Preface xiii
Chapter 1 What Is Operational Risk? 1
Brief History 2
Modern Definition of Operational Risk in a Hedge Fund Context 7
Operational Due Diligence versus Operational Risk 8
Key Areas 9
External Risks 12
Internal Risks 23
Blended Risks 36
The Five Core Themes 45
Chapter 2 The Importance of Operational Due Diligence 49
Why Should Investors Care about Operational Risk? 49
Morton’s Fork or a Hobson’s Choice? 50
Outright Fraud Still Exists 51
Hedge Fund Fraud Cannot Be Modeled 52
Small Discrepancies Add Up 52
Lack of Standardized Regulation 54
Each Hedge Fund Is Different 55
Ability to Generate an Informational Edge 56
Potential to Reduce Losses and Increase Returns 57
Considering Operational Risk Factors Presents a Different View into a Firm 57
Common Misconceptions 58
Other Considerations: There Is Not Necessarily a Positive Correlation between Assets and Operational Quality 60
A Study in Operational Failure: Bayou Hedge Fund Group 60
Affiliated Broker-Dealer 61
Large Discrepancies in the Performance of Onshore and Offshore Funds 62
Declining Capital of Broker-Dealer 63
Board of Directors: Members and Actions 63
Lavish Expenses of Broker-Dealers 63
Fake Audits Prepared by a Phony Auditor 64
Background Questions 64
Lack of Investor Communication 64
Ties to People Barred from the Securities Industry 65
Revision of Conflicted Marketing Materials 66
Other Anomalies 66
Chapter 3 Who Is Qualified to Perform an Operational Due Diligence Review? 69
Essential Skills 73
Primary Skills 74
Primary, Secondary, Blended, and Other Skills 84
In-house versus Outsourcing 85
Evolution of Independent Operational Rating Agencies 86
Benefits of Third-Party Rating Agencies 86
Criticisms of Third-Party Rating Agencies and Operational Due Diligence Providers 87
Factors to Consider before Performing an Operational Review of a Hedge Fund 90
Chapter 4 Creating an Initial Operational Profile 91
When Does an Operational Due Diligence Review Begin? 91
Documentation 92
The Piñata Problem 93
Due Diligence Questionnaire: To Use or Not to Use? 99
Background Investigations 101
Other Considerations 106
Importance of Onsite Visits 107
Which Office to Visit 108
Manager Interview Process 109
What Topics Should Be Covered During an Onsite Review? 111
Sample Topic Questions 113
In What Order Should These Topics Be Covered? 117
Service Provider Reviews 117
Qualitative Operational Report: Documenting the Operational Data 119
Chapter 5 Evaluating the Gray Areas: Examples 121
Scenario 1: “It Was Not Me”—Hedge Fund Manager Claims Mistaken Identity 121
Scenario 2: “It Was Me, But Everyone Was Doing It”—Are Regulatory Witch Hunts Real? 123
Scenario 3: “It Was Me, But I Did Nothing Wrong”—Manager Proved Not Guilty 127
Scenario 4: The Low-Profile Hedge Fund Manager—Is No News Good News? 129
Scenario 5: The Infrastructure Outsourcer—Can One Administrator Do Everything? 135
Scenario 6: The Mountain Climber—Can Plans for Large, Fast Growth Trip You Along the Way? 137
Scenario 7: The Stumbling Giant—Can a Large Manager Lose Sight of Small Controls? 140
Scenario 8: The Apologetic Headmaster—Are Junior Staff as Informed as Senior Management? 143
Chapter 6 Ten Tips for Performing an Operational Due Diligence Review 145
Tip 1: Avoid Meeting with the Wrong People or the Wrong Groups 146
Tip 2: Get Out of the Conference Room 147
Tip 3: Little White Lies Can Turn into Big Problems 149
Tip 4: Be Wary of Phantomware 151
Tip 5: Focus on Documentation and Negotiation 153
Tip 6: Read the Fine Print (Financial Statement Notes, etc.) 154
Tip 7: Reference Checking: Importance of In-Sample and Out-of-Sample References 156
Tip 8: Credit Analysis: Are Funds Financially Viable? 157
Tip 9: Long-Term Planning: Key Staff Retention, Succession Planning, and More 157
Tip 10: Growth Planning: Is the Manager Proactive or Reactive? 158
Chapter 7 Ongoing Operational Profile Monitoring 161
How Often Should Onsite Operational Reviews Be Conducted? 163
Remote Operational Due Diligence Monitoring 164
Media Monitoring 164
Litigation and Regulatory Monitoring 166
Hedge Fund Communication Reviews 166
Assets Under Management and Performance Monitoring 167
Operational Events 168
Effect of Discovery on the Magnitude of an Operational Event 169
Onsite Visit Frequency and Operational Events 169
Developmental Operational Traps 169
Chapter 8 Techniques for Modeling Operational Risk 179
Scoring Systems 179
Building a Scoring System: Category Determination 179
Category Definitions 185
Combinations of Category Definition Approaches 189
Category Weight Assignment 193
Weighting Aggregation Model 195
Weighting Disaggregation Model 197
WAM versus WDM 200
Category Weight Consistency and Reweighting Considerations 201
Factor Marginalization 202
Category Scale Determination and the Meaning of Scores 203
Threshold Self-Assessment and Determination 204
Score Assignment 206
Discretionary Penalties and Bonuses 212
Score Aggregation: Sum Totaling and Weighted Averages 214
Criticisms of Scorecard Models 215
Benefits of Scorecard Models 217
Visualization Techniques 217
Chapter 9 Bridging the Gap: Incorporating Operational Risk Consideration into the Portfolio Construction and Asset Allocation Process 225
Proactive Monitoring: Graphical Universe Creation 227
Proactive Management of Operational Risks 232
Protecting against Conglomeration Risks: Multivariate Commonality Analysis 233
Operational Directional Views 235
Example of Multivariate Commonality Analysis 236
First Objective: Total Diversity Goal 237
Second Objective: FSA Overweight Goal 239
Third Objective: FSA Underweight Goal 243
Conclusions of Scenario Analysis 243
Considering Operational Reviews in the Hedge Fund Portfolio Rebalancing Process 245
Operational Drag 245
Meta Risks 249
Operational Factor 250
Operational Scenario Analysis 253
Can Operational Risk Be Entirely Eliminated? 254
Factoring Operational Risk into Total Risk Calculations 256
Beyond Scorecard Approaches: Discounting Expected Return 257
Discounted Expected Returns with the Operational Factor 261
Operational Haircuts 262
Expected Return and Operational Risk 263
Shape of the Expected Return versus Operational Risk Curve 264
Second Operational Threshold 265
Final Thoughts 267
Chapter 10 Looking Ahead: Trends in the Space 269
Increased Use of Consultants 269
Commoditization of Background Investigations and Canned Operational Due Diligence Reports 272
Increased Reliance on Service Provider Consulting Services 277
Capture of Hedge Funds by Service Providers and Employees 278
Hedge Fund Pursuit of Audit Certifications 280
Operational Activism 281
AU 332 and FAS 157 283
Development of Hedges to Operational Risks 286
Links between Operational Risk and Credit Analysis 288
Proposed Reregulation of the Hedge Fund Industry 289
Index 293
JASON A. SCHARFMAN is a Director with Graystone Research at Morgan Stanley. His responsibilities include analyzing and reporting on the operational risks of alternative investments such as hedge funds, funds of hedge funds, and private equity considered for investment. He also makes recommendations to the firm's investment committee based on that analysis. He has written on the subject of operational due diligence and travels and speaks worldwide on hedge fund operational risks.
"Informative book by Jason Scharfman, on, well, pretty much everything you need to run a hedge fund…Scharfman also explains the reliance on technology that is becoming ever more apparent in hedge funds, the dangers of phantomware, and questions that should be asked before committing to any new technology." (hedgeco.net, January 26th, 2009) "In his book, Jason Scharfman identifies these operational risks and recommends a strong and innovative "operational" due diligence review program as the best defense against them. His book outlines a step-by-step guide that shows investors how to effectively detect and evaluate often-overlooked operational risk factors in hedge funds and other investments in order to provide hedge funds and their investors with the skills to understand and hopefully mitigate these risks." (The Hedge Fund Law Report, January 8, 2009)
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