1. OPERATIONAL DUE DILIGENCE INSIGHTS 2015
KNOWLEDGE SHARING
HELPING TO IMPROVE STABILITY & FACILITATE BUSINESS IN THE HEDGE FUND MARKET PLACE
PRISM LLCAlternative Investments
LAURI MARTIN HAAS
212 223 2288
LMARTIN@PRISMALTERNATIVES.COM
HTTP://WWW.PRISMALTERNATIVES.COM

2.
LAURI MARTIN HAAS TEL: 212-223-2288 E: LMARTIN@PRISMALTERNATIVES.COM
OPERATIONAL DUE DILIGENCE VIEWPOINTS
THIS ARTICLE IS PROPRIETARY AND IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. PRISM LLC IS NOT A REGISTERED INVESTMENT ADVISOR OR BROKER DEALER, AND PRISM LLC DOES NOT MAKE INVESTMENT RECOMMENDA-
TIONS. PRISM LLC CONDUCTS OPERATIONAL DUE DILIGENCE AND RELATED CONSULTING SERVICES ON HEDGE FUNDS. PRISM LLC STRONGLY RECOMMENDS CONDUCTING EXTENSIVE OPERATIONAL DUE DILIGENCE PRIOR TO MAKING
AN INVESTMENT IN A FUND AND ANNUALLY THEREAFTER ON AN ONGOING BASIS.
HEDGE FUND WIRE TRANSFER CONTROLS AND THE REGIONAL DIFFERENCES
Registered investment advisors with the
US Securities and Exchange Commission
generally have custody of client assets,
either directly or indirectly. Why is this ac-
ceptable practice in the United States and
not in other countries around the world?
Most hedge fund fraud cases i.e. Ponzi
schemes, misuse of assets, and expense
manipulations, have occurred in the United
States by US based investment managers.
Research has shown that far fewer cases
have occurred in the United Kingdom, Con-
tinental Europe, Hong Kong, and Singa-
pore. Local customs, parochial standards,
and regulations have contributed to the US
hedge fund industry’s higher than global
operational risk. Having personally evalu-
ated over 2,000 hedge funds in my career,
I can attest to the fact that “access to cli-
ent assets” is at the center of most frauds.
What is done differently by US
based hedge fund managers?
While a private fund manager generally
does not directly hold client assets, as
they usually rely on prime brokers, banks,
or other custodians, a US fund manager
is often “deemed to have custody” be-
cause it is party to an arrangement (such
as an investment management agree-
ment) under which it has the authority to
withdraw funds or securities from a client
account. This is typically done via a “pow-
er of attorney” in order to pay manage-
ment and performance fees to the fund’s
manager/general partner and to have
check writing authority to pay expenses.
Having said this, United States hedge fund
managers are permitted to have “custo-
dy” of client assets subject to having cer-
tain “controls” in place, according to SEC
Custody Rule 206(4)-2. These controls
include having a financial statement au-
dit completed within 120 days from fiscal
year end, or undergoing an annual sur-
prise custody examination by an indepen-
dent public accountant. As such, most US
hedge fund managers have the ability to
withdraw cash from the fund, and not sole-
ly the ability to process trade settlements.
Instead of prohibiting the custody i.e. pos-
session of client assets by registered
investment advisors, the United States
regulates the custody of client assets
by registered investment advisors. This
poses a conflict of interest, as the advi-
sor both chooses the investments and
has access and possession of client cash.
Why should an investment manager, which
often is a privately owned and some-
times closely controlled boutique, have
access and control to client funds? The
answer is that they probably shouldn’t.
If US investment advisors were subject
to different guidelines, some of which are
practiced overseas, for example were i)
prohibited from having custody of client
assets, ii) prohibited from having custody
of client assets unless they were subject
to a SSAE 16 Type II (which would likely
only occur with asset managers with over
$10 billion in AUM), or iii) prohibited from
making non-trading payments whereby
these payments were made only by a
third party (e.g. an independent admin-
istrator); I believe that the risk of fraud
in the US hedge fund and private equity
industry would decrease dramatically.
While in reality there are very few cases
of large scale frauds in our industry, we
do need to work to eliminate the window
of opportunity for financial loss resulting
from fraud and mis-use of client assets.
Custody Norms
The global norm is for a hedge fund to en-
gage independent qualified custodians to
custody 100% of its assets, and institution-
al banking relationships to process operat-
ing transactions for the fund (i.e. investor
subscriptions and withdrawals, and ex-
penses in certain cases). However, the US
norm is for hedge fund manager employ-
ees to process and pay a fund’s expenses
through the prime brokerage account which
they have control over, while the non-US
norm is for independent fund administra-
tors to process and pay fund expenses
through a bank account that they control.
Having said this, perhaps the process by
which fund expenses are paid could be
re-visited in America, as an ideal situation
for a sound internal control structure is for
the fund administrator to review, approve,
and process all payments to vendors out of
an administrator controlled bank account.
In summary, it is not ideal for a manager’s
employees to process expenses out of a
fund’s prime brokerage account, and it is
not ideal for a manager to pay expenses
and later be reimbursed by the fund. While
both of these scenarios are currently nor-
mal, standard, and acceptable practice in
the United States, they do expose funds
to a higher risk of operational errors or
worse, mis-appropriation of assets. In
Europe and Asia, expenses are normally
paid directly by the fund administrator.
MAY 2015

3.
LAURI MARTIN HAAS TEL: 212-223-2288 E: LMARTIN@PRISMALTERNATIVES.COM WWW.PRISMALTERNATIVES.COM
OPERATIONAL DUE DILIGENCE VIEWPOINTS
THIS ARTICLE IS PROPRIETARY AND IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. PRISM LLC IS NOT A REGISTERED INVESTMENT ADVISOR OR BROKER DEALER, AND PRISM LLC DOES NOT MAKE INVESTMENT RECOMMENDA-
TIONS. PRISM LLC CONDUCTS OPERATIONAL DUE DILIGENCE AND RELATED CONSULTING SERVICES ON HEDGE FUNDS. PRISM LLC STRONGLY RECOMMENDS CONDUCTING EXTENSIVE OPERATIONAL DUE DILIGENCE PRIOR TO MAKING
AN INVESTMENT IN A FUND AND ANNUALLY THEREAFTER ON AN ONGOING BASIS.
AVOIDING PONZI SCHEMES & HEDGE FUND FRAUDS
The single most important reason to conduct
hedge fund operational due diligence is to
avoid losing your capital. The most frightening
way to lose your capital is through a fraud or
Ponzi scheme. The largest Ponzi Scheme in
the history of hedge funds is Bernard Madoff.
There are clear guidelines that an investor should
follow in order to protect themselves from investing in
a financial fraud. Hedge fund frauds, often structured
in the form of a Ponzi Scheme, can result in a complete
lossofinvestorcapital.Thislosstypicallyleadsto years
of ongoing legal fees, which often negatively impacts
theinvestor’slifeorfranchiselongterm.PonziSchemes
often start out as legitimate investment strategies,
and fraud ensues in an effort to cover up losses
once performance or business targets are not met.
The following steps are critical to meeting the goal of
avoiding fraud:
1. Hire an unbiased third party to assess the fraud risk of the
hedge fund. The independence of this opinion is critical to
removing the inherent conflict of interest between choos-
ing performance or relationships over operational risk. This is
especially important if you are a fiduciary.
2. Ensure that the fund’s financial statements are audited by
an internationally recognized CPA firm. Obtain the audits
from the administrator and inspect them for tampering.
3. Confirm that the fund uses an independent administrator
that provides daily oversight of the fund’s cash flows.
4. Confirm that 100% of the fund’s assets are custodied by a
qualified custodian, and confirm the account balances
directly with the custodian.
5. Conduct at least three reference checks, including clients,
former employers, and counterparties.
6. Conduct background checks, including verification of edu-
cation, employment, registrations, and other public records.
7. Take an audit based, academic approach to conducting
ODD. Do not place heavy importance on “positive industry
talk”,“highly sellable stories”, or “old relationships”.
8. Ensure that every hedge fund allocation is protected by a
third party custodian and a known fund administrator, even
allocations to single traders running single investor funds.
9. Lastly but most importantly, maintain an unwavering atten-
tion to institutional standards, and never “look for a reason
to invest” or try to “qualify” the operational risk flags. Con-
ducting extensive due diligence can prove wasteful if the
investment decisions are undefendable when it comes to
fraud and operational risk.
The following flags have been seen in actual Ponzi
Schemes:
• Lack of transparency.
• Nepotism.
• Lack of a well known or independent custodian.
• Lack of an institutional fund administrator.
• Decentralized accounting i.e. use of several vendors.
• Unusual investment strategy.
• Unconventional and unprofessional behavior.
• Unqualified back office personnel.
• Affiliated broker dealer.
• Use of feeder funds.
• Use of unaudited SPVs (special purpose vehicles).
• Use of several SPVs (a tactic used to confuse auditors).
• Lack of audited GAAP financials (i.e. tax basis financials).
• Inconsistent due diligence information (e.g. headcount).
• Unexplained differences in custody account balances.
• Unusual discussions regarding liquidity.
• Past litigation with investors.
• Unusual related party transactions in the audit.
• Single signature wire transfer controls on fund accounts.
• Lack of industry standard marketing material.
• Highly paid fund directors.
• Denied access to the back office team.
• Service providers based in non financial centers, which are
not as well versed in hedge funds (DE, FLA, Netherlands).
One of the more important factors listed above is
“unconventional behavior”. This is a gray area, and
often will be a deciding factor on whether or not to
place professional trust in a hedge fund manager. Some
examples of unconventional behavior are dance music
playing on the firm’s voicemail, black card stock with silver
font used for audited financials, dogs onsite playing ball
in the trading room, portfolio manager out on a run when
you show up for a meeting, CFO looking for reasons to end
a meeting early, unusual or lack of updates on SEC Form
ADV. These are real life examples of hedge fund fraud
flags, and are provided here as a frame of reference.
Over the last 20 years, most hedge fund frauds have
operated via the manager’s use of fictitious client account
statements. This was the case not only with Madoff, but
it was the case with the large majority of historical fraud
related blowups. There are ways to avoid the risk of relying
on doctored statements. In short, requiring the use of an
institutional SSAE SOC 1 daily fund administrator, the use
of large custodians, and the use of a globally recognized
financial statement auditor with a large financial
services practice will limit your fraud risk substantially.
MAY 2015