Investor Dd - What Fm's Need to Know

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“We have seen a dramatic increase in 

the number o investor due diligence 

inquiries and site visits, especially rom 

institutional investors.” 

Christine Waldron, Senior Vice President  Alternative Investment Administration U.S. Bancorp Fund Services, LLC 

U.S. Bancorp Fund Services, LLC

March 2009 Edition

Providing industry insight into market trends, best practices & service solutions.

“The hedge und industry is on the verge o unprecedented regulatory change. Manager and portolio transparency, registration and increased reporting will require enhanced operational procedures to demonstrate a commitment to protect investor assets.” 

George J. Mazin, Partner Dechert, LLP 

A GUIDE TO HEDGE FUNDINVESTOR DUE DILIGENCEHelp Maae Uea he El Faal Laape

The volatility in the market, combined with recent hedge und scandals and raud, hasbrought investment practices into the limelight and caused increased requirements bythe OCC, SEC, FDIC, and FINRA or heightened transparency, risk management, andcompliance. With due diligence sharpened around investment processes and services,investors expect managers to rise above market uctuations, adapt, and evolve theirprocesses to ensure they are adjusting to regulatory changes and challenges. As investors,

particularly institutional investors, begin conducting ormal due diligence assessments o administration operations prior to placing assets with unds, management companies mustaugment their purely asset management ocus with comprehensive compliance programsand be aware o all red ags including perceived conict o internal administrationservices, valuation conicts o interest, or afliated prime brokerage arrangements. Anysingle area o perceived administration risk can create enough concern to drive investorsto dierent managers. In an economic environment that encourages increased regulations,leaner business practices, and requires aster and more sophisticated technology, managersmust take into account the entirety o their hedge und administration and develop aninrastructure to anticipate and prepare or investor due diligence.

MANAGER PREPAREDNESS FOR INVESTOR DUE DILIGENCE

Investors contemplating signifcant commitments will oten require an on-site due diligencetour o potential managers’ operations to cover the ollowing administration risk assessmentcategories:  » Service Structure  » Administration Firm Inormation  » Talent and Stafng Resources  » Technology Environment

» Valuation Procedures and Controls  » Compliance Procedures and Controls

» Investor Servicing Procedures and Controls

It is vital or managers to treat investor due diligence processes as they would external auditsbusiness risk assessments, or procurement processes. By taking the time to ully understandeach individual investor’s requirements, managers can prepare inormation and responsesin advance o ormal onsite due diligence and demonstrate ull transparency o operations,procedures, and the control environment. Your proactive response highlights yourcommitment to the investor by taking into consideration the nature and depth o inormationthey require and becomes an opportunity to strengthen the relationship and engenderinvestor education and loyalty.

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SERVICE STRUCTURE - WHO PROVIDES WHAT SERVICE?

The initial key questions and concerns raised by investors relate to the segregation o 

investment and administration duties or hedge unds. Investors require detailed inormation

regarding the frm’s und valuation, compliance, prime broker, custody, investor reporting,

legal, and audit unctions. Some investors have even gone as ar as electing to invest onlyin hedge unds that utilize an independent third party administrator and non-afliated

prime broker. Although internal administration will not necessarily create a conict o 

interest, investors now require more inormation prior to investing in order to gain comort

with a manager’s afliated administration arrangement in light o recent examples o 

manager raud. Investors are not only challenging the manager’s selection o hedge und

administration support, but also the choice o a qualifed independent audit frm, security

valuation sources, prime broker and custodian arrangements.

ADMINISTRATION FIRM INFORMATION

Investors require ownership and fnancial inormation todetermine the administrator’s fnancial soundness and stability,

and to identiy potential conicts o internal or third party

administrators. Administrators will be requested to provide a

description o each service oered, as well as the geographic

location o afliate service ofces and associated sta size.

A description o the administrator’s client base including

client concentration, asset concentration, portolios, and

number o investors, will speak to the diversity o the business

and the breadth and complexity o investment styles supported. Investors also require a

complete description o the service model and how they will be supported by the manager

or administrator or dierent types o investor inquiries. Managers are required to provideinormation concerning the administrator’s insurance coverage, NAV service quality

perormance, subscription and redemption processing errors, complaint fles as well as

compliance and audit exceptions.

TALENT AND STAFFING RESOURCES

The administrator’s talent and expertise is the most important

element o due diligence responses. The investor requires

comort that the management team and senior administration

talent possess the vision, authority, skills and accountability to

the und and investors in order to ulfll the role o independent

compliance oversight o the manager.

Investors will complete a thorough assessment o the

administrator’s investment securities talent, including industry

and specifc product service tenure, certifcations, and biographies. Responses should ocus

on the specifc product requirements related to the investor’s und selection with respect to

sta sourcing, efciency, and the administrator’s capacity. Investors require inormation

concerning the training and development o administration sta, especially concerning the

accounting or complex investment instruments such as fxed income derivatives.

“An $18 billion client selected our 

services based upon their institutional 

investor’s due diligence assessment 

o our services – proo that the back 

ofce is critical to growing assets.” 

Joe Neuberger, Executive Vice President U.S. Bancorp Fund Services, LLC  

due diligence topics:» Firm history, ownership

» Organization structure

» Company fnancials

» Services oered

» Client base

» Service perormance &

Quality Reporting

» Insurance coverage

» Litigation

due diligence topics:

» Management team

» Turnover

» Training programs

» Education

» Expertise regarding specifc

strategies

» Sta levels – accounting,compliance, tax, legal

» Internal audit sta

 A gUidE to HEdgE FUnd invEstor dUE diLigEncE

“The complexities o due diligence require hedge und investors to work closely with well capitalized third 

parties who can provide detailed analysis regarding custodial risk,perormance attribution, risk analysis and market exposure.” 

Steve Vermut, Managing Partner Merlin Securities 

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“Pending hedge und industry reorm m

require managers to enhance their poli

and procedures, including documentati

testing and audit support with respect t

the entire investment and administratio

control environment.” Chris Bellamy, CPA, Pa

Cohen Fund Audit Services

TECHNOLOGy ENVIRONMENT

Managers are required to demonstrate the efciency andstability o their technology environment, allowing the investorto assess the business risks associated with accuracy, timeliness,

change management, or technology ailure. Investors’interest in the manager’s administration technology considersthe sotware application eatures to automatically perormprocessing such as incentive ee calculations and tax allocations.Managers’ responses should ocus on the breadth o the undaccounting and investor accounting systems in addition tothe administrator’s ormal contingency plan preparedness.

Investors require a description o both physical and system data security access controlsto satisy confdentiality and control procedures regarding access to investor and portoliocash. I managers deliver investor statements electronically or provide investors access todocuments through a Web portal, they will want to also include a detailed description o theapplication’s security access, password administration, and confdentiality measures.

Managers should expect due diligence to ocus ontechnology automation and the efciency o theadministrator including data integration between theportolio accounting system, partner accounting sotware,tax reporting, investor reporting tools, security pricing,corporate actions, rate, and sub-accounting systems. (Seeincluded charts). Investors will request the administratorto identiy any unctions perormed “o-line” or manually,in order to understand accuracy and operational risks. Byalso describing all internal and external technical supportsta and resources available, managers will give their

investors confdence in the support and enhancement o their various technology applications.

VALUATION PROCEDURES AND CONTROLS

Investors require signifcant detail concerning NAV calculationprocedures including the source o valuation data, verifcationprocess, controls, and deadlines. Due to recent scandals, investorsare extremely sensitive to the involvement o managers in thecalculation and dissemination o the und and investor assetvaluations. Investors will gain comort in the valuation processto the extent the manager can demonstrate independence in the

calculation o the und’s NAV.

Investors also ocus on the source o NAV data including security prices, corporate actions,and rate inormation used in und valuations. The pricing o illiquid or complex derivativeinstruments generates heightened investor scrutiny to assess whether managers determinedthese values or obtained independent counterparty issuer/dealer valuations. Investors willalso request valuation policies and procedures approved by the und’s independent auditorand assess whether the annual audit includes an independent testing and verifcation o und valuations. Valuation deadlines are important or investors to understand NAVprocess efciency, service standards, and historic ability to meet those deadlines. Managers’experience in consistently delivering accurate NAVs within 1-3 days o a period-end providesinvestors with insight into the talent and efciency o their administration.

due diligence topics:

» Data security

» Portolio accounting

» Investor accounting

» Tax reporting sotware» Customer service sotware

» Reconciliation sotware

» Data eeds – pricing, rate and

corporate action data

» Disaster recovery

due diligence topics:

» Data security

» Security pricing sources

» Independent veriication

» Valuation procedures

» Valuation deadlines

LoanSub-Accounting

Broker & CustodianInformation

Pricing Services

Expenses

Corporate ActionServices

PARTNER

ACCOUNTINGSOFTWAREA

TAX

REPORTINGSOFTWARE

INVESTMENTMANAGER

PORTFOLIO

REPORTING

ALTERNATIVESERVICES

prf Asfwar

Interfaces

PORTFOLIO ACCOUNTING TECHNOLOGy 

 A gUidE to HEdgE FUnd invEstor dUE diLigEncE

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COMPLIANCE PROCEDURES AND CONTROLS

Never beore have und compliance procedures and controls been so important to the hedgeund industry. Investors require written compliance procedures, adherence to procedures,

and details on whether compliance testing is automated or manual. Investors are lookingor ormal compliance programs that include an identifed AML ofcer, chie compliance

ofcer, and risk ofcer. Managers will be requested to provide a SAS70 or similar document

demonstrating independent review o the control environment. Additional compliancetesting inquiries will ocus on investment restrictions, oering document compliance checks,

leverage restrictions, requency o testing investment restrictions, issuer concentration,diversifcation tests, and the reporting and review o compliance testing by management o 

the administrator.

INVESTOR SERVICING PROCEDURES AND CONTROLS

Investor due diligence involves

a review o all policies and

procedures related to investoraccounting and reporting

including AML compliance,subscriptions, redemptions,

payment processing, and investor capital accountreporting. Investors will careully assess the handling o 

all investor cash, procedures or review and approval o all subscriptions and disbursements, and internal and

external secondary authorizations. Investors will requireinormation concerning managers’ ability to accurately

perorm the accounting and processing o investorallocations, management and incentive ee calculations,

hot issues and side pocket allocations, tax estimates, and

investor statements. As in any experienced audit, the investor is looking or segregation o duties or these unctions as

well as a review and approval process. Descriptions o accurate and timely investor reporting is paramount in the duediligence process in order to gain investors’ confdence in the transparency o inormation concerning their investment.

CONCLUSION

The hedge und industry turmoil caused by current market conditions and hedge und manager scandals is driving investors to perorm risk assessments o hedge und administration support. By looking at investor due diligenceas an opportunity to showcase operations, and by being prepared or detailed questions, hedge und managers candemonstrate transparency, create investor confdence in their investment practices and administration, and secure assets

ABOUT THE AUTHORBob Kern - As an Executive Vice President or U.S. Bancorp Fund Services, LLC, Mr. Kern serves as Director o Business Development. With over 27 years o industry

experience, Mr. Kern works with investment management frms to customize mutual und and alternative product service solutions.

Headquartered in Milwaukee since 1969, U.S. Bancorp Fund Services, LLC currently provides services to more than 280 fund families, with more than 1,600

portfolios and over 1,800 fund classes and administers 4.2 million shareholder accounts with $513 billion in client assets. U.S. Bancorp Fund Services’ clients

include mutual funds, investment partnerships, hedge funds, separately managed accounts, fund-of-funds, and offshore funds. It is a subsidiary of U.S

Bancorp, the sixth largest bank in the United States with assets of $262 billion, NOTED IN THE 2008 CORPORATE PROFILE.

© 2009 U.s. Bap Fu see, LLc. All h eee.

031809

www.usbfs.com

PortfolioAccounting System

InvestorService Center

InvestorCRM Database

AMLVerification

INVESTMENTMANAGER

INVESTOR

TAXREPORTINGSOFTWARE

CAPITAL ACCOUNT

STATEMENTS

INVESTORCOMPLIANCE

REPORTS

Interfaces

ALTERNATIVESERVICES

parr Asfwar

INVESTOR SERVICES TECHNOLOGy 

due diligence topics:

» SAS 70 or similar external

report o controls

» Regulatory audits, results

» Procedure manuals

» Reconciliation process

» Disaster recovery test results» Audit exceptions

due diligence topics:

» AML process

» Investor reporting

» Cash processing

» Payment processing