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					Operational Due Diligence –
The Risks and The Need for
   Proactive Prevention
   Presented by:
   Howard Altman, Co-Managing Principal, Rothstein Kass
   Jeffrey Kollin, Director, Rothstein Kass
   Andrew De Montille, Senior Manager, Rothstein Kass

                   October 26, 2009
Current Environment

    Post the events of 2008, many hedge funds and alternative investment vehicles have
                              closed or have been acquired.

•    Acknowledgement that government regulations are coming.

•    Investors are demanding institutional type procedures/controls.

•    Cost savings are integral to hedge fund growth and survival and yet the due diligence
     process post-2008 will be more rigorous, expensive and time consuming.

                                          Page 2
Sample Proposed Legislation and Regulations

•   House
     –   Private Fund Investment Advisers Registration Act of 2009
     –   Over-the-Counter Derivatives Markets Act of 2009 (2 versions)
     –   Investor Protection Act of 2009
     –   Insurance Information Act of 2009
     –   Accountability and Transparency in Rating Agencies Act
     –   The Consumer Financial Protection Agency Act of 2009
•   Senate
     –   Comprehensive Derivatives Regulation Act of 2009
     –   Liability for Aiding and Abetting Securities Violations Act of 2009 (whistleblower statute)
     –   Commodity Speculation Reform Act of 2009
     –   Private Fund Transparency Act of 2009
     –   Fraud Enforcement and Recover Act of 2009
•   Agencies
     –   Joint Report of the SEC and CFTC on Harmonization of Regulation
     –   SEC Alternative Uptick Rule
     –   SEC Makes Rules to Prevent Naked Shorts Permanent

                                                Page 3
  New Era of Communication to Investors

                              Investor Landscape

• The days when a fund would get 80% of their capital from 20 investors is moving
  towards 90% from 10 investors.

                                      Page 4
What are Investors Looking for From Funds?
Alpha generation and pedigree are the new baseline for investors and they now strive for
institutional infrastructure even below the $1 billion mark. They are looking for
transparency into:

          • Analytics:
                     – Exposure (Daily (not just monthly) and over time);
                     – Concentration
                     – Correlation;
                     – Alpha vs. Longs and Shorts; and
                     – Attribution (Relative and Absolute).
          • Infrastructure:
                     – IT (DR, BCP) – Are they outsourced? Are they tested?
                     – Documentation (Ops Manual, Compliance Manual, DDQ’s, etc.) – Is
                       such documentation updated and tested?
                     – Vendor Contracts – Are they reviewed and tested?
                     – Can you handle managed accounts? Allocations?
          • Marketing:
                     – Have you modified your materials in the last 6 months?
                     – Do you know what investors you should be focusing on?

                                          Page 5
Why Hedge Funds and Their Investors Should
Systematically Assess Operational Risks?
•   As reports of hedge fund closures continue to emerge, investors are increasingly
    recognizing the critical role of due diligence processes in protecting capital and
    managing risks.

•   Such due diligence can increase investors’ confidence that hedge funds are avoiding
    unintended market exposures or unsuitable risk-adjusted returns.

•   To assure that risk exposures align with potential rewards, these processes typically
    focus on the portfolio manager’s qualifications and experience, along with the fund’s
    diversification guidelines, use of leverage, exit strategies and other asset
    management disciplines.

•   However, this may leave them exposed to a type of risk that has been directly
    associated with some of the largest hedge fund closures in history – operational risk.

                                          Page 6
What is Operational Risk and Why Is It So Important?

•   According to the U.S. Treasury, operational risk is defined as “the risk of loss
    resulting from inadequate or failed internal processes, people and systems, or from
    external events.”

•   The Basel Committee, an international risk management group created by the central
    bank Governors of the Group of Ten Nations, has established seven areas of loss
    events that arise from operational risks. As shown in the next slide, they range from
    failed transactions to terrorism and natural disasters.

•   In up or down markets, and even for strong investment managers using sound
    strategies, operational risks can turn successful hedge funds into failed enterprises.

•   Operational risks can be opaque even for hedge fund internal staffers who work in
    risk-sensitive operations areas. For this reason, deciphering operational risk is a
    specialized component of due diligence that typically requires a separate process and
    skill set.

                                          Page 7
Operational Risk Loss Event Categories

Risk Category                                    Examples
                                                 Intentional transaction errors, mismarking of positions,
Internal Fraud                                   embezzlement, tax evasion, insider trading, bribes and

External Fraud                                   Theft or robbery, forgery or check kiting and hacking.

                                                 Issues relating to employee compensation or benefits,
Employment Practices and Workplace Safety        occupational hazards and workers compensation and
                                                 discrimination claims.
                                                 Fiduciary violations, trading errors, suitability issues,
Clients, Products and Business Practices         churning, money laundering and failures in financial

Damage to Physical Assets                        Natural disasters, terrorism and vandalism.

                                                 Hardware and software failures and communication
Business Disruption and System Failures
                                                 system/utility disruptions
                                                 Intentional transaction errors, mismarking of positions,
Internal Fraud                                   embezzlement, tax evasion, insider trading, bribes and

                                            Page 8
Who Should Perform Operational Risk Assessments?

•   A hedge fund operational risk assessment can be undertaken by a single investor or
    commissioned by the hedge fund itself, with results distributed to multiple prospective

      In either case, it is best performed by an independent third-party
     specialist who can look at a hedge fund’s operational staff, systems
    and workflows with a critical eye for inefficiencies, vulnerabilities and
                             indicators of loss events.

                                          Page 9
 Operational Risk Assessment - Key Review Areas
A detailed work program which targets the key areas in operational due diligence allows
investors to gain comfort that best practices are being observed. Although each assessment
can be customized to the assignment, the process typically covers five areas:

 •   Organization                                               Consultants

 •   Internal Controls and
     Compliance                                     Fund-of-Funds        Hedge Funds

 •   Valuation Methods and
     Investor Reporting
 •   Trading and Operational
     Processes                                                            Pensions,
 •   Service Providers and                                               Foundations

                                          Page 10
Operational Risk Assessment Process Model

•   Many types of investors can take advantage of an independent operational risk
    assessment. A typical operational risk assessment process follows a four-step model,
    as described below:

                                        Page 11
Best practices
A typical Operational Risk Assessment would include the following engagement

    •   Assess existing procedural documentation and recommend best practices
        regarding process flows in order to strengthen the existing control environment.
    •   Identify control gaps and/or potential segregation of duties issues.
    •   Conduct interviews with appropriate personnel to validate their understanding of
        and compliance with documented procedures.
    •   Assess responsibilities assigned to trading, operations and accounting
    •   Design, develop and perform sample based procedures on fund trading activity
        and financial transactions to determine if key controls were functioning as
        described in the procedural documentation.
    •   Develop recommendations to strengthen controls, increase efficiency and
        enhance the infrastructure.

                                         Page 12
Value Proposition

•   The advantages of an operational risk assessment include:

    –   Increasing the awareness of general and specific operational risks among internal staff, at all
        levels of the fund.

    –   Creating a framework for efficient liability management, plus a better understanding of the
        fund’s cash and liquidity needs.

    –   Providing a rationale for the capital investments, operating expenses, and staff required for
        infrastructure improvements.

    –   Increasing the consistency and cost-efficiency of due diligence processes.

    –   Identifying opportunities to fully realize capabilities provided by prime brokers, administrators
        and other vendors.

    –   Enhancing operational and financing efficiency to upgrade the fund’s credit standing.

    –   Anticipating potential loss events and putting solutions to work faster, with contingency
        planning and pre-designated staff responsibilities.

                                               Page 13
Bottom Line Benefit

   The bottom line benefit of an operational risk assessment is that it creates the same
 transparency and accountability for a hedge fund’s processes, people and systems that
             traditional due diligence provide for investment management.

 To achieve this benefit, investors and consultants should choose operational risk
specialists with deep experience in hedge fund operations, an understanding of how
operational areas work together, and the independence to think critically and deliver
                   objective evaluation and constructive guidance.

                                        Page 14

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