Hedge Fund Operational Due Diligence E-Book

Jason A. Scharfman

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 531

Veröffentlichungsjahr: 2008

Beschreibung

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.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Preface

CHAPTER 1 - What Is Operational Risk?

BRIEF HISTORY

MODERN DEFINITION OF OPERATIONAL RISK IN A HEDGE FUND CONTEXT

OPERATIONAL DUE DILIGENCE VERSUS OPERATIONAL RISK

KEY AREAS

EXTERNAL RISKS

INTERNAL RISKS

BLENDED RISKS

THE FIVE CORE THEMES

CHAPTER 2 - The Importance of Operational Due Diligence

WHY SHOULD INVESTORS CARE ABOUT OPERATIONAL RISK?

MORTON’S FORK OR A HOBSON’S CHOICE?

OUTRIGHT FRAUD STILL EXISTS

HEDGE FUND FRAUD CANNOT BE MODELED

SMALL DISCREPANCIES ADD UP

LACK OF STANDARDIZED REGULATION

EACH HEDGE FUND IS DIFFERENT

ABILITY TO GENERATE AN INFORMATIONAL EDGE

POTENTIAL TO REDUCE LOSSES AND INCREASE RETURNS

CONSIDERING OPERATIONAL RISK FACTORS PRESENTS A DIFFERENT VIEW INTO A FIRM

COMMON MISCONCEPTIONS

OTHER CONSIDERATIONS: THERE IS NOT NECESSARILY A POSITIVE CORRELATION BETWEEN ...

A STUDY IN OPERATIONAL FAILURE: BAYOU HEDGE FUND GROUP

AFFILIATED BROKER-DEALER

LARGE DISCREPANCIES IN THE PERFORMANCE OF ONSHORE AND OFFSHORE FUNDS

DECLINING CAPITAL OF BROKER-DEALER

BOARD OF DIRECTORS: MEMBERS AND ACTIONS

LAVISH EXPENSES OF BROKER-DEALERS

FAKE AUDITS PREPARED BY A PHONY AUDITOR

BACKGROUND QUESTIONS

LACK OF INVESTOR COMMUNICATION

TIES TO PEOPLE BARRED FROM THE SECURITIES INDUSTRY

REVISION OF CONFLICTED MARKETING MATERIALS

OTHER ANOMALIES

CHAPTER 3 - Who Is Qualified to Perform an Operational Due Diligence Review?

ESSENTIAL SKILLS

PRIMARY SKILLS

PRIMARY, SECONDARY, BLENDED, AND OTHER SKILLS

IN-HOUSE VERSUS OUTSOURCING

EVOLUTION OF INDEPENDENT OPERATIONAL RATING AGENCIES

BENEFITS OF THIRD-PARTY RATING AGENCIES

CRITICISMS OF THIRD-PARTY RATING AGENCIES AND OPERATIONAL DUE DILIGENCE PROVIDERS

FACTORS TO CONSIDER BEFORE PERFORMING AN OPERATIONAL REVIEW OF A HEDGE FUND

CHAPTER 4 - Creating an Initial Operational Profile

WHEN DOES AN OPERATIONAL DUE DILIGENCE REVIEW BEGIN?

DOCUMENTATION

THE PIÑATA PROBLEM

DUE DILIGENCE QUESTIONNAIRE: TO USE OR NOT TO USE?

BACKGROUND INVESTIGATIONS

OTHER CONSIDERATIONS

IMPORTANCE OF ONSITE VISITS

WHICH OFFICE TO VISIT

MANAGER INTERVIEW PROCESS

WHAT TOPICS SHOULD BE COVERED DURING AN ONSITE REVIEW?

SAMPLE TOPIC QUESTIONS

IN WHAT ORDER SHOULD THESE TOPICS BE COVERED?

SERVICE PROVIDER REVIEWS

QUALITATIVE OPERATIONAL REPORT: DOCUMENTING THE OPERATIONAL DATA

CHAPTER 5 - Evaluating the Gray Areas: Examples

SCENARIO 1: “IT WAS NOT ME”—HEDGE FUND MANAGER CLAIMS MISTAKEN IDENTITY

SCENARIO 2: “IT WAS ME, BUT EVERYONE WAS DOING IT”—ARE REGULATORY WITCH-HUNTS REAL?

SCENARIO 3: “IT WAS ME, BUT I DID NOTHING WRONG”—MANAGER PROVED NOT GUILTY

SCENARIO 4: THE LOW-PROFILE HEDGE FUND MANAGER—IS NO NEWS GOOD NEWS?

SCENARIO 5: THE INFRASTRUCTURE OUTSOURCER—CAN ONE ADMINISTRATOR DO EVERYTHING?

SCENARIO 6: THE MOUNTAIN CLIMBER—CAN PLANS FOR LARGE, FAST GROWTH TRIP YOU ...

SCENARIO 7: THE STUMBLING GIANT—CAN A LARGE MANAGER LOSE SIGHT OF SMALL CONTROLS?

SCENARIO 8: THE APOLOGETIC HEADMASTER—ARE JUNIOR STAFF AS INFORMED AS SENIOR ...

CHAPTER 6 - Ten Tips for Performing an Operational Due Diligence Review

TIP 1: AVOID MEETING WITH THE WRONG PEOPLE OR THE WRONG GROUPS

TIP 2: GET OUT OF THE CONFERENCE ROOM

TIP 3: LITTLE WHITE LIES CAN TURN INTO BIG PROBLEMS

TIP 4: BE WARY OF PHANTOMWARE

TIP 5: FOCUS ON DOCUMENTATION AND NEGOTIATION

TIP 6: READ THE FINE PRINT (FINANCIAL STATEMENT NOTES, ETC.)

TIP 7: REFERENCE CHECKING: IMPORTANCE OF IN-SAMPLE AND OUT-OF-SAMPLE REFERENCES

TIP 8: CREDIT ANALYSIS: ARE FUNDS FINANCIALLY VIABLE?

TIP 9: LONG-TERM PLANNING: KEY STAFF RETENTION, SUCCESSION PLANNING, AND MORE

TIP 10: GROWTH PLANNING: IS THE MANAGER PROACTIVE OR REACTIVE?

CHAPTER 7 - Ongoing Operational Profile Monitoring

HOW OFTEN SHOULD ONSITE OPERATIONAL REVIEWS BE CONDUCTED?

REMOTE OPERATIONAL DUE DILIGENCE MONITORING

MEDIA MONITORING

LITIGATION AND REGULATORY MONITORING

HEDGE FUND COMMUNICATION REVIEWS

ASSETS UNDER MANAGEMENT AND PERFORMANCE MONITORING

OPERATIONAL EVENTS

EFFECT OF DISCOVERY ON THE MAGNITUDE OF AN OPERATIONAL EVENT

ONSITE VISIT FREQUENCY AND OPERATIONAL EVENTS

DEVELOPMENTAL OPERATIONAL TRAPS

CHAPTER 8 - Techniques for Modeling Operational Risk

SCORING SYSTEMS

BUILDING A SCORING SYSTEM: CATEGORY DETERMINATION

CATEGORY DEFINITIONS

COMBINATIONS OF CATEGORY DEFINITION APPROACHES

CATEGORY WEIGHT ASSIGNMENT

WEIGHTING AGGREGATION MODEL

WEIGHTING DISAGGREGATION MODEL

WAM VERSUS WDM

CATEGORY WEIGHT CONSISTENCY AND REWEIGHTING CONSIDERATIONS

FACTOR MARGINALIZATION

CATEGORY SCALE DETERMINATION AND THE MEANING OF SCORES

THRESHOLD SELF-ASSESSMENT AND DETERMINATION

SCORE ASSIGNMENT

DISCRETIONARY PENALTIES AND BONUSES

SCORE AGGREGATION: SUM TOTALING AND WEIGHTED AVERAGES

CRITICISMS OF SCORECARD MODELS

BENEFITS OF SCORECARD MODELS

VISUALIZATION TECHNIQUES

CHAPTER 9 - Bridging the Gap: Incorporating Operational Risk Considerations ...

PROACTIVE MONITORING: GRAPHICAL UNIVERSE CREATION

PROACTIVE MANAGEMENT OF OPERATIONAL RISKS

PROTECTING AGAINST CONGLOMERATION RISKS: MULTIVARIATE COMMONALITY ANALYSIS

OPERATIONAL DIRECTIONAL VIEWS

EXAMPLE OF MULTIVARIATE COMMONALITY ANALYSIS

FIRST OBJECTIVE: TOTAL DIVERSITY GOAL

SECOND OBJECTIVE: FSA OVERWEIGHT GOAL

THIRD OBJECTIVE: FSA UNDERWEIGHT GOAL

CONCLUSIONS OF SCENARIO ANALYSIS

CONSIDERING OPERATIONAL REVIEWS IN THE HEDGE FUND PORTFOLIO REBALANCING PROCESS

OPERATIONAL DRAG

META RISKS

OPERATIONAL FACTOR

OPERATIONAL SCENARIO ANALYSIS

CAN OPERATIONAL RISK BE ENTIRELY ELIMINATED?

FACTORING OPERATIONAL RISK INTO TOTAL RISK CALCULATIONS

BEYOND SCORECARD APPROACHES: DISCOUNTING EXPECTED RETURN

DISCOUNTED EXPECTED RETURNS WITH THE OPERATIONAL FACTOR

OPERATIONAL HAIRCUTS

EXPECTED RETURN AND OPERATIONAL RISK

SHAPE OF THE EXPECTED RETURN VERSUS OPERATIONAL RISK CURVE

SECOND OPERATIONAL THRESHOLD

FINAL THOUGHTS

CHAPTER 10 - Looking Ahead: Trends in the Space

INCREASED USE OF CONSULTANTS

COMMODITIZATION OF BACKGROUND INVESTIGATIONS AND CANNED OPERATIONAL DUE ...

INCREASED RELIANCE ON SERVICE PROVIDER CONSULTING SERVICES

CAPTURE OF HEDGE FUNDS BY SERVICE PROVIDERS AND EMPLOYEES

HEDGE FUND PURSUIT OF AUDIT CERTIFICATIONS

OPERATIONAL ACTIVISM

AU 332 AND FAS 157

DEVELOPMENT OF HEDGES TO OPERATIONAL RISKS

LINKS BETWEEN OPERATIONAL RISK AND CREDIT ANALYSIS

PROPOSED REREGULATION OF THE HEDGE FUND INDUSTRY

Index

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Copyright © 2009 by Jason A. Scharfman. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Scharfman, Jason A., 1978- Hedge fund operational due diligence : understanding the risks / Jason A. Scharfman. p. cm. - (Wiley finance series) Includes index.

eISBN : 978-0-470-46617-9

1. Hedge funds. 2. Risk management. I. Title. HG4530.S376 2009 332.64’524-dc22 2008023249

I dedicate this book to my wife, Rachel, for her unwaveringsupport, and to my entire family for theirconstant encouragement.

Preface

Within the pecking order of the hedge fund world, operational risk professionals have traditionally been thought of as being low on the totem pole. Indeed, many hedge fund investment professionals have at one point or another held the view that operational risk management is one of life’s necessary evils and merely a distraction from the “real” business of investing. Yet, ask any hedge fund investor his or her thoughts on the importance of operational due diligence, and you will likely receive a much different response. This book, in part, attempts to reconcile this difference of opinion, by detailing the motivations for comprehensive operational due diligence and outlining a flexible framework to diagnose a hedge fund’s operational risks.

This book is not intended to describe how to run a hedge fund; rather it is meant to provide guidance on how to effectively diagnose, evaluate, and monitor a hedge fund’s operational competencies. Performing these types of evaluations can unveil certain risks investors may not have been aware they were signing up for when they decided to invest in a hedge fund. Similarly, hedge fund personnel can utilize the techniques in this book to perform a self-diagnostic health check and determine areas in which there is need for operational improvements.

When I first began working with hedge funds, the term operational risk was limited solely to back-office concerns. Over time, the term slowly began to encompass more non-investment-related areas. Today, the field of operational due diligence is a diverse and unique area of hedge fund risk management that, partly as a result of several high-profile hedge fund blowups, has gained new prominence. One need only glance at the cover of The Wall Street Journal or turn on CNBC to learn about the latest debacle of hedge fund losses due to poor operational oversight and controls. Even as this book is being written, details are emerging surrounding record-breaking losses of over $7 billion at the French bank Société Générale, allegedly caused by trader Jérome Kerviel’s manipulation of the firm’s internal operational safeguards.

Specifically, this book has three main goals. The first is to provide those who work for hedge funds, as well as those who are invested or are considering investing in hedge funds, with an understanding of the importance and benefits of a comprehensive operational due diligence program. This is accomplished by outlining several arguments in favor of thorough operational due diligence and operational risk management. I have also included an analysis of the failed Bayou Hedge Fund Group to highlight how operational risks can bring down an organization.

The second goal is to provide an understanding of how to diagnose and analyze the operational risks that may be present in a hedge fund. I have outlined the primary, secondary, and blended operational risk factors present in the vast majority of modern hedge fund organizations. I have also included several hypothetical examples that are emblematic of the types of scenarios hedge fund investors might experience in the course of the operational due diligence process.

The third goal of this book is to examine techniques for the modeling of operational risk as well as how to factor the results of this operational risk analysis into the overall hedge fund asset allocation process. With regard to the latter, I have introduced several new concepts in this text, including operational threshold self-assessment, Multivariate Commonality Analysis, the concept of operational drag, and the calculation of the Operational Factor. All of these are powerful techniques that can enable hedge fund investors to extend the value of their operational due diligence efforts beyond that of merely a diagnostic filter.

An underlying goal of this book is to encourage discussion and debate about hedge fund operational risk and the arguments for and against increased transparency. It is inevitable that certain readers will disagree with some of the opinions and conclusions drawn in this book. I welcome the debate, and encourage all those interested in hedge funds to participate in furthering the discussions and research in the field of operational risk.

To summarize, a strong operational infrastructure provides a crucial backbone to the modern hedge fund, without which the smartest money managers in the world could not thrive. I hope that this book both educates and provides the practical tools necessary to produce more adept investors and operations personnel. As a final note, this book reflects my individual opinions and insights, and not those of any of my past or present employers.

Jason Scharfman November 2008

CHAPTER 1

What Is Operational Risk?

The world of hedge fund risk can be very broadly bifurcated into two distinct areas: those risks that are directly related to a hedge fund’s investments, and all others. These investment-related risks can be classified on a high level as market risk, credit risk, and all derivations thereof. Traditionally, investors have been more familiar with, and subsequently placed more focus on, these investment-related risks. There are numerous reasons for this. The marketplace and academics have developed commonly accepted, time-tested ways to quantify these risks through a host of analytical metrics. Through this quantification, both investors and market practitioners alike have been able to more easily correlate these investment-related risks to actual gains or losses for a specific hedge fund investment. Additionally, this quantification allows investors to aggregate similar risks into the context of a larger portfolio and manage these risks accordingly.

In the early 1990s, during the resurgence of hedge fund investing, non-investment-related risks were largely ignored. There were several likely reasons for this, including the lure of extremely positive hedge fund performance and the regulation of the mutual fund industry, which may have given early hedge fund investors a false sense of confidence in the widely unregulated hedge fund market, coupled with a lack of understanding and research in this area. Another reason most hedge fund investors were not focused on these risks most likely related to the fact that there had not been any direct hedge fund catastrophes to keep operational risks fresh in people’s minds. More recently, in the wake of a continuing stream of high-profile hedge fund failures, investors have begun to focus more carefully on the entire gamut of risks—both those directly related to investments and all others—involved when investing in hedge funds. As a result, in recent years, both individual investors and larger allocators alike have begun to bundle these residual non-investment-related risks under the umbrella of a newly defined category called operational risk. Before diving into a discussion regarding the current definitions of what exactly this operational risk category includes as it refers to hedge funds, it will be useful to gain some historical perspective on the development of this unique risk category.

BRIEF HISTORY