1 SKYBRIDGEVIEWS. A GUIDE TO hedge fund BUSINESS & OPERATIONAL DUE DILIGENCE. By Kenneth McDonald, Partner / hedge fund Business & Operational Due Diligence INTRODUCTION. Business and operational risks can materially impact a hedge fund investment. Therefore, investors should be aware of the potential effect these risks can have on their portfolios. This Paper strives to inform investors of these business and operational risks and emphasize the importance of a thorough due diligence program. hedge fund investors grasp that their capital will be subject to loss (or gain) from market and other investment-related risk.
2 However, they must also appreciate that their capital will be susceptible to loss but never gain from a number of non- investment related risks. These non-investment related risks are generally categorized as either business or operational risks, which are defined below. Table of Contents Business risk is the possibility of loss stemming from issues related to the hedge fund management firm that are not directly associated with market Introduction 1 movements. hedge fund business risk can be influenced by several factors, including the management firm's inability to attract sufficient assets under Case Studies: Business & Operational 2 management to cover overhead; its closing from repeated regulatory violations.
3 hedge fund Failures or its lack of a key personnel succession plan ( , the departure of a star What to Assess: The hedge fund 3 portfolio manager because the firm repeatedly refuses to grant the manager an ownership interest). What to Assess: The hedge fund Manager 5. Operational risk is the risk of loss stemming from issues related to middle Process: How to Obtain Information to and back office functions. These issues range from the misvaluation of a fund 's 12 investment portfolio; poor controls on the movement of cash; sloppy trade Make Assessments processing; or even the loss of trading capabilities from a power outage.
4 Conclusion 12. How important are these non-investment risks and how much should investors Sources & Disclaimers 13 worry about them? Consider the brief history and research enclosed in this White Paper . March 2016 1. A Guide To hedge fund Business & Operational Due Diligence I. Case Studies: Business & Operational hedge fund Failures First, we will take a look at four case studies written by industry portfolio's business and operational risk. experts to highlight the potential impact business and operational risks can present to a hedge fund investment.
5 hedge fund failures caused by operational issues have cost investors $80 billion 3. 50% of hedge fund failures were caused by operational issues alone 1 Case Study #3: In a 2009 White Paper , From Manhattan to Madoff: The Causes and Lessons of hedge fund Operational Case Study #1: In the 2003 Capital Markets Company, Ltd. Failure, 3 due diligence consultant Castle Hall Alternatives ( Capco ) White Paper , Understanding and Mitigating reviewed 327 hedge fund operational failures through their Operational Risk in hedge fund Investments, 1 former partners proprietary database, HedgeEvent, from its inception through Christopher Kundro and Stuart Feffer studied the causes of more June 30, 2009.
6 Using this research, Castle Hall came to the than 100 hedge fund failures dating back 20 years. The study following conclusions: concluded that 50% of the failures were due to operational risk Operational failures produced total investor losses of $80. issues, 38% were due to investment risk issues (market related billion ($15 billion excl. Madoff) over the period studied. risks), 6% were due business risk issues and 6% resulted from 31 separate operational failures each produced a loss in the combination of multiple risks. The Capco study found that the excess of $100 million.
7 hedge fund failures caused exclusively by operational risks The most common causes of operational failure were occurred as a result of the following: misappropriation of assets or theft and misrepresentation 5% from unauthorized trading. of the existence of assets. 7% from misappropriation of funds, primarily from The most liquid and simple strategies, including Equity fraud/theft. Long/Short and Managed Futures, incurred the most 7% from inadequate resources, such as technology, operational failures. processes and personnel. The misvaluation of fund assets is the most significant 14% from other issues.
8 Operational risk for hedge fund investors. 18% from misrepresentation of investments, including valuation and/or existence; and, Madoff further opened investors' eyes to the 49% from a combination of operational issues. importance of business & operational DD 4. Causes of Operational Risk in hedge Case Study #4: The FINAL case study we will examine, fund Failures1 Madoff: A Riot of Red Flags, 4 was published in 2009 by the Unauthorized Trading EDHEC Risk and Asset Management Research Centre (Nice, Misappropriation of Funds France) and written by finance professors Greg N.
9 Gregoriou of Inadequate Resources SUNY Plattsburgh and Fran ois-Serge Lhabitant of the EDHEC. Other Issues Business School. This study dissected the former Nasdaq Misrepresentation of Investments chairman's $65 billion fraud and found the following business Combination of Operational Issues and operational red flags: Affiliated service providers the broker executing and Source: Capco1 0% 10% 20% 30% 40% 50%. clearing trades, the entity holding positions and the entity determining valuations were all controlled by Madoff. Fraud has been a prevalent factor in The net result: independent checks and balances on what hedge fund failures 2 he was doing didn't exist.
10 Case Study #2: A second study, Quantification of hedge fund Use of an obscure, two-person audit firm with no Default Risk, 2 written by Corentin Christory, Stephane Daul and institutional client base. Jean-Rene Giraud was published in the Fall 2006 issue of the Family members controlled or were heavily involved in Journal of Alternative Investments. The study researched 109 significant areas of the firm's operations, including trading, hedge fund failures that took place between 1994-2005 and compliance, administration and legal. found that of the 109 failures, 54% were due to fraud, 33% were A tiny staff size relative to a then-disclosed $17 billion in due to financial issues and 13% were due to operational risks.