Summary prepared by Daemon Repp, Sr. Financial Analyst, Genesee Investments

Chris Lombardy of Kinetic Partners and Jonathan Choslovsky of Albourne Partners led the discussion.  Both Mr. Lombardy and Mr. Choslovsky focus on operational due diligence of hedge funds in their current roles.  Given the proliferation and magnitude of frauds in the past couple years, investors are placing added significance on thorough operational due diligence when evaluating hedge fund managers.  The conversation addressed three points:

-                     recent themes of investor due diligence and establishing an operations, compliance, and best practice infrastructure to meet the demands of operational due diligence reviews

-                     the changing US regulatory landscape for investment advisers

-                     recent themes of regulatory examinations

Gone are the days when due diligence focused solely on a hedge fund managers’ investing capabilities.  Nowadays, investors are also looking for good operational infrastructure, regardless of the size of the fund.  They want to see the fund operated at an “institutional” quality level.  This includes a well defined segregation of duties and quality service providers such as legal counsel, administrator, and prime broker.

Mr. Choslovsky pointed out that this focus on operations is a result of recent ponzi schemes that blew up funds in 2007 and 2008.  Prior to that, operational due diligence was largely an afterthought.  Recent trends include the insistence upon a third party administrator who can custody assets, transfer money, and verify pricing.  Another trend is the verification of AUM.  In nearly every ponzi scheme, the manager lies by overstating their AUM.  Mr. Choslovsky feels that verifying AUM is a full proof silver bullet for detecting a ponzi scheme.

Another trend is the focus on counterparty exposure.  ISDA agreements are more closely scrutinized.  How the agreements with the prime brokers structured and whether ISDA agreements are one or two-way are some examples of this focus.

Borrowing a term from banking, investors are keen to a fund’s asset/liability management (“ALM”).  More specifically, are a fund’s liquidity terms consistent with the types of investments it makes?  For example, a distressed debt manager with monthly liquidity on two weeks’ notice is not a favorable matchup.  Nor is a large cap US equity manager with annual liquidity.  A fund’s liquidity terms had not been given much through prior to 2008, and at the end of that year gates, suspensions, SPV’s, and retroactive side pockets all occurred.  This caused a lot of confusion and investor backlash.  In some cases, managers’ documents were written so long ago that they themselves did not know what they could do.

Currently, funds are setting themselves up with ALM in mind.  Managers now carefully consider how they would handle events similar to the end of 2008 when drafting their documents.  One popular method is to stagger the redemption windows.  This is most effectively accomplished by creating investor level gates, where each investor is only allowed to withdraw a maximum percentage, say 20-25%, of its capital at each redemption period.  This method is favored by investors over a fund level gate, as it eliminates much of the game theory in the redemption process.  Completely out of favor now is the stacked gate, where investors who redeemed at prior redemption periods and were gated are given preferential treatment over new redeemers at the next redemption window.

Investors are becoming more critical of a fund’s fee structure as well, both the management fee and the incentive fee.  Management fees have steadily increased over the years from 1.0% to 1.5% to 2.0% and sometimes even higher.  Investors expect that the management fee be used to cover the expenses the manager incurs in operating its business.  The fee should be fair and should not be so high that it incentivizes the manager to be an asset gatherer.  Investors are loathe to pay a high management fee for a fund that has grown large and feel that the fees should come down when the manager reaches a certain asset level.  There is a backlash against managers trying to run certain expenses that should be covered by the management fee through the fund instead.  While more forgiving for smaller funds, especially those that have shrunk and thus are generating less revenue than previously, there is little leeway in investors’ minds for large managers who try to put expenses through the fund.

As to incentive fees, investors want to pay for alpha, not beta.  This naturally leads to some kind of hurdle rate, whether fixed or floating based on some appropriate benchmark index.  Furthermore, if a fund has a strategy with a long lockup (greater than one year), then investors would expect that the incentive fees would not crystallize until after the lockup expires.

Transparency is another hot button issue, with the general consensus being that more is better.  Again, this became more of a necessity with the recent proliferation of ponzi schemes and the events in the markets during the fall of 2008.

Managed accounts were a popular issue a few years ago, but less so now.  It was suggested that the decline in popularity may be due to the fact that funds are more willing to give transparency than previously.  Transparency, along with no fear of being gated and no potential for a ponzi scheme are the benefits of a managed account for an investor.  They are also good for FOF who are seeking to manage their own ALM issues.  In general, managers do not like managed accounts due to the increased administrative burden.  This is especially true of larger managers who are not as desperate for the assets.  However, most all managers have an amount over which they will accept a managed account.

Mr. Lombardy gave the example of a client who conducts a “document request.”  More specifically, the client wants to know if a manager’s DDQ, PPM, monthly letters, and marketing documents are all consistent with each other.  This is a general test for a manager’s attention to detail and business coordination.  Mr. Lombardy recommended conducting this exercise periodically after investment as well.

It is consensus among investors that they would never invest in a fund without an audit report.  However, where the audit used to also be viewed as asset verification, that is no longer the case.  Investors recognize that the audit only verifies a fund’s year end assets and that much happens from one year end to the next.  Administrators and prime brokers are now used to verify asset levels.  In most cases, the administrator or prime broker must see that the investor has received permission from the manager before answering these types of questions.  Investors should view it as a red flag should service providers not freely answer these questions.

In verifying independent pricing, it is not just enough to know that it exists.  Investors now want to drill down further.  What level of service is the administrator providing in this regard?  How easy does the manager make it for the administrator to get independent quotes from the various brokers?  Is what the administrator saying about services provided consistent with what the manager says about the administrator’s services?  Exactly how are the obtained quotes used in establishing a price?  These are the types of questions that investors are demanding answers to.

The panelists emphasized the importance of a fund’s offering documents.  Managers need to be very careful about putting limits that are too restrictive into the offering documents.  Over time, managers tend to forget some of them, which could inadvertently lead to a misrepresentation.  This is essentially what happened to Wood River.  It is very important for managers to review their legal documents every year.

Brokerage fees are another area of increased scrutiny.  How does a specific broker’s fees compare to the industry standard?  Investors want to see managers check this at least annually and see that the research provided matches the commissions charged.  For micro cap and small cap stocks, 5¢ per share is reasonable.  For more liquid stocks, 2-3¢ is reasonable.  The quality of ideas the broker suggests, how they handle large block orders, and any kind of marketing they do should also be assessed in determining a reasonable commission.

During the Q&A session, there were some questions about emergent issues that the SEC is looking at.  Managers are closely monitoring whether or not they need to be registered.  Legislation in Congress is moving the requirement away from a client count threshold towards an asset level threshold.  Insider trading is a specific focus of the SEC, and not just of the tipper/tippee type.  The focus is more on the manager’s compliance department, and if it is monitoring analysts’ networking calls or paying attention to where they got their good performing trades.

There was a question about third party marketers.  The most important issue for a manager is to make sure that any third party marketer they use is a broker/dealer, because the manager’s fund is a security and the third party marketer is offering it.  If the third party is not a broker/dealer, then a client who loses money may be able to come after the manager for restitution.

There was also discussion of the kinds of disclosures a manager is required to make.  The consensus was anything that is material, where material means anything that would influence an investor making or keeping an investment in the manager’s fund.  One area of such disclosure is personnel movement.  Investors get very annoyed with managers who don’t disclose when certain employees are no longer with the manager.  Even more annoying is if it is an employee the manager said was important while working there and then says was unimportant or junior after he’s departed.

Over the last six months I have had the opportunity to meet with a number of individuals looking to start up a hedge fund. Whether it is a proprietary trader at a large investment bank or a portfolio manager/trader at an existing hedge fund, the result has been the same. They have not launched or are trading their own money. Why? First, capital raising is extremely difficult. Hedge fund investors, if they are allocating at all, are adding to existing positions in large hedge funds with established track records and institutional grade operations. There is little appetite for taking a flyer on a start-up hedge fund. The typical proprietary trader at a large investment bank has had no exposure to outside investors and thus, has no Rolodex to mine. The portfolio manager/trader may or may not have had exposure to investors while working at the hedge fund they are leaving. Some investors like to bet the jockey. To some extent, they believe that past performance is indicative of future results. For both groups, whether their performance record is portable is a big issue when it comes to marketing the fund.

Secondly, running a hedge fund "business" is vastly different from portfolio management or trading. Investors are looking for hedge funds that they believe will survive and thrive. Start up hedge funds face significant obstacles to execution on the business/operations side. Most start ups lack the money to invest in institutional grade systems and hire the people necessary to monitor the systems put in place. They take for granted the infrastructure they previously operated under while part of a larger organization. To gain the capital needed to launch a hedge fund business, some start-ups are seeking out seed capital but this is viewed as less than ideal given the trade offs in economics.

Third, the regulatory landscape is unsettled and many people believe that waiting until things stabilize will allow for better decision making. Examples here are the Volker proposals on proprietary trading, potential SEC registration rules, change in taxation of carried interest, increase in income/capital gain tax rates and Medicare taxes arising from the health care bill, etc.

Fourth, many of these individuals are on Gardening Leave and prohibited from starting a new venture until the expiration of the non-compete agreement.

Build it and they will come is not a mission statement. The good news is that once the obstacles clear, there will be a significant wave of start up hedge funds. They will need CFOs and COOs and CCOs and IT and back office. While the preference would be to hire experienced personnel to fill these slots, (and money well spent given the economics of greater AUM that experienced hires may have access to or help land) opportunities will arise for first timers to land one of these roles given the pressure on compensation.

-George Roeck

Andrew Rabinowitz and his wife founded R Baby Foundation in 2006, after their daughter was misdiagnosed in the hospital - a mistake that turned tragic.  R Baby Foundation is the first and only not-for-profit foundation uniquely focused on saving babies' lives through improving pediatric care.

"We are doing our 2nd Mother's Day Run/Walk in Central Park for adults and children including a 4 mile run, 1.3 mile health walk, kid's fun run ages 2-12 and a family fun festival with activities for the entire family (Nike sports clinics, Live kids entertainment by Raggs and songs for seeds, arts and crafts by appleseeds, pampering massages, music, giveaways and so much more!)

I wanted to invite you to spend a fun Mother's Day morning (8:00-11:30am) for a worthy cause by joining us and signing up for the R Baby Run/Walk - you can participate by running, walking, or just enjoying the festival. This is an official New York Road Runners event so we must get all our participants to register as soon as possible at www.rbabyrunwalk.org since they sold out last year. Once you register, you can help raise funds and awareness by sending out this type of email to your contacts. If you cannot attend but you still want to help you can also sign up as a virtual walker on the site and create a team by raising funds on-line to support R Baby. To register for the race or make a charitable donation please see www.rbabyrunwalk.org.

Any and all support is appreciated. I appreciate your consideration."

-Andrew Rabinowitz

Moving forward, the HFBOA will post our quarterly newsletter on the blog, making links available for sharing and download.

Here are permanent links to our 2009 Newsletters:

Industry Trends in Operational Due Diligence

Industry Trends in Treasury Management: How have hedge funds' views changed since Q3 of 2008?

Also, here are links to the 2009 luncheon recaps as well:

Business continuity and disaster recovery planning strategies 

HR Best Practices for hiring and terminating employees  

Operational Risk Measurement: Identifying & Capturing Meaningful Risk Measures

Regulatory and Legislative Initiatives in early 2009

Hot Legislative Topics in spring of 2009

Treasury Management

Just back from attending the GAIM Ops Cayman conference and there were a couple of interesting observations. While the purpose of this posting is not to provide a review of the conference, in general, attendance was up over the prior year and the mood was generally brighter, with more speakers saying that they were optimistic about the future of the hedge fund industry. 

Comments of note were as follows. One speaker said that some funds that had gated their investors or suspended redemptions entirely were getting feedback from investors that they were pleased with the results of those actions. Many strategies that were mauled in 2008 rebounded strongly in 2009 and had investors redeemed when they wanted to, they would have locked in losses at what is viewed as the low point of the cycle. Quite a change from the uproar that originally greeted the notice of gating/suspension. 

The mania of managed accounts appears to be tapering off. While there are still some investors that will only invest through a managed account, many investors are comfortable with the traditional fund structure-especially when they learn about the additional costs and administrative complexities associated with managed accounts. 

Another observation was that many hedge fund CFOs may be struggling with the implementation of FIN 48. In addition to the technical issues inherent in FIN 48, historically, hedge fund CFOs have been stronger on the accounting side than on the tax side. Most hedge funds are structured as pass thru entities and pay no tax (exceptions are withholding and transaction taxes) so the issues tended to be more focused on tax matters at the individual level (ordinary vs. capital, trader vs. investor, etc.). FIN 48 will force hedge fund CFOs to focus more on international tax issues and potential liabilities associated with structured products.

Sincerely,

-George Roeck
 Managing Director & Chief Financial Officer/Chief Compliance Officer, Agamas Capital Management, LP
and Member of HFBOA Board of Directors

Technology Requirements: “Do we really need this?”
Defining the items you must have, should have, and don’t need at all

The Topic:
A common struggle for hedge fund operations managers lies in determining how, and how much, to
spend budget on IT. It can be difficult to understand how much a fund relies on technology, how that
technology will be managed by in‐house IT staff, and how to scale up or downsize technology when
necessary. Are your stakeholders asking you tough questions about the IT budget? The current
economic environment makes things even more difficult. How has it affected your fund’s technology
spend?

At this roundtable event, Vinod Paul, Managing Director at Eze Castle Integration, will guide participants
through the process of evaluating a hedge fund’s IT and determining the value of all the systems and
software that make a fund run, including:

• Infrastructure requirements
• Trading applications/ connectivity
• BCP/DR, including data protection
• Cloud computing/ managed services
• Regulations/ required systems, including email/IM archiving
• Voice communications

Participants will leave the event with the ability to answer tough questions like:
What is currently/ what will be required by law?
What are the industry best practices?
Where should we spend more?
What can we eliminate from the budget?

Moderated by:
Vinod Paul, Managing Director
Matthew Bretan, Senior Business Consultant

The Recap of the Luncheon:
Some of the more salient points from the presentation are as follows (a copy of the slide show is
available for download from the HFBOA website):
Overview of Eze Castle (Eze):

Eze gained 103 clients in 2009, of which approximately half were new accounts from existing
relationships, and the balance was new relationships. Approximately 25 client relationships were
terminated due to the underlying funds winding‐down, but net client growth represented approximately
20 clients. Eze has serviced approximately 2,500 start‐up clients globally since inception.
Headquartered in Boston, MA, there are 7 US offices, as well as London, Singapore (Feb. 2010) and
expectations of a Hong Kong office by the end of 2010. There are 20 employees working for Eze. Eze is
a privately held company, with over 550 Hedge Funds who rely on their services. 90% of their clientele
is from Hedge Funds, the remainder is from broker dealers, private equity/VC firms, and Fund of Funds.
The majority of their clients are Hedge Funds with between $150mm to $750mm.
Of particular interest was the statistic that 90% of their clients do not have internal technologists as part
of their staff.

Infrastructure Needs:
Eze described the need for IT as both an infrastructure risk mitigation tool as well as an opportunity to
enhance operational efficiency. The technology foundation of a firm needs to be designed to address a
firm’s current and future needs, as well as be consistent with the firms and markets economic
capabilities and climate.

The trading aspect of a firm can utilize technology to better access market data (real time market data
and analytics,) providing direct links for order executions and management, facilitating more robust and
active trading strategies, and provide pipelines to various networks, such as broker dealers, clients, etc.
An example would be tying in the front office activity with the back office via order management, trade
capture, portfolio accounting, risk, security master, and other systems. The security, redundancy, and
seamlessness of the systems working in concert and individually need to be addressed.
The IT infrastructure also needs to consider compliance issues and the applicable regulatory regime.
Both best practices and most regulatory requirements demand both Disaster Recovery and a Business
Continuity programs. Sometimes considered under the same umbrella, Disaster Recovery focuses on
accessing technology from locations other than the primary location, and Business Continuity focuses on
the distinct processes involved with the firm which starts with the various policies and procedures, as
well as the technology component associated with each. Institutional investors have been increasing
their focus on both these areas.

Additional compliance concerns, such as retention of (and access to) e‐mails, instant messaging, and
other forms of electronic communications and access to social networks can be addressed (and only
addressed) by the technology infrastructure, while remaining compliant with firm and regulatory
requirements.

Investor Relations is also a key component of the IT infrastructure. Properly capturing relationships,
facilitating periodic reporting to investors, and allowing for such data to be easily accessed and queried
are points to consider, as well as compatibility with other systems throughout the firm.
Trends include Cloud Computing and Hedge Fund Hotels

Cloud Computing is essentially a means to have applications and hardware utilized on a service or
consumption based term of usage through the internet via a provider, as opposed to needing all of the
the upfront investment, hardware, and expertise in‐house to manage the IT infrastructure. The speed at
which applications could be run can be greatly enhanced via the Cloud, as most functionality takes place
via the providers systems, not the local PC.

Hedge Fund Hotels are a more common IT solution for newer firms, whereby office space and
technology are hosted by the sponsor, with varying degrees of on‐site support and shared resources and
facilities.
Both Cloud Computing and Hedge Fund Hote

ls are possible solutions for smaller or less seasoned firms
to tap into robust IT infrastructure, without the sunk costs or in‐house expertise needed to fully support
the IT process.

Connectivity via microwave (roof top dishes) is another alternative to the more traditional T1 lines using
fiber optic cable. This technology (which was a significant part of the question and answer session)
mitigates the possible issues with cable such as telecom closet mishaps (installer or other tenants
cutting cables in risers), work on the ground beneath the street that could interrupt the cable network,
etc. Mitigating such risks could save time and money by negating the need to execute Disaster Recovery
or Business Continuity Plans. Speed and cost were deemed to be comparable to cable, with the major
limitations being Line of Sight requirements, and certain high intensity light interference issues.
When asked, Eze mentioned that their services have been paid by both managers and funds, although
this decision is made by their clients, which they do not offer guidance on.

In summary, there are common functions within each firm that are addressed and enhanced by the IT
infrastructure. These functions need to be designed and evaluated not only based upon needs for
today, but also with growth/contraction concerns and changes to the economy and regulatory
environment. Utilizing an out‐sourced vendor can assist asset managers with the proper design,
implementation, and maintenance of such systems and can help ensure business viability and
competitiveness from an IT and Due Diligence perspective.

By Dan Federmann

Securities Lending
The last bastion of manual intervention in an automated trading world

The HFBOA luncheon was hosted on Thursday January 14th by Hedge Source LLC and dealt with issues and opportunities available to fund managers with respect to securities borrowing and lending. The presentation was lead by Allen Wolkow, the CEO of Hedge Source along with Janah Angelou, the COO.

Our speaker covered challenges many funds face when it comes to securities lending, as well as, viable techniques to more efficiently manage your fund’s securities lending business. Download the full recap.