operational due diligence insights - corgentum consulting newsletter

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January 2013

Operational Due Diligence Insights

- Regulatory Focus: Can Operational

Due Diligence Prevent Exposure to

Hedge Fund Insider Trading?

- Business Continuity Corner: A Post-

Sandy Analysis of Hedge Fund BCP/DR

Planning?

- Private Equity: Will the Coming

Private Equity Data Storm Influence LP

Operational Due Diligence?

- IT Hub: Evaluating Hedge Fund

Technology Consultants

- Service Providers: Analyzing Fund

Legal Counsel - Does It Matter As

Long As It's Legal?

-Term of the Month: Audit Holdback

- Fraud Spotlight: The Preposterous

Fraud of Andrey C. Hicks and Locust

Offshore Management

- Accounting Spotlight: Interpreting

Fund Expense Disclosures

- On the Calendar

In This IssueWelcome to Our January

2013 Edition

Welcome to the January 2013 issue of Corgentum Consulting's Operational

Due Diligence Insights. This newsletter serves as a resource for news,

opinions and insights focused on issues related to operational risk and

operational due diligence on fund managers including hedge funds, private

equity funds, real estate and traditional managers.

Can Operational Due Diligence

Prevent Exposure to Hedge

Fund Insider Trading?

There has been much news recently with regards to high profile hedge fund

insider trading cases such as Raj Rajaratnam's Galleon. As there seems to be acontinuing strong interest from the government in prosecuting insider trading

investors may be increasingly asking themselves what they can do to minimize

or perhaps even completely reduce, their exposure to hedge funds that either

may be accused of insider trading, or even worse guilty of it.

Before we can answer this question however, it is first useful to make sure we

understand what is meant by insider trading. To boil it down to its most simple

form, insider trading relates to people utilizing so-called "insider" information

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Insider Trading - Continued from page 1...

which they either:

(i) misappropriated (i.e. - stole)

(ii) obtained by legal means, or even by

accident, but:

a) shouldn't have acted upon; or

b) had a duty to disclose it

Of course there are a number of nuanced complexities

when it comes to analyzing the actual insider trading

laws themselves. An example of this is whether the so-

called duty to disclose was pro-actively requested by

the person obtaining the information or instead was

imposed upon them. However, such legal intricacies are

of little use to investors seeking to evaluate the overall

potential for insider trading to occur.

One of the big problems with insider trading

prosecutions from an

investors and fund

managers perspective, is

that it is an area in which

any bright line rules that

may have existed are now

seemingly in flux. Recent

legal decisions have

seemingly increased thescope of the type of

information that is now

considered illegal to trade

upon.

Additionally, insider trading is inherently

counterintuitive in some regards to what hedge funds

are paid to do - conduct research and utilize this

research to make investments. Insider trading rules, it

can be argued, stymie the efforts of analysts to collect

this information. It stands to reason that a hedge fund

analyst may be able to devote more time to collectingresearch, and be more skilled at it, then let us say a

regular retail investor. Is this insider trading for the

hedge fund analyst to act on this better information?

Well the answer, the insider trading rules explain,

depends on a number of factors including whether the

information is so-called Material Nonpublic

Information, often referred to be the acronym MNPI,

and how the analyst obtained this information.

Following the Information Flow: a Four Step Process

This is all well and good, but investors generally do not

have the transparency or the ability to follow aroundthe analysts of the hedge funds to determine how they

are obtaining research. Therefore, the question could

be posed, what are investors supposed to do?

The answer lies in understanding the nature of the

control environment surrounding both the investment

research process, as well as a fund's ability to act on

research obtained. But, how should an investor go

about assessing this environment? Detailed operational

due diligence can provide a number of valuable insights

in this regards.

Step 1: Determine research sources

One area which an investor can

evaluate during the operational

due diligence process relates to

firstly understanding the ways in

which a hedge fund's analysts

conduct research. In particular,

what research sources do they

utilize? Do they primarily read

industry journals and go onBloomberg? What about attending

conferences? Do the analysts

perhaps meet with the

management of any particular companies? Do they talk

to analysts at other hedge funds? What about analysts

in particular sectors at other firms outside of the hedge

fund industry? Are third-party expert networks utilized?

Step 2: Evaluate research oversight

After an investor makes a determination as to whatresearch sources a hedge fund utilizes, the next step is

to determine what actions the fund is taking to monitor

such relationships. This oversight can come in a number

of different forms, but is primarily driven by the

compliance function. During the operational due

diligence process an investor can ask a number of

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January 2013 | 3

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different questions to make an assessment as whether

or not the compliance function is actively policing the

analyst research process or not. Examples of the types

of questions investors can ask in this regard include:

Third-party expert networks:

Has the compliance function vetted a firm's

relationship with third-party expert networks?

If so, what did this assessment entail?

Has the hedge fund communicated its policies

with regards to material nonpublic information

and insider trading to the third-party network?

If so, has the network agreed in writing to

comply with these policies?

If hedge fund research personnel would like to

utilize such a network, must pre-approval be

obtained from the compliance function first?

What research does the compliance function

perform before granting pre-approval?

Once approved, has compliance taken any

additional measures to ensure compliance with

the hedge fund's policies? (i.e. - such as readinga disclaimer before the call begins)

Additionally, do compliance personnel listen in

on calls?

Is a log kept of the use of such third-party

networks?

Research sources in general:

Does the hedge fund have any bans on speaking

to individuals who either work at publiccompanies or have recently worked at such

companies? If so, what are the details of this

ban? How is it monitored and implemented?

Are any conflict checks performed to make sure

that a hedge fund analyst is not discussing a

company with someone with whom the hedge

fund may have already been conflicted out of

(i.e.- passing along tips)?

Are there sufficient prohibitions or limits on the

way gifts are given, and received, in order to

prevent any potential conflicts or bribery with

regards to information sharing?

Step 3: Evaluate trading oversight

It is worth noting at this point that just because a hedge

fund may come into possession of so-called material

nonpublic information, they are not necessarily guilty of

anything if they do not act on it.

This is where an analysis of the oversight of a hedge

fund trading procedures comes into play. After a hedge

fund has done its research and makes a determination

that it would like to trade in a certain security, investors

must determine what oversight is in place. One

common way hedge funds seek to prevent trading on

securities on which they may possess material

nonpublic information about is via a so-called restricted

list. In general, securities on the restricted list cannot be

traded by the firm. However, not all restricted lists are

created equal, and not all hedge funds maintain

restricted lists. In addition to determining whether or

not such a restricted list is actually in place, investors

can ask a number of questions to determine the

oversight and effectiveness of such lists including:

How are securities put on the list? Is there setcriteria or does one person make the

determination in their discretion?

If a security is placed on the restricted list, is

trading activity suspended for a certain pre-

defined period? (i.e. - 30 days)

How do securities come off of the restricted

list?

Who maintains the restricted list?

How often is it updated?

How is the list shared throughout the firm?







Are names of securities contained in the

restricted list hard-coded into any trading

systems or instead is it up to employees to

monitor the list?

Are employees allowed to trade in names of the

restricted list for their own personal securities

accounts?

Step 4: Is oversight provable and tested?

After taking measures to evaluate any internal hedge

fund oversight on the way in which a hedge fund

collects research and then trades on that data, are

investors finished?

The best compliance policy in the world is meaningless

unless it is a living policy. Investors

should take measures to ensure that

not only does a hedge fund have

such research and trading oversight

in place, but can demonstrate the

oversight. For example, if pre-

approvals are required before a

hedge fund analyst speaks to a third-

party expert network can the fund

produce an example of such a pre-approval form?

Similarly, it is important for hedge funds to back test

such policies. So for example, assume that a hedge fund

maintains a restricted list. Does the hedge fund

manager's compliance department perform random

back test audits of fund trading to check that no trading

in restricted names occurred?

So what does this all mean?

Returning to our original question, "Can OperationalDue Diligence Prevent Exposure to Hedge Fund Insider

Trading?" the short answer is - no. Hedge funds, like all

organizations are evolving entities. Employees come

and go. New funds are launched and closed. Revised

computer systems are put in place and old ones are

phased out. With these constant changes, it is

impossible to unequivocally state that due diligence,

operational or otherwise, can completely prevent

exposure to hedge fund with insider trading issues.

That being said, investors that conduct due diligence to

understand the ways in which research is conducted,

how trades are executed, and the internal oversight of

such processes will be more informed about the risks

involved . As with all operational due diligence,investors that dive deeper will be making more

informed investment decisions. Additionally, a hedge

fund with robust oversight of the research and trading

process will likely have a much lower likelihood of being

placed into situations where insider trading could be

alleged.

Conclusion:

In conclusion, investors that take the time to ask

questions and evaluate research and trading oversight

during the operational due diligence process are likely

to have more conviction that their hedge funds won't

be accused of insider trading - that is as long as

the hedge funds continue to follow these

policies.

A Post-Sandy

Analysis of Hedge

Fund BCP/DRPlanning

US based hedge funds recently faced a large scale real

world test of their business continuity and disaster

recovery plans in the form of a super storm named

Sandy. Hurricane Sandy represented a large

unprecedented weather event that caused flooding and

devastation throughout the eastern coast of the United

States including the major hedge fund centers of NewYork and Connecticut.

Some of the challenges faced by people and businesses,

including hedge funds, affected by the storm included

sustained power outages, inability to access office

buildings and office flooding.




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Business Continuity- Continued from page 4...

According to a recent Corgentum survey, 74% of

investors felt that their hedge fund was adequately

prepared to continue operational during hurricane

Sandy. In order to confirm these beliefs when a wide

scale storm or other BCP/DR event which may affect a

hedge fund occurs, investors should seize the

opportunity to vet the real-world effectiveness of their

hedge funds plans during the storm.

Some questions investors may want to ask regarding a

hedge funds reaction to the storm included:

At what point was the decision made to activate

the firm's business continuity and disaster

recovery plans? - If the plan was activated too

late perhaps it was either diminished ineffectiveness, or represented a failing of the

firm's judgment in having qualified personnel

making the decision whether or not to activate

BCP/DR plan

Were employees able to communicate with

each other during the storm?

If alternative off-site third-party locations were

part of a hedge fund's plans, did they perform

as expected?

If equipment was destroyed during the storm,

will it be covered by the hedge fund's insurance

policies? Is backup equipment available in the

interim?

What parts of the BCP/DR plan worked correctly

during the storm?

What plan problems or weaknesses came about

during the storm?

Is the hedge fund implementing any changes to

the plan based on lessons learned from the

storm?

Investors should ask such questions both of the hedge

funds with which they maintain existing investments as

well as with prospective firm's they may evaluate in the

future. Digging into the details of real-world activations

of BCP/DR plans can provide investors with valuable

insights of how effectively a hedge fund’s best laid plans

may hold up in a storm.

Will the Coming

Private Equity Data

Storm Influence LP

Operational Due

Diligence?

Private equity General Partners ("GPs") are under

increasing pressure to provide more transparency than

ever before. This transparency is not limited to any one

area (i.e. - investment performance or fund accounting

procedures).

Further complicating the problem is that these

requests, or in some cases demands, for additional data

come from multiple sources, the two primary onesbeing Limited Partners ("LPs") and regulators.

Turning to regulators first, there have been a number of

recent regulatory changes that will require most private

equity GPs to report to regulators more detailed

information than ever before. A recent example of this

is Form PF filings required by the US Securities and

Exchange Commission. Under these rules, which

targeted not only private equity firms but also a wide

variety of fund managers including hedge funds, GPs

were required to make a number of disclosures

including:

Reporting data related to the indebtedness of

portfolio companies a private equity fund may

control. This data includes revealing the identity

of the lenders of any bridge loans as well as

debt -to-equity ratios.






Private Equity - Continued from page 5...

Detailed portfolio analysis including geographic

and industry level breakouts

Detailed information concerning leverage, fund

borrowings and creditors

The enhanced US regulatory disclosure requirements

are not anomalous, and the European Union has also

followed suit in the form of the Alternative Investment

Fund Managers Directive ("AIFMD"). The original

version of AIFMD was adopted by the European

Parliament on November 11, 2010 and has since been

followed by AIFMD level 2, which was implemented on

December 12, 2012. Although the final text of the law is

still under review, AIFMD level 2 imposes a number of

additional guidelines and stricter reportingrequirements on fund managers (which in AIFMD terms

are referred to as Alternative Investment Funds or AIF's)

which includes private equity firms. Examples of these

new rules include:

Operating conditions for AIFMs, including rules

on remuneration, conflicts of interest, risk

management, liquidity management,

investment in securitization positions,

organizational requirements, and rules on

valuation

Rules on depositaries, including the depositary's

tasks and liability

Enhanced Reporting requirements and leverage

calculation

LPs have been quietly watching passage of these

additional regulations and reporting requirements. Now

that GPs have devoted all the time and resources to

analyzing, preparing and providing information to

regulators, LPs are increasingly asking GPs to share this

information with them as well.

Most GPs have predictably raised a number of

objections to sharing this data. For example, in the US

many GPs cite the fact that there is no legal

requirement for GPs to share the new Form PF filings

with LPs. Of course, it is not illegal for GPs to share

these filings with investors, however, some GPs utilize

this lack of legal obligation to do so as a shield to deflect

further LP inquiry in this regard.

Other GPs raise concerns that the data such as the

calculation of what is known as Form PF's Regulatory

Asset Under Management, commonly referred to as

RAUM, is either of no use to investors or that they willmisconstrue the information. For example, a GP may

point out that RAUM may be misleading to some

investors because it includes unfunded LP commitments

in its calculation whereas a typical AUM figure generally

does not.

The jury is still out on whether such GP concerns are

well founded, however, one thing is clear - LPs should

not let GPs dictate what information they should or

should not be interested in during the operational due

diligence process.

That being said, the GP’s objection does raise a valid

question - Are LPs equipped and prepared to evaluate

the data from increased GP transparency?

Whether this new data comes in the form of regulatory

filings or other sources LPs must consider:

Reviewing additional data requires the

allocation of more internal due diligence

resources

With the benefits of additional GP transparencylikely comes an elongated due diligence process

Specialized skill sets, which the LP may not

currently have internally, may be required to

fully evaluate additional GP information

LPs may benefit from engaging in dialogues with GPs to

not only negotiate the receipt of additional due

diligence data such as regulatory filings, but also to

provide a guide in understanding such documentation.

LPs however, run a very real risk of becoming too relianton GPs for such guidance and overlooking key

operational risk areas in the process.

Although enhanced transparency may seem to be

intuitively better for LPs, it also presents a number of




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Private Equity - Continued from page 6...

increased data analysis and resource management

challenges which should be planned for. Without such

preparation them find themselves awash in a sea of

data that they are unsure how to navigate.

Evaluating Hedge

Fund Technology

Consultants

It is common for many hedge fund managers, especially

smaller ones, to leverage off of external information

technology consultants. These consultants come in

many different forms and can provide a wide array of

services for fund managers. In general, common

services provided by information

technology consultants can

include:

Help desk support

Software development and

support

Hardware maintenance

New software or hardware vendor and package

selection

Implementation of new systems or hardware

Business continuity and disaster recovery

program design, testing and maintenance

During the operational due diligence process, investors

may sometimes find it difficult to obtain a straight

answer from their hedge fund managers with regards to

the work of these information technology consultants.

Perhaps it is because certain fund managers want to

emphasize the arguably more important role played by

dedicated in-house information technology personnel

(be they dedicated or shared) while minimizing the

external resources. Additionally, many hedge funds may

utilize certain consultants on an ad-hoc or as needed

basis and therefore, perhaps don't feel highlighting such

relationships matters much to investors performing

operational due diligence.

Investors should not be discouraged however, andshould take measures to evaluate the role of

information technology consultants. A good starting

point is speaking directly with the hedge fund managers

about the use of such consultants.

Learning what consultants do:

There are diagnostic benefits to such third-party

provider due diligence. By inquiring about these third-

party firms, investors will likely learn about the duties

performed by different information technology

consultants. The answers to these questions can

provide valuable insights into a number of different

areas including:

Where a hedge fund may be weaker internally

from a technology perspective and feels the

need to augment these deficiencies

with external resources?

Has there been turnover

among information technology

consultants in a particular function? If

so, why?

If the hedge fund utilizes a

consulting firm, as opposed to an

individual freelancer, what personnel from the

IT consultant are actually doing the work?

How often are the IT consultants in the offices

of the hedge fund manager? If not frequently,

do they access the firm's systems remotely?

Does the hedge fund control information access? After an investor has obtained a detailed understanding

of what a third-party information technology consultant

may actually do for a hedge fund, investors should next

inquire as to how the hedge fund controls the third-

party's access to, and use of fund data. Some questions






Technology - Continued from page 7...

investors may want to consider asking in this regards

may include:

Has the hedge fund taken policy based

measures to ensure IT consultants understand

keep information confidential? (i.e. - signing a

confidentiality agreement)

Are technological measures in place to limit the

IT consultants’ access to certain information?

Or does the hedge fund trust the IT consultant

blindly?

How does the hedge fund oversee the

implementation of any data security measures

either agreed to with the IT consultant or inplace from a technology perspective? (i.e.- is

there any testing of such controls?)

Why Due Diligence on IT Consultants Matters?

Hedge funds are information based organizations.

Technology supports the way in which a fund organizes,

utilizes and trades upon this information. When a hedge

fund effectively opens up its doors to a third-party firm

to assist in managing or improving upon this technology

investors should take notice. By incorporating ananalysis of the role of third-party information

technology consultants into the larger operational due

diligence process investors may learn new pieces of

information, which can provide valuable insights into

their overall assessment of a hedge fund's information

technology function.

Analyzing Fund Legal

Counsel - Does It

Matter As Long As It'sLegal?

When evaluating service providers during the

operational due diligence process, many investors may

tend to focus their initial efforts around certain specific

service provider functions. The short list of the common

cast of characters includes fund administrators, auditors

and counterparties. Other service providers may

unfortunately receive less attention.

Perhaps this is because of the perceived importance of

the roles performed by different providers. For

example, investors may feel, and rightly so, that

valuation is a key issue for hedge funds. Therefore,

understanding the role played by the service providers

related to valuation oversight such as the fund

administrator, may receive more attention at the

expense of the analysis of other service providers.

Another motivation for many investors in clustering

their service provider evaluations around a limited

subset of all a hedge fund's service providers, is the

notion of a risk based approach. Continuing ourvaluation example above, many investors view

valuation as not only a highly important issue for hedge

funds, but also one that is fraught with potential risk as

well. That is to say, there would be direct negative

implications for investors if a hedge fund began playing

games with fund valuations.

Such a risk may be compared to, for example, the risks

associated with a hedge fund utilizing a slightly less than

cutting edge piece of hardware for data storage. When

framed against valuation concerns, investors may feelthat the valuation risks outweigh the technology

concerns. For some investors this tradeoff

unfortunately results in a lesser degree of analysis on

third-party information technology service providers

that may have participated in assisting the hedge fund

in overseeing its hardware management.




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Legal Counsel - Continued from page 8...

Often this service provider clustering effect also

influences the ways in which certain investors overlook

the role played by a hedge fund's legal counsel. During

the operational due diligence process, some investors

may simply check to see if a hedge fund is working with

a large, well-known law firm. Other investors may go

further and attempt to confirm the relationship with

the legal counselors, but may be unsure what other

items they should evaluate.

The role played by a law firm working for a hedge fund

is not cookie cutter in nature. As could be said with all

service providers - they are

not created equal. This is

particularly true when it

comes to fund legal counsel.A number of differences may

exist with regards to not only

the quality of work they

perform for the hedge fund,

but the type of areas they

cover. As with all hedge fund

service providers, investors

would be well served to

capitalize on the opportunity to vet the role played by a

hedge fund's legal counsel during the initial due

diligence process.

For starters, investors should endeavor to cover what

could be considered the nuts and bolts of the

relationship with a law firm by attempting to

understanding answers to questions including:

What is the hourly billing rate charged to the

hedge fund?

Is a blended rate charged or instead does the

rate vary by the experience of the law firm

employee (including non-attorneys) performing

the work?

Are any hourly billing rate or fee caps in place?

Is the hedge fund notified if fee caps are being

approached?

Are flat fees charged for any projects?

Does the law firm have any particular expertise

that may be applicable to the hedge fund? (i.e. -

jurisdictional expertise, or experience in

performing legal work related to certain

investment products)

This above list is of course not comprehensive, but is

intended as a guide with which an investor could start a

conversation with a law firm in order to gauge certain

basic issues regarding its relationship with the hedge

fund. Beyond the basics, an investor could inquire

further into a number of different topics in an attempt

to understand the extent of the law firm's work with the

hedge fund. Examples of some items

an investor could cover may include:

Does the law firm provide

any compliance related services to

the hedge fund?

If the hedge fund works with

a separate compliance consultant,

does the law firm interact with them?

Has there been any personnel turnover among

the key individuals servicing the hedge fund's

account?

Can the law firm provide an example of a recent

matter on which it has worked for the funds?

If the funds or hedge fund management

company was (or currently is) involved in any

litigation, can the law firm walk the investor

through the litigation (and any outcomes)?

Does the law firm interact with any other law

firm's used by the hedge fund?

Can the law firm provide a summary of the

routine legal tasks performed for the firm?

Additionally, other more broad questions could be

asked of the law firm to gain an understanding of how

much they interact with, and understand, the hedge






Legal Counsel - Continued from page 9...

fund's business. Examples of these questions may

include:

Does the law firm generally understand the

hedge funds investment strategy?

If there have been any material developments

that have occurred at the hedge fund, is the law

firm aware of them?

Who at the hedge fund does the law firm

primarily deal with?

Has the scope of the work the hedge fund has

given the law firm increased or decreased over

the past two years? If so, why?

A law firm can play an important role in supporting the

successful overall operational management of a hedge

fund. In particular, in light of the increasingly complex

regulatory and legal environment, investors should be

cautious not to minimize the due diligence they perform

on third-party service providers such as law firms. By

delving into the details of such third-party relationships

investors will likely be surprised at the useful insights

they may learn.

Understanding Fund

Terms: Audit Holdback

Operational due diligence is a multidisciplinary subject.

An investor beginning the operational due diligence

process for the first time may encounter subjects with

which they have little to no familiarity. As the scope of

operational due diligence has become broadened inrecent years, even seasoned operational due diligence

professionals may encounter terms which they may be

unfamiliar. The purpose of this section of Operational

Due Diligence Insights is to cast a spotlight on some of

the words and terms which investors may have not

previously encountered, or which tend to get

overlooked in operational due diligence reviews.

This issue's word:

Audit Holdback

Defined:

An audit holdback refers to the amount that a hedgefund manager may hold on to when paying out a

redemption request to account for any variations that

may take place after a fund's audit is finalized.

What investors should know:

Investors frequently tend to ignore the concept of audit

holdbacks when submitting redemption requests only

to realize that a portion of their capital is effectively

stuck at the fund. Depending on the timing of an

investors redemption request audit holdbacks can allow

a hedge fund manager to generally hold onto capital for

a period of up to one year (i.e. - between fund audit

years).

Do not fall into this trap. It is important to evaluate

audit holdback percentages during the initial

operational due diligence process. Audit holdback

percentages are typically disclosed in a hedge fund's

offering memorandum as well as in the fund's audited

financial statements. There is no universal standard for

audit holdbacks but they generally range around the

10% level. Additionally, the timing with which hedgefund managers actually release investor funds after the

audit is released is not universal either and may range

over a period of a few days (i.e. - 10) to up to 90 or

more. Even worse, some managers may not even

specify this post-audit payout time period in their

offering documents. Investors that take measures to

evaluate the audit holdback amount and payout period

will likely find themselves being able to better manage

redemption pipelines. They will also be less surprised

when payouts are initially less than the full amount of

the redemption request.



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Fraud

Spotlight:

ThePreposterous Fraud of

Andrey C. Hicks and

Locust Offshore

Management

A man claiming to run a high profile hedge fund recently

pleaded guilty to stealing approximately $2.3 million

from investors. The plea came at the end of 2012 and

slipped off many people's radar, however, the

preposterousness of the case is worth revisiting.

In October 2012, the SEC charged Andrey C. Hicks and

his firm Locust Offshore Management with employing a

fraudulent scheme to dupe investors into investing in a

purported British Virgin Islands fund called the Locust

Offshore Fund, Ltd. The problem, the SEC alleged, was

that there was never any such fund. Furthermore, theSEC complaint alleged that, "Hicks has transferred

substantially all of the investors' funds to bank accounts

in his personal name and, on information and belief, for

his personal use."

Mr. Hicks claims about his firm were so outlandish that

it was reported he stated to prospective investors to

have grown "assets under management from $100M

USD to nearly $1B USD in six (6) months through capital

raising and high returns."

To provide some additional perspective on the

outlandishness of this case, here is partial description of

what Mr. Hicks claimed his firm was doing:

Locust Offshore Management, L.L.C. develops and

executes sophisticated quantitative strategies across

asset classes to produce absolute, risk-adjusted returns

with high alpha. The firm's quantitative strategies are

based on mathematical models developed by the fund's

manager, Andrey C. Hicks, during his tenure at Harvard

University and are executed by computer software.

Human involvement in the strategy life cycle is limited to

model and code development and refactoring. The firm

is primarily engaged in the U.S. equity markets and adheres to a market-neutral, risk-averse trading

philosophy.

Some of the more interesting things alleged by the SEC

include that Mr. Hicks:

Lied about his education - he claimed to have

obtained undergraduate in biochemistry (for

with a 4.0 grade point average) as well as a

graduate degree from Harvard. Mr. Hicks wasn't

satisfied claiming just any graduate degree such

as an MBA. Instead, he claimed to have

obtained a PhD in Applied Math in just two

years. According to the SEC, Mr. Hicks was

indeed enrolled at Harvard as an undergraduate

but was forced by the university to withdraw on

two separate occasions and he never

graduated.

Lied about his employment background - he

claimed to have not only worked at Barclay's

Capital (which was a lie) but that, "he grew his

book nearly two-fold and expanded his group’s

assets under management to roughly $16

[billion]" (which was also a lie)

Lied about the fund's auditor - he claimed Ernst

& Young served as the fund's auditor, they

didn't (besides there was never any fund to

audit)

Lied about the fund's prime broker and

custodian - he claimed that the fund had a

relationship with Credit Suisse - it didn't

Opened business a checking and savings

accounts for the firm and funds with the intent

to defraud investors






Fraud - Continued from page 11...

Created and maintained a website for the non-

existent firm and fund

Created fake offering documents for the fund

Created fake business cards, stationery and

email signature blocks describing Mr. Hicks as a

Locust's principal and the fund's director.

Unfortunately for Mr. Hicks, the SEC allegations were

true. Despite all these red flags, Mr. Hicks did attract

investors in the fund including celebrity basketball

player Kris Humphries.

He was eventually arrested while attempting to flee in

Switzerland. He has since pled guilty to five counts of

wire fraud and is scheduled to be sentenced on March

6, 2013. He faces up to five years in prison.

Interpreting Fund

Expense Disclosures

During the operational due diligence process one of the

core documents collected and analyzed by investors area hedge fund's audited financial statements. A key area

of focus for many investors in conducting an analysis of

these audited financials, is the analysis of fund level

expenses. Within the audits themselves, Investors are

generally provided with some guidance through a series

of expense related disclosures. But do these disclosures

add any real value to investors in analyzing fund

expenses? Additionally, what should investors goals be

in analyzing fund expenses?

Legitimate vs. Illegitimate Expenses

For risk assessment purposes within the context of

operational due diligence review, many investors would

most likely agree that in general fund expenses can be

grouped into two categories. The first category could be

so called legitimate expenses. That is to say, those

expenses that occur as part of the course of a hedge

fund's normal business and trading activities. These

expenses could include both investment or trading

related expenses such as interest and dividend expense

and stock loan fees.

Other expenses that many investors would perhaps

place in the, "legitimate" bucket would include

performance and management fees. Fees for items for

operational or non-investment related purposes such asfees paid to members of the Board of Directors, audit

and legal expenses could also be placed in the

legitimate bucket with little investor argument.

The second category of expenses investors tend to look

for could be called illegitimate expenses. These are

effectively the polar opposite of legitimate expenses,

and as the name implies, would not be items investors

expect to be charged to the fund during the normal

course of business. These could be items such as lavish

expenses for fund raising (i.e. - paying for the fund

manager to travel to a sales meeting in a private plane)

or the salary of any individual employee being charged

directly to a fund. During the operational due diligence

process investors that come across any of these

illegitimate expenses should certainly raise a red flag

and inquire further as to why such expenses are being

charged to the fund.

Beyond this fairly basic legitimate versus illegitimate

framework, investors face more complex additional

challenges in reviewing fund level expenses.

Evaluating Gray Area Expenses

As noted above, it may be easy for investors to classify

expenses at either end of the spectrum as being

legitimate or illegitimate. However, the classification of

expenses may become less clear when investors start to

dive into the details. It is with regards to these gray area

expenses that more comprehensive expense analysis is

often required.

For example, consider a hedge fund manager thatinvests in the distressed debt of companies. As part of

their research process, the fund manager sends analysts

to visit with the management of the target companies

in which it is considering purchasing debt. Most

investors would likely agree that such research trips are

not lavish or excessive but rather part of the hedge fund




January 2013 | 13

www.Corgentum.com

Fund Expenses - Continued from page 12...

manager’s standard operating procedure. Where

investors may differ in their opinions is whether the

expense of such research trips should be charged

directly to the funds themselves, or rather if the

expense for such trips should sit at the management

company level.

There are many other examples of areas where

investors, and fund managers, may disagree as the

appropriateness of allocating all or a portion of an

expense to the funds versus the management company.

Additional examples of these types of expenses may

include the allocation of a hedge fund's office rent

expense and expenses related to acquiring and

maintaining the information technology function

including hardware which may be used to execute thefunds trading strategies.

Regardless of which side

of the argument a

particular investor lands

on, from a due diligence

perspective it is

important that that

investors have

transparency with

regards to suchexpenses. Additionally,

investors should seek to

evaluate the consistency

of a hedge fund

manager’s approach in allocating such expenses. Said

another way, it is up to investors to understand what a

particular hedge funds rules of the expense allocation

game are before they can evaluate if a manager is

following them.

Figuring Out The Expense Allocation Rules

Where is an investors supposed to figure out what the

hedge fund's policy is with regards to allocating such

expenses? Well, a hedge fund's offering memorandum

might be a good start. The offering memorandum often

contains valuable information about not only what

expenses are anticipated to be charged to the fund,

(i.e. - legitimate versus illegitimate) but also the way in

which they will be allocated.

It is worth noting here the importance of incorporating

documents other than the audited financial statements

into the overall expense analysis process. Although, it

could be classified as a legal document, as compared toa purely accounting related document such as the

audits, investors should not be hesitant to seek out

information from other sources to guide their analysis.

This produces a more comprehensive well rounded

review, which runs less of a risk of ignoring key risk

areas simply because they may be interdisciplinary in

nature.

Returning to our discussion of expense allocation rules,

in addition to the offering memorandum, another

source of good source of information may be the

audited financial statements themselves. Often times

the Statement of Operations, also known as the Income

Statement, will provide valuable

information about the detail of

total fund level expenses. The

problem however, is that the

figures presented in these

statements are often in summary

format. For example, the

statements may indicate that

interest and dividends expense

was $100. It would arguably bemore useful for investors to know

more detail. So something like, the

interest expense was $30 and the

dividend expense was $70.

Another problem investors often encounter relates to

so-called rollup categories of expenses. These are

groups of expenses that are bundled together into a

single line-item. An example of such an expense

category would be "Professional fees and other." Under

US GAAP there is no universal rule as to what exactlyshould be lumped into such a category. Furthermore,

there is not even a general agreement among hedge

funds or investors as to what exactly may go into such a

category. Typically, an expense category such as this

would contain items such as Board of Director’s fees

and legal fees, however, investors should






not make any such assumptions. A hedge fund manager

could just as likely use such a broad category to bundle

gray area expenses which if brought to the attention of

some investors may raise questions.

Are investors left with any options when faced with

such rollup categories? One resource investors shouldconsider when faced with such issues are the notes

accompanying the financial statements. These notes

can sometimes provide additional clarification as to

what is included in rollup expense categories. Although

there are some general guidelines under US GAAP with

regards to minimum mandatory disclosures, once again

there is no universal requirement to provide such detail

in all cases.

Furthermore, a hedge fund's auditor is not generally

incentivized from either a financial or liability

perspective to write detailed clear disclosures. In this

case, investors should then not be afraid to approach

the fund manager directly and inquire as to what

actually goes into each category. This will provide

investors with more transparency to judge whether

allocation rules are being followed. Additionally,

investors engaging in such discussions with managers

may be surprised to learn about how much discretion a

fund manager may have in making determinations as to

how expenses are allocated.

One of the goals during expense analysis therefore,should be not only to diagnose the way in which a

hedge fund allocates expenses, but also to oversee that

discretionary choices by the manager are equitable to

all investors and in the best interest of the particular

fund vehicle in question. By engaging with fund

managers to conduct such reviews investors may find

their review of the fund expenses and disclosures may

bear fruit in other parts of the overall due diligence

process as well.



January 2013 | 15

www.Corgentum.com

About Corgentum Consulting

Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of

fund managers.

We work with investors including fund of funds, pensions, endowments, banks and family offices to

conduct the industry's most comprehensive operational due diligence reviews. Our work covers all fund

managers and strategies globally including hedge funds, private equity, real estate funds and traditional

funds. Our sole focus on operational due diligence, veteran experience, innovative original research and

fundamental bottom up approach to due diligence allows us to ensure that our clients avoid

unnecessary operational risks. More information is available at www.Corgentum.com or follow us on

Twitter @Corgentum.

Email: [email protected]

Main Tel. 201-918-520

On the Calendar

Please see below for a list of upcoming operational risk items of note and events:

Investment Education Symposium (New Orleans, LA) February 6-8, 2013. Corgentum to moderate Investing in Alternatives panel

Presented by Opal Financial Group

Investment Consultants Forum (New York, NY)March 4, 2013. Corgentum to moderate Manager Selection Process panel

Presented by Opal Financial Group

GAIM Ops Cayman (Grand Cayman, Cayman Islands)April 21-24, 2013. Corgentum 's Jason Scharfman to conduct pre-conference Private Equity Operational Du

Diligence workshop

Presented by IIR USA.

http://www.corgentum.com/



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