Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures

OPERATIONS SECTION

I abstracted the operations section of the Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures.  This is a long post but this should be required reading for investors and hedge funds. 


Organization and Control Environment
 

The firm should have a clear corporate organization chart presenting; parent companies, subsidiaries and other affiliated entities.

The firm should be structured to allow for adequate oversight of the primary functions within the firm. Investors will want to see a clear organization chart showing, at a minimum, reporting lines, team numbers, and the names of key professionals in order to understand how the team is organized by function.

The back office should have a strong voice in the firm, with a high level of authority and influence in the organization. There should be a senior chief operating officer (“COO” hereafter)/chief financial officer (“CFO” hereafter) independent of the investment process, with authority over operational processes.

The organization should demonstrate clear segregation of duties and levels of staffing given the complexity of strategy and risks.

The firm should re-evaluate resources as it grows or changes. Managers should explain where employees are located, how personnel in different locations interact and how their knowledge base is kept up to date.

Turnover is a reality, and often healthy, but should be manageable. Investors will expect to be notified of key hires and departures as well as want to understand the reasons behind recent turnover.

Internal organizational procedures, controls and systems should be documented,

Conflicts

Investors will want to see a documented conflicts policy, together with an understanding of what steps have been taken to identify and resolve conflicts, and the existence of a conflicts or compliance committee to manage conflicts and develop a framework for disclosure of conflicts

While managers will produce standard documentation that complies with legal and regulatory obligations, investors will expect substantially more disclosure in the form of due diligence questionnaires, historic reports and sample documentation such as operations manuals, valuation policies and samples of board meeting minutes (redacted if necessary).

Compliance

Investors expect to see a strong compliance culture at a firm starting at the top and a robust compliance

Where managers are preparing to become registered for the first time, a proper gap analysis and implementation plan should be in place. Investors will want to understand, in outline, the results of regulatory visits and may ask to see copies of key reports. Even if a firm is unregistered with a regulatory body, it still should operate to the same standards as if it was registered.

Investors will want to review the compliance manual that documents the procedures and controls.  The compliance manual should be updated regularly as a “live document”, is tailored to the business and that the policies in key areas are appropriate. When new policies are implemented, the manual should be updated accordingly with a copy given to every member of staff.

In addition investor Expectations and Preferences

• Annual declarations from employees to confirm they have read and complied with firm policies and procedures.

• Appropriate level of compliance oversight into issues such as personal account dealing, AML, KYC and employee gift reporting, as well as investment strategy issues.

• Written code of workplace ethics with adequate training.

• If preferential side letter terms to selected investors exist (e.g., fees, liquidity, transparency) those terms should be approved by fund board of directors and disclosed to all potential and existing investors of the fund.

Trade Processes

Managers should ensure that the infrastructure is appropriately tailored to the business, and they should assess the market, frequently, for new products or enhancements. The suite of portfolio systems should allow, where appropriate, for a high degree of automation and straight-through processing for reliable books and records.

There should be a centralized location for all portfolio data (data warehouse), with an extensive security master file and real-time reporting through direct market feeds. Managers should have systems that maintain comprehensive trading data (i.e., corporate actions, realized/unrealized gains, commissions, etc.) and a complete general ledger with partnership accounting; updated for current accounting requirements.

Timely reconciliation and resolution of reconciling items is an essential requirement to promptly identify duplicate, missing or incorrect transactions.

Investors expect hedge funds to be independently audited by a specialist audit firm with a recognized record for auditing hedge funds. Likewise, investors expect for the hedge fund to have an independent third party fund administrator

Investors expect the hedge fund manager to undertake a thorough due diligence process when recommending a service provider to ensure that they have the essential level of experience and expertise to carry out their roles to the required level.

Valuation

The process of valuing the hedge fund’s investments is at the forefront of every hedge fund operational due diligence review. Pricing is probably one of the most sensitive and important areas in hedge fund controls. There is room for manipulation, fraud, or even simple errors in valuing assets, with valuations artificially boosting fund performance or smoothing “mark to market” returns.

1. Separation from the front office: While the front office may be instrumental in the valuation of some assets, final authority should reside with the back office.

2. External oversight: External to the manager’s organization

The manager’s valuation committee should consist of senior management, with the majority represented by members who are independent of the investment team. Given that the pricing policy within the fund offering documents is generally vague, there should be a detailed documented pricing policy that describes the material aspects of the valuation process and valuation procedures and controls for each asset type.

The treatment of side pockets is often a source of contention, and there are some best practices that all funds should follow:

1. The fund should have clear documentation that defines a side pocket.

2. The fund should provide investors with a description of assets which have been side pocketed and pricing at the point of side pocketing.

3. Where possible, multiple price sources should be used to verify the valuation of each position in a fund’s portfolio.

Administrator

A good administration relationship can provide important third party oversight, but the administrator must have the appropriate capabilities and the fund manager should have the proper controls in place to monitor the quality of the administrator’s work. Roles and responsibilities should be defined in a clearly written SLA, and the manager should have a formal process to allow for a regular evaluation of their administrator’s performance.

Fund–specific monthly report independent of the manager which details the pricing sources used (including the reliance on manager prices quantified as a percentage of NAV) and fund counterparties for both liquid and illiquid portions of the fund portfolio and fund counterparties.

Business Continuity/Disaster Recovery

Business continuity planning (“BCP” hereafter) refers to a hedge fund manager’s ability to continue operating in the event of a disruption to its business. Disaster recovery (“DR” hereafter) relates to a hedge fund manager’s ability to restore itself back from a disaster event to the point where it was before the disaster occurred. BCP and DR planning spans all areas of the hedge fund organization.

All firms need to implement best practice procedures and infrastructure in order to protect the business in the event of natural disaster, terrorism, pandemics and other disruptions, although the BCP and DR plans should be bespoke in that they consider the risks of the manager’s strategy.

Investor Expectations and Preferences

• Well documented BCP and DR.

• Dedicated DR/BCP crisis team for oversight of key issues.

• Plan is managed by senior management (COO, CFO).

• Proprietary data appropriately backed up and housed at an offsite venue.

• Appropriate level of documentation on the firm’s recovery plan, with step by step guide to facilitate   best return to operations.

• BCP/DR plan is regularly stress tested.

• Key person(s) risk of the firm is considered, with appropriate policies in place