Hedge fund operational_due_diligence_insights_corgentum_january_2013

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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 Issue Welcome 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 a continuing 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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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 the scope 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 collecting research, 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 around the 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 on Bloomberg? 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 what research 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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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 reading a 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 public companies 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 set criteria 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?





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 Operational Due 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/DR Planning

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 New York 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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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 in effectiveness, 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 ones being 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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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 reporting requirements 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 will misconstrue 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 transparency likely 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 reliant on 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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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, and should 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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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 in place 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 an analysis 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's Legal? 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 our valuation 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 feel that 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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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 in recent 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 hedge fund 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 hedge fund 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: The

Preposterous 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, the SEC 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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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 are a 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 as fees 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 that invests 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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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 the funds 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 such expenses. 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 to a 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 be more 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 exactly should 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




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 should consider 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.

January 2013 | 15

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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 Due Diligence workshop Presented by IIR USA.

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