deflect further LP inquiry in this regard. Detailed portfolio analysis including geographic Other GPs raise concerns that the data such as the and industry level breakouts calculation of what is known as Form PF's Regulatory Asset Under Management, commonly referred to as Detailed information concerning leverage, fund RAUM, is either of no use to investors or that they will borrowings and creditors misconstrue the information. For example, a GP may point out that RAUM may be misleading to some The enhanced US regulatory disclosure requirements investors because it includes unfunded LP commitments are not anomalous, and the European Union has also in its calculation whereas a typical AUM figure generally followed suit in the form of the Alternative Investment does not. Fund Managers Directive ("AIFMD"). The original version of AIFMD was adopted by the European The jury is still out on whether such GP concerns are Parliament on November 11, 2010 and has since been well founded, however, one thing is clear - LPs should followed by AIFMD level 2, which was implemented on not let GPs dictate what information they should or December 12, 2012. Although the final text of the law is should not be interested in during the operational due still under review, AIFMD level 2 imposes a number of diligence process. additional guidelines and stricter reporting requirements on fund managers (which in AIFMD terms That being said, the GP’s objection does raise a valid are referred to as Alternative Investment Funds or AIF's) question - Are LPs equipped and prepared to evaluate which includes private equity firms. Examples of these the data from increased GP transparency? new rules include: Whether this new data comes in the form of regulatory filings or other sources LPs must consider: Operating conditions for AIFMs, including rules on remuneration, conflicts of interest, risk Reviewing additional data requires the management, liquidity management, allocation of more internal due diligence investment in securitization positions, resources organizational requirements, and rules on valuation With the benefits of additional GP transparency likely comes an elongated due diligence process Rules on depositaries, including the depositary's tasks and liability Specialized skill sets, which the LP may not currently have internally, may be required to Enhanced Reporting requirements and leverage fully evaluate additional GP information calculation LPs may benefit from engaging in dialogues with GPs to LPs have been quietly watching passage of these not only negotiate the receipt of additional due additional regulations and reporting requirements. Now diligence data such as regulatory filings, but also to that GPs have devoted all the time and resources to provide a guide in understanding such documentation. analyzing, preparing and providing information to LPs however, run a very real risk of becoming too reliant regulators, LPs are increasingly asking GPs to share this on GPs for such guidance and overlooking key information with them as well. operational risk areas in the process. Most GPs have predictably raised a number of Although enhanced transparency may seem to be objections to sharing this data. For example, in the US intuitively better for LPs, it also presents a number of many GPs cite the fact that there is no legal requirement for GPs to share the new Form PF filings …continued on next page with LPs. Of course, it is not illegal for GPs to share these filings with investors, however, some GPs utilize Corgentum Consulting ©2013 Corgentum Consulting, LLC January 2013 | 7 Private Equity - Continued from page 6... external resources. Additionally, many hedge funds may utilize certain consultants on an ad-hoc or as needed basis and therefore, perhaps don't feel highlighting such increased data analysis and resource management relationships matters much to investors performing challenges which should be planned for. Without such operational due diligence. preparation them find themselves awash in a sea of data that they are unsure how to navigate. Investors should not be discouraged however, and should take measures to evaluate the role of Evaluating Hedge information technology consultants. A good starting point is speaking directly with the hedge fund managers Fund Technology about the use of such consultants. Learning what consultants do: Consultants There are diagnostic benefits to such third-party provider due diligence. By inquiring about these third- party firms, investors will likely learn about the duties It is common for many hedge fund managers, especially performed by different information technology smaller ones, to leverage off of external information consultants. The answers to these questions can technology consultants. These consultants come in provide valuable insights into a number of different many different forms and can provide a wide array of areas including: services for fund managers. In general, common Where a hedge fund may be weaker internally services provided by information from a technology perspective and feels the technology consultants can need to augment these deficiencies include: with external resources? Help desk support Has there been turnover among information technology Software development and consultants in a particular function? If support so, why? Hardware maintenance If the hedge fund utilizes a consulting firm, as opposed to an New software or hardware vendor and package individual freelancer, what personnel from the selection IT consultant are actually doing the work? Implementation of new systems or hardware How often are the IT consultants in the offices of the hedge fund manager? If not frequently, Business continuity and disaster recovery do they access the firm's systems remotely? program design, testing and maintenance Does the hedge fund control information access? During the operational due diligence process, investors may sometimes find it difficult to obtain a straight After an investor has obtained a detailed understanding answer from their hedge fund managers with regards to of what a third-party information technology consultant the work of these information technology consultants. may actually do for a hedge fund, investors should next Perhaps it is because certain fund managers want to inquire as to how the hedge fund controls the third- emphasize the arguably more important role played by party's access to, and use of fund data. Some questions dedicated in-house information technology personnel (be they dedicated or shared) while minimizing the …continued on next page www.Corgentum.com 8 | Operational Due Diligence Insights Technology - Continued from page 7... Analyzing Fund Legal investors may want to consider asking in this regards may include: Counsel - Does It Has the hedge fund taken policy based measures to ensure IT consultants understand Matter As Long As It's keep information confidential? (i.e. - signing a confidentiality agreement) Legal? When evaluating service providers during the Are technological measures in place to limit the operational due diligence process, many investors may IT consultants’ access to certain information? tend to focus their initial efforts around certain specific Or does the hedge fund trust the IT consultant service provider functions. The short list of the common blindly? cast of characters includes fund administrators, auditors and counterparties. Other service providers may How does the hedge fund oversee the unfortunately receive less attention. implementation of any data security measures either agreed to with the IT consultant or in Perhaps this is because of the perceived importance of place from a technology perspective? (i.e.- is the roles performed by different providers. For there any testing of such controls?) example, investors may feel, and rightly so, that valuation is a key issue for hedge funds. Therefore, Why Due Diligence on IT Consultants Matters? understanding the role played by the service providers related to valuation oversight such as the fund Hedge funds are information based organizations. administrator, may receive more attention at the Technology supports the way in which a fund organizes, expense of the analysis of other service providers. utilizes and trades upon this information. When a hedge Another motivation for many investors in clustering fund effectively opens up its doors to a third-party firm their service provider evaluations around a limited to assist in managing or improving upon this technology subset of all a hedge fund's service providers, is the investors should take notice. By incorporating an notion of a risk based approach. Continuing our analysis of the role of third-party information valuation example above, many investors view technology consultants into the larger operational due valuation as not only a highly important issue for hedge diligence process investors may learn new pieces of funds, but also one that is fraught with potential risk as information, which can provide valuable insights into well. That is to say, there would be direct negative their overall assessment of a hedge fund's information implications for investors if a hedge fund began playing technology function. games with fund valuations. Such a risk may be compared to, for example, the risks associated with a hedge fund utilizing a slightly less than cutting edge piece of hardware for data storage. When framed against valuation concerns, investors may feel that the valuation risks outweigh the technology concerns. For some investors this tradeoff unfortunately results in a lesser degree of analysis on third-party information technology service providers that may have participated in assisting the hedge fund in overseeing its hardware management. …continued on next page Corgentum Consulting ©2013 Corgentum Consulting, LLC January 2013 | 9 Legal Counsel - Continued from page 8... Are flat fees charged for any projects? Does the law firm have any particular expertise Often this service provider clustering effect also that may be applicable to the hedge fund? (i.e. - influences the ways in which certain investors overlook jurisdictional expertise, or experience in the role played by a hedge fund's legal counsel. During performing legal work related to certain the operational due diligence process, some investors investment products) may simply check to see if a hedge fund is working with a large, well-known law firm. Other investors may go This above list is of course not comprehensive, but is further and attempt to confirm the relationship with intended as a guide with which an investor could start a the legal counselors, but may be unsure what other conversation with a law firm in order to gauge certain items they should evaluate. basic issues regarding its relationship with the hedge fund. Beyond the basics, an investor could inquire The role played by a law firm working for a hedge fund further into a number of different topics in an attempt is not cookie cutter in nature. As could be said with all to understand the extent of the law firm's work with the service providers - they are hedge fund. Examples of some items not created equal. This is an investor could cover may include: particularly true when it comes to fund legal counsel. A number of differences may Does the law firm provide any compliance related services to exist with regards to not only the hedge fund? the quality of work they perform for the hedge fund, but the type of areas they If the hedge fund works with cover. As with all hedge fund a separate compliance consultant, service providers, investors does the law firm interact with them? would be well served to capitalize on the opportunity to vet the role played by a Has there been any personnel turnover among hedge fund's legal counsel during the initial due the key individuals servicing the hedge fund's diligence process. account? For starters, investors should endeavor to cover what Can the law firm provide an example of a recent could be considered the nuts and bolts of the matter on which it has worked for the funds? relationship with a law firm by attempting to understanding answers to questions including: If the funds or hedge fund management What is the hourly billing rate charged to the company was (or currently is) involved in any hedge fund? litigation, can the law firm walk the investor through the litigation (and any outcomes)? Is a blended rate charged or instead does the rate vary by the experience of the law firm Does the law firm interact with any other law employee (including non-attorneys) performing firm's used by the hedge fund? the work? Can the law firm provide a summary of the Are any hourly billing rate or fee caps in place? routine legal tasks performed for the firm? Is the hedge fund notified if fee caps are being Additionally, other more broad questions could be approached? asked of the law firm to gain an understanding of how much they interact with, and understand, the hedge …continued on next page www.Corgentum.com 10 | Operational Due Diligence Insights Legal Counsel - Continued from page 9... This issue's word: Audit Holdback fund's business. Examples of these questions may include: Defined: Does the law firm generally understand the An audit holdback refers to the amount that a hedge hedge funds investment strategy? fund manager may hold on to when paying out a redemption request to account for any variations that If there have been any material developments may take place after a fund's audit is finalized. that have occurred at the hedge fund, is the law firm aware of them? What investors should know: Who at the hedge fund does the law firm Investors frequently tend to ignore the concept of audit primarily deal with? holdbacks when submitting redemption requests only to realize that a portion of their capital is effectively Has the scope of the work the hedge fund has stuck at the fund. Depending on the timing of an given the law firm increased or decreased over investors redemption request audit holdbacks can allow the past two years? If so, why? a hedge fund manager to generally hold onto capital for a period of up to one year (i.e. - between fund audit A law firm can play an important role in supporting the years). successful overall operational management of a hedge fund. In particular, in light of the increasingly complex Do not fall into this trap. It is important to evaluate regulatory and legal environment, investors should be audit holdback percentages during the initial cautious not to minimize the due diligence they perform operational due diligence process. Audit holdback on third-party service providers such as law firms. By percentages are typically disclosed in a hedge fund's delving into the details of such third-party relationships offering memorandum as well as in the fund's audited investors will likely be surprised at the useful insights financial statements. There is no universal standard for they may learn. audit holdbacks but they generally range around the 10% level. Additionally, the timing with which hedge Understanding Fund fund managers actually release investor funds after the audit is released is not universal either and may range Terms: Audit Holdback over a period of a few days (i.e. - 10) to up to 90 or more. Even worse, some managers may not even specify this post-audit payout time period in their offering documents. Investors that take measures to Operational due diligence is a multidisciplinary subject. evaluate the audit holdback amount and payout period An investor beginning the operational due diligence will likely find themselves being able to better manage process for the first time may encounter subjects with redemption pipelines. They will also be less surprised which they have little to no familiarity. As the scope of when payouts are initially less than the full amount of operational due diligence has become broadened in the redemption request. recent years, even seasoned operational due diligence professionals may encounter terms which they may be unfamiliar. The purpose of this section of Operational Due Diligence Insights is to cast a spotlight on some of the words and terms which investors may have not previously encountered, or which tend to get overlooked in operational due diligence reviews. Corgentum Consulting ©2013 Corgentum Consulting, LLC January 2013 | 11 with high alpha. The firm's quantitative strategies are Fraud based on mathematical models developed by the fund's manager, Andrey C. Hicks, during his tenure at Harvard University and are executed by computer software. Spotlight: Human involvement in the strategy life cycle is limited to model and code development and refactoring. The firm The is primarily engaged in the U.S. equity markets and adheres to a market-neutral, risk-averse trading Preposterous Fraud of philosophy. Andrey C. Hicks and Some of the more interesting things alleged by the SEC include that Mr. Hicks: Locust Offshore Lied about his education - he claimed to have obtained undergraduate in biochemistry (for Management with a 4.0 grade point average) as well as a graduate degree from Harvard. Mr. Hicks wasn't satisfied claiming just any graduate degree such as an MBA. Instead, he claimed to have A man claiming to run a high profile hedge fund recently obtained a PhD in Applied Math in just two pleaded guilty to stealing approximately $2.3 million years. According to the SEC, Mr. Hicks was from investors. The plea came at the end of 2012 and indeed enrolled at Harvard as an undergraduate slipped off many people's radar, however, the but was forced by the university to withdraw on preposterousness of the case is worth revisiting. two separate occasions and he never In October 2012, the SEC charged Andrey C. Hicks and graduated. his firm Locust Offshore Management with employing a fraudulent scheme to dupe investors into investing in a Lied about his employment background - he purported British Virgin Islands fund called the Locust claimed to have not only worked at Barclay's Offshore Fund, Ltd. The problem, the SEC alleged, was Capital (which was a lie) but that, "he grew his that there was never any such fund. Furthermore, the book nearly two-fold and expanded his group’s SEC complaint alleged that, "Hicks has transferred assets under management to roughly $16 substantially all of the investors' funds to bank accounts [billion]" (which was also a lie) in his personal name and, on information and belief, for his personal use." Lied about the fund's auditor - he claimed Ernst Mr. Hicks claims about his firm were so outlandish that & Young served as the fund's auditor, they it was reported he stated to prospective investors to didn't (besides there was never any fund to have grown "assets under management from $100M audit) USD to nearly $1B USD in six (6) months through capital raising and high returns." Lied about the fund's prime broker and custodian - he claimed that the fund had a To provide some additional perspective on the relationship with Credit Suisse - it didn't outlandishness of this case, here is partial description of Opened business a checking and savings what Mr. Hicks claimed his firm was doing: accounts for the firm and funds with the intent to defraud investors Locust Offshore Management, L.L.C. develops and executes sophisticated quantitative strategies across asset classes to produce absolute, risk-adjusted returns …continued on next page www.Corgentum.com 12 | Operational Due Diligence Insights Fraud - Continued from page 11... related expenses such as interest and dividend expense and stock loan fees. Created and maintained a website for the non- Other expenses that many investors would perhaps existent firm and fund place in the, "legitimate" bucket would include performance and management fees. Fees for items for Created fake offering documents for the fund operational or non-investment related purposes such as fees paid to members of the Board of Directors, audit Created fake business cards, stationery and and legal expenses could also be placed in the email signature blocks describing Mr. Hicks as a legitimate bucket with little investor argument. Locust's principal and the fund's director. The second category of expenses investors tend to look Unfortunately for Mr. Hicks, the SEC allegations were for could be called illegitimate expenses. These are true. Despite all these red flags, Mr. Hicks did attract effectively the polar opposite of legitimate expenses, investors in the fund including celebrity basketball and as the name implies, would not be items investors player Kris Humphries. expect to be charged to the fund during the normal course of business. These could be items such as lavish He was eventually arrested while attempting to flee in expenses for fund raising (i.e. - paying for the fund Switzerland. He has since pled guilty to five counts of manager to travel to a sales meeting in a private plane) wire fraud and is scheduled to be sentenced on March or the salary of any individual employee being charged 6, 2013. He faces up to five years in prison. directly to a fund. During the operational due diligence process investors that come across any of these Interpreting Fund illegitimate expenses should certainly raise a red flag and inquire further as to why such expenses are being charged to the fund. Expense Disclosures Beyond this fairly basic legitimate versus illegitimate framework, investors face more complex additional During the operational due diligence process one of the challenges in reviewing fund level expenses. core documents collected and analyzed by investors are a hedge fund's audited financial statements. A key area Evaluating Gray Area Expenses of focus for many investors in conducting an analysis of these audited financials, is the analysis of fund level As noted above, it may be easy for investors to classify expenses. Within the audits themselves, Investors are expenses at either end of the spectrum as being generally provided with some guidance through a series legitimate or illegitimate. However, the classification of of expense related disclosures. But do these disclosures expenses may become less clear when investors start to add any real value to investors in analyzing fund dive into the details. It is with regards to these gray area expenses? Additionally, what should investors goals be expenses that more comprehensive expense analysis is in analyzing fund expenses? often required. Legitimate vs. Illegitimate Expenses For example, consider a hedge fund manager that invests in the distressed debt of companies. As part of For risk assessment purposes within the context of their research process, the fund manager sends analysts operational due diligence review, many investors would to visit with the management of the target companies most likely agree that in general fund expenses can be in which it is considering purchasing debt. Most grouped into two categories. The first category could be investors would likely agree that such research trips are so called legitimate expenses. That is to say, those not lavish or excessive but rather part of the hedge fund expenses that occur as part of the course of a hedge fund's normal business and trading activities. These …continued on next page expenses could include both investment or trading Corgentum Consulting ©2013 Corgentum Consulting, LLC January 2013 | 13 Fund Expenses - Continued from page 12... (i.e. - legitimate versus illegitimate) but also the way in which they will be allocated. manager’s standard operating procedure. Where It is worth noting here the importance of incorporating investors may differ in their opinions is whether the documents other than the audited financial statements expense of such research trips should be charged into the overall expense analysis process. Although, it directly to the funds themselves, or rather if the could be classified as a legal document, as compared to expense for such trips should sit at the management a purely accounting related document such as the company level. audits, investors should not be hesitant to seek out information from other sources to guide their analysis. There are many other examples of areas where This produces a more comprehensive well rounded investors, and fund managers, may disagree as the review, which runs less of a risk of ignoring key risk appropriateness of allocating all or a portion of an areas simply because they may be interdisciplinary in expense to the funds versus the management company. nature. Additional examples of these types of expenses may include the allocation of a hedge fund's office rent Returning to our discussion of expense allocation rules, expense and expenses related to acquiring and in addition to the offering memorandum, another maintaining the information technology function source of good source of information may be the including hardware which may be used to execute the audited financial statements themselves. Often times funds trading strategies. the Statement of Operations, also known as the Income Statement, will provide valuable Regardless of which side information about the detail of of the argument a total fund level expenses. The particular investor lands problem however, is that the on, from a due diligence figures presented in these perspective it is statements are often in summary important that that format. For example, the investors have statements may indicate that transparency with interest and dividends expense regards to such was $100. It would arguably be expenses. Additionally, more useful for investors to know investors should seek to more detail. So something like, the evaluate the consistency interest expense was $30 and the of a hedge fund dividend expense was $70. manager’s approach in allocating such expenses. Said another way, it is up to investors to understand what a Another problem investors often encounter relates to particular hedge funds rules of the expense allocation so-called rollup categories of expenses. These are game are before they can evaluate if a manager is groups of expenses that are bundled together into a following them. single line-item. An example of such an expense category would be "Professional fees and other." Under Figuring Out The Expense Allocation Rules US GAAP there is no universal rule as to what exactly should be lumped into such a category. Furthermore, Where is an investors supposed to figure out what the there is not even a general agreement among hedge hedge fund's policy is with regards to allocating such funds or investors as to what exactly may go into such a expenses? Well, a hedge fund's offering memorandum category. Typically, an expense category such as this might be a good start. The offering memorandum often would contain items such as Board of Director’s fees contains valuable information about not only what and legal fees, however, investors should expenses are anticipated to be charged to the fund, …continued on next page www.Corgentum.com 14 | Operational Due Diligence Insights not make any such assumptions. A hedge fund manager could just as likely use such a broad category to bundle gray area expenses which if brought to the attention of some investors may raise questions. Are investors left with any options when faced with such rollup categories? One resource investors should consider when faced with such issues are the notes accompanying the financial statements. These notes can sometimes provide additional clarification as to what is included in rollup expense categories. Although there are some general guidelines under US GAAP with regards to minimum mandatory disclosures, once again there is no universal requirement to provide such detail in all cases. Furthermore, a hedge fund's auditor is not generally incentivized from either a financial or liability perspective to write detailed clear disclosures. In this case, investors should then not be afraid to approach the fund manager directly and inquire as to what actually goes into each category. This will provide investors with more transparency to judge whether allocation rules are being followed. Additionally, investors engaging in such discussions with managers may be surprised to learn about how much discretion a fund manager may have in making determinations as to how expenses are allocated. One of the goals during expense analysis therefore, should be not only to diagnose the way in which a hedge fund allocates expenses, but also to oversee that discretionary choices by the manager are equitable to all investors and in the best interest of the particular fund vehicle in question. By engaging with fund managers to conduct such reviews investors may find their review of the fund expenses and disclosures may bear fruit in other parts of the overall due diligence process as well. Corgentum Consulting ©2013 Corgentum Consulting, LLC January 2013 | 15 On the Calendar Please see below for a list of upcoming operational risk items of note and events: Investment Education Symposium (New Orleans, LA) February 6-8, 2013. Corgentum to moderate Investing in Alternatives panel Presented by Opal Financial Group Investment Consultants Forum (New York, NY) March 4, 2013. Corgentum to moderate Manager Selection Process panel Presented by Opal Financial Group GAIM Ops Cayman (Grand Cayman, Cayman Islands) April 21-24, 2013. Corgentum 's Jason Scharfman to conduct pre-conference Private Equity Operational Due Diligence workshop Presented by IIR USA. About Corgentum Consulting Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers. We work with investors including fund of funds, pensions, endowments, banks and family offices to conduct the industry's most comprehensive operational due diligence reviews. Our work covers all fund managers and strategies globally including hedge funds, private equity, real estate funds and traditional funds. Our sole focus on operational due diligence, veteran experience, innovative original research and fundamental bottom up approach to due diligence allows us to ensure that our clients avoid unnecessary operational risks. More information is available at www.Corgentum.com or follow us on Twitter @Corgentum. Email: Info@Corgentum.com Main Tel. 201-918-520 www.Corgentum.com
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