As the CFO and co-Head of Operational Due Diligence at Protégé Partners, a multi-billion dollar Fund of Funds complex that focuses on investing with and seeding smaller specialized managers, I often find myself on both sides of the operational due diligence table. I am frequently walking through our infrastructure and control environment with large institutional prospective investors, benefiting from the various perspectives that such institutions offer through their reviews based upon their unique geographical presence, investor base or corporate philosophy. On the other side of the table, I get the chance to turn my hat around and play grand inquisitor, questioning my existing or potential managers regarding their operational process and procedures.
What I have found is that most reviews comprise a balance of both qualitative and quantitative measures. When you strip out the investment performance from the review process, the pure operational due diligence review tends to be more qualitative. For example, knowing a Hedge Fund has reputable service providers, ensuring maximum independence throughout the valuation and verification process; and having enough direct knowledge about those service providers (i.e., not relying on the manager) is more valuable to me than a scoring mechanism that attributes points to numerous categories of operational criteria.
I was recently interviewed by Susan Trammell who is writing an article for CFA Magazine "Can Hedge Fund Operational Risk be Quantified?" (expected publication September 2010) and I found myself sticking to the qualitative aspect of a due diligence review. Practical experience is extremely valuable; and having been on both sides of the table, you can balance practical risks versus hypothetical risks-- piercing through perception issues and surface level procedures that don’t have the depth to accomplish what is ultimately desired.
While there certainly is no single approach to Operational Due Diligence that can be championed above all others, one must consider the uniqueness of each Hedge Fund that is being reviewed and allow for non-systematic evaluation to take place. A simple example of this is that the mere existence of an administrator is not necessarily a box that can be checked off satisfactorily for independence of NAV calculation. The administrator should be reviewing properly authorized instructions from the manager, reconciling independently to the street and independently gathering valuation data from recognized pricing organizations or sources. NAV light (fortunately a dying concept) gives the facade of independence and segregation of duties through an administrator, but in reality the manager themselves is still ultimately providing the inputs into the NAV calculation process. Another example would be reliance on SAS 70 certified administrators or other service providers. One must not just check a box and assign a score if a SAS 70 exists. The appropriate questions should include: "Does the SAS 70 contain all the controls that you believe should be adhered to?", "Is your target Hedge Fund excluded from the SAS 70 testing?" and "Does your target Hedge Fund have bespoke procedures or processes that are covered through a typical SAS 70 review?". While the initial questions are all necessary, simply checking a box and creating a quantitative measurement score does not necessarily give you any further practical comfort. A thorough Operational Due Diligence approach should always embrace old fashioned elbow grease, flexibility to work outside of a checklist, and the ability to customize your review and approach as necessary.
Despite the depth of tactics needed for successful Operational Due Diligence approaches; there are some simple scoring techniques that can be employed that will raise red flags. Implementing these techniques will provide both the investment and operational due diligence teams with additional data points for further focus and scrutiny. One such measurement is known as the Bias Ratio, invented by my partner Adil Abdulali of Protégé Partners (white paper and related articles attached for your reference).
The Bias Ratio is designed to detect the presence of return smoothing or subjective pricing policies for a Hedge Fund. This ratio measures the shape of return histograms around the critical area surrounding zero percent return. Managers with hard to value securities or securities valued predominantly by use of broker quotes could deviate from a systematic valuation procedure when faced with a slightly negative return. For example, discarding a third broker quote because it appears to be an outlier could bring a monthly fund return from (0.5%) up to 0.0% or even a slightly positive return. Some of the biggest hedge fund frauds have started with simple or minor cover ups such as return smoothing.
The Bias Ratio is then measured against a peer group to determine if the critical area of returns is in line with their peers. Any outliers are identified as potential candidates for return smoothing (which may be tantamount to fraud) or perhaps the existence of difficult or hard to value securities (of which a prospective or current investor may not have known the manager invested ). I particularly like this tool as it allows me to dig deeper into a manager’s valuation process and bring to bear my qualitative approach by using a fairly transparent quantitative measurement to prove why I need to look further.
What I like most about this technique is that it can be applied to any particular style of due diligence. It is not intended to replace an existing process and can be used effectively by due diligence teams of varying expertise levels. Even now however, despite changing their due diligence techniques, some of our peers (who may still feel the cold ripples of the Madoff fraud) are not using the Bias Ratio as much as they should. The attached article by Riskdata shows how the Madoff fraud would have been identified (i.e., a red flag would have appeared signaling the need for further due diligence).
While debate will continue amongst the quantitative analysts and the qualitative practitioners regarding the optimal due diligence approach, there are simple tools that already exist, such as the Bias Ratio, that respect the approach of both camps and can be layered into the due diligence process.
Dan Federmann, CPA, CFA
Managing Director & Chief Financial Officer
Protégé Partners, LLC
Links to white paper and articles:
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