Practical Operational Due Diligence on Hedge Funds E-Book

Rajiv Jaitly

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

Seitenzahl: 1940

Veröffentlichungsjahr: 2016

Beschreibung

Tighten due diligence procedures for more successful hedge fund investment

Practical Operational Due Diligence on Hedge Funds is an encyclopaedic, comprehensive reference, written from the perspective of an experienced practitioner. Accompanied by a useful archive of factual material on different hedge fund issues, including failures, fines, and closures, this book focuses on the areas due diligence professionals should address, and explains why they're important. Extensive discussion of publicised cases identifies the manager entities and actual fund vehicles involved, and provides commentary on what could have been done differently in each case, backed by actual regulatory materials, such as SEC complaints, that recreate the events that took place. Readers gain a deeper understanding of the many facets of due diligence and the many possible pitfalls, learning how standardise processes and avoid major errors and oversights.

The amount of money managed by hedge funds has almost doubled from the $1 trillion under management at the time of the financial crisis. Hedge funds can be extremely risky, but can be extremely profitable — as money increasingly flows back in, due diligence on these alternative investments becomes more and more critical. This book provides complete guidance toward the due diligence process, with plentiful real-world examples.

• Identify the areas of due diligence and what can go wrong
• Create procedures and checklists to minimise errors
• Learn what publicised cases could have done differently
• Gain a deeper understanding of massive failures and successes

Proper due diligence can be a massive undertaking, but thoroughness is essential when the price of failure is so high. Practical Operational Due Diligence on Hedge Funds provides the details professionals need to be on point every time.

Leseprobe

Table of Contents

Series Page

Title Page

Copyright

Dedication

Preface

Acknowledgments

About the Author

Disclaimer

Part I: Processes and Procedures

Chapter 1: What is a Hedge Fund?

1.1 THE ROLE OF A HEDGE FUND IN AN INVESTMENT PORTFOLIO

Chapter 2: Defining Operational Issues

2.1 CLASSIFYING PROBLEMS AND FAILURES

2.2 FRAUD

2.3 INSOLVENCY AND WINDING UP

2.4 INVESTMENT LOSSES OUTSIDE THE FUND'S STATED VOLATILITY RANGE

2.5 OPERATIONAL PROBLEMS, FUND DEFAULTS AND MATERIAL BREACHES OF CONTRACT

2.6 REGULATORY INTERVENTION RESULTING IN A SETTLEMENT, FINE OR FUND CLOSURE

2.7 WHAT HAPPENS WHEN IT ALL GOES WRONG

Chapter 3: Structures for Investment in Alternatives

3.1 A QUICK PRIMER ON FUND STRUCTURES

3.2 LIMITED COMPANIES

3.3 UNIT TRUSTS

3.4 PARTNERSHIPS

3.5 MANAGED ACCOUNTS

3.6 MASTER FEEDER AND MINI MASTER STRUCTURES

3.7 UMBRELLA STRUCTURES

3.8 UCITS

3.9 THE CHANGING LANDSCAPE AND THE IMPLICATIONS FOR INVESTORS

3.10 REGULATORY ARBITRAGE

Chapter 4: Is the Fund for Real? Establishing the Basics

4.1 CONSTITUTIONAL DOCUMENTS

4.2 FUND CONTRACTS AND THE BASICS OF CONTRACT REVIEWS

4.3 SERVICE PROVIDERS TO THE FUND

4.4 MANAGER VISITS

4.5 BACKGROUND CHECKS

4.6 INITIAL QUESTIONNAIRES TO COMMENCE DUE DILIGENCE WORK

4.7 “GENERIC RISKS” IN DOCUMENTS AND CONTRACTS

Chapter 5: Understanding Fund Operations and Controls

5.1 INVESTMENT STRATEGIES AND WHAT THEY INVOLVE

5.2 OPERATIONAL STRUCTURES REQUIRED TO SUPPORT AN INVESTMENT STRATEGY

5.3 ESTABLISHING THE EXISTENCE OF CONTROLS

Chapter 6: Governance – Managing Risk Through a Non-Executive Board

6.1 INVESTOR-NOMINATED DIRECTORS

6.2 MANAGING RISK AS A NON-EXECUTIVE BOARD

Chapter 7: Reporting to Members and Statutory Reporting

7.1 STATUTORY REPORTING

7.2 FINANCIAL STATEMENTS

7.3 DESIGNING A TEMPLATE FOR REVIEWING FINANCIAL STATEMENTS

7.4 SHAREHOLDER VOTING: THE AUTOMATIC PROXY

7.5 INVESTOR REPORTING AND TRANSPARENCY

7.6 CONFLICTS OF INTEREST AND TRANSPARENCY

Chapter 8: The Curse of Leverage (Fund Liabilities)

8.1 WHO PROVIDES FINANCE

8.2 HOW FINANCING IS SECURED

8.3 HOW COLLATERAL CREATES FUND RISK

8.4 UNDERSTANDING DEFAULT CLAUSES AND COVENANTS

8.5 COLLATERAL MANAGEMENT AND THE CONCEPT OF MARGINING

8.6 REHYPOTHECATION

8.7 BLOW-UPS DUE TO LEVERAGE

Chapter 9: Fund Assets

9.1 VALUATION CONCEPTS

9.2 DESIGNING PRINCIPLES FOR VALUATIONS

9.3 VALUATIONS FROM AN ACCOUNTING PERSPECTIVE

9.4 AIMA RECOMMENDATIONS

9.5 VALUING LEVEL 3 INVESTMENTS AND ILLIQUID INVESTMENTS

9.6 VALUATION TRICKS AND DISCREPANCIES INCLUDING ACCOUNTING AND DEALING NAVS

9.7 LIQUIDITY

9.8 STYLE DRIFT

9.9 THE SIDE POCKET

9.10 REVIEWING DERIVATIVE TRANSACTIONS

9.11 BETTING THE HOUSE AND ITS CONTENTS

9.12 NAKED SHORTS AND OPTIONS

9.13 MONTHLY REPORTING AND WHAT IT MEANS

9.14 HEDGING CURRENCY RISK AND IMPLICATIONS FOR LIQUIDITY

9.15 REALISING FEES ON A FUND AND DEFERRALS

9.16 THE BASICS ON TAXATION OF HEDGE FUNDS

Chapter 10: Fraud

10.1 PHANTOM FUNDS AND THEFT

10.2 PONZI SCHEMES

10.3 INTENTIONAL MISVALUATION

10.4 PREFERENTIAL TREATMENT

10.5 MISREPRESENTATION/MISREPORTING

10.6 THE NICK LEESON SYNDROME: ROGUE TRADERS

10.7 COVERING UP MISTAKES

Chapter 11: Fees: the Essence of Hedge Funds

11.1 HIGH WATER MARKS, HURDLES AND CLAW BACK PROVISIONS

11.2 WHAT DOES IT COST TO RUN A FUND?

11.3 CAN INVESTORS POSE A RISK TO THE SURVIVAL OF A FUND?

11.4 THE GATE

11.5 REDEMPTION TERMS AND LOCK-UPS

11.6 FEES ON SIDE POCKETS AND ILLIQUIDS

11.7 THE CAPITAL BASE OF THE FUND

11.8 ALIGNING INTERESTS

11.9 ARRIVALS AND DEPARTURES: FUND DILUTION, REBALANCING AND BOX MANAGEMENT

Chapter 12: Regulatory Actions, Politics and Market Confidence

12.1 CHARACTERISTICS OF SUCCESSFUL COMPLAINTS AND DEFENCES

12.2 THE BASICS OF AN SEC COMPLAINT

12.3 INVESTIGATIONS BY THE UK FINANCIAL CONDUCT AUTHORITY

12.4 LARGE FINANCIAL SERVICES FIRMS VS SMALL FINANCIAL SERVICES FIRMS

12.5 MANAGING ELECTRONIC DISCOVERY

12.6 AIFMD

12.7 DEVELOPMENTS IN THE ASIA PACIFIC REGION

12.8 INVESTOR PROTECTION THROUGH REGULATION

12.9 IDENTIFYING FUTURE RISKS

Chapter 13: Key Man Risk, Disaster Recovery and Business Continuity

13.1 THE HOUSE OF CARDS – DISASTER RECOVERY OR BUSINESS CONTINUITY

13.2 WHOSE INFORMATION IS IT ANYWAY?

13.3 INSURANCE

Chapter 14: Negotiating Terms and Exercising Rights

14.1 THE SUBSCRIPTION DOCUMENT

14.2 THE NECESSITY FOR SIDE AGREEMENTS

14.3 THE IMPLICATIONS OF SIDE AGREEMENTS

14.4 THINGS TO CONSIDER

14.5 EXERCISING SHAREHOLDER RIGHTS

14.6 TAKING OVER THE MANAGEMENT OF THE FUND

14.7 EXITING OR REDEEMING FROM A FUND

Chapter 15: Risk Ratings and Scoring

15.1 SCORING: TEMPTATIONS AND DANGERS

15.2 RISK MAPPING AND SOX CONTROLS

15.4 EXTERNAL RATING AGENCIES

15.5 OUTSOURCING DUE DILIGENCE BY FUNDS OF FUNDS AND INSTITUTIONS

Chapter 16: Marketing to Investors

16.1 WHAT THE PROSPECTUS DOES NOT SAY

16.2 DOES OPERATIONAL RISK REALLY MATTER?

16.3 MARKETING AS A DIFFERENTIATING FACTOR

16.4 CAREER RISK MANAGEMENT

16.5 INVESTMENT SELECTION PROCESSES –THE DECEPTIVENESS OF THE POWER OF VETO AND OVERRIDING CONTROLS

Part II: Case Studies

Chapter 17: Case Studies Pre-2000

17.1 FLESCHNER BECKER ASSOCIATES

17.2 D.E. SHAW & CO LP

17.3 ASKIN CAPITAL MANAGEMENT L.P.

17.4 GUARENTE-HARRINGTON ASSOCIATES

17.5 HUBSHMAN MANAGEMENT CORP

17.6 INVESTOR OVERSEAS SERVICES LIMITED

17.7 LONG-TERM CAPITAL MANAGEMENT L.P.

17.8 NIEDERHOFFER INVESTMENTS INC/NCZ COMMODITIES INC

17.9 ODEY ASSET MANAGEMENT LTD

17.10 OMEGA ADVISORS INC

17.11 PHAROS CAPITAL MANAGEMENT LP

17.12 PIPER CAPITAL MANAGEMENT INC

17.13 STEADMAN SECURITY CORPORATION

17.14 STEINHARDT MANAGEMENT COMPANY INC

17.15 TAKARA ASSET MANAGEMENT CORPORATION

Chapter 18: Case Studies 2000

18.1 ASHBURY CAPITAL MANAGEMENT LLC

18.2 LASER ADVISERS INC

18.3 MANHATTAN CAPITAL MANAGEMENT, INC

18.4 MARICOPA INTERNATIONAL INVESTMENT CORPORATION

18.5 PENTA INVESTMENT ADVISERS LTD

18.6 SOROS FUND MANAGEMENT LLC

18.7 TIGER MANAGEMENT CORP.

Chapter 19: Case Studies 2001

19.1 E THOMAS JUNG AND E THOMAS JUNG PARTNERS LTD

19.2 MARQUE MILLENNIUM GROUP, INC.

19.3 HEARTLAND ADVISORS INC

Chapter 20: Case Studies 2002

20.1 BEACON HILL ASSET MANAGEMENT LLC

20.2 INTEGRAL INVESTMENT MANAGEMENT LP

20.3 KLESCH & CO LIMITED

20.4 ORCA FUNDS INC

20.5 TROUT TRADING MANAGEMENT COMPANY LTD

Chapter 21: Case Studies 2003

21.1 CPTR LLC

21.2 CANARY INVESTMENT MANAGEMENT LLC

21.3 EIFUKU INVESTMENT MANAGEMENT LIMITED

21.4 J.T. INVESTMENT GROUP INC AND NEW RESOURCE INVESTMENT GROUP INC

21.5 LANCER MANAGEMENT GROUP LLC AND LANCER MANAGEMENT GROUP II LLC

21.6 LIPPER HOLDINGS, LLC

21.7 MILLENNIUM CAPITAL GROUP LLC

Chapter 22: Case Studies 2004

22.1 DOBBINS OFFSHORE CAPITAL LLC

22.2 FOUNTAINHEAD ASSET MANAGEMENT LLC

22.3 LF GLOBAL INVESTMENTS LLC

22.4 NEXTRA INVESTMENT MANAGEMENT SGR

Chapter 23: Case Studies 2005

23.1 CREEDON KELLER & PARTNERS

23.2 AMAN CAPITAL MANAGEMENT PTE LTD

23.3 APPLEGATE INVESTMENTS

23.4 AMERINDO INVESTMENT ADVISORS INC

23.5 LAKE DOW CAPITAL, LLC

23.6 BAILEY COATES ASSET MANAGEMENT LLP

23.7 BAYOU MANAGEMENT LLC

23.8 AJR CAPITAL INC AND CENTURY MAXIM FUND INC.

23.9 DURUS CAPITAL MANAGEMENT LLC

23.10 ENTRUST CAPITAL MANAGEMENT INC

23.11 EPG CAPITAL MANAGEMENT INC

23.12 HMC INTERNATIONAL, LLC

23.13 K.L. GROUP LLC, KL FLORIDA LLC & KL TRIANGULUM MANAGEMENT LLC

23.14 HUNTER CAPITAL MANAGEMENT LP

23.15 LINUXOR ASSET MANAGEMENT LLC

23.16 LYCEUM CAPITAL LP

23.17 MARIN CAPITAL PARTNERS LLC

23.18 MILLENNIUM MANAGEMENT LLC

23.19 NORSHIELD ASSET MANAGEMENT (CANADA) LTD

23.20 PHILADELPHIA ALTERNATIVE ASSET MANAGEMENT COMPANY LLC

23.21 PHOENIX KAPITALDIENST GMBH

23.22 PIPPIN INVESTMENTS

23.23 PORTUS ALTERNATIVE ASSET MANAGEMENT INC

23.24 REFCO INC.

23.25 SPRINGER INVESTMENT MANAGEMENT INC

23.26 TENET ASSET MANAGEMENT LLC

23.27 MELHADO, FLYNN & ASSOCIATES INC

23.28 VERAS INVESTMENT PARTNERS LLC

23.29 WOOD RIVER CAPITAL MANAGEMENT LLC

Chapter 24: Case Studies 2006

24.1 AMARANTH ADVISORS LLC

24.2 ARCHEUS CAPITAL MANAGEMENT LLC

24.3 BENCHMARK ASSET MANAGEMENT – UK

24.4 CAPITALWORKS INVESTMENT PARTNERS, LLC

24.5 CMG-CAPITAL MANAGEMENT GROUP HOLDING COMPANY, LLC

24.6 DIRECTORS FINANCIAL GROUP LTD

24.7 ENDEAVOUR FUNDS MANAGEMENT LIMITED

24.8 GLOBAL CROWN CAPITAL LLC AND J&C GLOBAL SECURITIES INVESTMENTS LLC

24.9 GLG PARTNERS INC

24.10 INTERNATIONAL MANAGEMENT ASSOCIATES LLC

24.11 BRUMMER & PARTNERS

24.12 MANCHESTER TRADING LLC

24.13 MOTHERROCK LP

24.14 LANGLEY CAPITAL LLC

24.15 RCG CAPITAL ADVISORS LLC

24.16 SAMARITAN ASSET MANAGEMENT SERVICES INC

24.17 SEAFORTH MERIDIAN ADVISORS LLC

24.18 PLUSFUNDS GROUP INC

24.19 SPINNER ASSET MANAGEMENT LLC

24.20 VIPER CAPITAL MANAGEMENT LLC AND COMPASS FUND MANAGEMENT LLC

Chapter 25: Cases Studies 2007

25.1 ABSOLUTE CAPITAL GROUP LTD

25.2 ABSOLUTE CAPITAL MANAGEMENT LTD

25.3 ARAGON CAPITAL MANAGEMENT LLC

25.4 AXA INVESTMENT MANAGERS INC

25.5 BASIS CAPITAL FUNDS MANAGEMENT LTD

25.6 BEACON ROCK CAPITAL, LLC

25.7 BEAR STEARNS ASSET MANAGEMENT INC

25.8 CAMBRIDGE PLACE INVESTMENT MANAGEMENT LLP

25.9 CHEYNE CAPITAL MANAGEMENT (UK) LLP

25.10 CLARION MANAGEMENT LLC

25.11 COOPER HILL PARTNERS LLC

25.12 DSJ INTERNATIONAL RESOURCES LTD (CHELSEY CAPITAL)

25.13 EVERCREST CAPITAL (PTY) LTD

25.14 FORSYTH PARTNERS LTD

25.15 BRADDOCK FINANCIAL CORPORATION

25.16 GERONIMO FINANCIAL ASSET MANAGEMENT LLC

25.17 GOLDLINK CAPITAL ASSET MANAGEMENT LIMITED

25.18 CARIBBEAN COMMODITIES LTD

25.19 HAIDAR CAPITAL MANAGEMENT LLC

25.20 LAKE SHORE ASSET MANAGEMENT LTD

25.21 LYDIA CAPITAL LLC

25.22 BEAR STEARNS & CO INC

25.23 MDL CAPITAL MANAGEMENT INC

25.24 MERCURIUS CAPITAL MANAGEMENT LIMITED

25.25 GOLDMAN SACHS GROUP INC

25.26 ODDO AND CIE/ODDO ASSET MANAGEMENT

25.27 EIGER CAPITAL LIMITED

25.28 SACHSEN LB

25.29 BNP PARIBAS SA

25.30 PIRATE CAPITAL LLC

25.31 QUATTRO GLOBAL CAPITAL LLC

25.32 IKB CREDIT ASSET MANAGEMENT GMBH

25.33 RITCHIE CAPITAL MANAGEMENT LLC

25.34 RUBICON FUND MANAGEMENT LLP

25.35 SENTINEL MANAGEMENT GROUP INC

25.36 SOWOOD CAPITAL MANAGEMENT LP

25.37 STRATIX ASSET MANAGEMENT LLC

25.38 SYNAPSE INVESTMENT MANAGEMENT LLP

25.39 TPG-AXON CAPITAL MANAGEMENT LP

25.40 TRIBECA GLOBAL MANAGEMENT LLC

25.41 DILLON READ CAPITAL MANAGEMENT LLC

25.42 UBS SECURITIES LLC

25.43 UNION INVESTMENT ASSET MANAGEMENT HOLDING AG

25.44 UNITED CAPITAL MARKETS HOLDINGS INC

25.45 WHARTON ASSET MANAGEMENT GB LTD

Chapter 26: Case Studies 2008

26.1 CITIGROUP GLOBAL MARKETS INC MAT/ASTA FUNDS

26.2 GABRIEL CAPITAL CORPORATION

26.3 BLUE RIVER ASSET MANAGEMENT LLC

26.4 BLUEBAY ASSET MANAGEMENT PLC

26.5 CARLYLE INVESTMENT MANAGEMENT LLC

26.6 CENTAURUS CAPITAL LTD

26.7 1861 CAPITAL MANAGEMENT LLC

26.8 ANDOR CAPITAL MANAGEMENT LLC

26.9 CERES CAPITAL PARTNERS LLC

26.10 CITADEL LLC

26.11 COADUM ADVISERS INC & MANSELL CAPITAL PARTNERS III LLC

26.12 CORNERSTONE QUANTITATIVE INVESTMENT GROUP INC

26.13 CITIGROUP CAPITAL MARKETS INC – CSO PARTNERS FUND

26.14 DALTON STRATEGIC PARTNERSHIP LLP

26.15 D.B. ZWIRN & CO. L.P.

26.16 DEEPHAVEN CAPITAL MANAGEMENT LLC AND KNIGHT CAPITAL GROUP

26.17 DRAKE CAPITAL MANAGEMENT LLC

26.18 DREIER LLP

26.19 ENDEAVOUR CAPITAL LLP

26.20 EPIC CAPITAL MANAGEMENT INC

26.21 DELTAONE CAPITAL PARTNERS CORP

26.22 CITIGROUP ALTERNATIVE INVESTMENTS LLC

26.23 FAIRFIELD GREENWICH ADVISORS LLC

26.24 FOCUS CAPITAL INVESTORS LLC

26.25 FORTRESS INVESTMENT GROUP LLC

26.26 FRONT STREET CAPITAL CORPORATION

26.27 GLOBAL OPPORTUNITIES (GO) CAPITAL ASSET MANAGEMENT B.V.

26.28 BARCLAYS BANK PLC

26.29 GORDIAN KNOT LTD

26.30 GRADIENT CAPITAL PARTNERS LLP

26.31 HEADSTART ADVISERS LIMITED

26.32 HERITAGE WEALTH MANAGEMENT INC

26.33 HIGHLAND CAPITAL MANAGEMENT LP

26.34 ING (NZ) LIMITED

26.35 INSANA CAPITAL PARTNERS LP

26.36 LAHDE CAPITAL MANAGEMENT LLC

26.37 LAWRENCE ASSET MANAGEMENT LP

26.38 LIBERTYVIEW CAPITAL MANAGEMENT INC

26.39 LONDON DIVERSIFIED FUND MANAGEMENT LLP

26.40 UBS THIRD PARTY MANAGEMENT COMPANY S.A. AND ACCESS PARTNERS S.A.

26.41 TREMONT GROUP HOLDINGS INC

26.42 BERNARD L. MADOFF INVESTMENT SECURITIES LLC

26.43 KINGATE MANAGEMENT LTD

26.44 MANHASSET CAPITAL MANAGEMENT LLC

26.45 MAXAM CAPITAL MANAGEMENT LLC

26.46 MKM LONGBOAT CAPITAL ADVISORS LLP

26.47 MORGAN ASSET MANAGEMENT INC

26.48 OAK GROUP INC

26.49 OKUMUS CAPITAL LLC

26.50 CITIGROUP INC – OLD LANE PARTNERS LP

26.51 BANCO SANTANDER SA

26.52 ORE HILL PARTNERS LLC

26.53 OSPRAIE MANAGEMENT LLC

26.54 PARDUS CAPITAL MANAGEMENT LP

26.55 PARKCENTRAL CAPITAL MANAGEMENT LP

26.56 PELOTON PARTNERS LLP

26.57 PENTAGON CAPITAL MANAGEMENT PLC

26.58 PLATINUM GROVE ASSET MANAGEMENT LP

26.59 POLAR CAPITAL LLP

26.60 POLYGON INVESTMENT PARTNERS LLP

26.61 POWE CAPITAL MANAGEMENT LLP

26.62 QUANTEK ASSET MANAGEMENT LLC

26.63 REGAN & COMPANY

26.64 ROCKWATER MUNICIPAL ADVISORS LLC

26.65 DEUTSCHE BANK AG

26.66 RUMSON CAPITAL LLC

26.67 RUSSELL CAPITAL INC

26.68 WINDMILL MANAGEMENT LLC

26.69 SAILFISH CAPITAL PARTNERS LLC

26.70 SALIDA CAPITAL LP

26.71 SATELLITE ASSET MANAGEMENT LP

26.72 SEXTANT CAPITAL MANAGEMENT INC

26.73 STANDARD BANK PLC

26.74 STONE & YOUNGBERG LLC

26.75 GALLOWAY CAPITAL MANAGEMENT LLC

26.76 TANTALLON CAPITAL ADVISORS PTE LTD

26.77 TEQUESTA CAPITAL ADVISORS LP

26.78 TOSCAFUND ASSET MANAGEMENT LLP

26.79 JO HAMBRO CAPITAL MANAGEMENT LTD

26.80 TURNBERRY CAPITAL MANAGEMENT LP

26.81 FIRST REPUBLIC INVESTMENT MANAGEMENT INC

26.82 WEBB ASSET MANAGEMENT CANADA INC

Chapter 27: Case Studies 2009

27.1 SCOOP MANAGEMENT INC & SCOOP CAPITAL LLC

27.2 ASENQUA INC

27.3 ASTARRA ASSET MANAGEMENT PTY LIMITED

27.4 ATTICUS CAPITAL

27.5 AUSTIN CAPITAL MANAGEMENT, LTD

27.6 ACORN CAPITAL MANAGEMENT LLC

27.7 BOSTON PROVIDENT LP

27.8 CHAIS 1991 FAMILY TRUST

27.9 CEREBRUS CAPITAL MANAGEMENT LP

27.10 COHMAD SECURITIES CORPORATION

27.11 CRW MANAGEMENT LP

27.12 DYNAMIC DECISIONS CAPITAL MANAGEMENT LTD

27.13 EVERGREEN INVESTMENT MANAGEMENT COMPANY LLC

27.14 FINVEST ASSET MANAGEMENT LLC

27.15 GALLEON MANAGEMENT LP

27.16 HFV ASSET MANAGEMENT LP

27.17 JADIS INVESTMENTS LLC

27.18 JWM PARTNERS LLC

27.19 K1 FONDS GBR

27.20 LANCELOT INVESTMENT MANAGEMENT LLC

27.21 LOCKE CAPITAL MANAGEMENT INC

27.22 LODGE CAPITAL GROUP LLC

27.23 M.A.G. CAPITAL LLC

27.24 NEW CASTLE FUNDS, LLC

27.25 NEW STAR ASSET MANAGEMENT GROUP PLC

27.26 NORTHERN RIVERS CAPITAL MANAGEMENT INC

27.27 NYLON CAPITAL LLP

27.28 NORTH HILLS MANAGEMENT LLC

27.29 ONYX CAPITAL LLC

27.30 CROSSROAD CAPITAL MANAGEMENT LLC

27.31 PEQUOT CAPITAL MANAGEMENT INC

27.32 PONTA NEGRA GROUP LLC

27.33 RAPTOR CAPITAL MANAGEMENT LP

27.34 RCS HEDGE FUND

27.35 RUDERMAN CAPITAL MANAGEMENT LLC

27.36 SAND DOLLAR INVESTING PARTNERS LLC

27.37 SNC ASSET MANAGEMENT INC

27.38 SOLARIS MANAGEMENT LLC

27.39 3V CAPITAL MANAGEMENT LLC

27.40 WEAVERING CAPITAL (UK) LTD

27.41 WEST END CAPITAL MANAGEMENT LLC & WEST END FINANCIAL ADVISORS LLC

27.42 WESTGATE CAPITAL MANAGEMENT LLC

27.43 WESTRIDGE CAPITAL MANAGEMENT INC

27.44 S2 CAPITAL MANAGEMENT LLC

Chapter 28: Case Studies 2010

28.1 CAMULOS CAPITAL LP

28.2 DIAMONDBACK CAPITAL MANAGEMENT LLC

28.3 EASY EQUITY ASSET MANAGEMENT INC

28.4 EBULLIO CAPITAL MANAGEMENT LLP

28.5 FRONTPOINT PARTNERS LLC

28.6 GARTMORE GROUP PLC

28.7 GEM CAPITAL LLC

28.8 GLOBAL HOLDINGS LLC

28.9 GRIFPHON ASSET MANAGEMENT LLC AND SASQUATCH CAPITAL LLC

28.10 GSC GROUP INC AND J.P. MORGAN SECURITIES LLC

28.11 CHIMAY CAPITAL MANAGEMENT INC

28.12 HORSEMAN CAPITAL MANAGEMENT, L.P.

28.13 IMPERIUM INVESTMENT ADVISORS LLC

28.14 LANEXA MANAGEMENT LLC

28.15 LIFE'S GOOD INC

28.16 ONYX CAPITAL ADVISORS LLC

28.17 PEF ADVISORS LLC

28.18 GARCIA CAPITAL MANAGEMENT LLC

28.19 GOLDMAN SACHS & CO

28.20 PLAINFIELD ASSET MANAGEMENT LLC

28.21 SOUTHRIDGE CAPITAL MANAGEMENT LLC

28.22 THINKSTRATEGY CAPITAL MANAGEMENT LLC/LILABOC LLC

28.23 COWEN GROUP INC

Chapter 29: Case Studies 2011

29.1 AXA ROSENBERG INVESTMENT MANAGEMENT LLC

29.2 BARAI CAPITAL MANAGEMENT LP

29.3 BAYSTAR CAPITAL MANAGEMENT LLC

29.4 BENCHMARK ASSET MANAGERS LLC, AND HARVEST MANAGERS LLC

29.5 360 GLOBAL CAPITAL LLC

29.6 AETHRA ASSET MANAGEMENT B.V.

29.7 3 DEGREES ASSET MANAGEMENT PTE LTD

29.8 FLETCHER ASSET MANAGEMENT INC

29.9 DUMA CAPITAL MANAGEMENT LLC AND DUMA CAPITAL PARTNERS LLC

29.10 HARBINGER CAPITAL PARTNERS LLC

29.11 ALNBRI MANAGEMENT, LLC & MANAGED ACCOUNTS ASSET MANAGEMENT LLC

29.12 IU GROUP INC

29.13 JAMES CAIRD ASSET MANAGEMENT LLP

29.14 JUNO MOTHER EARTH ASSET MANAGEMENT LLC

29.15 KOMODO CAPITAL MANAGEMENT PTE LTD

29.16 LEADDOG CAPITAL MARKETS LLC

29.17 LIQUID CAPITAL MANAGEMENT, LLC

29.18 LOCUST OFFSHORE MANAGEMENT, LLC

29.19 LONGACRE FUND MANAGEMENT LLC

29.20 MICHAEL KENWOOD ASSET MANAGEMENT LLC

29.21 MILLENNIUM GLOBAL INVESTMENTS LTD

29.22 NEURAL MARKETS LLC

29.23 NEW CENTURY INVESTMENT MANAGEMENT LLC

29.24 O.S.S. CAPITAL MANAGEMENT LP

29.25 PAULSON & CO INC

29.26 PEGASUS INVESTMENT MANAGEMENT LLC

29.27 RAB CAPITAL LTD

29.28 SEATOWN HOLDINGS PTE

29.29 SHK ASSET MANAGEMENT LLC

29.30 SJK INVESTMENT MANAGEMENT LLC

29.31 SPENCER HOUSE CAPITAL MANAGEMENT LLP

29.32 TASK CAPITAL MANAGEMENT LLC, ARM CAPITAL MANAGEMENT LLC & VIGILANT CAPITAL MANAGEMENT LLC

29.33 TONTINE CAPITAL MANAGEMENT LLC

29.34 TRAFALGAR ASSET MANAGERS LIMITED

29.35 VANQUISH CAPITAL GROUP LLC

29.36 WCM CAPITAL INC

29.37 WESSEX ASSET MANAGEMENT LIMITED

Chapter 30: Case Studies 2012

30.1 ABANTE CAPITAL (PROPRIETARY) LIMITED AND BASILEUS CAPITAL (PTY) LTD

30.2 TELL INVESTMENTS LLP

30.3 TIG ADVISORS LLC

30.4 TRADEWINDS GLOBAL INVESTORS LLC

30.5 VORAS CAPITAL MANAGEMENT LLC

30.6 BLUEGOLD CAPITAL MANAGEMENT LLP

30.7 THADDEUS CAPITAL MANAGEMENT (HK) LIMITED

30.8 BRICKELL FUND LLC

30.9 ALETHEIA RESEARCH AND MANAGEMENT INC

Appendix A: Index of Case Studies by Investment Manager

Appendix B: UK Serious Fraud Office Hedge Fund Investor Questionnaire

Index

List of Funds

List of Fund Managers

End User License Agreement

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Guide

Cover

Table of Contents

Begin Reading

List of Tables

Chapter 2: Defining Operational Issues

Table 2.1 A taxonomy of fraud in alternative investments

Chapter 9: Fund Assets

Table 9.1 Segregation of fair value responsibilities

Table 9.2 Comparison of AIMA recommendations with IOSC Principles

Chapter 12: Regulatory Actions, Politics and Market Confidence

Table 12.1 Ten most common complaints during FY 2010

Table 12.2 Ten most common complaints

Chapter 15: Risk Ratings and Scoring

Table 15.1 Key functions and processes for each individual (i.e. What do they do, why would it matter if they didn't do it and how would you know?).

Table 15.2 Generic departmental risks (i.e. What are they and how are they covered?).

Table 15.3 Hedge fund scoring template

Table 15.4 Prime brokerage scoring template

Table 15.5 Liquidity profile scoring template

Table 15.6 Auditors scoring template

Table 15.7 Regulatory issues scoring template

Table 15.8 Transparency scoring template

Table 15.9 Fund management scoring template

Table 15.10 Contractual arrangements scoring template

Table 15.11 Operational controls risk escalation and segregation scoring template

Table 15.12 Cash and trading controls scoring template

Table 15.13 Operational staff quality and manager background scoring template

Table 15.14 Service providers scoring template

Table 15.15 Insurance arrangements scoring template

Table 15.16 Disaster recovery arrangements scoring template

Table 15.17 Investor profile and concentration scoring template

Table 15.18 Scoring template for overall view

Chapter 17: Case Studies Pre-2000

Table 17.1 Comparison of LTCM's leverage to major securities and future firms

Chapter 26: Case Studies 2008

Table 26.1 The Global Energy Fund performance

Chapter 29: Case Studies 2011

Table 29.1 Terms for investors in Rivulet Capital

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Practical Operational Due Diligence on Hedge Funds

Processes, Procedures and Case Studies

RAJIV JAITLY

This edition first published 2016

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ToMum & DadandRahul & Anuradha

Pray to God sailor, but row for the shore.

—nautical proverb

Preface

In the business world, the rearview mirror is always clearer than the windshield

.

–Warren Buffet

We all talk about blow-ups in the world of hedge funds. Indeed, it is a word that strikes fear in the heart of any due diligence professional. Yet it is a loose term which means different things to different people.

To some it may be catastrophic losses from a trade, to others an inability to make a strategy viable. Often it may be a failure to recover from cumulative or even one-off trading losses. It may be caused by operational failure, the unexpected loss of key staff or a service provider failing. Frequently it is the impact of leverage, or sometimes because fraudulent activity is exposed.

This book is an attempt to consolidate collective experience on issues that arise in hedge fund due diligence and covers more than just “blow-ups”, as it is intended to address structural issues and problems that may have been identifiable during the due diligence process and which investors should arguably have known about prior to investment. The book is based on the premise that often (but not always), most of the information to make due diligence judgements is available to investors who are prepared to do the work – particularly institutional investors – but factors such as career risk, remuneration policies and governance practices mean that the realities of the risks and dangers may be ignored. This can make it difficult to challenge views which are sometimes no more than “received wisdom” against the probabilities of a problem occurring around an identified issue. When issues cannot be challenged and addressed openly then in such an environment the fable of the emperor's new clothes is likely to flourish – such as in the case of Madoff, where the issues and risks were arguably well known to many investors but where few dared to challenge the status quo and point out that the emperor had no new clothes.

It is of course much easier to apply the benefits of hindsight to problems that have eventually transpired, but this book's contention is that even though there are cases where it would have been difficult if not impossible to identify potential failure or problems, it is often the case that some, if not all, the signals to pay attention to were available prior to the making of investment decisions in many instances, and that these were more often than not ignored. In order to learn from those experiences, applying hindsight is no bad thing – particularly where it is clear that the evidence would have been available to make the right judgement calls.

This book is not just about fraud but also includes situations – commercial and otherwise – that perfectly legitimate businesses have found themselves in. Some have managed to navigate through them and come out at the other end having survived either in their original form or through a change in shape and direction. Others have had to close and exit from the business. The focus of the book is to use these situations as case studies for what the due diligence teams should have been able to identify. It is also important to acknowledge why in some cases it would not have been possible to do anything. The book also tries to assess what impact each set of circumstances had. Failures of investment strategies and the inability to raise capital are also discussed in terms of their operational impact. Some case studies have little or no information about them but appear nonetheless because they are examples of businesses that started and closed in short order. Many have similar themes.

The case studies also include plenty of examples of fraud. No amount of due diligence is likely to prevent someone minded to commit fraud, and inevitably mistakes do get made. But if investors are prepared to invest resource in due diligence functions and, more importantly, pay attention to what they unearth, then it should be possible to recognise many of the indicators to avoid. Indeed, there are now consultants who are beginning to collate signals that may constitute red flags ahead of investment for precisely that reason. Of course, some of the problems cited may be evident in many hedge funds that continue to operate and generate returns for their investors today, such as in relation to some of the conflict of interest issues raised here. However, in these circumstances, I would argue that investors have either had to invest blindly or by taking a leap of faith. I believe that there should be very little justification for investments – particularly by institutional investors responsible for managing the money of others – to proceed in this way.

Analysing what we know of problems linked to hedge funds, it is often possible to identify some basic steps that investors might have taken in their due diligence to avoid the issues they were confronted with. Many funds of hedge funds in the early 2000s made much of their due diligence processes to explain why they had avoided investing in Long Term Capital Management (LTCM) – one of the first of the “too big to fail” blow-ups. Some failures such as Madoff are simpler to classify as failures of investor due diligence. Any analysis also needs to take into account how markets and market practice have evolved as only 10 years after LTCM, Amaranth's problems barely caused a ripple in the market.

As an insolvency practitioner I have been lucky during the course of my working life to work in one form or another on some of the major failures arising from or resulting in insolvencies in the UK. The exposure I had in the 80s and 90s to companies such as Polly Peck, BCCI, Maxwell Communications and Frazer Nash, to name a few, provided the best possible training grounds for the direction my career eventually took, giving me a ringside seat in the world of hedge funds, where I have worked since 2000 and where I have even had the opportunity to deal with some of those who feature in this book. In writing a book such as this I have had to tread a fine line to ensure that the access I had to highly sensitive information was respected and I have therefore restricted the analysis to just those matters that can be easily accessed from information found in the public domain such as on the internet. I have been mindful of the fact that a lot of information continues to remain behind closed doors. This has meant that some of the analysis is limited, but I hope it will still shed light on the possible approaches one might choose to adopt on what was publicly available.

I am also conscious that many names of managers mentioned in the context of a book such as this may view their inclusion as being unfair or pejorative because they continue to be successful businesses where investors remain invested – but the case studies have been chosen because the problems faced by the hedge funds managed by these managers were the subject of press comment at the time, and, in some cases, caused investors problems because of a wide range of issues including trading losses, structural problems such as key man risk, client redemptions, insolvency and formal regulatory actions which investors should, in many instances, have been able to identify prior to investment. Whilst there is always a risk that a manager views its inclusion as a case study pejoratively, I hope that the facts that I have accessed and analysed and drawn conclusions from will stand on their own. Ultimately the responsibility for including or excluding a name is dependent on the research I did and is mine alone.

Acknowledgments

The case studies in this book would not have been possible without the vast library that is the internet and all those who post information on it.

I have been immensely privileged to be involved in the industry that is the world of hedge funds. It is full of interesting people. But it is also a world populated by some people prepared to take shortcuts in the name of expediency, where nothing is necessarily ever quite as it seems and where the stakes can be immensely high.

It is for those whose job it is to conduct operational due diligence on funds and who are responsible for verifying the claims of others and identifying potential problems for which they may even eventually be held responsible, that this book has been written. The consequences for them of the problems that can arise can be significant. It would be good to think that this work might help to point them in the right direction and that they might be able to benefit from my experience.

There are far too many people to name individually who have contributed to the making of this book – whether through discussions on due diligence within my teams or in making investment decisions or indeed in arriving at practical solutions to problems. Without them there would be no experience to reflect in this book – and for that I am immensely grateful to all of them.

Finally, my thanks to Dr Chris Jones, who breathed life into this book through his introductions to John Wiley and to the Naked Short Club – a radio programme – which was to lead me to Matthias Knab, who very kindly reintroduced me to John Wiley and triggered this publication, and of course to Thomas Hyrkiel at John Wiley, who persevered with its publication.

About the Author

Rajiv Jaitly is the managing partner at Jaitly LLP a consultancy that provides independent fund governance expertise and due diligence services to global clients. He set up and managed due diligence and investment management (middle and back office) operations for major groups of companies such as UBS, Santander and AXA. More recently he has also worked with the Regulatory Policy team of the UK Pensions Regulator advising on matters including asset protection, fund costs, employer covenants, capital adequacy and auto-enrolment for 2012. He was appointed an expert by the Office of Fair Trading in 2013 for its market study on defined contribution pensions. He was also commissioned by the UK Financial Services Consumer Panel to write a report on fund costs, which was published in November 2014.

Disclaimer

While the author has used his reasonable efforts in preparing this book, he makes no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaims any implied warranties of merchantability or fitness for a particular purpose. The advice and strategies contained herein may not be appropriate for your particular circumstances or for the legal environment within which you operate and it does not constitute legal, financial or investment advice.

Whilst the author has used his reasonable endeavours to ensure the accuracy of the material as described herein at the time of writing this, the author is not responsible for checking the up-to-date position of the law, technical matters or facts relating to situations discussed in the book after the date of writing.

The rules and regulations relating to matters discussed in the book are continuously evolving and other subsequent events may have occurred on the case studies discussed such as further developments on the case law referred to, which may not be publicly available or has occurred since the time of writing. Many of the matters discussed in the book are based on internet research that was accessible without registration and which was not behind paywalls. No warranties are given on the accuracy, completeness or up-to-date position of the material accessed and no liability is accepted to any party for the discussions in relation to such material. The material by its very nature is difficult to verify and is based on reports and papers published on the internet and because of the changing nature of the internet no warranties can be given that URLs or other references and contents therein remain accurate or continue to be maintained or remain accessible.

This book is designed to assess the impact of those reports and papers for due diligence professionals by presenting the author's views on reported matters and processes. You should always consult with a professional who understands your circumstances and the up-to-date position relating to applicable rules and regulations and technical matters prior to taking any action relating to matters discussed herein. Neither the author nor the publisher shall be liable for any loss of profit or any other commercial damages including but not limited to any special, incidental, consequential, or other damages whatsoever or howsoever arising.

Part IProcesses and Procedures

Chapter 1What is a Hedge Fund?

In the investment world, “I run a hedge fund” has the same meaning as “I'm a consultant” in the rest of the business world

.

1

Whenever I have interviewed staff for roles in operational risk and due diligence for alternative investments – one of the questions I tend to ask is “what is a hedge fund?” The responses in my view provide a good indication of the way someone approaches this industry and the range of answers has been a source of much discussion amongst members of my teams. It is not an easy question to answer and formal definitions are scarce.

Alternative investments themselves appear easy enough to identify by eliminating traditional investing but even here the boundaries continue to blur with 130/30 funds, REITs and the ability to use derivatives beyond just efficient portfolio management as regulators have come to accept the use of such instruments. The Alternative Investment Funds Directive (AIFMD) in Europe makes the definition even more interesting as possibly everything that is a collective investment but not an Undertaking in Collective Investments in Transferable Securities (UCITS) is now likely to be an Alternative Investment Fund if it does not fall under one of the specified exemptions.

To quote Circuit Judge Randolph in Phillip Goldstein, et al v Securities and Exchange Commission: “‘Hedge funds’ are notoriously difficult to define. The term appears nowhere in the federal securities laws, and even industry participants do not agree upon a single definition.” He also refers to an SEC Roundtable on Hedge Funds in 2003 where David Vaughan, a partner in law firm Decherts, cited 14 different definitions for hedge funds found in government and industry publications. Referring to the President's Working Group on Financial Markets, Hedge Funds, Leverage and the Lessons of Long Term Capital Management (1999) he points out that “[t]he term is commonly used as a catch-all for ‘any pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public.’”

Hedge funds are hard to pin down by definition but have some common characteristics:

The main vehicles/structures in which the investments are managed (funds) tend to be in a jurisdiction that is not the same as that of the investment manager – generally for tax, regulatory and disclosure reasons (although onshore hedge funds are getting more common in Europe and have always been common in the US, where the manager will often have an onshore and an offshore version of the funds).

The funds generally have a lighter form of regulatory overview and the investment managers are often subject to lighter regulatory regimes (although AIFMD has changed that in Europe as has the Dodd–Frank Act in the US).

The funds are able to use leverage which can be unlimited even though the manager may indicate the level of leverage they expect to employ in the prospectus.

There is little prescription on the form that the offering documents for the fund need to take, the types of disclosure required in them and the nature of reporting to investors.

There is minimal proscription on the types of investment activity and instruments that the manager can use or enter into on behalf of the fund unless restrictions are voluntarily adopted in the fund documents or rules that arise from a listing need to be complied with.

A number of the significant operational activities such as trade settlement, administration, transfer agency and custody are outsourced to third parties who may themselves be in another jurisdiction.

These funds are not generally available to the investing public and there are generally qualification requirements in respect of nationality and types of investors including investor sophistication and knowledge (ironically, often measured by the amount of wealth the investor has).

There is an assumption of

caveat emptor

when investing in these funds as it is assumed that the investor has done its homework prior to investing and these investments are for institutional and very wealthy investors who generally hold non-voting preferential interests in the fund.

The focus of the investment manager of the fund is normally to preserve capital and to try to achieve absolute returns for their investors rather than returns relative to an index.

The manager is usually remunerated for its efforts by a fixed fee with reference to the assets being managed and a variable fee with reference to the returns it is able to generate.

The governance of the fund is generally determined and controlled for all practical purposes by the investment manager to the fund, e.g. through the use of management shares which retain the voting rights in the fund for most things other than adverse changes to the investor's rights.

The risks of investing in these funds – apart from the investment risks themselves – are driven primarily by the structure of the fund, its service providers and the contracts with these third parties for services, the manner and extent of control over investments, the independence of governance and the nature of the instruments and the manner in which they are used. Fraud can also be an issue, but the chances of detecting fraud (as opposed to its indicators) are, in my view, low in any due diligence review. In relation to fraud the best one can expect to do is identify those environments in which fraud is possible and seek to avoid or control them. But for the investor, in the absence of fraud, the main impact hedge fund risks have on the safety of their investment can be summed up simply into:

asset loss/investment risks – whether through leverage, trading bets, concentration, market events;

liquidity and exit risks;

valuation risks; and

reporting risks.

Operational risk in a hedge fund context has been evolving as a concept and different people have different views on what it means. Even looking at the books currently available on the subject, the approaches differ, emphasising the backgrounds of the authors – whether it be a quantitative modelling approach or one that emphasises background research. For the purposes of this book, operational risk covers all those risks that are not investment risks and this defines the scope of the due diligence requirements discussed in this work. Some risks arguably are both operational and investment risks – leverage, liquidity, concentration risk and counterparty risk are some examples – but the focus of the investment professional is different to that of the operational risk professional, even in these areas of overlap, and therefore in my view merits discussion. In any event operational due diligence cannot be done in isolation of the investment due diligence. The two should be done in tandem if they are to be effective.

These characteristics make operational risk and the operational due diligence process an essential element of investing in alternative investment funds.

Although this book focuses on hedge funds, its application to other alternative investment funds is not significantly different because the principles do not differ, except perhaps in minor detail and regulatory focus.

1.1 THE ROLE OF A HEDGE FUND IN AN INVESTMENT PORTFOLIO

A lot of empirical research appears to suggest that active investment management rarely beats the market. So why bother? I am no expert in this area, but sophisticated investors consider hedge funds for the following reasons:

Alternative investment funds tend to operate on a tax-neutral basis, which makes them attractive to investors to maximise tax planning opportunities.

A lot of investment talent in the industry has moved to the world of alternative fund investment and this is one of the ways to tap into that talent.

These investments provide a degree of diversification.

Research suggests that although the main driver of returns is asset allocation strategy; investors who understand this and can identify the right alternative investment funds for their time horizons can benefit from such investments.

Alternative investment funds focus on capital preservation and absolute returns – theoretically this means that a manager can go to cash if they are not comfortable with the investment environment.

Although leverage can magnify the risks of loss, such investments give the opportunity to get leveraged exposure, thereby increasing the return (and of course loss) potential.

It is argued that the manager and investor's interests are more greatly aligned through the fee structure and level of investment by the manager in the fund.

It therefore seems clear that there is a place for hedge funds and alternative investments in the market and that as these products evolve, due diligence processes need to evolve to enable investors to take sensible decisions in the light of the risks that they identify and assess. This makes understanding some of the structural and operational issues of previous due diligence exercises important.

1

http://www.dummies.com/how-to/content/what-is-a-hedge-fund.html

. This material is reproduced with permission of John Wiley & Sons, Inc.

Chapter 2Defining Operational Issues

It's fine to celebrate success but it is more important to heed the lessons of failure

.

– Bill Gates

Whenever an investor asks an investment manager if they have been involved in a failure or “blow-up” you can palpably sense the eyes glazing over. I have heard of some interesting justifications as to why the existence of a particular fund in a portfolio or a particular matter did not constitute a blow-up and therefore did not require disclosure to an investor or adviser asking the question. The problem in part is created by the vagueness of the term itself – everyone thinks they know what a blow-up is and generally it is never something they have been involved in!

Vagueness can be a problem in due diligence. It often means that the question and answer relate to different interpretations. Precision is boring but necessary to ensure that the right question has been asked in order to get the required accurate answer.

A CRS Report for Congress on Hedge Fund Failures in December 20061 cited a study which classified hedge fund failures into three broad categories:

financial issues;

operational issues; and

fraud.

But a blow-up from an investor's perspective is usually two-dimensional – it is either because the investor has suffered an investment loss or is unable to get their money out of a fund when they want to, having suffered such a loss. The reasons for this may be investment-related or operational. This book primarily deals with those issues that would be operational. I say primarily, because of the overlaps that inevitably exist.

The analysis needs to be about whether an investor has done enough to address the probabilities of these two dimensions arising prior to making an investment. If they have not, then it is my contention that in a number of (but not all) cases they are unlikely to have covered all the areas that are the subject matter of this book in making an investment decision or have ignored the signs that the work may have uncovered. These are the real issues this book addresses – the funds themselves simply present the symptoms to study.

How these two dimensions play out is a function of some more nuances. For our purposes let us try to tie this down.

2.1 CLASSIFYING PROBLEMS AND FAILURES

Operational issues in a hedge fund context arise in respect of these two dimensions from circumstances such as:

accusations of fraud;

insolvency and winding up proceedings;

investment losses that exceed the fund's “normal” “volatility range”;

operational problems and structural issues including fund defaults and material breaches of contract, leading to significant investor withdrawals, imposition of gates, suspension of redemptions or fund closure (which could be from a failure to raise capital or the loss of a key man); and

regulatory intervention resulting in a settlement or fine or fund closure.

Significant withdrawals of funds by investors mean different things to different people – whether it should be defined depends on the effect those withdrawals have.

It is perhaps worth making one statement as an overarching principle for all due diligence – whatever kind it may be and in whatever context it is applied to in this book:

If it sounds too good to be true, it generally is.

2.2 FRAUD

Fraud is a type of criminal activity, defined as “intentional deception to obtain an advantage, avoid an obligation or cause loss to another person or company”

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– Serious Fraud Office website, United Kingdom

Perhaps the most damning finding of the survey is that initial red flags are now raised more frequently than ever before, yet responses to these early warning signs have fallen significantly. Every ignored red flag is potentially a missed opportunity to stop fraud

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– KPMG Survey June 2011, Who is the typical fraudster?

Fraud is not as simple as it may first sound, as it can take a number of forms, for example:

deception in the provision of information and results – misrepresentation;

deception in the purpose for which funds are used – misappropriation;

failure to disclose information; and

abuse of position.

The United Kingdom Serious Fraud Office (SFO) have developed an interesting taxonomy of fraud which splits fraud into seven areas.2 This taxonomy can be adapted to analyse the types of fraud that we see in the world of hedge funds by reducing it to three broad areas – fraud linked to an individual, fraud through a corporate shell conducted by a group of people acting together and market abuse. Each of these can be further categorised depending on the nature of the fraud in order to assist analysis (Table 2.1). Where the founder of an organisation has had allegations of fraud levelled at them resulting in the demise of the fund, this would be classified as corporate fraud even though there may be a number of innocent employees, because the corporate structure can facilitate the fraud.

Table 2.1 A taxonomy of fraud in alternative investments

1. Individual Fraud

committed by an individual

Theft

Deception

False accounting

Abuse of position of trust

Manipulation of information

Exploiting assets and information

Pyramid or Ponzi schemes

Insolvency/bankruptcy-related frauds

PR theft

False claims

Failures to disclose

Corruption and bribery

Tax, public funding and grants fraud

2. Corporate Fraud