%img src=http://96.125.163.6/

conrad/wp-content/uploads/2012/07/fivi238590881.jpg /% Originally published by Complinet, Inc., www.complinet.com. the leading provider of compliance intelligence for the financial services industry.

Nov 30 2009 Sara Grillo and Donald Conrad of Conrad Capital Management recommended

When conducting operational due diligence, look at the business from a technical and subjective lens. Essentially, you are handing over your clients trust to these funds and their vendors. Do not look at the mechanics of the processes only. Due diligence should never be taken at face value. Look at the fund from all perspectives. What types of clients they are to their vendors, who they are as people, what is the culture and level of integrity of the overall organization, and what are the possible changes to their business model?

Potential red flags include:

1. room door did not unlock itself: somebody at the company left it unlocked. Just inspecting the mechanics of an operation is not enough, because processes can change rapidly. You should look at the level of competence and integrity of the people handling the day-to-day tasks, and consider how their performance would be altered under pressure. People are a commonly overlooked facet of the evaluation. Ask yourself: How likely is it that every employee here is following the rules that the company sets, to the letter of the law? Assign a probability before the visit, and then reassess this probability afterward.

2. financial statements and tax returns, for example, should be staple items readily on hand. If these documents are not able to be furnished within 24 to 48 hours of request, this could signal a more serious issue. As an example, during a routine examination, a fund company refused to produce evidence of a formal audit for the last three years. Another fund took over a week to produce a list of eight standard documents. Both were red flags.

3. low leverage means less risk, the opposite is true if the reason is that the fund has perhaps suffered denial of credit. Strategies commonly employing a high degree of leverage are equity long/short, Equity Market Neutral, distressed debt, and fixed-income arbitrage.

4. managers may not be optimal due to low capacity for outside ownership. low or lack of a management interest in buying the fund may be a sign that none of the cooks want to eat their cooking first.

5. Perform the basic checks with a high degree of scrutiny, and it is unlikely you will miss much. Obey simple logic, but think things through and consider every possible outcome. It is useful to have somebody on the staff play devils advocate and argue against the groupthink so as to expose the likelihood of unforeseen circumstances. There is however a certain subjective element to the examination. The pieces should fit together logically with a flow that is natural. Performing operational due diligence is akin to acting like a detective. You have to pay attention to basic human instinct. Before signing off, take a few minutes to step back and review the information. Ask yourself if everything fits together.

For example:

o The number of trades performed daily should make sense given your strategy. Daily trading volume, for example, should be low for distressed debt but high for a global macro strategy that obeys a high-frequency algorithm.

o The service providers should make sense given the and business of the fund. For example, a $20bn fund doing business with a small prime broker located in the Cayman Islands may seem illogical.

6. terminated vendors what the reason was for the termination. You may be surprised at how often the stories do not match up. Use this probe as an opportunity for how the fund does business. If its partnerships seem strained, think about how that may affect the service that you and your clients receive down the line.

7. auditors, prime brokers and others say. For example:If the fund says the average amount of trades they make is 15 �� ask the prime broker the same question. If the response is significantly different, you may have a problem.

o Ask the auditor what they see as the primary weaknesses of the funds operations. If the fund says something different, it is possible that there is miscommunication, or someone is covering something up.

8. of the courtship phase during which the fund is vying for your business. If cooperation is weak, think about how hard it will be to work together once the fund has less incentive to please you because you have handed over your money and trust.

9. are shorter or written records are lacking. consider any simulated or back-tested results with a high degree of caution. Do your research to ascertain if these backtests are representative of what a similar fund would have experienced given the time period, climate, etc.

10. operational controls. However, for registered funds, the ADV discloses problems that can span the range of its felonies to less egregious offenses such as minor lawsuits. Consider the offense, the time of occurrence and the specific people involved.

11.that you are likely to receive given your relative to other clients. It is nice to be among the best-performing funds, but that is only part of the total relationship. If your statements are going to be delivered later than you require, due to a low status on the totem pole, think about how that could affect your clients.

� Adopt a bedside manner. You want to be as invisible as possible to observe the true processes at work. Putting employees on the defensive is only going to distort your perception of how things really work.

� Be sure to conduct an onsite visit. It is recommended to schedule the visit within a reasonably short period of time so youll see what you are really going to get.

� Examine every aspect of the companys operations. If you need a general guideline for the types of queries performed, you may reference a standard questionnaire that can be downloaded from the Managed Funds Association.

� For the purpose of validation, it is recommended that a team of people, not just one person, are present at the onsite examination.

� Have a pre-visit and post-visit meeting with the operations team, as well as the investment personnel who made the buy decision. Record your expectations beforehand and note your observations after the meeting.

� Do not assume anything. Verify, verify, verify and document your findings.

� Do not become friendly or informal with the fund employees at any point. Limit the use of subject company resources, gifts and facilities. In our practice, we are highly reluctant to let the fund company buy us lunch when we conduct the onsite evaluation.

� Do not ignore your instincts. If there is something that bothers you, pay attention to what may be driving it. Make notes.

� Do not rely on your memory. Write everything down so you can accurately relay your observations to a court of law if pressed about the details. Store these records in a separate file in your office.

� Do not interfere with the internal company processes. The due diligence teams purpose and goals should not disrupt the ability of the company to perform their duties for their clients.

We use the analogy of the mechanic conducting a car inspection. As an operations due diligence analyst, it is incumbent upon you to kick the tires to provide assurance that basic, fundamental best practices are being followed. Keep in mind that hedge funds may have to drive over ever-changing, rocky terrain. To continue the analogy, the mechanic for these types of cars has to inspect current procedures; but just as importantly, you should assure that the fund employs a comprehensive risk-management process that will endure given whatever changes it is reasonable to imagine as imminent.

a B.A. from Harvard College, an M.B.A from New York University Stern School of Business, and has passed all three levels of the CFA examination. Ms. Grillo worked for three years at Rochdale Investment Management in various roles such as Portfolio Strategy Analyst, Equity Analyst Associate, and a Hedge Fund of Funds Due Diligence analyst. Ms. Grillo worked in equity research at Lehman Brothers, as well as a small start up Hedge Fund of Funds vehicle, before joining CCM.

since founding the company in 1997. For seven years, Mr. Conrad has served as lead fund manager for a proprietary Fund of Funds vehicle. Conrad Capital Management provides operational due diligence consulting services for alternative investments on a third party basis as well. Mr. Conrad started his career in 1981 at First Investors Corporation; he was then recruited by E.F. Hutton Company, which eventually became the company formerly known as Shearson, Lehman, Hutton, and served as senior vice president.

Originally published by Complinet, Inc., www.complinet.com. the leading provider of compliance intelligence for the financial services industry.

This information is designed to provide a general overview with regard to the subject matter covered and is not state specific. The authors, publisher and host are not providing legal, accounting or specific advice to your situtation.

Conrad Capital Management, Inc.

1377 Motor Parkway, Suite 406