OPERATIONAL DUE DILIGENCE INSIGHTS 2015

KNOWLEDGE SHARING HELPING TO IMPROVE STABILITY & FACILITATE BUSINESS IN THE HEDGE FUND MARKET PLACE

PRISM LLCA l t e r n a t i v e I n v e s t m e n t s

LAURI MARTIN HAAS212 223 2288LMARTIN@PRISMALTERNATIVES.COMHTTP://WWW.PRISMALTERNATIVES.COM

 

 

LAURI MARTIN HAAS TEL: 212-223-2288 E: LMARTIN@PRISMALTERNATIVES.COM

OPERATIONAL DUE DILIGENCE VIEWPOINTS

THIS ARTICLE IS PROPRIETARY AND IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. PRISM LLC IS NOT A REGISTERED INVESTMENT ADVISOR OR BROKER DEALER, AND PRISM LLC DOES NOT MAKE INVESTMENT RECOMMENDA-TIONS. PRISM LLC CONDUCTS OPERATIONAL DUE DILIGENCE AND RELATED CONSULTING SERVICES ON HEDGE FUNDS. PRISM LLC STRONGLY RECOMMENDS CONDUCTING EXTENSIVE OPERATIONAL DUE DILIGENCE PRIOR TO MAKING

AN INVESTMENT IN A FUND AND ANNUALLY THEREAFTER ON AN ONGOING BASIS.

HEDGE FUND WIRE TRANSFER CONTROLS AND THE REGIONAL DIFFERENCES

Registered investment advisors with the US Securities and Exchange Commission generally have custody of client assets, either directly or indirectly. Why is this ac-ceptable practice in the United States and not in other countries around the world?

Most hedge fund fraud cases i.e. Ponzi schemes, misuse of assets, and expense manipulations, have occurred in the United States by US based investment managers. Research has shown that far fewer cases have occurred in the United Kingdom, Con-tinental Europe, Hong Kong, and Singa-pore. Local customs, parochial standards, and regulations have contributed to the US hedge fund industry’s higher than global operational risk. Having personally evalu-ated over 2,000 hedge funds in my career, I can attest to the fact that “access to cli-ent assets” is at the center of most frauds.

What is done differently by US based hedge fund managers?

While a private fund manager generally does not directly hold client assets, as they usually rely on prime brokers, banks, or other custodians, a US fund manager is often “deemed to have custody” be-cause it is party to an arrangement (such as an investment management agree-ment) under which it has the authority to withdraw funds or securities from a client account. This is typically done via a “pow-er of attorney” in order to pay manage-ment and performance fees to the fund’s manager/general partner and to have check writing authority to pay expenses.Having said this, United States hedge fund managers are permitted to have “custo-dy” of client assets subject to having cer-tain “controls” in place, according to SEC Custody Rule 206(4)-2. These controls

include having a financial statement au-dit completed within 120 days from fiscal year end, or undergoing an annual sur-prise custody examination by an indepen-dent public accountant. As such, most US hedge fund managers have the ability to withdraw cash from the fund, and not sole-ly the ability to process trade settlements. Instead of prohibiting the custody i.e. pos-session of client assets by registered investment advisors, the United States regulates the custody of client assets by registered investment advisors. This poses a conflict of interest, as the advi-sor both chooses the investments and has access and possession of client cash.

Why should an investment manager, which often is a privately owned and some-times closely controlled boutique, have access and control to client funds? The answer is that they probably shouldn’t.

If US investment advisors were subject to different guidelines, some of which are practiced overseas, for example were i) prohibited from having custody of client assets, ii) prohibited from having custody of client assets unless they were subject to a SSAE 16 Type II (which would likely only occur with asset managers with over $10 billion in AUM), or iii) prohibited from making non-trading payments whereby these payments were made only by a third party (e.g. an independent admin-istrator); I believe that the risk of fraud in the US hedge fund and private equity industry would decrease dramatically. While in reality there are very few cases of large scale frauds in our industry, we do need to work to eliminate the window of opportunity for financial loss resulting from fraud and mis-use of client assets.

Custody Norms

The global norm is for a hedge fund to en-gage independent qualified custodians to custody 100% of its assets, and institution-al banking relationships to process operat-ing transactions for the fund (i.e. investor subscriptions and withdrawals, and ex-penses in certain cases). However, the US norm is for hedge fund manager employ-ees to process and pay a fund’s expenses through the prime brokerage account which they have control over, while the non-US norm is for independent fund administra-tors to process and pay fund expenses through a bank account that they control.

Having said this, perhaps the process by which fund expenses are paid could be re-visited in America, as an ideal situation for a sound internal control structure is for the fund administrator to review, approve, and process all payments to vendors out of an administrator controlled bank account. In summary, it is not ideal for a manager’s employees to process expenses out of a fund’s prime brokerage account, and it is not ideal for a manager to pay expenses and later be reimbursed by the fund. While both of these scenarios are currently nor-mal, standard, and acceptable practice in the United States, they do expose funds to a higher risk of operational errors or worse, mis-appropriation of assets. In Europe and Asia, expenses are normally paid directly by the fund administrator.

MAY 2015

 LAURI MARTIN HAAS TEL: 212-223-2288 E: LMARTIN@PRISMALTERNATIVES.COM WWW.PRISMALTERNATIVES.COM

OPERATIONAL DUE DILIGENCE VIEWPOINTS

THIS ARTICLE IS PROPRIETARY AND IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. PRISM LLC IS NOT A REGISTERED INVESTMENT ADVISOR OR BROKER DEALER, AND PRISM LLC DOES NOT MAKE INVESTMENT RECOMMENDA-TIONS. PRISM LLC CONDUCTS OPERATIONAL DUE DILIGENCE AND RELATED CONSULTING SERVICES ON HEDGE FUNDS. PRISM LLC STRONGLY RECOMMENDS CONDUCTING EXTENSIVE OPERATIONAL DUE DILIGENCE PRIOR TO MAKING

AN INVESTMENT IN A FUND AND ANNUALLY THEREAFTER ON AN ONGOING BASIS.

AVOIDING PONZI SCHEMES & HEDGE FUND FRAUDS

The single most important reason to conduct hedge fund operational due diligence is to avoid losing your capital. The most frightening way to lose your capital is through a fraud or Ponzi scheme. The largest Ponzi Scheme in the history of hedge funds is Bernard Madoff.

There are clear guidelines that an investor should follow in order to protect themselves from investing in a financial fraud. Hedge fund frauds, often structured in the form of a Ponzi Scheme, can result in a complete loss of investor capital. This loss typically leads to years of ongoing legal fees, which often negatively impacts the investor’s life or franchise long term. Ponzi Schemes often start out as legitimate investment strategies, and fraud ensues in an effort to cover up losses once performance or business targets are not met.

The following steps are critical to meeting the goal of avoiding fraud:

1. Hire an unbiased third party to assess the fraud risk of the hedge fund. The independence of this opinion is critical to removing the inherent conflict of interest between choos-ing performance or relationships over operational risk. This is especially important if you are a fiduciary.

2. Ensure that the fund’s financial statements are audited by an internationally recognized CPA firm. Obtain the audits from the administrator and inspect them for tampering.

3. Confirm that the fund uses an independent administrator that provides daily oversight of the fund’s cash flows.

4. Confirm that 100% of the fund’s assets are custodied by a qualified custodian, and confirm the account balances directly with the custodian.

5. Conduct at least three reference checks, including clients, former employers, and counterparties.

6. Conduct background checks, including verification of edu-cation, employment, registrations, and other public records.

7. Take an audit based, academic approach to conducting ODD. Do not place heavy importance on “positive industry talk”,“highly sellable stories”, or “old relationships”.

8. Ensure that every hedge fund allocation is protected by a third party custodian and a known fund administrator, even allocations to single traders running single investor funds.

9. Lastly but most importantly, maintain an unwavering atten-tion to institutional standards, and never “look for a reason to invest” or try to “qualify” the operational risk flags. Con-ducting extensive due diligence can prove wasteful if the investment decisions are undefendable when it comes to fraud and operational risk.

The following flags have been seen in actual Ponzi Schemes:

• Lack of transparency.• Nepotism.• Lack of a well known or independent custodian.• Lack of an institutional fund administrator.• Decentralized accounting i.e. use of several vendors.• Unusual investment strategy.• Unconventional and unprofessional behavior.• Unqualified back office personnel. • Affiliated broker dealer.• Use of feeder funds.• Use of unaudited SPVs (special purpose vehicles).• Use of several SPVs (a tactic used to confuse auditors).• Lack of audited GAAP financials (i.e. tax basis financials).• Inconsistent due diligence information (e.g. headcount).• Unexplained differences in custody account balances.• Unusual discussions regarding liquidity.• Past litigation with investors.• Unusual related party transactions in the audit.• Single signature wire transfer controls on fund accounts.• Lack of industry standard marketing material.• Highly paid fund directors.• Denied access to the back office team.• Service providers based in non financial centers, which are

not as well versed in hedge funds (DE, FLA, Netherlands).

One of the more important factors listed above is “unconventional behavior”. This is a gray area, and often will be a deciding factor on whether or not to place professional trust in a hedge fund manager. Some examples of unconventional behavior are dance music playing on the firm’s voicemail, black card stock with silver font used for audited financials, dogs onsite playing ball in the trading room, portfolio manager out on a run when you show up for a meeting, CFO looking for reasons to end a meeting early, unusual or lack of updates on SEC Form ADV. These are real life examples of hedge fund fraud flags, and are provided here as a frame of reference.

Over the last 20 years, most hedge fund frauds have operated via the manager’s use of fictitious client account statements. This was the case not only with Madoff, but it was the case with the large majority of historical fraud related blowups. There are ways to avoid the risk of relying on doctored statements. In short, requiring the use of an institutional SSAE SOC 1 daily fund administrator, the use of large custodians, and the use of a globally recognized financial statement auditor with a large financial services practice will limit your fraud risk substantially.

MAY 2015