Operational Due Diligence


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October 26, 2009 Operational Due Diligence –The Risks and The Need for Proactive Prevention Presented by: Howard Altman, Co-Managing Principal, Rothstein Kass Jeffrey Kollin, Director, Rothstein Kass Andrew De Montille, Senior Manager, Rothstein Kass

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Page 2 Current Environment Current Environment Post the events of 2008, many hedge funds and alternative investment vehicles have closed or have been acquired. Acknowledgement that government regulations are coming. Investors are demanding institutional type procedures/controls. Cost savings are integral to hedge fund growth and survival and yet the due diligence process post-2008 will be more rigorous, expensive and time consuming.

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Page 3 Sample Proposed Legislation and Regulations Sample Proposed Legislation and Regulations House Private Fund Investment Advisers Registration Act of 2009 Over-the-Counter Derivatives Markets Act of 2009 (2 versions) Investor Protection Act of 2009 Insurance Information Act of 2009 Accountability and Transparency in Rating Agencies Act The Consumer Financial Protection Agency Act of 2009 Senate Comprehensive Derivatives Regulation Act of 2009 Liability for Aiding and Abetting Securities Violations Act of 2009 (whistleblower statute) Commodity Speculation Reform Act of 2009 Private Fund Transparency Act of 2009 Fraud Enforcement and Recover Act of 2009 Agencies Joint Report of the SEC and CFTC on Harmonization of Regulation SEC Alternative Uptick Rule SEC Makes Rules to Prevent Naked Shorts Permanent

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Page 4 New Era of Communication to Investors New Era of Communication to Investors Investor Landscape The days when a fund would get 80% of their capital from 20 investors is moving towards 90% from 10 investors.

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Page 5 What are Investors Looking for From Funds? What are Investors Looking for From Funds? Alpha generation and pedigree are the new baseline for investors and they now strive for institutional infrastructure even below the $1 billion mark. They are looking for transparency into: Analytics: Exposure (Daily (not just monthly) and over time); Concentration Correlation; Alpha vs. Longs and Shorts; and Attribution (Relative and Absolute). Infrastructure: IT (DR, BCP) – Are they outsourced? Are they tested? Documentation (Ops Manual, Compliance Manual, DDQ’s, etc.) – Is such documentation updated and tested? Vendor Contracts – Are they reviewed and tested? Can you handle managed accounts? Allocations? Marketing: Have you modified your materials in the last 6 months? Do you know what investors you should be focusing on?

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Page 6 Why Hedge Funds and Their Investors Should Systematically Assess Operational Risks? Why Hedge Funds and Their Investors Should Systematically Assess Operational Risks? As reports of hedge fund closures continue to emerge, investors are increasingly recognizing the critical role of due diligence processes in protecting capital and managing risks. Such due diligence can increase investors’ confidence that hedge funds are avoiding unintended market exposures or unsuitable risk-adjusted returns. To assure that risk exposures align with potential rewards, these processes typically focus on the portfolio manager’s qualifications and experience, along with the fund’s diversification guidelines, use of leverage, exit strategies and other asset management disciplines. However, this may leave them exposed to a type of risk that has been directly associated with some of the largest hedge fund closures in history – operational risk.

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Page 7 What is Operational Risk and Why Is It So Important? What is Operational Risk and Why Is It So Important? According to the U.S. Treasury, operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.” The Basel Committee, an international risk management group created by the central bank Governors of the Group of Ten Nations, has established seven areas of loss events that arise from operational risks. As shown in the next slide, they range from failed transactions to terrorism and natural disasters. In up or down markets, and even for strong investment managers using sound strategies, operational risks can turn successful hedge funds into failed enterprises. Operational risks can be opaque even for hedge fund internal staffers who work in risk-sensitive operations areas. For this reason, deciphering operational risk is a specialized component of due diligence that typically requires a separate process and skill set.

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Page 8 Operational Risk Loss Event Categories Operational Risk Loss Event Categories

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Page 9 Who Should Perform Operational Risk Assessments? Who Should Perform Operational Risk Assessments? A hedge fund operational risk assessment can be undertaken by a single investor or commissioned by the hedge fund itself, with results distributed to multiple prospective investors. In either case, it is best performed by an independent third-party specialist who can look at a hedge fund’s operational staff, systems and workflows with a critical eye for inefficiencies, vulnerabilities and indicators of loss events.

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Page 10 Operational Risk Assessment - Key Review Areas Operational Risk Assessment - Key Review Areas Organization Internal Controls and Compliance Valuation Methods and Investor Reporting Trading and Operational Processes Service Providers and Counterparties Interested Parties Hedge Funds Consultants Pensions, Endowment, Foundations Fund-of-Funds Family Offices A detailed work program which targets the key areas in operational due diligence allows investors to gain comfort that best practices are being observed. Although each assessment can be customized to the assignment, the process typically covers five areas:

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Page 11 Operational Risk Assessment Process Model Operational Risk Assessment Process Model Many types of investors can take advantage of an independent operational risk assessment. A typical operational risk assessment process follows a four-step model, as described below:

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Page 12 Best practices Best practices A typical Operational Risk Assessment would include the following engagement procedures: Assess existing procedural documentation and recommend best practices regarding process flows in order to strengthen the existing control environment. Identify control gaps and/or potential segregation of duties issues. Conduct interviews with appropriate personnel to validate their understanding of and compliance with documented procedures. Assess responsibilities assigned to trading, operations and accounting personnel. Design, develop and perform sample based procedures on fund trading activity and financial transactions to determine if key controls were functioning as described in the procedural documentation. Develop recommendations to strengthen controls, increase efficiency and enhance the infrastructure.

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Page 13 Value Proposition Value Proposition The advantages of an operational risk assessment include: Increasing the awareness of general and specific operational risks among internal staff, at all levels of the fund. Creating a framework for efficient liability management, plus a better understanding of the fund’s cash and liquidity needs. Providing a rationale for the capital investments, operating expenses, and staff required for infrastructure improvements. Increasing the consistency and cost-efficiency of due diligence processes. Identifying opportunities to fully realize capabilities provided by prime brokers, administrators and other vendors. Enhancing operational and financing efficiency to upgrade the fund’s credit standing. Anticipating potential loss events and putting solutions to work faster, with contingency planning and pre-designated staff responsibilities.

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Page 14 Bottom Line Benefit Bottom Line Benefit The bottom line benefit of an operational risk assessment is that it creates the same transparency and accountability for a hedge fund’s processes, people and systems that traditional due diligence provide for investment management. To achieve this benefit, investors and consultants should choose operational risk specialists with deep experience in hedge fund operations, an understanding of how operational areas work together, and the independence to think critically and deliver objective evaluation and constructive guidance.

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Page 15 Questions?

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