Operational Due Diligence Insights - Corgentum Consulting Newsletter by CorgentumConsulting


Corgentum Consulting's Quarterly Hedge Fund Operational Due Diligence Newsletter. Available at www.Corgentum.com. January 2013 edition.

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									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
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
                                                             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

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                                                                                                        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)
                                                                    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)?

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
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

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                                                                                                     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
        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

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
                                                            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

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                                                                                                   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

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)
                                                            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
                                                            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

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                                                                                                    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

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
       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

                                                              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

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.
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

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


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