operational due diligence insights - corgentum consulting newsletter
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January 2013
Operational Due Diligence Insights
- Regulatory Focus: Can Operational
Due Diligence Prevent Exposure to
Hedge Fund Insider Trading?
- Business Continuity Corner: A Post-
Sandy Analysis of Hedge Fund BCP/DR
Planning?
- Private Equity: Will the Coming
Private Equity Data Storm Influence LP
Operational Due Diligence?
- IT Hub: Evaluating Hedge Fund
Technology Consultants
- Service Providers: Analyzing Fund
Legal Counsel - Does It Matter As
Long As It's Legal?
-Term of the Month: Audit Holdback
- Fraud Spotlight: The Preposterous
Fraud of Andrey C. Hicks and Locust
Offshore Management
- Accounting Spotlight: Interpreting
Fund Expense Disclosures
- On the Calendar
In This IssueWelcome to Our January
2013 Edition
Welcome to the January 2013 issue of Corgentum Consulting's Operational
Due Diligence Insights. This newsletter serves as a resource for news,
opinions and insights focused on issues related to operational risk and
operational due diligence on fund managers including hedge funds, private
equity funds, real estate and traditional managers.
Can Operational Due Diligence
Prevent Exposure to Hedge
Fund Insider Trading?
There has been much news recently with regards to high profile hedge fund
insider trading cases such as Raj Rajaratnam's Galleon. As there seems to be acontinuing strong interest from the government in prosecuting insider trading
investors may be increasingly asking themselves what they can do to minimize
or perhaps even completely reduce, their exposure to hedge funds that either
may be accused of insider trading, or even worse guilty of it.
Before we can answer this question however, it is first useful to make sure we
understand what is meant by insider trading. To boil it down to its most simple
form, insider trading relates to people utilizing so-called "insider" information
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Insider Trading - Continued from page 1...
which they either:
(i) misappropriated (i.e. - stole)
(ii) obtained by legal means, or even by
accident, but:
a) shouldn't have acted upon; or
b) had a duty to disclose it
Of course there are a number of nuanced complexities
when it comes to analyzing the actual insider trading
laws themselves. An example of this is whether the so-
called duty to disclose was pro-actively requested by
the person obtaining the information or instead was
imposed upon them. However, such legal intricacies are
of little use to investors seeking to evaluate the overall
potential for insider trading to occur.
One of the big problems with insider trading
prosecutions from an
investors and fund
managers perspective, is
that it is an area in which
any bright line rules that
may have existed are now
seemingly in flux. Recent
legal decisions have
seemingly increased thescope of the type of
information that is now
considered illegal to trade
upon.
Additionally, insider trading is inherently
counterintuitive in some regards to what hedge funds
are paid to do - conduct research and utilize this
research to make investments. Insider trading rules, it
can be argued, stymie the efforts of analysts to collect
this information. It stands to reason that a hedge fund
analyst may be able to devote more time to collectingresearch, and be more skilled at it, then let us say a
regular retail investor. Is this insider trading for the
hedge fund analyst to act on this better information?
Well the answer, the insider trading rules explain,
depends on a number of factors including whether the
information is so-called Material Nonpublic
Information, often referred to be the acronym MNPI,
and how the analyst obtained this information.
Following the Information Flow: a Four Step Process
This is all well and good, but investors generally do not
have the transparency or the ability to follow aroundthe analysts of the hedge funds to determine how they
are obtaining research. Therefore, the question could
be posed, what are investors supposed to do?
The answer lies in understanding the nature of the
control environment surrounding both the investment
research process, as well as a fund's ability to act on
research obtained. But, how should an investor go
about assessing this environment? Detailed operational
due diligence can provide a number of valuable insights
in this regards.
Step 1: Determine research sources
One area which an investor can
evaluate during the operational
due diligence process relates to
firstly understanding the ways in
which a hedge fund's analysts
conduct research. In particular,
what research sources do they
utilize? Do they primarily read
industry journals and go onBloomberg? What about attending
conferences? Do the analysts
perhaps meet with the
management of any particular companies? Do they talk
to analysts at other hedge funds? What about analysts
in particular sectors at other firms outside of the hedge
fund industry? Are third-party expert networks utilized?
Step 2: Evaluate research oversight
After an investor makes a determination as to whatresearch sources a hedge fund utilizes, the next step is
to determine what actions the fund is taking to monitor
such relationships. This oversight can come in a number
of different forms, but is primarily driven by the
compliance function. During the operational due
diligence process an investor can ask a number of
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Insider Trading - Continued from page 2...
different questions to make an assessment as whether
or not the compliance function is actively policing the
analyst research process or not. Examples of the types
of questions investors can ask in this regard include:
Third-party expert networks:
Has the compliance function vetted a firm's
relationship with third-party expert networks?
If so, what did this assessment entail?
Has the hedge fund communicated its policies
with regards to material nonpublic information
and insider trading to the third-party network?
If so, has the network agreed in writing to
comply with these policies?
If hedge fund research personnel would like to
utilize such a network, must pre-approval be
obtained from the compliance function first?
What research does the compliance function
perform before granting pre-approval?
Once approved, has compliance taken any
additional measures to ensure compliance with
the hedge fund's policies? (i.e. - such as readinga disclaimer before the call begins)
Additionally, do compliance personnel listen in
on calls?
Is a log kept of the use of such third-party
networks?
Research sources in general:
Does the hedge fund have any bans on speaking
to individuals who either work at publiccompanies or have recently worked at such
companies? If so, what are the details of this
ban? How is it monitored and implemented?
Are any conflict checks performed to make sure
that a hedge fund analyst is not discussing a
company with someone with whom the hedge
fund may have already been conflicted out of
(i.e.- passing along tips)?
Are there sufficient prohibitions or limits on the
way gifts are given, and received, in order to
prevent any potential conflicts or bribery with
regards to information sharing?
Step 3: Evaluate trading oversight
It is worth noting at this point that just because a hedge
fund may come into possession of so-called material
nonpublic information, they are not necessarily guilty of
anything if they do not act on it.
This is where an analysis of the oversight of a hedge
fund trading procedures comes into play. After a hedge
fund has done its research and makes a determination
that it would like to trade in a certain security, investors
must determine what oversight is in place. One
common way hedge funds seek to prevent trading on
securities on which they may possess material
nonpublic information about is via a so-called restricted
list. In general, securities on the restricted list cannot be
traded by the firm. However, not all restricted lists are
created equal, and not all hedge funds maintain
restricted lists. In addition to determining whether or
not such a restricted list is actually in place, investors
can ask a number of questions to determine the
oversight and effectiveness of such lists including:
How are securities put on the list? Is there setcriteria or does one person make the
determination in their discretion?
If a security is placed on the restricted list, is
trading activity suspended for a certain pre-
defined period? (i.e. - 30 days)
How do securities come off of the restricted
list?
Who maintains the restricted list?
How often is it updated?
How is the list shared throughout the firm?
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Insider Trading - Continued from page 3...
Are names of securities contained in the
restricted list hard-coded into any trading
systems or instead is it up to employees to
monitor the list?
Are employees allowed to trade in names of the
restricted list for their own personal securities
accounts?
Step 4: Is oversight provable and tested?
After taking measures to evaluate any internal hedge
fund oversight on the way in which a hedge fund
collects research and then trades on that data, are
investors finished?
The best compliance policy in the world is meaningless
unless it is a living policy. Investors
should take measures to ensure that
not only does a hedge fund have
such research and trading oversight
in place, but can demonstrate the
oversight. For example, if pre-
approvals are required before a
hedge fund analyst speaks to a third-
party expert network can the fund
produce an example of such a pre-approval form?
Similarly, it is important for hedge funds to back test
such policies. So for example, assume that a hedge fund
maintains a restricted list. Does the hedge fund
manager's compliance department perform random
back test audits of fund trading to check that no trading
in restricted names occurred?
So what does this all mean?
Returning to our original question, "Can OperationalDue Diligence Prevent Exposure to Hedge Fund Insider
Trading?" the short answer is - no. Hedge funds, like all
organizations are evolving entities. Employees come
and go. New funds are launched and closed. Revised
computer systems are put in place and old ones are
phased out. With these constant changes, it is
impossible to unequivocally state that due diligence,
operational or otherwise, can completely prevent
exposure to hedge fund with insider trading issues.
That being said, investors that conduct due diligence to
understand the ways in which research is conducted,
how trades are executed, and the internal oversight of
such processes will be more informed about the risks
involved . As with all operational due diligence,investors that dive deeper will be making more
informed investment decisions. Additionally, a hedge
fund with robust oversight of the research and trading
process will likely have a much lower likelihood of being
placed into situations where insider trading could be
alleged.
Conclusion:
In conclusion, investors that take the time to ask
questions and evaluate research and trading oversight
during the operational due diligence process are likely
to have more conviction that their hedge funds won't
be accused of insider trading - that is as long as
the hedge funds continue to follow these
policies.
A Post-Sandy
Analysis of Hedge
Fund BCP/DRPlanning
US based hedge funds recently faced a large scale real
world test of their business continuity and disaster
recovery plans in the form of a super storm named
Sandy. Hurricane Sandy represented a large
unprecedented weather event that caused flooding and
devastation throughout the eastern coast of the United
States including the major hedge fund centers of NewYork and Connecticut.
Some of the challenges faced by people and businesses,
including hedge funds, affected by the storm included
sustained power outages, inability to access office
buildings and office flooding.
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Business Continuity- Continued from page 4...
According to a recent Corgentum survey, 74% of
investors felt that their hedge fund was adequately
prepared to continue operational during hurricane
Sandy. In order to confirm these beliefs when a wide
scale storm or other BCP/DR event which may affect a
hedge fund occurs, investors should seize the
opportunity to vet the real-world effectiveness of their
hedge funds plans during the storm.
Some questions investors may want to ask regarding a
hedge funds reaction to the storm included:
At what point was the decision made to activate
the firm's business continuity and disaster
recovery plans? - If the plan was activated too
late perhaps it was either diminished ineffectiveness, or represented a failing of the
firm's judgment in having qualified personnel
making the decision whether or not to activate
BCP/DR plan
Were employees able to communicate with
each other during the storm?
If alternative off-site third-party locations were
part of a hedge fund's plans, did they perform
as expected?
If equipment was destroyed during the storm,
will it be covered by the hedge fund's insurance
policies? Is backup equipment available in the
interim?
What parts of the BCP/DR plan worked correctly
during the storm?
What plan problems or weaknesses came about
during the storm?
Is the hedge fund implementing any changes to
the plan based on lessons learned from the
storm?
Investors should ask such questions both of the hedge
funds with which they maintain existing investments as
well as with prospective firm's they may evaluate in the
future. Digging into the details of real-world activations
of BCP/DR plans can provide investors with valuable
insights of how effectively a hedge fund’s best laid plans
may hold up in a storm.
Will the Coming
Private Equity Data
Storm Influence LP
Operational Due
Diligence?
Private equity General Partners ("GPs") are under
increasing pressure to provide more transparency than
ever before. This transparency is not limited to any one
area (i.e. - investment performance or fund accounting
procedures).
Further complicating the problem is that these
requests, or in some cases demands, for additional data
come from multiple sources, the two primary onesbeing Limited Partners ("LPs") and regulators.
Turning to regulators first, there have been a number of
recent regulatory changes that will require most private
equity GPs to report to regulators more detailed
information than ever before. A recent example of this
is Form PF filings required by the US Securities and
Exchange Commission. Under these rules, which
targeted not only private equity firms but also a wide
variety of fund managers including hedge funds, GPs
were required to make a number of disclosures
including:
Reporting data related to the indebtedness of
portfolio companies a private equity fund may
control. This data includes revealing the identity
of the lenders of any bridge loans as well as
debt -to-equity ratios.
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Private Equity - Continued from page 5...
Detailed portfolio analysis including geographic
and industry level breakouts
Detailed information concerning leverage, fund
borrowings and creditors
The enhanced US regulatory disclosure requirements
are not anomalous, and the European Union has also
followed suit in the form of the Alternative Investment
Fund Managers Directive ("AIFMD"). The original
version of AIFMD was adopted by the European
Parliament on November 11, 2010 and has since been
followed by AIFMD level 2, which was implemented on
December 12, 2012. Although the final text of the law is
still under review, AIFMD level 2 imposes a number of
additional guidelines and stricter reportingrequirements on fund managers (which in AIFMD terms
are referred to as Alternative Investment Funds or AIF's)
which includes private equity firms. Examples of these
new rules include:
Operating conditions for AIFMs, including rules
on remuneration, conflicts of interest, risk
management, liquidity management,
investment in securitization positions,
organizational requirements, and rules on
valuation
Rules on depositaries, including the depositary's
tasks and liability
Enhanced Reporting requirements and leverage
calculation
LPs have been quietly watching passage of these
additional regulations and reporting requirements. Now
that GPs have devoted all the time and resources to
analyzing, preparing and providing information to
regulators, LPs are increasingly asking GPs to share this
information with them as well.
Most GPs have predictably raised a number of
objections to sharing this data. For example, in the US
many GPs cite the fact that there is no legal
requirement for GPs to share the new Form PF filings
with LPs. Of course, it is not illegal for GPs to share
these filings with investors, however, some GPs utilize
this lack of legal obligation to do so as a shield to deflect
further LP inquiry in this regard.
Other GPs raise concerns that the data such as the
calculation of what is known as Form PF's Regulatory
Asset Under Management, commonly referred to as
RAUM, is either of no use to investors or that they willmisconstrue the information. For example, a GP may
point out that RAUM may be misleading to some
investors because it includes unfunded LP commitments
in its calculation whereas a typical AUM figure generally
does not.
The jury is still out on whether such GP concerns are
well founded, however, one thing is clear - LPs should
not let GPs dictate what information they should or
should not be interested in during the operational due
diligence process.
That being said, the GP’s objection does raise a valid
question - Are LPs equipped and prepared to evaluate
the data from increased GP transparency?
Whether this new data comes in the form of regulatory
filings or other sources LPs must consider:
Reviewing additional data requires the
allocation of more internal due diligence
resources
With the benefits of additional GP transparencylikely comes an elongated due diligence process
Specialized skill sets, which the LP may not
currently have internally, may be required to
fully evaluate additional GP information
LPs may benefit from engaging in dialogues with GPs to
not only negotiate the receipt of additional due
diligence data such as regulatory filings, but also to
provide a guide in understanding such documentation.
LPs however, run a very real risk of becoming too relianton GPs for such guidance and overlooking key
operational risk areas in the process.
Although enhanced transparency may seem to be
intuitively better for LPs, it also presents a number of
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Private Equity - Continued from page 6...
increased data analysis and resource management
challenges which should be planned for. Without such
preparation them find themselves awash in a sea of
data that they are unsure how to navigate.
Evaluating Hedge
Fund Technology
Consultants
It is common for many hedge fund managers, especially
smaller ones, to leverage off of external information
technology consultants. These consultants come in
many different forms and can provide a wide array of
services for fund managers. In general, common
services provided by information
technology consultants can
include:
Help desk support
Software development and
support
Hardware maintenance
New software or hardware vendor and package
selection
Implementation of new systems or hardware
Business continuity and disaster recovery
program design, testing and maintenance
During the operational due diligence process, investors
may sometimes find it difficult to obtain a straight
answer from their hedge fund managers with regards to
the work of these information technology consultants.
Perhaps it is because certain fund managers want to
emphasize the arguably more important role played by
dedicated in-house information technology personnel
(be they dedicated or shared) while minimizing the
external resources. Additionally, many hedge funds may
utilize certain consultants on an ad-hoc or as needed
basis and therefore, perhaps don't feel highlighting such
relationships matters much to investors performing
operational due diligence.
Investors should not be discouraged however, andshould take measures to evaluate the role of
information technology consultants. A good starting
point is speaking directly with the hedge fund managers
about the use of such consultants.
Learning what consultants do:
There are diagnostic benefits to such third-party
provider due diligence. By inquiring about these third-
party firms, investors will likely learn about the duties
performed by different information technology
consultants. The answers to these questions can
provide valuable insights into a number of different
areas including:
Where a hedge fund may be weaker internally
from a technology perspective and feels the
need to augment these deficiencies
with external resources?
Has there been turnover
among information technology
consultants in a particular function? If
so, why?
If the hedge fund utilizes a
consulting firm, as opposed to an
individual freelancer, what personnel from the
IT consultant are actually doing the work?
How often are the IT consultants in the offices
of the hedge fund manager? If not frequently,
do they access the firm's systems remotely?
Does the hedge fund control information access? After an investor has obtained a detailed understanding
of what a third-party information technology consultant
may actually do for a hedge fund, investors should next
inquire as to how the hedge fund controls the third-
party's access to, and use of fund data. Some questions
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Technology - Continued from page 7...
investors may want to consider asking in this regards
may include:
Has the hedge fund taken policy based
measures to ensure IT consultants understand
keep information confidential? (i.e. - signing a
confidentiality agreement)
Are technological measures in place to limit the
IT consultants’ access to certain information?
Or does the hedge fund trust the IT consultant
blindly?
How does the hedge fund oversee the
implementation of any data security measures
either agreed to with the IT consultant or inplace from a technology perspective? (i.e.- is
there any testing of such controls?)
Why Due Diligence on IT Consultants Matters?
Hedge funds are information based organizations.
Technology supports the way in which a fund organizes,
utilizes and trades upon this information. When a hedge
fund effectively opens up its doors to a third-party firm
to assist in managing or improving upon this technology
investors should take notice. By incorporating ananalysis of the role of third-party information
technology consultants into the larger operational due
diligence process investors may learn new pieces of
information, which can provide valuable insights into
their overall assessment of a hedge fund's information
technology function.
Analyzing Fund Legal
Counsel - Does It
Matter As Long As It'sLegal?
When evaluating service providers during the
operational due diligence process, many investors may
tend to focus their initial efforts around certain specific
service provider functions. The short list of the common
cast of characters includes fund administrators, auditors
and counterparties. Other service providers may
unfortunately receive less attention.
Perhaps this is because of the perceived importance of
the roles performed by different providers. For
example, investors may feel, and rightly so, that
valuation is a key issue for hedge funds. Therefore,
understanding the role played by the service providers
related to valuation oversight such as the fund
administrator, may receive more attention at the
expense of the analysis of other service providers.
Another motivation for many investors in clustering
their service provider evaluations around a limited
subset of all a hedge fund's service providers, is the
notion of a risk based approach. Continuing ourvaluation example above, many investors view
valuation as not only a highly important issue for hedge
funds, but also one that is fraught with potential risk as
well. That is to say, there would be direct negative
implications for investors if a hedge fund began playing
games with fund valuations.
Such a risk may be compared to, for example, the risks
associated with a hedge fund utilizing a slightly less than
cutting edge piece of hardware for data storage. When
framed against valuation concerns, investors may feelthat the valuation risks outweigh the technology
concerns. For some investors this tradeoff
unfortunately results in a lesser degree of analysis on
third-party information technology service providers
that may have participated in assisting the hedge fund
in overseeing its hardware management.
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Often this service provider clustering effect also
influences the ways in which certain investors overlook
the role played by a hedge fund's legal counsel. During
the operational due diligence process, some investors
may simply check to see if a hedge fund is working with
a large, well-known law firm. Other investors may go
further and attempt to confirm the relationship with
the legal counselors, but may be unsure what other
items they should evaluate.
The role played by a law firm working for a hedge fund
is not cookie cutter in nature. As could be said with all
service providers - they are
not created equal. This is
particularly true when it
comes to fund legal counsel.A number of differences may
exist with regards to not only
the quality of work they
perform for the hedge fund,
but the type of areas they
cover. As with all hedge fund
service providers, investors
would be well served to
capitalize on the opportunity to vet the role played by a
hedge fund's legal counsel during the initial due
diligence process.
For starters, investors should endeavor to cover what
could be considered the nuts and bolts of the
relationship with a law firm by attempting to
understanding answers to questions including:
What is the hourly billing rate charged to the
hedge fund?
Is a blended rate charged or instead does the
rate vary by the experience of the law firm
employee (including non-attorneys) performing
the work?
Are any hourly billing rate or fee caps in place?
Is the hedge fund notified if fee caps are being
approached?
Are flat fees charged for any projects?
Does the law firm have any particular expertise
that may be applicable to the hedge fund? (i.e. -
jurisdictional expertise, or experience in
performing legal work related to certain
investment products)
This above list is of course not comprehensive, but is
intended as a guide with which an investor could start a
conversation with a law firm in order to gauge certain
basic issues regarding its relationship with the hedge
fund. Beyond the basics, an investor could inquire
further into a number of different topics in an attempt
to understand the extent of the law firm's work with the
hedge fund. Examples of some items
an investor could cover may include:
Does the law firm provide
any compliance related services to
the hedge fund?
If the hedge fund works with
a separate compliance consultant,
does the law firm interact with them?
Has there been any personnel turnover among
the key individuals servicing the hedge fund's
account?
Can the law firm provide an example of a recent
matter on which it has worked for the funds?
If the funds or hedge fund management
company was (or currently is) involved in any
litigation, can the law firm walk the investor
through the litigation (and any outcomes)?
Does the law firm interact with any other law
firm's used by the hedge fund?
Can the law firm provide a summary of the
routine legal tasks performed for the firm?
Additionally, other more broad questions could be
asked of the law firm to gain an understanding of how
much they interact with, and understand, the hedge
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Legal Counsel - Continued from page 9...
fund's business. Examples of these questions may
include:
Does the law firm generally understand the
hedge funds investment strategy?
If there have been any material developments
that have occurred at the hedge fund, is the law
firm aware of them?
Who at the hedge fund does the law firm
primarily deal with?
Has the scope of the work the hedge fund has
given the law firm increased or decreased over
the past two years? If so, why?
A law firm can play an important role in supporting the
successful overall operational management of a hedge
fund. In particular, in light of the increasingly complex
regulatory and legal environment, investors should be
cautious not to minimize the due diligence they perform
on third-party service providers such as law firms. By
delving into the details of such third-party relationships
investors will likely be surprised at the useful insights
they may learn.
Understanding Fund
Terms: Audit Holdback
Operational due diligence is a multidisciplinary subject.
An investor beginning the operational due diligence
process for the first time may encounter subjects with
which they have little to no familiarity. As the scope of
operational due diligence has become broadened inrecent years, even seasoned operational due diligence
professionals may encounter terms which they may be
unfamiliar. The purpose of this section of Operational
Due Diligence Insights is to cast a spotlight on some of
the words and terms which investors may have not
previously encountered, or which tend to get
overlooked in operational due diligence reviews.
This issue's word:
Audit Holdback
Defined:
An audit holdback refers to the amount that a hedgefund manager may hold on to when paying out a
redemption request to account for any variations that
may take place after a fund's audit is finalized.
What investors should know:
Investors frequently tend to ignore the concept of audit
holdbacks when submitting redemption requests only
to realize that a portion of their capital is effectively
stuck at the fund. Depending on the timing of an
investors redemption request audit holdbacks can allow
a hedge fund manager to generally hold onto capital for
a period of up to one year (i.e. - between fund audit
years).
Do not fall into this trap. It is important to evaluate
audit holdback percentages during the initial
operational due diligence process. Audit holdback
percentages are typically disclosed in a hedge fund's
offering memorandum as well as in the fund's audited
financial statements. There is no universal standard for
audit holdbacks but they generally range around the
10% level. Additionally, the timing with which hedgefund managers actually release investor funds after the
audit is released is not universal either and may range
over a period of a few days (i.e. - 10) to up to 90 or
more. Even worse, some managers may not even
specify this post-audit payout time period in their
offering documents. Investors that take measures to
evaluate the audit holdback amount and payout period
will likely find themselves being able to better manage
redemption pipelines. They will also be less surprised
when payouts are initially less than the full amount of
the redemption request.
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Fraud
Spotlight:
ThePreposterous Fraud of
Andrey C. Hicks and
Locust Offshore
Management
A man claiming to run a high profile hedge fund recently
pleaded guilty to stealing approximately $2.3 million
from investors. The plea came at the end of 2012 and
slipped off many people's radar, however, the
preposterousness of the case is worth revisiting.
In October 2012, the SEC charged Andrey C. Hicks and
his firm Locust Offshore Management with employing a
fraudulent scheme to dupe investors into investing in a
purported British Virgin Islands fund called the Locust
Offshore Fund, Ltd. The problem, the SEC alleged, was
that there was never any such fund. Furthermore, theSEC complaint alleged that, "Hicks has transferred
substantially all of the investors' funds to bank accounts
in his personal name and, on information and belief, for
his personal use."
Mr. Hicks claims about his firm were so outlandish that
it was reported he stated to prospective investors to
have grown "assets under management from $100M
USD to nearly $1B USD in six (6) months through capital
raising and high returns."
To provide some additional perspective on the
outlandishness of this case, here is partial description of
what Mr. Hicks claimed his firm was doing:
Locust Offshore Management, L.L.C. develops and
executes sophisticated quantitative strategies across
asset classes to produce absolute, risk-adjusted returns
with high alpha. The firm's quantitative strategies are
based on mathematical models developed by the fund's
manager, Andrey C. Hicks, during his tenure at Harvard
University and are executed by computer software.
Human involvement in the strategy life cycle is limited to
model and code development and refactoring. The firm
is primarily engaged in the U.S. equity markets and adheres to a market-neutral, risk-averse trading
philosophy.
Some of the more interesting things alleged by the SEC
include that Mr. Hicks:
Lied about his education - he claimed to have
obtained undergraduate in biochemistry (for
with a 4.0 grade point average) as well as a
graduate degree from Harvard. Mr. Hicks wasn't
satisfied claiming just any graduate degree such
as an MBA. Instead, he claimed to have
obtained a PhD in Applied Math in just two
years. According to the SEC, Mr. Hicks was
indeed enrolled at Harvard as an undergraduate
but was forced by the university to withdraw on
two separate occasions and he never
graduated.
Lied about his employment background - he
claimed to have not only worked at Barclay's
Capital (which was a lie) but that, "he grew his
book nearly two-fold and expanded his group’s
assets under management to roughly $16
[billion]" (which was also a lie)
Lied about the fund's auditor - he claimed Ernst
& Young served as the fund's auditor, they
didn't (besides there was never any fund to
audit)
Lied about the fund's prime broker and
custodian - he claimed that the fund had a
relationship with Credit Suisse - it didn't
Opened business a checking and savings
accounts for the firm and funds with the intent
to defraud investors
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Fraud - Continued from page 11...
Created and maintained a website for the non-
existent firm and fund
Created fake offering documents for the fund
Created fake business cards, stationery and
email signature blocks describing Mr. Hicks as a
Locust's principal and the fund's director.
Unfortunately for Mr. Hicks, the SEC allegations were
true. Despite all these red flags, Mr. Hicks did attract
investors in the fund including celebrity basketball
player Kris Humphries.
He was eventually arrested while attempting to flee in
Switzerland. He has since pled guilty to five counts of
wire fraud and is scheduled to be sentenced on March
6, 2013. He faces up to five years in prison.
Interpreting Fund
Expense Disclosures
During the operational due diligence process one of the
core documents collected and analyzed by investors area hedge fund's audited financial statements. A key area
of focus for many investors in conducting an analysis of
these audited financials, is the analysis of fund level
expenses. Within the audits themselves, Investors are
generally provided with some guidance through a series
of expense related disclosures. But do these disclosures
add any real value to investors in analyzing fund
expenses? Additionally, what should investors goals be
in analyzing fund expenses?
Legitimate vs. Illegitimate Expenses
For risk assessment purposes within the context of
operational due diligence review, many investors would
most likely agree that in general fund expenses can be
grouped into two categories. The first category could be
so called legitimate expenses. That is to say, those
expenses that occur as part of the course of a hedge
fund's normal business and trading activities. These
expenses could include both investment or trading
related expenses such as interest and dividend expense
and stock loan fees.
Other expenses that many investors would perhaps
place in the, "legitimate" bucket would include
performance and management fees. Fees for items for
operational or non-investment related purposes such asfees paid to members of the Board of Directors, audit
and legal expenses could also be placed in the
legitimate bucket with little investor argument.
The second category of expenses investors tend to look
for could be called illegitimate expenses. These are
effectively the polar opposite of legitimate expenses,
and as the name implies, would not be items investors
expect to be charged to the fund during the normal
course of business. These could be items such as lavish
expenses for fund raising (i.e. - paying for the fund
manager to travel to a sales meeting in a private plane)
or the salary of any individual employee being charged
directly to a fund. During the operational due diligence
process investors that come across any of these
illegitimate expenses should certainly raise a red flag
and inquire further as to why such expenses are being
charged to the fund.
Beyond this fairly basic legitimate versus illegitimate
framework, investors face more complex additional
challenges in reviewing fund level expenses.
Evaluating Gray Area Expenses
As noted above, it may be easy for investors to classify
expenses at either end of the spectrum as being
legitimate or illegitimate. However, the classification of
expenses may become less clear when investors start to
dive into the details. It is with regards to these gray area
expenses that more comprehensive expense analysis is
often required.
For example, consider a hedge fund manager thatinvests in the distressed debt of companies. As part of
their research process, the fund manager sends analysts
to visit with the management of the target companies
in which it is considering purchasing debt. Most
investors would likely agree that such research trips are
not lavish or excessive but rather part of the hedge fund
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Fund Expenses - Continued from page 12...
manager’s standard operating procedure. Where
investors may differ in their opinions is whether the
expense of such research trips should be charged
directly to the funds themselves, or rather if the
expense for such trips should sit at the management
company level.
There are many other examples of areas where
investors, and fund managers, may disagree as the
appropriateness of allocating all or a portion of an
expense to the funds versus the management company.
Additional examples of these types of expenses may
include the allocation of a hedge fund's office rent
expense and expenses related to acquiring and
maintaining the information technology function
including hardware which may be used to execute thefunds trading strategies.
Regardless of which side
of the argument a
particular investor lands
on, from a due diligence
perspective it is
important that that
investors have
transparency with
regards to suchexpenses. Additionally,
investors should seek to
evaluate the consistency
of a hedge fund
manager’s approach in allocating such expenses. Said
another way, it is up to investors to understand what a
particular hedge funds rules of the expense allocation
game are before they can evaluate if a manager is
following them.
Figuring Out The Expense Allocation Rules
Where is an investors supposed to figure out what the
hedge fund's policy is with regards to allocating such
expenses? Well, a hedge fund's offering memorandum
might be a good start. The offering memorandum often
contains valuable information about not only what
expenses are anticipated to be charged to the fund,
(i.e. - legitimate versus illegitimate) but also the way in
which they will be allocated.
It is worth noting here the importance of incorporating
documents other than the audited financial statements
into the overall expense analysis process. Although, it
could be classified as a legal document, as compared toa purely accounting related document such as the
audits, investors should not be hesitant to seek out
information from other sources to guide their analysis.
This produces a more comprehensive well rounded
review, which runs less of a risk of ignoring key risk
areas simply because they may be interdisciplinary in
nature.
Returning to our discussion of expense allocation rules,
in addition to the offering memorandum, another
source of good source of information may be the
audited financial statements themselves. Often times
the Statement of Operations, also known as the Income
Statement, will provide valuable
information about the detail of
total fund level expenses. The
problem however, is that the
figures presented in these
statements are often in summary
format. For example, the
statements may indicate that
interest and dividends expense
was $100. It would arguably bemore useful for investors to know
more detail. So something like, the
interest expense was $30 and the
dividend expense was $70.
Another problem investors often encounter relates to
so-called rollup categories of expenses. These are
groups of expenses that are bundled together into a
single line-item. An example of such an expense
category would be "Professional fees and other." Under
US GAAP there is no universal rule as to what exactlyshould be lumped into such a category. Furthermore,
there is not even a general agreement among hedge
funds or investors as to what exactly may go into such a
category. Typically, an expense category such as this
would contain items such as Board of Director’s fees
and legal fees, however, investors should
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not make any such assumptions. A hedge fund manager
could just as likely use such a broad category to bundle
gray area expenses which if brought to the attention of
some investors may raise questions.
Are investors left with any options when faced with
such rollup categories? One resource investors shouldconsider when faced with such issues are the notes
accompanying the financial statements. These notes
can sometimes provide additional clarification as to
what is included in rollup expense categories. Although
there are some general guidelines under US GAAP with
regards to minimum mandatory disclosures, once again
there is no universal requirement to provide such detail
in all cases.
Furthermore, a hedge fund's auditor is not generally
incentivized from either a financial or liability
perspective to write detailed clear disclosures. In this
case, investors should then not be afraid to approach
the fund manager directly and inquire as to what
actually goes into each category. This will provide
investors with more transparency to judge whether
allocation rules are being followed. Additionally,
investors engaging in such discussions with managers
may be surprised to learn about how much discretion a
fund manager may have in making determinations as to
how expenses are allocated.
One of the goals during expense analysis therefore,should be not only to diagnose the way in which a
hedge fund allocates expenses, but also to oversee that
discretionary choices by the manager are equitable to
all investors and in the best interest of the particular
fund vehicle in question. By engaging with fund
managers to conduct such reviews investors may find
their review of the fund expenses and disclosures may
bear fruit in other parts of the overall due diligence
process as well.
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About Corgentum Consulting
Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of
fund managers.
We work with investors including fund of funds, pensions, endowments, banks and family offices to
conduct the industry's most comprehensive operational due diligence reviews. Our work covers all fund
managers and strategies globally including hedge funds, private equity, real estate funds and traditional
funds. Our sole focus on operational due diligence, veteran experience, innovative original research and
fundamental bottom up approach to due diligence allows us to ensure that our clients avoid
unnecessary operational risks. More information is available at www.Corgentum.com or follow us on
Twitter @Corgentum.
Email: [email protected]
Main Tel. 201-918-520
On the Calendar
Please see below for a list of upcoming operational risk items of note and events:
Investment Education Symposium (New Orleans, LA) February 6-8, 2013. Corgentum to moderate Investing in Alternatives panel
Presented by Opal Financial Group
Investment Consultants Forum (New York, NY)March 4, 2013. Corgentum to moderate Manager Selection Process panel
Presented by Opal Financial Group
GAIM Ops Cayman (Grand Cayman, Cayman Islands)April 21-24, 2013. Corgentum 's Jason Scharfman to conduct pre-conference Private Equity Operational Du
Diligence workshop
Presented by IIR USA.