40.1 OPERATIONAL DUE DILIGENCE

Hedge fund due diligence is the process by which a potential investor obtains a sufficient understanding of a hedge fund in order to make an informed decision in regard to investing. Issues typically considered during the due diligence process include the hedge fund's investment strategy, the character of the organization, the way the fund operates, the management of its associated risks, and the credibility of its business model. Not surprisingly, due diligence is considered by many as the most critical stage in hedge fund investing due to regulators' relatively light oversight of hedge funds, the general lack of transparency regarding hedge fund portfolio positions, and the difficulty of establishing reliable performance benchmarks. If performed well, due diligence can reduce risk, increase returns, and make investors more secure in their investment. On the other hand, if performed poorly, it can put investors' capital at risk.

Although there appears to be a wide variation in due diligence standards between different hedge fund investors, most generally agree that due diligence should include a review of the fund's marketing materials, investor correspondence, legal/audit documents, regulatory and professional records, background checks, and investment performance. Generic due diligence questionnaires are usually a good starting point in understanding how a hedge fund operates. To be effective, however, due diligence must involve significantly more than just a check-the-box approach. Interviews with key professionals of the fund and discussions with current investors are just as critical as reviews of the documents.

How long does a typical hedge fund due diligence process take? The length of the due diligence process varies widely, since it depends on the complexity of the fund, its geographic location, the size of the organization, the availability and quality of the information supplied by the manager, and the sophistication and knowledge of the investor. According to Anson (2006), a thorough investor should expect to spend 75 to 100 hours in reviewing a hedge fund manager before investing. In 2007, Andrew Golden, president of the Princeton University Investment Company, testified that his organization spends at least 400 hours on initial due diligence before investing in a hedge fund, and then approximately 70 hours per year on ongoing due diligence. A conservative estimate of the cost of due diligence is typically $50,000 to $100,000 per hedge fund, an amount that puts small funds of funds at a competitive disadvantage.

Overall, due diligence is a complex and iterative process that requires judgment, experience, and a variety of skills. Ideally, one needs to possess the skills of an accountant, a trader, an investment analyst, a psychotherapist, a business manager, a human resources manager, and a headhunter. Due diligence also requires a healthy dose of skepticism, combined with strong common sense. Investors may conduct due diligence themselves or use the services of consulting firms, law firms, accounting firms, or other third-party service providers.

40.1.1 Losses Caused by Problems with People

Hedge funds are managed by people. The people who manage hedge funds differ in their degree of integrity, intelligence, and passion for investing. It would be unadvisable to invest with a manager who is intelligent and passionate but possesses no integrity. Such an allocation carries a very high risk of disaster. The importance of integrity, therefore, is paramount.

When investors look at candidate managers, they need to attain insight into the manager's level of integrity. This key insight must be stressed at the onset of the due diligence process. Integrity in an organization trickles down from the tone at the top; thus, the emphasis on ethical behavior must originate with the fund manager. Finding managers with tremendous integrity helps mitigate potential operational risks. Investors want to be assured that when conflicts of interest arise, as they so often do during the course of business, the managers will carry out their fiduciary duty by acting in the interest of the investor and not themselves.

For illustrative purposes, let us create a hypothetical hedge fund with minimal operational risk. First, the hedge fund manager has ironclad integrity. This manager builds a world-class organization by spending a great deal of time and consideration hiring the most qualified people for the operational side of the business. These highly qualified employees go on to build a world-class infrastructure, with proper procedures for checks and balances in place. They also apply best-practice policies and procedures in all areas of the business. Every aspect of the operational due diligence is extremely transparent as the manager has already anticipated a thorough due diligence process by investors. This fund is preemptive in answering operational questions. The reputation of the manager and the hedge fund is well known and the manager is highly regarded among brokers, consultants, vendors, and other hedge fund managers. This is the ideal manager with minimal operational risk. Unfortunately, since many hedge funds are not this well prepared, much work needs to be done before investing.

Interestingly enough, when evaluating hedge funds, insight may be gained by looking at where the manager first learned and practiced investing. Was it at a top investment bank that had sophisticated compliance rules/checks and balances in place, or was it at a “swing for the fences” day-trading shop riddled with bandits? Many times, managers develop their behavior and level of business integrity based on where they were trained in their early days, so each aspect of a manager's past experiences needs to be closely examined. Granted, there are cases in which hedge fund managers begin their careers at a top investment bank's proprietary trading desk only to later derail under the stress of managing money and to start cutting corners, spiraling downward. As entertaining as such stories may be, it is hoped that managers who gained experience in a firm with an ethical culture would be more likely to continue that ethical culture in their own fund than would managers who spent their formative years in a less ethical firm.

There is a dependable correlation that the higher the integrity of a manager, the lower the likelihood of fraud. Fraud is the hedge fund risk that results in the most sensational headlines and could very likely terminate careers, even for a chief investment officer at a large pension fund. Fraud is likely the biggest fear for institutional investors who claim to have a rigorous due diligence process. An institutional investor that fails to detect fraud while being staffed with a large operational due diligence team may be accused of incompetence or negligence.

One needs only to browse the business section of a financial newspaper to see that hedge fund fraud risk is real; investors are periodically being duped by unscrupulous hedge funds or investment managers. Operational due diligence teams would do well to follow the old adage: “If it's too good to be true, it's probably not true.” This common sense too frequently loses out to the desire to pick the next great hedge fund manager.

Why would an investor not follow through with conducting thorough due diligence? The following are the most common circumstances for when an investor becomes lax in this area:

• Small family offices or high-net-worth investors may not have the necessary resources to do the proper amount of due diligence on a given manager. They ask friends and trusted advisers about which hedge fund managers they should consider rather than undertaking a substantive due diligence process themselves.
• A highly sought-after manager that has been closed for many years is suddenly open to new investors. An investor's eagerness to invest with the manager trumps the seemingly tedious operational due diligence process and shortcuts are taken, with the investor relying on the fund manager's previous track record.

Due diligence team leaders do not typically possess strong or type A personalities, such as that of an overly eager fund-of-funds (FoF) portfolio manager; rather, they are trained with strong middle-office and back-office experiences and are generally much more detailed oriented. Given the time-consuming process of due diligence and the coordination among accountants, lawyers, analysts, and so forth, an impatient FoF portfolio manager's desire to make an investment may override the well-supported and documented doubts of the due diligence manager.

Of course a hedge fund manager who spends a lot of time in the gray area in terms of integrity can also put up the best risk-adjusted returns. A few successful hedge fund managers have been censored or investigated by the regulatory agencies for walking a fine line between compliance and violation of the federal securities laws by too aggressively pursuing opportunities or structural inefficiencies to deliver alpha. This merciless pursuit of alpha has generated tremendous benefit to investors. These hedge funds, however, come with issues. Therefore, a balance has to be struck between managers with clean backgrounds and the generation of returns.

40.1.2 Confirm Biographies

The process of doing due diligence on a given manager begins by examining the biographies reported in the presentation materials. Investigators should confirm degrees from business school, undergraduate programs, professional certificates, and so forth. Since biographies are examined extensively and sometimes used to build credibility for the manager, some managers may inflate certain accomplishments. It's also possible that marketing staff may rewrite biographies to give a much more positive spin to the manager's prior experiences and accomplishments. There are many vendors who will confirm degrees, run criminal checks, provide credit scores, and so forth on a given manager. Some larger FoFs and institutional investors have been known to procure private investigators to give a detailed account of a manager's past.

40.1.3 Triangulation

After the most superficial level of investigation, manager biographies, investors may attempt to triangulate the manager. Triangulation is the process of attaining deeper useful information about a manager from a source that is familiar with the manager. That is, an investigator will try to find someone in the manager's network who may personally know the manager and is willing to answer the investor's questions about the manager.

Many times there are conference calls centered around the strengths and weaknesses of the hedge fund manager, discussing whether the manager has integrity, is a moneymaker, is a good or a very difficult person, and so forth. Some of the best managers have very strong personality traits. Some managers may demand extremely long hours at work, others may force their employees to think exactly like them, and others may subject potential employees to a personality test to ensure they will fit into the organization. Hedge fund organizations naturally run the gambit of different cultural nuances, considering the many colorful characters and strong idiosyncrasies of their founders.

40.1.4 Personnel Turnover

Managing people and building a business are skills that can prove to be drastically different from finding great investments or generating alpha. Often, a great hedge fund manager may not have the requisite skills to manage people. Growing a business, therefore, becomes difficult for such a manager. Careful monitoring should be in place as a hedge fund evolves over time. Is the manager self-aware enough to understand that hiring a world-class operations manager could contribute to more success? Contrast that to a manager who tries to wear all the hats in the organization and ends up with very weak operations.

It may be relatively easy to manage a small team with less than $100 million of AUM. Once success propels a firm's AUM above $100 million, the firm becomes a very different organization. As the business grows, due diligence staff should be constantly updating the questions asked, such as whether the right people are in place, and whether the operations of the hedge fund are growing accordingly.

Just as there are some people who are good at the start-up phase of a business and others who are better at managing a large organization, hedge fund managers should be expected to be aware of the different stages of their business growth cycle. Due diligence staff will have to readjust their focus as the hedge fund business grows. Another way to think about this is that the due diligence on a start-up hedge fund is vastly different from the due diligence on a larger, established fund. It is important, therefore, to understand at what development stage the hedge fund is at the time the investor initiates due diligence.

40.1.5 Prior Employees

Contacting individuals who have left the hedge fund can be a great source of insight into the organization. Ex-employees will typically have fewer motives to paint a bright and rosy picture of the organization and may be more likely, therefore, to give a straightforward answer to most questions. Some caution must be exercised in contacting ex-employees, however, because their prior bad experiences may bias their opinions of the organization. Emotions may have been implicated as they left the organization, and the effects may not have waned. Nonetheless, proper due diligence requires contacting people who have previously worked at the hedge fund and documenting any criticism of the organization.

It is important to know not only why an employee has left the hedge fund but also who replaced the employee, especially if the employee is part of senior management or has compliance duties. Clearly the investor should see red flags if the ex-employee left because the hedge fund lost its largest client or the books were marked too aggressively or senior management was behaving inappropriately. Even if the departure was due strictly to personal reasons, the investor must analyze how the replacement of personnel impacts the operations of the fund.

40.1.6 Losses Caused by Problems with Processes

This section focuses on operational processes of a hedge fund. How has the hedge fund been legally organized? Who really owns the hedge fund? What is the firm's AUM, and how many funds does it manage? What are the organizational conflicts of interest? The answers to these questions will clarify what potential conflicts of interest exist within the hedge fund.

An organized hedge fund that prioritizes minimizing violations of federal securities laws will have very transparent operational procedures. The most compliance-minded of hedge funds will have a written set of operational policies and procedures in place and will conduct regular testing to ensure their effectiveness. In general, operational procedures change as an organization grows or contracts. This proves to be another important reason as to why investors must be sensitive to the changes in an organization and perform due diligence continually.

When a well-funded hedge fund launches with a tremendous amount of AUM, the fund can afford world-class operational teams and support. It can also afford the priciest legal team, accountants, and custodians. On the other side of the spectrum, many hedge funds start out with a shoestring budget, and may have used legal documents prepared for another fund just to get started. As such, understanding each component of the organization, from its origins to the current development, may be a daunting task.

Process due diligence requires the assistance of the hedge fund manager and its employees. The more each side warms up to each other, the more easily information will flow from the hedge fund to the investor. The investor warms up by seriously considering investing in a particular hedge fund. At times, however, the hedge fund may be oversubscribed and will only accept investments from investors who will not tax the hedge fund resources with an unnecessarily long due diligence process. In these instances, the hedge fund may be cagey in disclosing information about its internal processes. This means that the investor must figure out a way to obtain sufficient comfort with the investment while being more or less forced to use an abridged due diligence process. This trade-off between confidence with the sufficiency of an abridged due diligence process and access to a hot manager occurs frequently, especially when flows into hedge funds are very active.

How many times will a hedge fund take a call from an investor for the purpose of due diligence? Generally speaking, once a good relationship is established with a given hedge fund and after an allocation has been made, having remaining questions answered on the operational side becomes much easier. The monitoring may become even more transparent, as most hedge funds are very appreciative of their investors and provide all information needed to satisfy the investor. Hedge funds understand that their investors have to perform their requisite due diligence on an ongoing basis and that they may even be obligated to report to a pension fund board or other investors (as is the case in a fund of funds). Hedge funds also generally favor informed investors who take an active interest in the hedge fund's internal workings, as these types of investors tend to stick with the fund through the difficult periods. Investors who have a more superficial understanding of the operations of the hedge fund are quicker to redeem at the first sign of poor performance.

40.1.7 Organizational Structure

A hedge fund is typically organized as a pooled investment vehicle in which the general partner (GP) is responsible for the operations of the fund, and limited partners (LPs) may make investments into the partnership but limit their liability to the paid-in amount. Generally, there is a minimum of one GP and one LP. Due diligence should cover both the GP and the LPs through inquiries, such as the following:

• Is there a dominant GP, or is the ownership spread out over several main partners?
• Are the LPs high-net-worth families who maintain secrecy over their identity, or do they consist of institutional investors with a record of a thorough due diligence process?
• Are the LPs approachable to answer questions about the fund?

A hedge fund reveals most of the information needed to understand its organizational structure through its subscription agreement, offering memorandum, due diligence packages, one-page summary, investor presentation, and so on. Unfortunately, some hedge funds maintain very complex organizational structures. These organizations may have had prior changes in GPs due to retirement of founders, reorganizations, or a refocus of products. These hedge funds are much more difficult to understand, as typically the history of the GP's ownership and funds or product lines have experienced many changes. It becomes very difficult to re-create the historical changes in the organization without proper guidance.

Note that the due diligence process starts with a snapshot of what the hedge funds look like at the present moment. As the due diligence process unfolds and the investor spends more time interacting with hedge fund personnel, the increased familiarity will lead to a better and deeper understanding of the fund's operations. In turn, the hedge fund will likely become increasingly transparent to the due diligence requests of the investor.

40.1.8 Ownership

Understanding the ownership structure is no doubt a key component and will give tremendous insight into the underlying motives of the parties of interest. Also, ownership provides insight into the possible turnover of staff at the hedge fund. Figuring out who owns what is very challenging, as an investor may not be given information about the equity breakdown (as this is naturally a sensitive subject to the GP). In some instances, due diligence reports will be unable to give any specific information regarding ownership and will have to either vaguely state that the majority of the fund is owned by the partners or give some other general reference as to who owns the GP.

Some hedge funds may obscure the ownership structure by stating that the principals own the majority of the GP. However, if an investor is seriously considering relatively large investments, hedge funds will often provide such information in a confidential manner.

There are times when the ownership may change abruptly, such as when hedge fund managers suddenly leave or are otherwise unable to perform their duties in the funds. Since some hedge funds revolve around a single individual who makes the discretionary calls on investments, some institutional investors have minimized their risks by demanding a side letter with a key-person provision. A key-person provision gives investors more flexible redemption terms (e.g., a shorter notice period or a waiver of a lockup or holding period) if a key person is no longer part of the hedge fund. By being allowed to redeem, investors do not have to keep their money invested in a fund for which they have not had a chance to undertake due diligence on the replacement of the key person. It must be noted that a side letter, which puts into writing a special arrangement between the investor and the hedge fund that is not available to all investors, raises a number of concerns, such as fairness to other investors, and thus a hedge fund may be reluctant to grant a side letter.

40.1.9 Assets under Management

The previous section contained some discussion of the evolution of the organization as its AUM increases or decreases. What do the changes in AUM mean to an investor? Decreasing AUM typically signals a potential reduction in staff, as AUM is determinant of revenues generated by the fund (in the form of management fees). These projections help the hedge fund determine the number of employees it is able to hire and maintain. As AUM diminishes and staff size shrinks, tasks and responsibilities are simply taken on by the remaining employees. In such situations, the investor should keep in mind that the remaining staff, if disgruntled by the increased workload and stagnant pay, may be looking for other employment opportunities. On the other hand, increasing AUM typically signals that the hedge fund may bring on board seasoned staff to help grow the business and make it more institutional grade. Additionally, the organization may implement more structure as it increases the sophistication of its operations (e.g., implementing a formal compliance program or compiling a written set of operational policies and procedures). Substantial changes in AUM may also raise other concerns. Are redeeming investors expressing concern about the fund manager, or are their redemptions solely due to rebalancing or normal trading activity? When AUM rises, will the liquidity and the inefficient pricing of the targeted securities decline and reduce the fund's potential alpha?

40.1.10 Fee Structure

Hedge funds typically charge investors a management fee of 1% to 2% of assets and a 20% incentive fee (subject to a high-water mark), but there are many variations from this common fee schedule.

Typically, the management fee is deducted before calculating the fund's returns so that it may more accurately reflect the appreciation of the investor's investment. In addition, assets held in so-called side pockets are generally not included when the hedge fund calculates performance fees. Since investors may invest in a hedge fund at different times throughout the years, many funds, particularly offshore funds, employ different approaches that serve to allocate the appropriate portion of a performance fee or high-water mark to each investor.

40.1.11 Redemption Terms

During the due diligence process, investors must acquire information about the limitations to redeem their investments from the hedge fund. Most hedge funds use the following mechanisms to limit an investor's ability to withdraw assets:

40.1.11.1 Initial Lockup Periods

Some hedge funds do not allow investors to withdraw any part of their investments in the fund until at least 12 months have passed and will apply this restriction to each part of the investment (i.e., if an investor makes an investment in the fund on January 2011, the investor cannot redeem the investment until January 2012; if the investor makes a second investment on March 2011, that portion of the investment has a lockup until March 2012). Hedge funds that hold particularly illiquid securities, such as distressed or activist funds, may have an even longer lockup period. Hard lockup provisions do not allow redemptions for any reason during the lockup period. Other funds may offer a soft lockup provision, in which the hedge fund will allow withdrawals during the lockup period if the investor pays a penalty to the fund to compensate other investors for the trading costs caused by the liquidation of the exiting investor's holdings.

40.1.11.2 Withdrawals and Redemptions

During the financial crisis of 2008, many investors attempted to redeem their shares in some hedge funds, only to experience their first gate. A gating provision, which should be disclosed in the prospectus, is a restriction placed by the hedge fund that limits the amount of withdrawals during a redemption period. Some gates will allow only a certain percentage of assets to be redeemed in each period. Others will allow redemption on a first-come, first-served basis, or offer some pro rata distribution. In any case, gates caused many investors severe heartache during 2008. Hedge funds impose gates in the investment terms to prevent a run on the fund. In a run scenario, most of the fund's assets are withdrawn, which can force the sale of positions at distressed prices. The argument is that if a large number of redemptions occur and the hedge fund has to liquidate a big position, the subsequent forced sell-off may hurt the remaining investors.

A hedge fund will usually permit withdrawals or redemptions from the fund only at specified intervals (enumerated in the offering documents) by providing written notice 30 days or more in advance.

40.1.12 Client Profile

To whom do hedge funds cater? If a given hedge fund's client list includes many high-net-worth investors who are limited in their ability to conduct proper due diligence, then that should be well documented. Compare this to a hedge fund that primarily pursues institutional investors, who are generally known to undertake painstakingly long and detailed due diligence on hedge funds. The client base of the hedge fund subsequently sheds light on a very important detail of the fund.

Many institutional investors share experiences and notes with other institutional investors, especially about their hedge fund experiences. Building a relationship with other investors who have undertaken arduous due diligence processes (and maintained very detailed notes) and have established an intimate relationship with hedge fund managers is exceedingly important. Having a strong and extensive network of friends in the institutional investment community is extremely helpful.

40.1.13 Follow the Cash

One of the important questions in due diligence has to do with who has the power to move cash. Does cash movement require one person to sign, or does it require a dual signature? A small amount of cash can typically be moved by a single signature, most often that of the COO. A large movement of cash should require a dual signature.

Following the cash begins by taking a very skeptical opinion of the manager. Assume that he is a thief with intent to defraud investors at every opportunity. Assuming this, focus on how he would be able to steal investor funds. Finally, review the hedge fund's policies that respond to the possible risk of asset theft and decide whether those policies are sufficient and consistently examined for effectiveness.

Note that if the hedge fund's operational policies allow for any opportunity for the commingling of accounts, this is a critical risk that needs to be prominently documented. Following the cash through the organization, from the investment stage to withdrawals and redemptions, must be thoroughly understood. Strong internal controls should be in place for any institutional-grade hedge funds.

40.1.14 Valuation, Administration, and Prime Brokers

Parallel to following the cash, due diligence should be conducted by following a trade from idea origination to confirmation and settlement. For exchange-traded securities such as stocks, exchange-traded funds (ETFs), and futures, this process should be particularly transparent, since valuations are typically done on the closing prices or last trade as printed on the exchange. Once less liquid securities or over-the-counter (OTC) products are involved, important questions of proper valuations arise.

As a general rule, if a hedge fund's returns are far from average, then the investor should immediately investigate the hedge fund's operations, specifically the direction of trades and the valuations. For example, if a mortgage-backed hedge fund is consistently earning returns of +1% each month while all other mortgage funds are contemporaneously flat, alarms should be ringing and questions should be asked of the hedge fund: Was it net short mortgages while others remained net long, or does the valuation process have any bearing on the performance?

The due diligence process should also monitor the process of subscriptions and redemptions for the hedge fund. In other words, how fluid and transparent is the relationship between the given hedge fund and the administrator of the fund? Typically, fund administrators maintain the hedge fund's books and records and facilitate any subscription/redemption requests. In particular, the administrator role includes (1) maintaining the fund's financial books and records, (2) computing the net asset value (NAV) of the fund, (3) paying/receiving the fund's expenses/income, (4) reconciling the daily and monthly brokerage statements, (5) settling daily trades, (6) pricing securities, (7) calculating and paying dividends and distributions (when necessary), and (8) (possibly) supervising the liquidation and orderly dissolution of the fund.

A hedge fund that has a good working relationship with a well-known administrator gives more confidence to potential investors. If a hedge fund employs a small or unknown administrator, then this relationship should be vetted closely before investing. Errors in NAV calculations and deficiencies in accounting controls and procedures should be recorded and closely monitored.

Hedge fund relationships with prime brokers (PBs) are a key source of understanding the firm. After the collapse of Lehman Brothers, many hedge funds attempt to diversify PB concentration by having relationships with multiple PBs. Investors will often find newer hedge funds through PB capital introduction events. Beyond introducing hedge funds to investors, PBs typically serve the following additional services: (1) global custody, (2) securities lending, (3) facilitating leverage, (4) portfolio reporting and risk reports, (5) specific operational support, (6) office leasing and servicing, (7) capital (human capital) introduction, and (8) consulting and advisory services.

Prime brokers have tremendous access to the hedge fund flow of information. Such information includes new launches, capital movements, and concentrated positions. Therefore, having a few trusted PB contacts can help build key insights into the hedge fund industry. Many times PBs will have covered the given hedge fund manager at prior positions, as these relationships often survive firm changes on either side.

40.1.15 Idea Generation

It is critical to understand how ideas are generated, because there is a risk that the hedge fund will run out of great investment ideas. Though this may not be directly related to operational risk, it is related to the investment process. Suppose a hedge fund starts to run out of investment ideas that generate returns. Out of desperation, the hedge fund managers or analysts start attending idea dinners. Now suppose that at one of these dinners, there is consensus that a given company is excessively overvalued, after which many attendees begin to build a short position on the company. While these managers may be correct, it is an irrelevant fact for the purposes of this illustration because the unfortunate consequence of so many acting on this belief in the market leads to the trade becoming very crowded very quickly. Such crowded trades will continue to be one of the most tragic self-created risks for hedge fund managers.

As an example, take the Volkswagen (VW) and Porsche short squeeze that occurred in October 2008. At the time, Porsche had a reasonably large position in VW. By most fundamental analysis, VW was expensive, and under normal conditions the price of VW should have eventually reflected the fundamentals. It was well known that many hedge funds had short positions in VW. What was not well known, however, was that Porsche was employing options to covertly build an even larger position in VW. On October 28, 2008, short sellers got caught short and propelled VW to become Germany's largest company by market capitalization as frantic short covering ensued. Porsche surprised the markets with an announcement that it had gained control of 74% of VW's voting shares. On January 25, 2010, the New York Times ran an article entitled “Hedge Funds Sue Porsche for Billion Lost on VW.” What should be noted was that the four hedge funds that sustained losses did so on their short positions in VW. The losses amounted to hundreds of millions of dollars per hedge fund.

The ability to generate unique ideas away from mainstream sources is one way to mitigate the risk of investing in overcrowded positions. Alternatively, investors could supplement their analysis by employing Form 13F reports or cross-referencing other managers' positions.

40.1.16 Losses Caused by Problems with Technology

Technology constantly changes because business operations are tempted to include the latest and greatest technologies. But upgrades in operational systems, however marginal, may introduce risks. For example, when upgrades occur, slight changes may cause email systems to go down or result in loss of computer access. Even with third-party vendors, outages due to power loss may render technology useless for some time. Additionally, more serious technology problems may occur if the trading desk or trading platform malfunctions. Backup systems should be well understood, and business continuity and contingency plans should be in place.

Investors can reasonably expect a hedge fund to have a backup system and a fully functioning disaster recovery site. Another important area of concern is the flexibility of virtual private network (VPN) access from home, as this may compromise security. This risk is elevated for more quantitatively driven hedge funds, which typically rely on proprietary code and algorithms.

Recently, some hedge funds have dabbled in employing cloud computing, for which end users do not need to know the physical location and configuration of the systems that deliver these computing services. One of the advantages this presents for a hedge fund is cost-efficiency when hedge fund managers want to outsource most of their information technology (IT) responsibilities. Questions remain about the security of such systems and the risks if the cloud goes down. As hedge funds embrace new and different technologies, investors should craft new questions to understand and analyze the changes. The main point here is that as technology infrastructure changes the business process of a hedge fund, investors need to be perpetually aware of these developments and the potential risks they pose to their investment.

40.1.17 Losses Caused by External Events

December 21, 2012, according to the Mayan calendar, is considered an external event. Will hedge funds be prepared for the end of the world? Will recovery sites come through and back up all the critical information? What happens if a comet knocks out the northeastern U.S. electricity grid and all the backups fail? Will investors have enough information to recover their investments? Thinking about these kinds of external events, regardless of how rare and unrealistic they may be, must yield some credible answers. At a minimum, the operations of the hedge fund should have some documented contingency plans.

External events are very difficult to anticipate, since they often occur when and where most people least expect them to occur. Suppose a hedge fund that worried about sensitive information about clients, portfolios, algorithms, and so on, sets up an impenetrable firewall around its internal servers to prevent hackers or cyber attacks. Then one day, an attack is launched on an exchange where this hedge fund exclusively trades. Alternatively, what happens if this hedge fund's administrator is attacked and exposes or loses sensitive account information? There are many unanticipated scenarios that leave hedge fund operations exposed to external risks.

Since natural disasters have occurred and are expected to occur, it is vitally important to understand how the organization is set up to respond to such events. The bulk of the costs in preparing for disaster are attributed to the location of the backup recovery center. If someone has a hedge fund in New York City and the backup recovery center is located in New Jersey, what happens if the whole northeastern electric grid goes down? Unfortunately, building a backup center in California would be too cost prohibitive for most hedge funds. When risk-control decisions are made due to external events, does the organization examine the options through a fiduciary lens, or are decisions made strictly on the basis of minimizing costs? These are just some of the issues that need to be well understood when assessing losses caused by problems from external events.

40.1.18 Current Best Practices for the Hedge Fund Industry

On January 15, 2009, the Asset Managers' Committee (AMC) published a report to set new standards of best practices in answer to the President's Working Group on Financial Markets. The report attempts to reduce systemic risk and foster investor protection.

AMC identified five key areas where best practices would result in a reduction of systemic risk and increase investor protection:

AMC's recommendations are very detailed and probably more relevant for a larger multistrategy hedge fund with lots of resources to apply to the operational side of the business. In any case, it is a solid framework to build on.