Bart Mallon Speaker at Hedge Fund Compliance and Due Diligence Webinar

Due diligence continues to be a hot topic for fund managers; compliance has been a central issue for managers ever since SEC registration was required for those managers with more than $150M of AUM. Below is a release for webinar which will be taking place later this month. Bart Mallon will be speaking about the legal issues involved with compliance and due diligence.

Registration is free and sign up is here .

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Corgentum Consulting Hosts Hedge Fund Operational Due Diligence Webinar on Compliance and Legal Risk

Corgentum Consulting will host a complimentary Webinar titled, ‘Techniques for Analyzing Hedge Fund Compliance and Legal Risks During Operational Due Diligence’ on October 23, 2012, at 10:30am EDT

NEW YORK – Oct. 1, 2012 – Corgentum Consulting, the leading provider of the industry’s most comprehensive hedge fund operational due diligence reviews, will host a complimentary Webinar titled, “Techniques for Analyzing Hedge Fund Compliance and Legal Risks During Operational Due Diligence” on October 23, 2012, at 10:30am EDT. Join the speakers as they examine the effective techniques for evaluating a fund’s legal and compliance risks.

The global hedge fund regulatory landscape has undergone a number of recent significant changes. New SEC registration requirements and Form PF filings in the US continue to challenge hedge funds. Internationally, increased calls for Asian hedge fund regulation in countries such as Singapore and Australia, as well as discussions surrounding MiFID II and the EU passport directive in Europe, continue to complicate the web of legal and regulatory rules.

DATE: October 23, 2012

TIME: 10:30am to 11:30am EDT

SPEAKERS:

• Jason Scharfman, Managing Partner, Corgentum Consulting

• Paul Brook, Principal, Compliance Solutions Associates

• Bart Mallon. Partner, Cole-Frieman Mallon & Hunt LLP

Some of the topics that will be covered during the Webinar include:

• Techniques for evaluating fund compliance programs

• Evaluating legal documentation risk

• Understanding the effects of recent hedge fund case law

• Monitoring ongoing fund adherence to regulatory requirements

If you are interested in joining the “Techniques for Analyzing Hedge Fund Compliance and Legal Risks During Operational Due Diligence” Webinar, please visit https://www1.gotomeeting.com/register/389516416 or contact corgentum@cognitomedia.com.

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About Corgentum Consulting

Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers. The firm works with investors including fund of funds, pensions, endowments, banks and family offices to conduct the industrys most comprehensive operational due diligence reviews. Corgentums work covers all fund strategies globally including hedge funds, private equity, real estate funds, and traditional funds. The firms sole focus on operational due diligence, veteran experience, innovative original research and fundamental bottom up approach to due diligence allows Corgentum to ensure that the firms clients avoid unnecessary operational risks. Corgentum is headquartered at 26 Journal Square, Suite 1005 in Jersey City, New Jersey, 07306. Phone 201-360-2430. The Web site is www.corgentum.com.

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Cole-Frieman & Mallon LLP provides hedge fund compliance and legal services to investment management community. Bart Mallon can be reached directly at 415-868-5345.

In March, Deutsche Bank’s Hedge Fund Capital Group presented a closer look at the current status of the hedge fund industry in its “2010 Alternative Investment Survey” report (see press release ).  The report focuses on responses from 606 investors.  42% of the respondents were Fund of Funds, 21% were asset management companies, 12% were family offices/high net worth individuals, and the remaining group consisted of corporations, foundations and endowments, insurance companies, investment consultants, private banks, and private and public pensions.

This article summarizes the 2010 outlook from investors and the increasing relevance of the seeding business.  In particular, it presents the strategies being favored/disfavored, regional markets being favored/disfavored, predicted allocation amounts, and other information related to due diligence and reasons for investing in hedge funds.

For the most part, investors are optimistic about 2010 and money is flowing back into the industry.  Strategies for this year reflect concerns about the lack of transparency and protection in uncertain markets in 2008 and 2009.  Investors are making choices that ride on renewed confidence in the industry and that favor reduced volatility.

Investors Generally Optimistic for the Future

Investor sentiment about how the hedge fund industry will fare in 2010 has greatly improved.  In 2009, 41% predicted net asset outflows of over $150 billion and 30% predicted outflows of over $200 billion.  In contrast, 73% of investors surveyed this year predict net asset inflows of over $100 billion and fewer than 2% are predicting outflows.  Consistent with those percentages, investors are also predicting a positive 2010 performance on the leading indices (S&P500, MSCI World, and MSCI EM).

Favored and Disfavored Strategies

Surveyed investors predict that some of the best strategies for 2010 are global macro, equity long/short, distressed, and event driven.  In fact, equity long/short makes up the largest portion of hedge fund assets.  51% of investors plan to add assets to this strategy (an increase from 31% in 2009), 38% plan to maintain their assets in the strategy, and 5% plan to reduce assets.  Event driven also performed very well in 2009 with 42% of surveyed investors now planning to add assets to this strategy and 41% planning to maintain their assets.  Investor interest in merger arbitrage has also jumped greatly from 6% intending to increase exposure to 26% in 2010.  While 29% of investors planned to reduce exposure in 2009, only 4% now seek to reduce exposure.

The strategies that are anticipated to perform the worst in 2010 include cash, volatility arbitrage, CTA, convertible arbitrage, market neutral, and asset backed securities.  Market neutral was one of the worst strategies for 2009 when other strategies were bouncing back.  The percentage of investors seeking to add assets to this strategy has decreased from 26% in 2008 to only 17% this year.  In terms of cash allocation, only 3% of investors plan to increase exposure (a drop from 13% last year), 43% plan to maintain their assets, and a whopping 32% plan to reduce their assets.

Regional Allocations

Overall, investors predict that the Asia region (excluding Japan) will perform the best in 2010 and the Western European region will perform the worst.  This year, 45% of investors plan to invest in Asian (excluding Japan) fundsa significant jump from only 18% in 2009.  Interest in investing in Chinese and Japanese funds is high compared with other countries.  The percentage of investors that do not plan to allocate to each country is 22% and 23% respectively. In contrast, 52% of investors do not plan to allocate in Russia, 44% do not plan to allocate in Eastern and Central Europe (excluding Russia), and 37% of investors do not plan to allocate in India.

Surveyed investors expressed a similar interest in the Emerging Markets, with 38% wanting to increase exposure, 38% wanting to maintain exposure, and only 6% wanting to reduce exposure.  These findings are in response to the strong 2009 returns after a rough 2008 that saw many Emerging Market funds close.  In contrast, investors anticipate the Western European region will not fare wellwith 56% seeking to maintain their current assets, 23% seeking to increase exposure, and 12% seeking to reduce exposure.

Investors are increasingly investing in hedge funds.  In fact, 76% of consultants surveyed indicated that their clients were increasing allocations to this investment vehicle.   When asked what the main benefit of investing in hedge funds was, 68% of the investors surveyed indicated that hedge funds provide “better risk adjusted returns.”  This benefit is particularly valuable in a volatile and uncertain market.   “Diversification,” which was previously the number one answer, remains a close second.

Amount Currently Invested in Hedge Funds

Currently, over 50% of surveyed investors still manage less than $1 billion in hedge funds.  The Hedge Fund Capital Group expressed concern about this figure, explaining that more than $1 billion AUM is often necessary to build the institutional infrastructure for greater investments and to perform vigorous due diligence.  On the other side of the range, the number of investors with under $100 million invested in hedge funds is decreasing.  The Hedge Fund Capital Group explains that these funds have likely simply shut down due to the economy and inability to attract institutional investors, pension funds, endowments, and other larger investors.

A majority of surveyed investors have track records of investing in hedge funds for longer than five years (only 17% have less than 5 years), with nearly all of those with 15 or more years of experience based in North America, compared with their European and Asian investor bases.

Hedge Fund Managers

Since 2008 and in part due to the market, investors have been reducing the number of managers they use.  They have also started disfavoring portfolios that are too diverse due to the fact that due diligence requirements are now more costly and timely.  In addition to reducing the number of managers investors place their money with, investors are also preferring to place their money in larger hedge funds with AUMs of over $1 billion.  Those investors focused on managers with smaller AUMs are generally based in Asia or Europe.

Allocations

In 2009, most investors made 5-10 initial allocations.  Those investors who made over 10 initial allocations in 2009 were concentrated in Europea total of 54%.  But in terms of follow-on allocations, U.S. based investors led the pack, with 50% making over 30 follow-on allocations.

Redemptions

Despite generally positive performance last year, investors are continuing to make redemptionsthe Hedge Fund Capital Group explains this as a result of those managers who have not performed during the market bounce or those that froze assets and their investors are only now able to begin redeeming.  The investors that have made the most partial redemptions30 or more in the last year, were primarily fund of funds and private banks.  This finding is consistent with the perception that these investors are performance chasers.

Available Cash to Allocate

Compared with 2009, surveyed investors are generally holding less cash.  50% of investors are either fully invested or only holding 0-5% cash.  But the good news is that 29% have 10% or more cash available for investment.

Following up on the previous findings, surveyed investors are confident for 2010.  Those that predict they will be fully invested in the next six months increased from 18% to 21%.  Those that predict they will hold 0-5% cash increased from 32% to 39%, demonstrating a goal of investing more.

Hedge Fund Managers

Challenges and Assessing a Manager

In terms of the biggest challenges investors faced in 2009 and 2010, “selecting and monitoring manager” posed the biggest challenge, with “lack of transparency” also ranking highly.  This year, “investments frozen with a manager” was a new category and also ranked very high.  When assessing a hedge fund manager, investors used to cite the 3Ps: performance, philosophy, and pedigree.   While those qualities continue to be important, investors have increasingly focused on risk management and transparency.     This reflects greater caution and less reliance merely on manager pedigree.  Performance ranks first, risk management ranks second, and philosophy ranks third in terms of importance.

Length of Due Diligence Process

The due diligence process has gotten more costly and timely.  For most investorsover 50%, need 3-6 months to conduct due diligence of a manager.  This statistic is consistent over the last three years.  The percentage of investors who can complete this in less than 3 months has increased slightly and so has the percentage of those who need 7-12 months.

Seeding Business

The institutionalization of hedge fund investing is making it increasingly difficult for new launches to attract investors. While a minimum of $50 million AUM was once sufficient, the critical minimum is now $100 million.  Emerging managers are therefore increasingly turning to the seeding business “to overcome the hurdle of reaching the critical size to gain visibility and profitability.”  17% of the investors surveyed seed managers.  The majority of seeders are U.S. based59%, with 30% in Europe, 9% in Asia, and 2% in Australia.  Funds of funds are the primary investors that seed, with asset management companies and high net worth individuals following.

45% of fund of funds seed managers, followed 26% of asset management companies and 17% of family office/high net worth individuals.

There are three seeding business models: (1) revenue split, (2) equity split, and (3) platform.  Under the revenue split model, seeders provide capital in exchange for participation in management and incentive fees.  Nearly half of seeders surveyed use this model.  Seeders provide capital in exchange for equity ownership and generally take active partnership role under the equity split model.  19% of seeders surveyed adopt that model.  Finally, under the platform model, established hedge funds and financial institutions provide capital and “turnkey” solutions in exchange for profit share.  Only 9% of seeders surveyed adopt the platform model.  Before a manager turns to the seeding business, it should consider the support offered by the seeder, including the form of operations, risk management, marketing, strategic assistance and business development, and compliance and legal support.  In addition to providing funding, well-respected seeders can also provide reputational capital.

For the most part, the average seeding ticket ranges from $25 million to $75 million, with fewer under $10 million and even fewer greater than $100 million.

6% of the surveyed investors consider themselves to be investment consultants.  The findings show that there has been an increasing presence of such consultants in the hedge fund industry.  These firms serve as the “bridge between investment managers and pension funds.”  The largest percentage of the consultants’ client base is the family office/high net worth individuals, followed by government funds, and fund of funds.

Hedge fund investors are also more frequently turning to consultants to perform extensive due diligence.  These investors do not have the resources to perform increasingly rigorous due diligence and rely on consultants.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

The following article is written by Chris Addy, president and CEO of Castle Hall Alternatives which is a hedge fund due diligence firm.

For funds raising assets from institutional investors, the due diligence process will be quite familiar and Chris describes some of the frustrations from the investor/due diligence standpoint.  I would imagine that these issues will continue to arise as more service providers strive to find ways to limit their potential future liability.  Please feel free to comment below.

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A recap on some audit issues

Looking back over our posts over the past year or so, weve commented on a number of issues which impact investors due diligence procedures when thinking about the audit process, the financial statements, and the auditor themselves.

We thought it would be useful to recap on a group of issues which continue to be troubling:

1) And why cant the auditor identify themselves?

Back in November, we commented on the challenge of getting the Big 4 audit firms to admit that they are, actually, the auditor of the fund in question.  In the six months since then, practices appear to have standardized: typically, the Big 4 will now provide a form response, but only after the investor has signed an extensive disclaimer letter.  The slight snag?  The disclaimer is usually so wide ranging that it appears to materially impact the investors ability to sue the auditor in the event of audit failure (which, of course, is the idea).  We advise our clients not to sign it.

As a counterpoint, it is worth noting and forcefully reminding the Big 4 that every other auditor on the planet makes the confirmation process smooth and effective.  Castle Hall is particularly appreciative of the responsiveness and professionalism of Rothstein Kass each time we make an audit confirmation request.  In fact, that reminds medo I actually need a Big 4 auditor?

2) And its pretty much the same for SAS 70s..

Unfortunately, the SAS 70 process is pretty much the same it is becoming increasingly difficult for the end investor to obtain a copy of the SAS 70 document for many administrators.  This is, of course, despite the fact that the SAS 70 is now a key marketing point in the admin industry.

Its particularly annoying when the SAS 70 is stated only to available (i) to the auditors of (ii) the administrators clients, the funds.  The first point makes the SAS 70 process seem more than a little self serving, as the auditors give each other work for the sake of it.  The second raises the broader issue (and one of our favorite topics) of who exactly is the administrators client the fund or the investor?

A particular black mark goes to those administrators who will not provide investors with a copy of the SAS 70 under any circumstances, and insist on providing a summary of the SAS 70prepared by themselves.  And exactly how is the investor supposed to place any reliance on that?

An honorable mention in the hall of shame must go, however, to those administrators who try to charge the costs of their SAS 70 review through to their fund clients as an out of pocket expense.  In other words, the admin expects the funds shareholders to pay for their own SAS 70.

And no, we still cant see it.

3) Who distributes the financial statements?

While the confirmation issue above is tediously annoying, thinking practically, the risk that a hedge fund simply fabricates a relationship with PwC or KPMG is pretty remote.  What is more likely is that a reputable audit firm has been appointed and completes their workbut a manager then elects to change some or all of the financial statements and gives investors a set of fake accounts.  As we have said before, a copy of Adobe photoshop only costs $500.

The double irony is that, even with the audit confirmation we discussed above, the auditor does not send the investor the accounts directly.  There is, therefore, no way of getting a direct confirmation from the auditor that the accounts in your possession are, in fact, genuine.

One suggestion we have heard would be, in the offshore world at least, for investors to access financial statements direct from the Cayman Monetary Authority (perhaps via a secure website with appropriate authorizations).  This would draw on the requirement that the fund auditors must give the Cayman authority a copy of the (genuine) accounts themselves.  An excellent idea.Cayman?

As a more immediate solution, we are always anxious to confirm that the fund administrator receives the audited financials direct from the auditor and thereafter sends them to investors.  This is a great control it ensures that the financial statements are authentic, and it also unequivocally confirms the identity of the auditor at the same time.

The snag?  While this is crucially important, administrators seem pretty casual about the whole process.  Admins are generally happy to do this, but only if a fund asks for this service, and many admins are certainly far from proactive on this topic.  There are some admins, mind you, that dont want to get involved (we came across one admin that had decided, on a related point, that they would not send offering memos to investors.)

In our mind, this is a vital control and should be mandatory for every administrator.  Getting the financials from the admin is just as important as ensuring that the investor monthly NAV statements come from the admin and not from the manager.

4) And who is the audit report addressed to?

Another particular bugbear is the obsession of one of the Big 4 audit firms in Cayman to change the addressee of the audit report from to the board of directors and shareholders to just to the board of directors.  The objective, of course, is transparent and predictable the auditor is looking to enhance the concept of privity and assert that the firm only has a relationship with the Board and no relationship none, never, nada with the investor.

The irony here the directors who are now the sole recipient of the audit are usually our rent a director friends who sit on a few hundred other hedge fund boards.  And does anyone really think including the partner at the Big 4 firm signing the opinion that these guys really have time to read every set of audited financial statements from cover to cover?

One solution here could the Cayman regulator mandate that the audit opinion must be addressed to the shareholders in order to be meet Cayman requirements?  Again, this would be a small change that would send a very helpful, investor friendly signal from this jurisdiction.

5) In fact, do you even have to leave the office?

A final observation reflects what seems to be an emerging trend over the past audit cycle certain auditors (and certain offices of certain auditors in particular) seem to be adopting a desk fieldwork process.  We have recently completed due diligence on a number of funds albeit usually long short equity when both the administrator and the manager stated that the audit team had never came on site to do any audit work.  All work was done remotely from the auditors own offices.

Now, aside from the fact that fieldwork is called fieldwork for a reason (eryoure in the field) we see this as a worrying trend.  It stands to question that the quality of the audit is not the same if you never look the individual responsible for preparing the accounts in the eye.

As a counterpoint to our observations, we do continue to recognize that the audit process is ever more challenging and that many skilled professionals work incredibly hard, especially during busy season. As just one example, we were recently speaking with the audit partner of a Big 4 firm discussing FIN 48 a tortuous challenge for the profession.

At the same time, the audit process is critical for investors and were certainly entitled to ask tough questions we are sophisticated, after all.

Its also worth noting that the auditors ever increasing fees are, of course, borne by the end allocator.  Were happy to pay.provided we get good value.  Net net, the hedge fund audit profession would certainly be well served to make things a little easier for the person cutting the pay cheque.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Risk Without Reward is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is one of the top hedge fund law firms and provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

For more articles by Chris Addy, please see the Castle Hall Alternatives post where we have listed our reprinted articles.

Importance of Brand Identity Emphasized in Recent White Paper

There has been a clear trend over the last 12-18 months for hedge funds to focus on a number of operational issues in order to become more attractive to institutional investors.  While much of focus has been on the risk management side, I have seen more recent emphasis placed on brand building and image refinement.  This can take many forms of course, including making sure that your hedge fund marketing pieces look professional. However, it is becoming evident managers will need to go further and make sure their entire product offering is designed for the needs of their target investors.

In a recent white paper, produced BK Communications Group. this argument was expanded upon and discussed in depth.  The following are the overview highlights of the white paper:

• Performance alone isn’t enough to get allocations.  Recent surveys of institutional investors find reputation has become a primary consideration when choosing a hedge fund manager.  And with institutions now representing up to 70% of hedge fund investors, the demand has increased for high-level communications that speak to a sophisticated audience.
• A step-by-step program to build a strong brand identity – the sum total of associations people have with an organization – can help a fund manager heighten name recognition and credibility.  Professional-level materials that reflect the brand identity can position a fund to take advantage of opportunities in the institutional space and beyond.
• A strong brand identity can also help fund managers weather severe setbacks by allowing them to draw on a reservoir of good associations already in place.
• Managers often underestimate the importance of marketing communications, and can be misinformed about what they are allowed to communicate.  Many lack the internal resources or capability to effectively build a brand identity and get their message out across a spectrum of materials and media.

While many in the industry understand that performance is not everything, many managers do not believe this (for some managers, growth is an offshoot of fantastic performance, see David Einhorn. but this is not always the case).  I think that this paper presents important information for such managers.  As the industry continues to become more instiutionalized, I believe we will see a greater emphasis placed on brandbuilding and I believe consultants will play a larger part in the investment process (including helping the manager to complete the due diligence process ).

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Please contact us if you have a question on this issue or if you would like to start a hedge fund.  Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

Thoughts on Business Continuity Planning

Over the past week, I have attended a couple of interesting panel discussions on the hedge fund industry.  At these events, one of the common themes was that the investment management industry is changing and hedge fund management companies need to make sure that operations are tight this means that a management company should have developed and robust procedures for disasters including, as the article below indicates, pandemics.  It is expected that this topic will become even more important if the impact of the H1N1 virus does not abate.

The article below was provided by Lisa Smith of Eze Castle Integration. an IT solutions firm for hedge fund management companies. This article is part of our guide to Hedge Fund Business & Technical Issues .

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Business Continuity: A Look at Pandemic Response Planning

By: Lisa Smith, Certified Business Continuity Planner, Eze Castle Integration

As the last several months have unfolded, one thing has become clear: the influenza A (H1N1) virus is not going away.  After the initial panic subsided, fear and concern seemed to diminish even though the World Health Organization and U.S. Centers for Disease Control insist that the threat is not over.  Now, nearly five months since the first case of H1N1 was reported in Mexico, a pandemic has emerged as predicted.

As of November 1, 2009, 199+ countries have reported laboratory confirmed cases of pandemic influenza H1N1 2009, including over 482,000 cases and 6,000 deaths (World Health Organization).  U.S. health officials estimate that the virus could directly and indirectly affect up to 40 percent of the nationwide workforce over the next two years (Centers for Disease Control).

What does this mean for hedge funds?  It is more important than ever to ensure a firm can and will remain functional if you are affected by a pandemic. Particularly, hedge funds must be mindful of the repercussions of the virus, as a decrease in staff could cause potential downtime.

Below are six essential pandemic response steps that firms need to undertake to ensure their businesses remain at peak performance, even if an outbreak occurs in the office.

Begin response procedures BEFORE a disaster strikes.

Organizational resiliency starts by strengthening your organization during normal business operations prior to a disaster such as a pandemic.  It should not take a disaster to compel your firm to evaluate its business continuity and response processes.  One should be in place long before disasters strike.

Identify who will serve as crisis leaders and be in charge of handling situational changes that may occur, including communication to other employees about response procedures and alternative site locations.  An ideal crisis leader is someone who demonstrates good leadership skills during normal business operations and has experience dealing with crises.  Typical crisis leaders are members of the senior management team (i.e. COO, CFO or Portfolio Manager).  Firms must also ensure all employees are mentally and physically able to respond to changes, especially if they are telecommuting.

Also, certify that all employees are cross-trained within the organization; if there is a staff shortage as a result of a pandemic, employees will need to fill additional roles and responsibilities.  Non-critical employees, including business development, accounting and research analysts, may be able to take larger roles and assist during a pandemic response phase.

Develop disaster / pandemic procedures based on a variety of scenarios.

Be proactive.  As part of the planning process, create a list of potential scenarios and define your firm’s response strategies.  Impact scenarios should include both potential internal and external occurrences.

For instance, what is your response if access to your office building is restricted due to extensive H1N1 exposure?  How will you access your email, market data and portfolio management systems?  Where will employees work and how will they communicate with colleagues and counterparties?

Externally, how will you operate if your prime broker or fund administrator contacts are unavailable?  Being prepared will ensure your business operations continue seamlessly and without interruption.

Thoroughly review and modify your business’ Employee Assistance Program (EAP).

An EAP provides assistance and access to counseling services for issues in and out of the workplace.  In the event of a disaster, employees may wish to speak with a professional counselor to deal with any stress or negative emotions that have resulted from the event.  If you cannot provide a physical counseling presence, provide a list of area clinics that offer comparable services.  In advance, consider preparing educational materials that inform employees of the various stress indicators and reactions they may experience as a result of a disaster.  If employees know that support is available prior to a disaster, it will mitigate panic and stress, and they will be better able to adapt to changes in their environment.

You should also inform employees about current sick leave and family support policies in the event that someone is forced to take an extended leave of absence.

In addition to developing and strengthening your EAP, you might also consider having upper management and emergency response team leaders partake in Critical Incident Stress Management (CISM) training, which will provide advanced preparation for responding to critical situations.

Test alternate site and remote access capabilities.

If a crisis situation is directly affecting your physical workspace or your employees, you must be prepared to provide alternatives.  You may choose to move business operations to an alternate site where employees can go without risk.  An alternate site would make sense for crisis situations that are confined to specific areas, such as natural disasters, outages or other situations.

In a pandemic situation – particularly if you have had any outbreaks of illness amongst your employees – you may choose to allow employees to work remotely.  If this is a viable alternative, ensure ahead of time that you have adequate capacity and infrastructure to support multiple virtual private networks (VPN) and remote access capabilities.  Confirm the number of Citrix licenses you have available; if there are not enough to support your complete staff, you may need to consolidate responsibilities.

Review your business response plan and procedures with team members and leaders.

Develop communication notification and escalation procedures for response team leaders and assign internal notification tasks to each leader.  Identify if there are external business partners who need to be notified as well (i.e. investors, service providers, etc.).  Assign a primary and secondary spokesperson in case the public needs to be notified, and ensure the spokesperson(s) has training and experience dealing with the media.  If your spokesperson does not have training, now is the time to arrange for crisis communications training.

Test your pandemic response plan.

It is important to test your company’s response plan with leaders and response team members to ensure there are no glitches or obstacles in the event of a real disaster.  Test internal communication strategies – from response team leaders to staff members.  This can be done manually or through an automatic notification system.  You can also send employees to work at the alternate site or to work remotely to ensure there are no technical issues that can affect productivity.  It is imperative that the teams and employees are able to work together and build trusting relationships today.  A strong foundation that includes good performance and trusting relationships will enable your business to recover from any kind of crisis.

Business Continuity Professionals say that “planning” helps mitigate panic and downtime.  It takes work and resources to develop a resilient organization prior to an interruption or disaster, but it is imperative if businesses want to stay operational.  Businesses cannot function without employees that maintain knowledge and expertise to operate the business, and those employees need to know what to do during an interruption or disaster.  Without a plan, you will spend the entire time chasing the incident instead of recovering from it.

www.eci.com .

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Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the forex registration website.  He can be reached directly at 415-868-5345.

Hedge Fund Due Diligence Firm Discusses Agreed Upon Procedures

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Operational Issues and Failures ).  Today we are publishing a piece by Chris which discusses hard to value hedge fund assets (so called Level III assets).  In certain situations hedge fund audit firms will be engaged to perform an Agreed Upon Procedures review of the pricing of these assets.  As discussed in the article below, agreed upon procedures engagements do not provide hedge fund investors with a great deal of comfort with regard to the pricing of these assets.  It is unclear whether in the future investors will push back with regard to such engagements and require more robust pricing audits.  The problem with more robust procedures, obviously, is increased cost (because of increased liability for the audit firms).

Managers who are engaging audit firms pursuant to agreed upon procedures should be aware that they may face tougher questions from investors going forward.

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Agreed Upon Procedures

A number of our recent posts have focused on the challenges of the hedge fund administrator s role in relation to security valuation.  We will, of course, return to this topic but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from todays administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments.  (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from comparable securities (essentially mark to model, albeit with mainstream models); and Level III, everything else.)

This leaves investors with a challenge if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument.  It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments assuming the administrator has washed their hands of the problem are third party pricing agents and auditor agreed upon procedures, or AUP.  We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client.  The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.

Our first comment is, unfortunately, an Emporer Has No Clothes observation.  The significant majority of hedge fund AUP engagements we have seen require the auditor to test a funds pricing on a quarterly basis.  This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags.  Firstly, many AUP only test a sample of prices, not the whole portfolio.  Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a sample basis. )

The bigger problem, however, is the type of testing completed by the auditor.  In way, way too many cases, the auditor tests security prices back to the managers own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors.  If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low?  Even more importantly, if all the auditor does is to check prices back to pieces of paper in the managers own pricing file, how does the auditor know that those pieces of paper are genuine?  As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis.  A full, GAAP audit review is, of course, performed at year end this does include independent pricing (although investor fyi auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud.  In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point.  Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance?  Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?

To this point, the actual audit standard applicable to AUP is available here .  The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioners report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular.  Per the standard, a client requests an auditor to complete AUP to assist specified parties to evaluate subject matter or an assertion.  In our case, the assertion would be are hard to value securities valued correctly at quarter end.

However, the specified party is usually the manager itself, making the client and specified party the same person.  The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place!  However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are sufficient for their needs.  So, even if the investor believes that the AUP are not sufficient for their needs which is hardly a long stretch the investor has to sign that the procedures are sufficient if they are to even see the auditors work.  With this magic piece of paper, the auditor has met its requirements and can sleep easy.  Meanwhile, the auditor will send a bill to guess who the fund, meaning that investors have, once more, had to foot the bill.

As always, Caveat Emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

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