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Understanding and Mitigating Operational Risk in Hedge Fund Investments

A Capco White Paper

March 2003

© 2005 – The Capital Markets Company Ltd. – All rights reserved.

Reproduction or disclosure to third parties of this document, or any part thereof, is only permitted with the prior and express written permission of The Capital Markets Company Ltd.

Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 2 of 13 31-May-2005

Table of contents

1. Background 3

2. Approach 4

3. Initial Findings 5 3.1 An alarmingly high proportion of hedge fund failures can be attributed to operational issues 5 3.2 The most common operational issues related to hedge fund losses have been Misrepresentation of

Fund Investments, Misappropriation of Investor Funds, Unauthorized Trading, and Inadequate Resources. 5

3.3 Of Funds that failed as the result of operational risk only, nearly half had multiple operational issues. 7 3.4 The most frequent combination of operational issues was Misappropriation of Investor Funds and

Misrepresentation of Fund Investments. 8 3.5 Operational Risk in hedge funds is typically driven by people/operations, technology and

data/information. 9 3.6 Effective operational due diligence is an important component of the investment process. 9 3.7 Traditional approaches to operational reviews fall short of the mark. 9

4. Effective Operational Due Diligence for Hedge Funds 11

5. It Only Gets More Challenging from Here 12

Understanding and Mitigating Operational Risk in Hedge Fund Investments

A Capco White Paper

March 2003


1. Background

Over the past decade, interest in hedge fund investments has taken off. Drawn by the prospect of high absolute returns and their low correlation to traditional investments, investors are increasingly looking to hedge funds to improve the overall risk/return profile of their investment portfolios. It is estimated that there are some $600 billion invested in approximately 6,000 hedge funds worldwide. Since 2000, this trend has been further supported by the poor performance of traditional investments and strategies. Many believe that we are now on the verge of a mass ‘retailization’ of hedge fund investing with leaders from the mutual fund industry introducing hedge fund products for the mass affluent.

As the hedge fund industry has grown explosively, so too has the list of fund failures and burned investors. On close to a monthly basis we continue to hear about the catastrophic losses incurred by some of the industries best known managers with the most recent including Gotham Partners and Beacon Hill.

To better understand the reasons why hedge funds fail in ways that often result in substantial investor losses and how such failures could be prevented or at least avoided, Capco initiated an ongoing proprietary study of the industry in mid 2002. The initial findings from this study have been very compelling and are not expected to change significantly as it progresses.

In a nutshell, our initial analysis finds that operational issues account for an alarmingly high proportion of hedge fund failures (50%) and that expanding due diligence and monitoring practices to understand ‘back-office’ capabilities can make a big difference in preventing or avoiding these failures.


2. Approach

The study is based on a proprietary database of hedge fund failures going back over 20 years that captures details of losses, litigation and root causes. For this study, failed funds have been defined as those that have been forced to cease investment operations for reasons outside of management’s control as distinguished from discretionary fund closures that are much more frequent and are often driven by the business or market expectations of the fund manager.

Our initial findings are based on over 100 failed funds over this period with the primary cause of each fund’s failure attributed to at least one of the following factors representing 3 basic categories of risk:

Investment Risk

Market and related risks associated with the overall fund or a specific position

Business Risk

Risks associated with a fund that are not directly related to market movements, such as failure to reach a base level of assets under management or a change in management of the fund

Operational Risk

Risks associated with supporting the operating environment of the fund. The operating environment includes middle and back office functions such as trade processing, accounting, administration, valuation and reporting

In circumstances where it is difficult to isolate the leading causes of a fund’s failure to a single category, we have attributed failure to a combination of Multiple Risks that span these categories.

To understand common operational due diligence practices employed in the industry Capco has conducted informal interviews and discussions with leading hedge fund managers and consultants.


3. Initial Findings

3.1 An alarmingly high proportion of hedge fund failures can be attributed to operational issues

54% of failed funds had identifiable operational issues and half of all failures could be attributed to operational risk alone.

Figure 1. Failed Funds with Operational Issues and Primary Causes of Fund Failure

3.2 The most common operational issues related to hedge fund losses have been Misrepresentation of Fund Investments, Misappropriation of Investor Funds, Unauthorized Trading, and Inadequate Resources.

Misrepresentation of investments

The act of creating or causing the generation of reports and valuations with false and misleading information.

Misappropriation of funds /general fraud

Investment Managers who knowingly move money out of the fund for personal use, either as an outright theft or to cover pre existing trading losses.

Funds with Operational Issues

54%

Distribution of Failed Funds with Operational Issues

Funds without Operational Issues

46%

Distribution of Fund Failures

Investment Risk Only

38%

Operational Risk Only

50%

Business Risk Only6%

Multiple Risks6%

Funds with Operational Issues

54%

Distribution of Failed Funds with Operational Issues

Funds without Operational Issues

46%



38%


50%


Multiple Risks6%


38%


50%


Multiple Risks6%


Unauthorized trading & style breaches

Making investments outside of the stated fund strategy or changing the investment style of the fund without the approval of investors.

Inadequate resources for fund strategy(s)

Technology, processes or personnel that are not able to properly handle operating volumes or the types of investments and activities that the fund engages in.

Figure 2. Distribution of Operational Issues Contributing to Operational Risk in Hedge Funds

These problems have contributed to substantial investor losses in hedge funds that could possibly have been prevented or avoided with a more comprehensive due diligence and monitoring approach. For example, in the case of last year’s failure of the Lipper convertible arbitrage funds, had investors scrutinized and monitored the funds’ valuation practices closely, there is a good chance that they would have recognized their limited use of objective third parties to verify the pricing of illiquid securities and avoided investing in these funds.

(Additional examples are summarized in figure 3).

Breakdown of Operational Issues

Misrepresentation of Investments

Misappropriation of Funds

Inadequate Resources

Unauthorized Trading

41%

30%

14%6%9% Other

Breakdown of Operational Issues

Misrepresentation of Investments


Inadequate Resources


41%

30%

14%6%9% Other


Figure 3. Sample Cases

3.3 Of Funds that failed as the result of operational risk only, nearly half had multiple operational issues.

Figure 4. Breakdown of Fund Failures Attributed to Operational Risk Only by Operational Issue

Breakdown of Fund Failures by Operational Issue


7%Misrepresentation

of Investments18%


5%

Other14%

Combination of Operational

Issues49%

InadequateResources

7%


38%


50%


Multiple Risks6%


Breakdown of Fund Failures by Operational Issue


7%Misrepresentation

of Investments18%


5%

Other14%

Combination of Operational

Issues49%

InadequateResources

7%


38%


50%


Multiple Risks6%


Strategy : Market Neutral

Total Estimated Loss/Redemption : 700+ Million USD

Primary Operational Issue: Unauthorized Trading

Highlights:fund marketed as a market neutral fundbetting on drop in interest rates leveraged 10 to 1lost 60% of value in 7 months

Strategy : Fixed Income Arbitrage


Primary Operational Issue: Inadequate Resources/ Infrastructure

Highlights:fund had a steady track record for many yearsshifted to new trading/investment strategy risk mgt system could not fully support new security typesresulted in high volatility leading to losses and draw-downs

Strategy : Convertible Arbitrage & International

Total Estimated Loss : 300+ Million USD

Primary Operational Issue: Misrepresentation of Investments

Highlights:hedge fund manager wrote down $315 millionattributed it to a conservative pricing of illiquid securitiespricing was done w/o a third party verification

Strategy : Long/Short Equity


Primary Operational Issue: Misappropriation of Funds/Fraud

Highlights:fund had initial minimal loss that was hidden fund manager mis-represented performanceattracted additional investments and opened more fundsmanagement used fund assets for personal expenses

Strategy : Market Neutral


Primary Operational Issue: Unauthorized Trading

Highlights:fund marketed as a market neutral fundbetting on drop in interest rates leveraged 10 to 1lost 60% of value in 7 months

Strategy : Fixed Income Arbitrage


Primary Operational Issue: Inadequate Resources/ Infrastructure

Highlights:fund had a steady track record for many yearsshifted to new trading/investment strategy risk mgt system could not fully support new security typesresulted in high volatility leading to losses and draw-downs

Strategy : Convertible Arbitrage & International


Primary Operational Issue: Misrepresentation of Investments

Highlights:hedge fund manager wrote down $315 millionattributed it to a conservative pricing of illiquid securitiespricing was done w/o a third party verification

Strategy : Long/Short Equity


Primary Operational Issue: Misappropriation of Funds/Fraud

Highlights:fund had initial minimal loss that was hidden fund manager mis-represented performanceattracted additional investments and opened more fundsmanagement used fund assets for personal expenses


3.4 The most frequent combination of operational issues was Misappropriation of Investor Funds and Misrepresentation of Fund Investments.

The misrepresentation of fund investments and activities is clearly a major problem in both its prevalence among failed funds and its relationship to other issues and risks. Although most managers do not set out to defraud investors from day one, but many clearly have done so, we have found numerous occasions where on the back of poor investment performance, managers ‘modified’ the valuation of their funds and/or their investment results to buy time until actual results hopefully improved.

Although it may be impossible to foresee which managers will attempt to defraud investors their funds, it is critical that investors understand to what extent the opportunity exists to manipulate and misrepresent fund investments should their managers feel the urge. This can be accomplished through more complete scrutiny of a hedge fund’s operations and technology capabilities and a detailed understanding of the information flows between a fund and its supporting service providers that typically include, prime brokers and administrators).

Knowing that a fund has very tight controls over cash flows and seeks third party verification of a valuations to ensure they are current and appropriate will not eliminate the risk of fraud, but will go a long way in limiting the manager’s opportunity to do so.

Relying solely on a fund’s administrators and auditors is not be enough. For example, to hide substantial investment losses, the Manhattan fund allegedly created fictitious account statements that materially overstated the value of the fund. These statements were provided to investors, potential investors as well as the funds’ administrator and auditor for more than 3 years with neither the administrator nor the auditor catching the problem.

Figure 5. Breakdown of Most Frequent Combinations of Operational Issues

Breakdown of Combined Operational Issues

Misrepresentation of Investments & Misappropriation of Funds

Unauthorized Trading & Misappropriation of Funds

Unauthorized Trading & Inadequate ResourcesUnauthorized Trading & Misrepresentation of Investments

74%

9%13%

4%

Breakdown of Combined Operational Issues

Misrepresentation of Investments & Misappropriation of Funds

Unauthorized Trading & Misappropriation of Funds

Unauthorized Trading & Inadequate ResourcesUnauthorized Trading & Misrepresentation of Investments

74%

9%13%

4%


3.5 Operational Risk in hedge funds is typically driven by people/ operations, technology and data/information.

People/Operations

Fraud; misrepresentation; processing errors; poorly trained/insufficient staff; inadequate policies and procedures; lack of board/management oversight

Technology

Lack of automation; system limitations; insufficient scalability; viruses; disasters

Data/Information

Poor data sources; unreliable information; timeliness, accessibility of data

3.6 Effective operational due diligence is an important component of the investment process.

Operational due diligence can help address some fundamental questions affecting investment decisions yet tends to be the least monitored of all hedge fund related risks.

Transparency Underlying positions in the invested funds for use in generating risk analysis as well as tracking potential style drift

Capacity Selecting funds that have capacity to accept additional subscriptions

Survivorship Confidence that the underlying funds will continue to operate to alleviate the need for reallocation of invested funds

Flow of Funds Ensuring the proper controls, processes and information links are in place to allow quick valuations, and timely allocation and investment of subscriptions

3.7 Traditional approaches to operational reviews fall short of the mark.

For the most part they are:

• an ancillary component of the overall investment due diligence process • based on a generic view across multiple managers, fund types and strategies


• focused on specific functions • focused on specific aspects of the operating environment • focused internally • often reduced to a background check and character assessment of fund managers

As a consequence, information about the efficiency, effectiveness, capacity and control of hedge funds is rarely assessed in sufficient detail to inform investment decisions and identify appropriate mitigation opportunities.


4. Effective Operational Due Diligence for Hedge Funds

Capco has defined 5 key characteristics of an effective operational due diligence approach for hedge funds:

1) Provides a comprehensive view of the structure, quality and control of the people, operations, technology and data supporting the fund

2) Covers internal processes, systems and information flows

3) Covers the processes, systems, information flows and interfaces provided by external parties such as prime brokers, administrators, custodians, etc.

4) Analyzes the unique requirements of each fund/strategy as they can vary considerably depending upon fund objectives and investment style

5) Assessments are updated on a periodic and event driven basis


5. It Only Gets More Challenging from Here

Despite lukewarm performance results for 2002, the hedge fund industry is expected to maintain its steep growth trajectory. We expect that the anticipated growth in hedge fund investing will be accompanied by increased performance and operational demands as the number of new managers grows, the breadth and complexity of investment strategies expands and new forms of regulation are considered and eventually adopted.

All of this suggests that the operational risks associated with these investments will only grow more important. For the hedge fund investor, effective operational due diligence and monitoring will be key to reducing the potential of catastrophic losses and improving long term investment results in this sector.

Capco confidential information

Appendix:

Sources: Grosvenor Capital; Undiscovered Managers

Number of Hedge Funds (1990 - 2000)

Hedge Fund Assets (1990 - 2000)

Number of Hedge Funds (1990 - 2000)

Hedge Fund Assets (1990 - 2000)

Exhibit 89

Risks

Valuation issues and operational risk in hedge funds

Christopher KundroPartner, Capco

Stuart FefferPartner, Capco

Abstract

In our recent study on the root causes of hedge fund failures,

we identified a number of operational risk factors that together

seem to account for approximately half of catastrophic cases.

Issues related to valuation - the determination of fair-market-

value for all of the positions that make up a fund - underlie

many of these operational risk factors. Recently, valuation

problems have also been much in the news. These headlines

suggest that the industry is not yet taking the steps needed to

address problems in the valuation process. In fact, we believe

that issues related to valuation of portfolios will likely become

the next major 'black eye' for the hedge fund industry. Unless

certain practices discussed in this paper become more wide-

spread, we believe that hedge funds face a potential crisis of

confidence with institutional and high net worth investors.

Therefore, we are using this paper to consider the issues

related to the valuation of hedge fund portfolios more closely,

in particular as they pertain to the issue of managing opera-

tional risks associated with hedge fund investments.

41

1 Feffer. S., and C. Kundro, 2003, ‘Understanding and mitigating operational risk in

hedge fund investing,’ white paper series, Capco Institute, March


IntroductionIn our recent study on the root causes of hedge fund failures,

we identified a number of operational risk factors that

together seem to account for approximately half of cata-

strophic cases1. These factors included misappropriation of

funds and fraud, misrepresentation, unauthorized trading or

trading outside of guidelines, and resource/infrastructure

insufficiencies. Issues related to valuation – the determination

of fair-market-value for all of the positions that make up a

fund – underlie many of these operational risk factors. Most

instances of fraud and misrepresentation involved some form

of deception regarding the value of assets held by the fund,

and many of the resource/infrastructure problems we studied

eventually manifested themselves through some form of

inability to accurately price or risk the funds book. While valu-

ation issues were not specifically identified in our original

study as a major category of operational risk on its own, vari-

ous aspects of the valuation problem have played either a pri-

mary or contributing role in more than a third (35%) of cases

of failures that we studied.

Recently, valuation problems have also been much in the

news. They figure prominently in the SEC’s staff report on

‘Implications of the growth of hedge funds,’ in news accounts

of a high-profile departure of a top fund manager at a leading

hedge fund group, and in the recent market-timing scandals in

the mutual fund world (it being an issue with mutual fund val-

uations that creates the opportunity for market timers in the

first place).

These headlines suggest that the industry is not yet taking the

steps necessary to address problems in the valuation process.

In fact, we believe that issues related to valuation of portfolios

will likely become the next major ‘black eye’ for the hedge

fund industry. Unless certain practices (discussed below)

become more widespread, we believe that the hedge funds

face a potential crisis of confidence with institutional and high

net worth investors. Therefore, we are using this paper to con-

sider the issues related to the valuation of hedge fund portfo-

lios more closely, in particular as they pertain to the issue of

managing operational risks associated with hedge fund invest-

ments.

What is the valuation issue?The issue around valuations in hedge fund portfolios concerns

how to ensure that a fund uses fair and proper prices for posi-

tions that are held in the fund. The net value of these posi-

tions, after fees and expenses, is the Net Asset Value (NAV) of

the fund, and is used as the basis for all subscriptions, redemp-

tions, and performance calculations.

For some types of investments, in particular for non-concen-

trated positions in liquid securities, fair and impartial valua-

tions are fairly easy to achieve – recent transaction prices as

well as marketable bids and offers are readily available and are

visible on major wires and feeds, such as Bloomberg and

Reuters. But, for many other investments favored by some

types of hedge funds, this is not necessarily the case. Some

securities may trade infrequently and transactional prices

may not be available. In these cases, broker quotes must be

sought to get a sense for what the position is worth. Some

securities are highly complex, and may be difficult to value

without the use of a mathematical model. However, in thinly

traded markets quotes can be difficult to obtain and may be

unreliable (broker quotes for some types of mortgage backed

securities can easily vary by 20-30%). Mathematical models

make use of assumptions and forecasts that are subjective

and open to question.

Put these natural, inherent difficulties in pricing complex or

illiquid investments together with a powerful financial incen-

tive to show strong (or hide weak) performance, and then sit-

uate these factors in an environment with minimal regulatory

oversight, or without strict discipline and internal controls

(still far too typical in the hedge fund industry), and there is

potential for trouble.

Trouble is precisely what the industry has seen. At Lipper

Convertibles, a convertible bond hedge fund that recently col-

lapsed, it appears that several portfolio managers made use of

42


the opacity of the convertibles market to misvalue their port-

folio significantly. Similar issues were behind the collapse of

Beacon Hill and others.

It certainly seems that these kinds of issues are increasing in

their frequency, severity, and visibility. This has been driven by

three key trends:

■ The increasing sophistication of financial instruments -

New types of structures are invented constantly.

Their complexity often make them difficult to price, and it

can be very difficult to guarantee standard or accurate

pricing procedures. In many of these cases valuation issues

can be compounded due to the inherent or synthetic

leverage of many of these instruments.

■ The increasing number of funds that are using complex

instruments - As the hedge fund market grows, new

managers are emerging every day, and many of them are

focused on parts of the market where pricing and valuation

issues are most prevalent.

■ A broadening investor base - Institutional investors are

increasing their allocations to hedge funds, and some types

of institutions which have not previously been sizable

hedge fund investors (e.g. pension funds) are aggressively

entering the market. In addition, many funds-of-funds are

looking to push hedge fund like products to middle-market

and affluent retail investors. This has increased attention to

the sector, and is resulting in increasing regulatory and

media scrutiny.

Because of this increased attention to hedge funds at a time

when the factors that make pricing and valuation difficult are

becoming even more prevalent, we believe that valuation

problems will likely continue to occur, and to attract significant

attention from the financial and general business press.

Causes of valuation problemsWhen there are valuation problems at a fund they are gener-

ally caused by one of three factors:

■ Fraud/misrepresentation - Occasionally a valuation

problem will be part of a deliberate attempt to inflate the

value of a fund, either to hide unrealized losses, to be able

to report stronger performance, or to cover up broader

theft and fraud. This appears to have been true,

for example, in the case involving the failure of the

Manhattan Fund.

■ Mistakes or adjustments - As mentioned above, some

securities frequently traded by hedge funds can be

extremely difficult to value. And even when prices are

readily available, some positions may require adjustment

anyway - positions that comprise a large proportion of a

single issue, for example, should be discounted to reflect

the likelihood that they cannot be liquidated without a

significant market impact. Also, if a security is held in a

large enough quantity where public disclosure (i.e. Schedule

13D) is required, an adjustment may need to be made if all

or part of the position can not be sold anonymously.

Occasionally, positions will simply be mis-marked, and may

cause a sudden and unexpected impact to fund valuation

when the marks are corrected or the position is reversed.

There can also be a significant variation depending on

which ‘correct’ price is being used – i.e., the bid, offer, or

mid-point – especially when it comes to thinly traded or

illiquid instruments where bid/offer spreads can be sizeable.

■ Process, systems, or procedural problems - There are

times when a fund may be following its own policies

consistently and accurately, but a flaw in the valuation

procedures or processes cause a systemic mis-marking of

the book. This is most common in cases where a fund is

trading instruments that cannot be handled by its regular

processing systems and some kind of workaround is devised

which later proves to be flawed. Issues that may occur are

not limited to incorrect pricing. Entire positions can be

incorrectly captured on the fund’s books and records.

Sometimes total positions are completely excluded in error.

Mortgages, bank loans, OTC derivatives, convertible bonds,

and non-dollar instruments of all kinds can be prone to

these kinds of issues if underlying systems do not fully

support them.

43


Sometimes, even when technology support is robust and pro-

cedures are both well-defined and widely monitored, flaws in

the valuation process can have wide-ranging effects. In the

recent mutual fund market-timing scandals, for instance, it

was a flaw in the basic rules around fund valuations (reporting

values as of the end of the standard market day in the U.S.,

without adjustment for news that may have moved markets)

which created much of the opportunity for market timing in

the first place.

Other procedural factors that can affect valuation include:

when a quote is being obtained from a third party (e.g., bro-

ker/dealer) as a basis for valuation, questions related to which

third party and who at that third party can be critical. Is the

broker/dealer a counterparty to that transaction and therefore

has a potential conflict of interest? Is the individual providing

the quote a junior or senior executive and are they truly capa-

ble of providing an accurate price, especially when complex

modeling is involved? The point is that sometimes ‘the devil is

in the details,’ namely the task level procedures for obtaining

prices on a regular basis.

In cases of hedge fund failures where valuation was a primary

or contributing factor (35% of the total), we found that fraud

and misrepresentation was the cause in 57% of cases.

Process, procedural, or systems problems accounted for 30%

of these valuation-related failures and mistakes or adjust-

ments were implicated in the remaining 13%.

We believe that the likelihood of all of these types of valuation

problems occurring can be reduced and their effects mitigat-

ed should they occur, if the hedge fund industry begins to

adopt some sound practices that have been common in other

parts of the financial industry for some time. These are dis-

cussed in more detail below.

Some strategies are more vulnerable than othersWhile it is possible for any fund to experience valuation issues,

it has been our experience that some types of funds are more

prone to the problem than others. Unless there is some kind of

broader fraud or malfeasance, funds that invest exclusively in

highly liquid instruments for which prices are readily available

(most U.S. and major-market equities, for example) are far less

likely to significantly mis-mark a portfolio than funds that trade

complex over-the-counter instruments or illiquid securities.

We believe fund managers and investors should take particu-

lar care in looking at valuation procedures for the following

types of instruments:

■ Convertible bonds - These can be extremely complex to

value and have limited liquidity. Broker quotes for

convertibles can vary significantly for the same issue, and it

can be difficult to determine the size for which any given

quote is good. (In one convertible portfolio we recently

studied, for example, the average difference between

highest and lowest bid on the same issue was around 5%,

with the largest deltas as high as 20%).

■ Mortgages, mortgage-backed securities, and asset-

backed securities - These are also difficult to value and

may be subject to both liquidity problems and high

dispersion of market-maker quotes. They also have special

processing requirements, and most firms that trade them

must use a dedicated system for booking, valuing, and

processing these securities. Funds that trade these

instruments as part of a broader fixed-income strategy,

therefore, will often be carrying mortgage and asset-backed

securities on a different system from the rest of the

portfolio, requiring either integration or manual

44 - The Journal of financial transformation

Fraud/Misrepresentation 57%

Causes of valuation issues implicated in hedge fund failures

Process, systems, or procedural

problems 30%

Mistakes or adjustments

13%


intervention to consolidate. These systems and procedures

should get special attention by fund management or during

investor due diligence.

■ Credit default swaps - Credit derivatives are growing in

popularity and are often used by hedge funds to take on

credit exposure or to hedge a portfolio. Depending on the

specific circumstances of the issuer covered by the swap,

these can also be difficult to unwind and market-maker

quotes can be difficult to obtain.

■ Other over-the-counter derivatives - New types of

complex swaps, options, and hybrids are being developed

constantly, and some hedge funds will make use of highly

customized instruments in their portfolios. Procedures for

valuing and booking these trades should receive special

attention.

■ Bank debt and loans, distressed debt - These are often

both illiquid and difficult to model, requiring significant

credit expertise.

■ Non-dollar and emerging markets - Many funds that

begin with a focus on U.S. markets will put in place an

infrastructure that accommodates U.S. dollar-denominated

securities, but may not properly book and track non-dollar

securities. This additional processing complexity can, if

these funds begin to trade in other markets without

upgrading their infrastructure, create an environment

that is more prone than average to valuation mistakes and

processing problems. Securities issued in some emerging

markets, even when a fund is experienced with non-dollar

investing, can be difficult to value and may be subject to

liquidity concerns as well.

■ Highly concentrated positions, and positions that make

up a large proportion of a single issue - As mentioned

above, these types of positions (even when in a highly liquid

security that is not difficult to price) may require

adjustments to reflect the true liquidation value of the

position, and the fact that it cannot be disposed of without

a significant market impact.

It is worth noting that while complex, thinly traded, or illiquid

instruments are more likely to have pricing issues. In fact, even

fairly actively traded securities with prices readily available

from independent third party sources can occasionally be

‘stale’ due to bad market feeds, human error, or other issues.

This has also been publicly discussed as an issue with mutual

funds in recent months. Investors should take steps during due

diligence to ensure that all automated prices are validated

prior to month-end valuations and as part of other reporting

and subscription/redemption cycles.

Recommendations to the hedge fund industryWe believe that the aforementioned problems could be largely

mitigated or averted if the hedge fund industry were to adopt

some practices related to valuations that have long been com-

mon in other parts of the financial sector. In particular, fund

management companies and investors should: 1) Insist on

strict independence and separation of duties; 2) Ensure con-

sistency in the valuation process, and; 3) Require a level of

management supervision and oversight. More details on these

recommendations are included below.

The Managed Funds Association has published a set of ‘Sound

Practices for Hedge Fund Managers,’ which they recommend

for adoption by the hedge fund industry,2 and the Internation-

al Association of Financial Engineers’ Investor Risk Committee

has published a description of concepts related to valuation

that they recommend as a basis for discussion between finan-

cial institutions and stakeholders.3 While we agree with virtu-

ally all of the concepts and practices that these organizations

endorse, we believe that they do not go far enough in advo-

cating more robust controls around valuations. Therefore we

make the following suggestions.

Insist on strict independence and separation of dutiesSeparation of duties and independence in mark-to-market has

long been a fundamental principle of control in financial insti-

tutions, but is still inconsistently applied in the hedge fund

industry. A breakdown in separation of duties seems to have

been a factor in almost every valuation-related hedge fund

failure that we have studied. In short, independence and

452 Managed Funds Association, ‘2003 Sound Practices for Hedge Fund Managers,’

published and distributed by the Managed Funds Association, Washington, DC, 2003.

3 International Association of Financial Engineers, Investor Risk Committee,

‘Valuation concepts for investment companies and their stakeholders,’ IAFE, 2003.


separation of duties means that the person who performs

checks or approves valuations should not receive incentives or

inducements based directly on the performance of the invest-

ment being valued, and should not report to managers who do.

The trader or portfolio manager should never perform final

valuations (it often makes sense, however, for the trader or

manager to do their own valuation as a ‘reasonableness check’

on an independent process), and wherever possible an inde-

pendent third-party should check valuations prepared by the

manager themselves. Wherever possible, a fund manager

should keep a financial/accounting staff independent of the

portfolio management team to prepare and validate marks-to-

market. In most cases, these staff will report to the CFO or the

COO of the fund management company, and should be com-

pensated based on the overall profitability results of the man-

agement company rather than directly based on the perform-

ance of any of the investment vehicles managed by the firm.

In some cases fund administrators will perform this role for a

fund manager. Some valuation services will also prepare

marks on an ‘outsourced’ basis for a fund manager. Many

funds will also employ an auditor to test valuations used for

financial statements to investors. We believe that a fund man-

ager should always use an external third party to verify that

portfolio valuations are accurate before they are reported to

investors. This would be in addition to the fund auditor, who

often will examine valuations less frequently and after they

have been reported.

Ensure consistency in the valuation processDaily mark-to-market and monthly/quarterly pre-statement

valuations should always be performed according to a well

defined process. The application of sources, methods, rules,

and models should always be applied consistently, with any

deviations or unusual circumstances clearly noted and docu-

mentation saved.

These processes may change over time in response to

changes in the markets for certain types of securities, to make

use of better information, or for other good management rea-

sons. However, when it appears that valuation choices are

made situationally, without a clearly documented rationale, we

believe that an investor should seriously consider the safety of

their capital.

Require a level of supervision and oversightIf the fund manager performs valuations themselves, there

should be a set of clearly documented policies and proce-

dures, as well as a way of ensuring that those polices and pro-

cedures are actually followed in practice – generally through

external validation, testing, and audit.

After the collapse of Lipper Convertibles, Ken Lipper who ran

the management company, commented to the media through

his attorney that he was unaware of any mispricing issues

prior to the collapse of the fund and that it had been valued by

the portfolio managers responsible for investing it. To us, if

true, this represents an abdication of management’s duty to

oversee the valuation process. Management should review val-

uations, and there should be evidence that pricing discrepan-

cies have been brought to management’s attention and that

action has been taken when appropriate. Especially in a fund

that invests in the problem-prone instruments mentioned

above, a certain number of honest valuation discrepancies are

inevitable. Whether a fund manager acknowledges that they

occur, how they handle them, and whether they document the

results can speak volumes about the quality of supervision

over the valuation process. This management oversight is crit-

ical to ensuring the soundness and safety of investor assets in

a fund.

Sometimes it can be smart for a fund manager to outsource

some of the mechanics to a third party pricing service. Even in

the case of complex instruments – such as certain OTC deriva-

tives and asset-backed securities – there are service providers

that can price them and also offer operations outsourcing and

risk management services as well. We believe that any move

which increases the independence and objectivity of the valu-

ation process should be viewed positively by investors.

46 - The Journal of financial transformation


ConclusionClearly, pricing and valuation has become a significant issue

for the hedge fund industry, and we believe that its signifi-

cance is likely to increase – particularly as it relates to funds

that trade strategies and instruments that are particularly

prone to the types of problems we discuss here. But there are

a set of practices, long standard in other parts of the financial

sector, that we believe can mitigate losses and prevent prob-

lems, at least in many cases. We further believe that they rep-

resent the hedge fund industry’s best chance at avoiding a

damaging public ‘black eye.’

47

Exhibit 90

104 - The journal of financial transformation

Hedge fund managers have long been aware of the need for

investors to conduct thorough due diligence when assessing

the merits of their investment strategy. Yet, over the past few

years, there has been an increasing focus on operational due

diligence because of the increasing inflows of institutional capi-

tal into hedge funds and some well publicized fraud cases which

have caused losses for even some of the most sophisticated

investors in the industry. Regulators are also focusing their

attention on hedge funds due to both the tremendous growth

of this asset class over the past few years and the increasing

demand from retail investors and public pension plans.

Operational risk can be described accurately as ‘risk without

reward,’ as it is the only risk that investors face that is not

rewarded with potentially increased returns.

This paper aims to help hedge fund investors and manag-

ers understand why operational risk is particularly relevant

in the hedge fund industry today and to identify the areas

investors need to focus on when evaluating the operational

risk of hedge funds.

Investors bewareOperational risk is particularly relevant in the hedge fund

industry as the type and quality of fund management orga-

nizations varies widely across the marketplace. It is quite

possible for a long/short equity manager to have a billion

dollars of assets under management and yet have as few as

ten employees on their direct payroll. Hedge fund managers

range from small private offices and boutique operations,

through to deeply resourced institutional money managers,

with a myriad of variations in between.

The diversity of hedge fund investment management orga-

nizations means that investors cannot simply assume that a

fund manager has an operational infrastructure sufficient to

protect shareholder assets. Exciting investment returns may

blind an investor to the true infrastructure deficiencies that

can exist behind the scenes. In addition, managers are incen-

tivized by performance fees and many hedge funds trade

in complex financial instruments which often have greater

valuation subjectivity than those utilized in the traditional,

long-only world. In this environment, the overriding mantra

must be ‘investors beware.’

The positive news on operational infrastructure has been the

recent entry of major outsourcing providers to the alterna-

tive investment industry. This has increased the availability

of robust middle-office functionality to hedge fund managers

who have outgrown their boutique beginnings and who now

require the type of process-driven operating environment

that their counterparts in the long-only world have tradition-

ally enjoyed.

five key operational considerationsInstitutional investors are increasingly scrutinizing the oper-

ational controls and procedures of hedge fund firms. A good

operational due diligence review should cover the manager’s

organization, fund structure, back office, valuation, and inde-

pendent oversight. Some of the items within these five key

areas which sophisticated investors and hedge fund manag-

ers should focus on are:

Experience of operations personnel

All hedge fund managers should appoint an experienced

CFO or COO who is able to take ownership of the opera-

tions function of the hedge fund firm. The CFO/COO should

ensure that there are sufficient operations and settlement

staff (both in terms of numbers and experience) relative to

the size and complexity of the funds under management.

Hedge fund operational risk: meeting the demand for higher transparency and best practiceReiko NahumChief Executive Office, Amber Partners

David AldrichManaging Director, The Bank of New York Mellon

105

Managers can make a common mistake in the early stages

of building their business by not hiring a CFO/COO at launch

due to cost constraints or because the back-office fund

accounting functions are being performed by an independent

third-party administrator. It is important that someone other

than the portfolio manager has responsibility for the day-to-

day business management of the firm to enable the portfolio

manager to concentrate solely on generating alpha. In fact,

regardless of the decision to utilize an outsourced provider

of operational services, it is clear that a strong CFO/COO is

a major asset to the management of a hedge fund business.

Furthermore, even if middle-and/or back-office functions

have been outsourced, there should be operations staff who

have responsibility in assisting and overseeing the service

provider’s work in detail. This includes chasing up outstand-

ing confirmations, cash and position reconciling items, and

trade breaks.

compliance

Every firm should have a compliance manual which sets

out key compliance policies in areas such as personal trad-

ing, trade errors, know your customer checks, soft dollar

commission usage, etc. A chief compliance officer should

be responsible for ensuring that compliance policies are

being adequately monitored and enforced. Lack of adequate

compliance policies and controls to effectively monitor and

enforce such policies may lead to future regulatory failings.

Internal controls and procedures

The complexity of the manager’s investment strategy is

one of the most important considerations when evaluating

the adequacy of the firm’s internal control environment.

Managers who trade in complex OTC derivative instruments

will need to ensure, for instance, that there are sufficient

back-office staff to chase up and review long form confirma-

tions. Firms which trade in heavy volumes should invest in

third-party trade capture and order management procedures

which utilize and apply, where possible, straight through

processing capabilities to the accounting systems so as to

reduce the need for manual intervention.

Robust internal controls and procedures should be in place

over each stage of the trading cycle: trade authoriza-

tion, execution, confirmation, settlement, reconciliation, and

accounting. Adequate segregation of duties should be pres-

ent between those who are authorized to trade and those

who are responsible for recording trade activity to prevent

unrecorded trading losses. Given the incidence of frauds in

certain jurisdictions involving the theft of fund assets, both

wire transfers and other asset movements must be tightly

controlled. No manager should allow assets to be moved

outside the fund on a single signature and there should be

effective segregation of duties over cash movements.

Portfolio pricing

Valuation of assets is one of the most frequently discussed

topics of operational risk amongst investors, as this is the

area most at risk of manager manipulation. Regulators in the

U.S. and U.K. are also increasing their attention on industry

pricing practices and are seeking more independence of

valuations. There is a risk of using asset valuations to artifi-

cially boost fund performance or to smooth ‘mark-to-market’

losses. Many funds publicize their Sharpe ratios, and damp-

ening volatility can both falsely influence the Sharpe ratio,

as well as incorrectly implying higher returns. Other signals

to look for include those funds that have more small winning

months than small losing months, which might suggest that

smoothing has been applied to returns rather than recogniz-

ing small losses accurately. The presence and choice of a

third-party fund administrator and auditors will be indicative

of the independence of these processes from the influence

of the manager.

It is important for investors to distinguish between valua-

tion risk arising from investments rather than operational

risk. When the investment strategy trades in thinly traded or

illiquid instruments, investors must accept that valuation risk

exists as it is inherent in the nature of the securities traded;

in some cases, only the counterparty may be able to provide a

price. However, investors can reduce valuation risk resulting

from poor operational controls and procedures surrounding

106 - The journal of financial transformation

the pricing process by ensuring that the fund is following

three best practice principles of valuation: transparency, con-

sistency, and independent oversight:

n Valuation transparency — addresses the extent to which

the investment manager clearly communicates to inves-

tors the specific methods and processes used to value

securities when determining the NAV for dealing purposes.

Whilst transparency may be a lesser issue for long/short

equity funds holding liquid stocks, best practice for more

complex funds is to develop a comprehensive, written ‘pric-

ing matrix,’ which describes in detail the specific methods

used to value each type of instrument. This pricing policy

will be maintained by the third-party administrator and can

normally be made available to investors at the direction

of the manager. Language contained within an offshore

fund’s prospectus describing NAV calculation is normally

too generic for this purpose. Best practice transparency

standards may also extend to the application of predeter-

mined policies and thresholds to challenge and override

prices. Formal documentation of valuation exceptions may

also involve the use of a valuation committee, which will

minute changes to policy, pricing, or exceptions that have

been included in particular NAVs.

n Price consistency — reflects the need for similar securi-

ties to be valued the same way both at a point in time and

over time. If a fund bases month-end valuations for certain

instruments on broker quotes for example, procedures

should be in place to ensure that the source of quotations

cannot be ‘cherry picked’ to select the most favorable

mark at each month-end, be it the highest mark, or the

sources which best smooth portfolio performance. Equally,

if multiple quotes are available they should be averaged

in the same way, across all funds managed by the firm,

to ensure consistent sampling of market price dispersion

month to month.

n An independent valuation process is a critical factor —

internal to a manager’s organization, independence means

that the back-office should oversee the month-end pricing

process, rather than front-office personnel. Such control

and oversight ensures that managers do not mark their

own books without back-office verification. External to

the manager’s organization, the most effective way to

ensure independence in the valuation process is for funds

to appoint a leading independent third-party administrator

who is tasked with oversight over the month-end valuation

process. Best practice calls for the administrator to cal-

culate the monthly NAV incorporating valuations derived

exclusively from sources independent of the manager.

Such sources include brokers, price vendors, and third-

party valuation agents for complex OTC derivatives.

Quality of service providers

Failure to appoint well-known, proven, and independent ser-

vice providers may be a warning sign. Funds should always

be independently audited, preferably by a ‘big four’ or spe-

cialist audit firm with a market reputation for auditing hedge

funds. All prime brokers and other counterparties should be

high quality financial institutions and there should be trans-

parency in the identities of counterparties that are chosen

by the manager.

The independent third-party administrator plays an extreme-

ly important role in protecting investor assets by calculating

the net asset value of the fund, independent of the manager.

Business practice varies according to location with regards

to the appointment of third-party administrators and as

to the precise definition of their roles and responsibilities.

Investors need to check these details and have due diligence

reports produced on the role of the administrator.

Consolidation in the administration industry has created a

top-tier of fund administration firms and it is advisable to

select funds which have hired firms with adequate capital

resources to invest in IT systems, high caliber staff, and

training programs. Note that not all administration work

is created equal and anything less than full service fund

administration (i.e., preparation of a complete set of account-

ing records) increases operational risk for investors. Some

administrators only review the manager’s own accounting

records, known as a ‘NAV light’ and do not reprice the port-

107

folio. A small number of funds do not appoint a third-party

administrator at all. Investors in these funds must consider

the manager’s reasons and what compensating controls, if

any, are present in such circumstances where independent

oversight over the trading NAV is absent.

conclusionOperational risk in hedge funds is a potential ‘time bomb’ for

investors. Investors must increase their focus on this aspect

of their investments and not wait for either the regulators or

a disaster to alert them to these risks. Hedge fund investors,

while primarily focused on their headline risk, should also

keep in mind that good operational due diligence will help

them avoid funds which may suffer a drag on performance

due to weak controls, frequent errors, or poor internal infor-

mation. Overall, investors who consider operational factors

will make better informed investment decisions and receive

more secure returns. Chief Investment Officers, investment

committees, and ultimately boards of directors will take

comfort that sufficient attention has been paid to the opera-

tional, as well as investment, issues within the portfolios

under their charge.

Exhibit 91

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