AIM64.3: Explain the role of the due diligence processinsuccessfully identifying inadequateorfoiled internal process.
Thehedgefundindustryis notedfor itslackoftransparency. Hedgefundmanagersare reluctantto revealdetailsabout thefund,especially if they engagein proprietarytrading strategies. Fund managersarenotrequired to registerwiththeSEC,thoughsomefundsdo
sovoluntarily.Evenfund informationreported in publicdatabases,such asLipperTASS andCISDM,ofteninclude unverified,voluntarily providedinformation aboutspecific funds.
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In thisenvironment, theduediligenceprocessiscriticallyimportant.Duediligence identifiesinadequateorfailed internal processesby uncoveringandverifyinginformation.
As noted, third-party due diligencefirmsgatherandverify information about thefundfrom a numherofsources,includingtheoffering documentsof die fund,marketingmaterials,
interviewswithfund managers, forms filledout byfund managers,background checksof key employees,and interviews with prime brokersand administrators,
Firmswho use oneof theBig 4accounting firmsaresubjecttoduediligencein thesense that diese firms typically pre-screen managersfor variousoperational riskfactors before cakingthefundon asaclient.Oneofthe redflagsin theBernieMadoffPonzischeme wasthe lackofaknownauditingfirm. MadofPsfirm,which had billionsofdollars under
management,wasaudited byFriehlingandHorowitz, a three-personaccounting firm operatingoutofastrip mall.
Byverifyingand cross-checkinginformation acrosssources,dieduediligenceprocess can uncover failuresin die internalprocessesof thefund,whichinturnlead toincreased operational risk,
Professor’sNote: One wouldassumethat would-be investorsengagein due diligenceto uncover riskfactorsand either avoid the riskorprice the riskinto theexpected return.However, Brown etal.find, surprisingly, thatinvestors
appeartochasepast returnsregardless oftheoperationalrisk characteristics
ofthefund. Despiteidentifiable operational risk factors thatsurfacedin the
duediligence reportsexaminedin theBrown etaLstudy, theflow of capital
into someproblem hedge funds wasunabated. Infact, thestudy findsthat
therewerehigherinvestorflows after the duediligencereport, indicating
thatinvestors arecomfortableinvestingin thesefunds despitetheexposure to
operationalrisks uncovered by third-partyduediligenceproviders.
©
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KEY CONCEPTS
AIM64.1
Investors delegate investmentdecision-makingauthoritytomanagersofmutual funds andhedge funds.The behavioroffundmanagers, atleast with respect tohedgefunds, is generallyunobservableto investors.In thisprincipal-agent relationshipthatexistsbetween investorsand managers, trustisessential.
Operationalrisk,asdefined bythe BaselCommitteeon BankingSupervision,is risk of director indirect lossresultingfrom inadequateorfailed internalprocesses,people,and
systemsorfrom externalevents.”Operational risk has resultedin morehedgefundfailures than other typesofrisk,accordingtoseveralstudies.
Third-party due diligencefirms collect and verify informationabouLhedgefundmanagers.
Typicalclients includefunds-of-hedgefunds,aswellas institutions andwealthy individuals.
Third-party duediligencefirmsexamineandcross-validateinformationfromoffering andmarketingdocuments, interviewswith fund managers,forms filledoutby managers,
interviewswithauditorsandfund administratorsregardingaudited information,
performancefigures,assetsunder management,and operationalcontrols.Theyalsoperform backgroundcheckson the managersandkey employeesof thefund.
AIM64.2
Past regulatoryandleg4problems,andperhapsmoreimportantlyalack ofhonestyfrom managersregarding theseproblems,is aleadingindicatoroffuture operational problems.
Funds diat havelegalandregulatory problems,referred to asproblem funds,aregenerally
moreilliquid,are lesslikelytouseindependent pricing procedures, arelesslikelyto have aBig 4auditor,are morelikelytoswitchdatavendorsinaddition tohavingverification problemswith respecttosignatures for fund transfers,arelarger than non-problem funds, andgenerally have pooreroperationalcontrolsinplace.
AIM64.3
The duediligence processplaysanimportant roleinidentifyinginadequateor foiled internal processes. Thehedge fund industryis non-transparent,andmanagersarereluctant
toreveal information, especiallyiftheyfollowa proprietarytradingstrategy. Thedue diligenceprocess is critical in uncoveringandverifyinginformation about funds andfund managers.
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CONCEPT CHECKERS
Akey goalof thethird-partyduediligenceprocessis to:
A. generate truthfuloffering andmarketingdocumentsforthehedgefund.
B. provideanindependent auditingreport thatinvestors can trust.
C. identifyimperfectorfailed internal processesof the fund.
D* perform backgroundchecksonmanagers and keyemployees.
Afundwith pastlegal orregulatory problemsis:
A. morelikelytochooseaBig4 auditingfirm.
B. lesslikelytoswitchdatavendors.
C. generally largerthannon-problemfunds.
D* generallymoreliquid.
Theduediligenceprocessidentifiesinadequateinternal processesby:
A. verifyinginformation about the fund.
B. analyzingdatafrom publicsources,such asthe LipperTASSandCISDM
databases.
C. takingon the roleof auditortoidentify problemsbefore theauditor does.
D. registeringdie fund with die Securities and ExchangeCommissionasan investmentadvisor*
1.
2.
3.
4. Athird-partyduediligencereport reveals bodi quantitativeandqualitativefactors regardingdie potentialoperational riskin hedgefund activities.Examplesof qualitativefactors thatareevaluatedin theduediligenceprocessincludeall of the followingexcept;
A. substantiationof die accuracy of die dataprovided bythe fund.
B. how thedailyaccounting of the fundisaccomplished.
C. themethodbywhich portfoliovaluesaredetermined.
D* howhedgefundleveragechangesover time.
Given dierecentfinancialfailures, investors haveplaced greateremphasison determining thelegitimacyoffund reported returns.An operationalrisk measure,
knownasthein-score,can beappliedin these situationssince it isbaseddirecdyon datapulledfromaduediligencereport. Whichof the followingstatements most
accuratelydescribesthe validationof theu measure?Exposureto the risk that this score measureswouldlead to;
A. anincreased likelihoodof gpod performancethat canbeexplained bymarket risk andoperational riskexposure.
B. adecreased likelihoodof lowerperformance thatcannotbeexplained bymarket riskoroperational riskexposure.
C. adecreasedlikelihoodofpoorperformance thatcan heexplained by operational risk exposure.
D* anincreased likelihoodofpoor performancethatcannotheexplained bymarket risk exposure.
5.
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CONCEPT CHECKER ANSWERS
1„ C Thethird-partyduediligenceprocessinvolvescollectingandverifyinginformation to
identityimperfectorfailedinternalprocesses.Performing backgroundchecksonmanagers andkey employeesis partof that process. Duediligencefirms alsoverify auditingreportsand cross-check informationthatis inmarketingdocuments.
2. C Problemfunds[withlegaland/orregulatoryissues),arcgenerally largerthan non-prohlcm funds. TheyarclesslikelytouseaBig 4auditingfirm,morelikelytoswitch datavendors, andarcgenerallylessliquidwith longer lock-upandredemption periodsthannon-problem funds.
3. A Informationisgatheredand verifiedinthe duediligenceprocessinanattempt toidentify inadequateorfailedinternalprocesses.
4. D Hedgefund leverageisrevealedin TASSandCISDM databasesandismeasured usinga quantitativeapproach. Examplesofqualitativefactorsrevealedby third-partyduediligence
reportsinclude:the methodbywhichasset/portfoliovaluesarcdetermined, howandby
whom theday-to-dayaccountingof the fund isaccomplished,suhstandationof theaccuracy of thedataprovided bythefund,and how controlprocessesarcperformed.
5. D The uvseonecan be validatedasameasureofopcradonalriskbyusingaunivariatetest to showthat exposuretooperational riskwouldmostlikelyleadtopoorperformance.This poorperformance wouldnotbeeasilyexplained byexposure tomarket risk.
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