exhibit 85 - bernard l. madoff investment securities llc ... · investor funds, unauthorized...
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Exhibit 85
Exhibit 86
Exhibit 87
Exhibit 88
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
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 3 of 13 31-May-2005
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.
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 4 of 13 31-May-2005
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.
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 5 of 13 31-May-2005
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%
Distribution of Fund Failures
Investment Risk Only
38%
Operational Risk Only
50%
Business Risk Only6%
Multiple Risks6%
Investment Risk Only
38%
Operational Risk Only
50%
Business Risk Only6%
Multiple Risks6%
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 6 of 13 31-May-2005
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
Misappropriation of Funds
Inadequate Resources
Unauthorized Trading
41%
30%
14%6%9% Other
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 7 of 13 31-May-2005
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
Misappropriation of Funds
7%Misrepresentation
of Investments18%
Unauthorized Trading
5%
Other14%
Combination of Operational
Issues49%
InadequateResources
7%
Investment Risk Only
38%
Operational Risk Only
50%
Business Risk Only6%
Multiple Risks6%
Distribution of Fund Failures
Breakdown of Fund Failures by Operational Issue
Misappropriation of Funds
7%Misrepresentation
of Investments18%
Unauthorized Trading
5%
Other14%
Combination of Operational
Issues49%
InadequateResources
7%
Investment Risk Only
38%
Operational Risk Only
50%
Business Risk Only6%
Multiple Risks6%
Distribution of Fund Failures
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
Total Estimated Loss/Redemption : 500+ Million USD
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
Total Estimated Loss : 40+ Million USD
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
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
Total Estimated Loss/Redemption : 500+ Million USD
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
Total Estimated Loss : 40+ Million USD
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
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 8 of 13 31-May-2005
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%
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 9 of 13 31-May-2005
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
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 10 of 13 31-May-2005
• 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.
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 11 of 13 31-May-2005
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
Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper 12 of 13 31-May-2005
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
Valuation issues and operational risk in hedge funds
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
Valuation issues and operational risk in hedge funds
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
Valuation issues and operational risk in hedge funds
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%
Valuation issues and operational risk in hedge funds
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.
Valuation issues and operational risk in hedge funds
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
Valuation issues and operational risk in hedge funds
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