Hedge Fund Operational Due Diligence: Understanding the Risks(Wiley Finance)

How to diagnose and monitor key hedge fund operational risks With the various scandals taking place with hedge funds, now more than ever, both financial and operational risks must be examined. Revealing how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds, such as multi-jurisdictional regulatory coordination, organizational nesting, and vaporware, Hedge Fund Operational Due Diligence includes real-world examples drawn from the author's experiences dealing with the operational risks of a global platform of over 80 hedge funds, funds of hedge funds, private equity, and real estate managers.

Table of Contents:
Preface xiii Chapter 1 What Is Operational Risk? 1 Brief History 2 Modern Definition of Operational Risk in a Hedge Fund Context 7 Operational Due Diligence versus Operational Risk 8 Key Areas 9 External Risks 12 Internal Risks 23 Blended Risks 36 The Five Core Themes 45 Chapter 2 The Importance of Operational Due Diligence 49 Why Should Investors Care about Operational Risk? 49 Morton’s Fork or a Hobson’s Choice? 50 Outright Fraud Still Exists 51 Hedge Fund Fraud Cannot Be Modeled 52 Small Discrepancies Add Up 52 Lack of Standardized Regulation 54 Each Hedge Fund Is Different 55 Ability to Generate an Informational Edge 56 Potential to Reduce Losses and Increase Returns 57 Considering Operational Risk Factors Presents a Different View into a Firm 57 Common Misconceptions 58 Other Considerations: There Is Not Necessarily a Positive Correlation between Assets and Operational Quality 60 A Study in Operational Failure: Bayou Hedge Fund Group 60 Affiliated Broker-Dealer 61 Large Discrepancies in the Performance of Onshore and Offshore Funds 62 Declining Capital of Broker-Dealer 63 Board of Directors: Members and Actions 63 Lavish Expenses of Broker-Dealers 63 Fake Audits Prepared by a Phony Auditor 64 Background Questions 64 Lack of Investor Communication 64 Ties to People Barred from the Securities Industry 65 Revision of Conflicted Marketing Materials 66 Other Anomalies 66 Chapter 3 Who Is Qualified to Perform an Operational Due Diligence Review? 69 Essential Skills 73 Primary Skills 74 Primary, Secondary, Blended, and Other Skills 84 In-house versus Outsourcing 85 Evolution of Independent Operational Rating Agencies 86 Benefits of Third-Party Rating Agencies 86 Criticisms of Third-Party Rating Agencies and Operational Due Diligence Providers 87 Factors to Consider before Performing an Operational Review of a Hedge Fund 90 Chapter 4 Creating an Initial Operational Profile 91 When Does an Operational Due Diligence Review Begin? 91 Documentation 92 The Piñata Problem 93 Due Diligence Questionnaire: To Use or Not to Use? 99 Background Investigations 101 Other Considerations 106 Importance of Onsite Visits 107 Which Office to Visit 108 Manager Interview Process 109 What Topics Should Be Covered During an Onsite Review? 111 Sample Topic Questions 113 In What Order Should These Topics Be Covered? 117 Service Provider Reviews 117 Qualitative Operational Report: Documenting the Operational Data 119 Chapter 5 Evaluating the Gray Areas: Examples 121 Scenario 1: “It Was Not Me”—Hedge Fund Manager Claims Mistaken Identity 121 Scenario 2: “It Was Me, But Everyone Was Doing It”—Are Regulatory Witch Hunts Real? 123 Scenario 3: “It Was Me, But I Did Nothing Wrong”—Manager Proved Not Guilty 127 Scenario 4: The Low-Profile Hedge Fund Manager—Is No News Good News? 129 Scenario 5: The Infrastructure Outsourcer—Can One Administrator Do Everything? 135 Scenario 6: The Mountain Climber—Can Plans for Large, Fast Growth Trip You Along the Way? 137 Scenario 7: The Stumbling Giant—Can a Large Manager Lose Sight of Small Controls? 140 Scenario 8: The Apologetic Headmaster—Are Junior Staff as Informed as Senior Management? 143 Chapter 6 Ten Tips for Performing an Operational Due Diligence Review 145 Tip 1: Avoid Meeting with the Wrong People or the Wrong Groups 146 Tip 2: Get Out of the Conference Room 147 Tip 3: Little White Lies Can Turn into Big Problems 149 Tip 4: Be Wary of Phantomware 151 Tip 5: Focus on Documentation and Negotiation 153 Tip 6: Read the Fine Print (Financial Statement Notes, etc.) 154 Tip 7: Reference Checking: Importance of In-Sample and Out-of-Sample References 156 Tip 8: Credit Analysis: Are Funds Financially Viable? 157 Tip 9: Long-Term Planning: Key Staff Retention, Succession Planning, and More 157 Tip 10: Growth Planning: Is the Manager Proactive or Reactive? 158 Chapter 7 Ongoing Operational Profile Monitoring 161 How Often Should Onsite Operational Reviews Be Conducted? 163 Remote Operational Due Diligence Monitoring 164 Media Monitoring 164 Litigation and Regulatory Monitoring 166 Hedge Fund Communication Reviews 166 Assets Under Management and Performance Monitoring 167 Operational Events 168 Effect of Discovery on the Magnitude of an Operational Event 169 Onsite Visit Frequency and Operational Events 169 Developmental Operational Traps 169 Chapter 8 Techniques for Modeling Operational Risk 179 Scoring Systems 179 Building a Scoring System: Category Determination 179 Category Definitions 185 Combinations of Category Definition Approaches 189 Category Weight Assignment 193 Weighting Aggregation Model 195 Weighting Disaggregation Model 197 WAM versus WDM 200 Category Weight Consistency and Reweighting Considerations 201 Factor Marginalization 202 Category Scale Determination and the Meaning of Scores 203 Threshold Self-Assessment and Determination 204 Score Assignment 206 Discretionary Penalties and Bonuses 212 Score Aggregation: Sum Totaling and Weighted Averages 214 Criticisms of Scorecard Models 215 Benefits of Scorecard Models 217 Visualization Techniques 217 Chapter 9 Bridging the Gap: Incorporating Operational Risk Consideration into the Portfolio Construction and Asset Allocation Process 225 Proactive Monitoring: Graphical Universe Creation 227 Proactive Management of Operational Risks 232 Protecting against Conglomeration Risks: Multivariate Commonality Analysis 233 Operational Directional Views 235 Example of Multivariate Commonality Analysis 236 First Objective: Total Diversity Goal 237 Second Objective: FSA Overweight Goal 239 Third Objective: FSA Underweight Goal 243 Conclusions of Scenario Analysis 243 Considering Operational Reviews in the Hedge Fund Portfolio Rebalancing Process 245 Operational Drag 245 Meta Risks 249 Operational Factor 250 Operational Scenario Analysis 253 Can Operational Risk Be Entirely Eliminated? 254 Factoring Operational Risk into Total Risk Calculations 256 Beyond Scorecard Approaches: Discounting Expected Return 257 Discounted Expected Returns with the Operational Factor 261 Operational Haircuts 262 Expected Return and Operational Risk 263 Shape of the Expected Return versus Operational Risk Curve 264 Second Operational Threshold 265 Final Thoughts 267 Chapter 10 Looking Ahead: Trends in the Space 269 Increased Use of Consultants 269 Commoditization of Background Investigations and Canned Operational Due Diligence Reports 272 Increased Reliance on Service Provider Consulting Services 277 Capture of Hedge Funds by Service Providers and Employees 278 Hedge Fund Pursuit of Audit Certifications 280 Operational Activism 281 AU 332 and FAS 157 283 Development of Hedges to Operational Risks 286 Links between Operational Risk and Credit Analysis 288 Proposed Reregulation of the Hedge Fund Industry 289 Index 293

About the Author :
JASON A. SCHARFMAN is a Director with Graystone Research at Morgan Stanley. His responsibilities include analyzing and reporting on the operational risks of alternative investments such as hedge funds, funds of hedge funds, and private equity considered for investment. He also makes recommendations to the firm's investment committee based on that analysis. He has written on the subject of operational due diligence and travels and speaks worldwide on hedge fund operational risks.

Review :
"Informative book by Jason Scharfman, on, well, pretty much everything you need to run a hedge fund…Scharfman also explains the reliance on technology that is becoming ever more apparent in hedge funds, the dangers of phantomware, and questions that should be asked before committing to any new technology." (hedgeco.net, January 26th, 2009) "In his book, Jason Scharfman identifies these operational risks and recommends a strong and innovative "operational" due diligence review program as the best defense against them. His book outlines a step-by-step guide that shows investors how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds and other investments in order to provide hedge funds and their investors with the skills to understand and hopefully mitigate these risks." (The Hedge Fund Law Report, January 8, 2009)