Hedge Fund Operational Due Diligence:What Managers Need to Know

December 9, 2010

Our Speakers

Jason Scharfman, Managing Partner

Corgentum Consulting

Vinod Paul, Managing Director

Eze Castle Integration

Paul Chain, President

AIS Fund Administration

Agenda

The Investor Perspective– Impact of Dodd-Frank Reform on Due Diligence

Technology Considerations for Due Diligence– Top 5 Technology Best Practices

Recommendations for Fund Managers

Q&A

Hedge Fund Operational Due Diligence

Confidential – Not for distribution

© 2010 Corgentum Consulting, LLC

Presented by: Jason Scharfman, Managing Partner

www.Corgentum.com

What Topics Are Investors Focused On?

5

Confidential – Not for distribution

Technology and Systems

Business continuity and Disaster recovery

Legal/Compliance

Regulatory

Assets and investor concentration

Quality and length of relationship with tier-one service providers

Reputation of employees (including senior mgmt.) and firm

Valuation techniques and pricing sources

Compensation and employee turnover

Firm stability including expense analysis

Operations connectivity

Trade lifecycle

Fund terms Transparency and reporting

Counterparty oversight

Cash controls and management

What Topics Are Investors Focused On? – part 2

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Confidential – Not for distribution

Insurance Independence and oversight of the board of directors

Quality and length of relationship with tier-two service providers

Tax practices

What Investors Are Looking for During Operational Due Diligence

Documentation: Accurate description of practices in place

Absence of overly broad or conflicting documentation

Manager understanding of documentation

Process transparency Forthcoming attitude to assist investor in

understanding the operational practices in place

Reasoned understanding of why certain operational choices were made

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Confidential – Not for distribution

The Impact of Dodd-Frank on Due Diligence

Dodd-Frank is an artificial operational floor

Institutional investors perform due diligence at a much high standard than minimum SEC requirements

There will be heightened scrutiny of legal/compliance: Has a hedge fund appropriately budgeted for the increased costs

of compliance associated with Dodd-Frank?

With the increased focus on compliance has a hedge fund spoken to the appropriate service providers to ensure that quality individuals and adequate services are dedicated to the hedge fund's account?

What changes in compliance policies and procedures has a hedge fund undertaken? How have these changes been communicated to staff?

Has a hedge fund developed an reporting and technology infrastructure to meet new requirements?

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Confidential – Not for distribution

Hedge fund preparation for operational due diligence?

Understand your investors goals

Do not mistake operational due diligence for merely discussing traditional “back-office” type issues

Be prepared to demonstrate your strengths

Be pro-active in highlighting any operational weaknesses

Ensure you can discuss reasons for your operational choices

Do not be afraid to respond that you will follow up with certain type of information

Ask for and listen to investor feedback

Mock operational due diligence walkthrough

9

Confidential – Not for distribution

On-going Investor Operational Activism

In the post-Madoff environment investors are more likely to make their voice heard in regards to operational issues

Many hedge funds have been forced to implement operational changes due to shifting market perceptions (i.e. – third-party administration)

Investors will likely perform on-going operational due diligence to, in part, monitor how a hedge fund responded to feedback

Investors appreciate hedge fund which develop a dialogue with them regarding operational issues

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Confidential – Not for distribution

Why this all matters? : Less Operational Risk = More Allocations

A shifting allocation perspective

Traditional allocation models would not differentiate between hedge fund A and B (as long as a hedge fund was above the minimum threshold it was acceptable)

Modern fund of hedge funds and other institutional hedge fund allocation models would allocate more to hedge fund B (less operational risk for a higher expected return)

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Why this all matters? : Case Study - Multiple “Small” Issues:

NegativeMedia

NegativeMedia

Inefficient Legacy

AdministratorStill Utilized

Inefficient Legacy

AdministratorStill Utilized

ExtendedDelay inGeneva

Implementation

ExtendedDelay inGeneva

Implementation

No OffsiteBCP/DR

Site

No OffsiteBCP/DR

Site

No InternalValuation

Committee

No InternalValuation

Committee

“Affiliated”Board

Members

“Affiliated”Board

Members

CCO Unawareof OutsideBusiness

Directorships

CCO Unawareof OutsideBusiness

Directorships

PersonnelTurnoverPersonnelTurnover

Not being reported? or Policy

not enforced?

Culture of compliance? /

Policy revisions?

Compensation issues?

Lack of independent oversight?

Lack of internal operational planning?

Reputational risks?

Level of pre-employment screening?

Service provider

oversight?

Retention scheme issues?

Code of Ethics Violations?

Input of IT into organizational

planning?

Information security issues?

Reduced InvestmentNo Investment

Elongated Due Diligence ProcessElongated Due Diligence Process

Sufficient internalchecks and balances?

Sufficient internalchecks and balances?

Are different parts of theorganization connecting?Are different parts of theorganization connecting?

Is the businessscalable?

Is the businessscalable?

Appropriate oversightfrom senior management?

Appropriate oversightfrom senior management?

Financial stabilityquestions?

Financial stabilityquestions?

Top 5 Technology Best Practices for Hedge Fund Operational Due Diligence

Vinod Paul, Managing Director, Eze Castle Integration

Eze Castle Integration OverviewEze Castle is a firm’s partner to eliminate enterprise infrastructure risk and enhance operations. We provide a foundation for investment firms at any stage of their lifecycle.

Hedge Fund

Technology

Managed Services

Compliance

Comms

Founded 1995

Mission To be the leading provider of IT services and technology solutions to the investment community worldwide

Offices Boston, Chicago, Dallas, Geneva, London, Los Angeles, Minneapolis, New York City, San Francisco, Singapore and Stamford

Clients Over 550 hedge fund clients, managing $300B+ of assets

83 firms with $1B+ AUM

# 1 Educate your investors.

Explain the designs and processes of your operations, particularly when it comes to your technology.– Technology matters today

Anticipate questions your investors may have– Be prepared with clear and concise answers– Ask your service providers for supporting info

Dedicate 20% of your presentation to educational content

Investors want to know where management fees are being allocated

Identify costs around:– Staffing: payroll, taxes, health and benefit costs, etc.– Building and facilities: consider office expenses and

lease obligation– Technology: If you don’t have an in-house IT staff, ask

your IT service provider to do this– Legal and Administrator fees– One time versus recurring

#2 Outline your budget.

Sample Technology BudgetEnterprise Infrastructure - Data + Networking Year 1 Year 2Hardware and Software    Email, IM & Bloomberg Archival    Project Labor    Total Enterprise Infrastructure - Hardware    Enterprise Infrastructure - Voice Year 1 Year 2Avaya Voice Hardware & Labor    Total Enterprise Infrastructure - Voice    Enterprise Infrastructure - 3rd Party Services Year 1 Year 2Central Copier - Multifunctional Copier    Blackberry Voice & Data Service    Bloomberg Users    Verizon PRI Usage Including Taxes    Total Enterprise Infrastructure - Services    Enterprise Infrastructure - Circuits Year 1 Year 2ISP A    ISP B    ISP 1 - PRI    ISP 2 - POTS    Bloomberg Circuit    Total Enterprise Infrastructure - Circuits    Additional Services Year 1 Year 2Disaster Recovery    Monthly Service    Total Enterprise Infrastructure - Misc.    TOTAL EXPENDITURE    

#3 Communicate with your service providers.

Don’t be afraid to call them if you need clarification on their systems, processes, documentation, etc. – For example, ask your technology provider to create a

“technology blueprint” for you.

Technology BlueprintFirewall Client Site

RouterISP Edge Router

Desktop Server LAN

Define your technology requirements– High-speed, high resiliency, secure– Communications of the firm

• Voice, Data, Market Vendor, Disaster recovery replication

– Applications– Disaster Recovery & Business Continuity– Compliance

#4 Test, test, test.

Test your systems.– Especially your disaster recovery system (at least

quarterly) and show the results to investors

Regular test instills confidence and opens lines of communications with investors

Demonstrates your operational excellence

Disaster Recovery vs. Business Continuity

#5 Make operational excellence a priority.

Investors want to see that funds are serious and that they value operations and technology as vital aspects to their businesses.

Advanced planning is essential; Anticipate and prepare for change– Use operational benchmarking to assess areas for

improvement– Proactively prepare operations for upcoming

regulations– Document everything– Be committed to transparency

The Authority on Hedge Fund Operations

Hedge Fund Operational Due Diligence What Managers Need to Know

Due Diligence: What Manager’s Need to Know 24

AIS Fund Administration

The AIS daily model combined with our team approach results in ahigh level of responsiveness and exceptional service to our clients

Paul Chain, PresidentGlobal Sales & Marketing | Trading

 

Quality provider   ●     Fixed Income     ●     Derivatives   ●    Daily Model

Due Diligence: What Manager’s Need to Know

What is the Driving Force Behind Operational Due Diligence Procedures?

Due Diligence: What Manager’s Need to Know 26

Impetus for changeBayou Group - $450M

Lipper Convertible - $350M

KL Financial - $81M

Petters Group Worldwide - $3.5M

Beacon Hill Asset Management – $400M

Stanford Financial Group - $8B

Amaranth Advisors – $6.4B

Madoff – $64.8B

Due Diligence: What Manager’s Need to Know 27

Evolution of Due Diligence

Investors need to be educated

• Due Diligence Officer is no longer a Junior Person

• Industry standard, not a hobby• Process is still evolving, not where it should be

Due Diligence: What Manager’s Need to Know 28

Changing Position of Investor

• Paradigm shift• Managers and Administrators can help

– Big vs. small allocators– Tick the box vs. sophisticated investor– Education and advice– Watch lists

Know Your Customer

Due Diligence: What Manager’s Need to Know 29

Actionable Due Diligence Recommendations• Process is evolving, need to adapt with it• Ask questions

– What is their view of due diligence process– What is important to them– What is their background

• Don’t make assumptions on what they know/don’t know about process

• You’ll be in a position to learn or educate – which is it?– If they want to tick the box, help tick the box– If they want to understand the process, help them understand

• Before meeting ends, make sure you’ve communicated your views on

process

Meet the needs of your customer

Eze Castle Integration OverviewFounded 1995

Mission To be the leading provider of IT services and technology solutions to the investment community worldwide

Headquarters

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New York City, Chicago, Dallas, Geneva, Minneapolis, Los Angeles, San Francisco, Singapore, Stamford and London.

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