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Operational Due Diligence Insights
       In This Issue
                                       Welcome to Our First Issue
- Increased Fund Regulatory            Welcome to the inaugural issue of Corgentum Consulting's Operational Due
 Requirements Complicate               Diligence Insights. This newsletter will serve as a resource for news, opinions
 Compliance Diligence                  and insights focused on issues related to operational risk and operational
                                       due diligence on fund managers including hedge funds, private equity funds
- Backup Power Generation - Are
                                       and traditional managers.
 Fund's Prepared for Blackouts?

- Diagnosing Information Security
                                        Increased Fund Regulatory
- Business Continuity and DR

- Financial Statement Risk:
                                        Requirements Complicate
  The Master-Feeder Conundrum           Compliance Diligence
-Focus on Private Equity
                                       In the context of investors attempting to evaluate the sum total of operational
-Term of The Month: Reserves           risk in fund managers, no area is currently more rife with changes than the
                                       legal and compliance area. The passage of Dodd-Frank and the subsequent
-New Book Provides Tools to Evaluate   flurry of governmental rules and regulations have metastasized into a complex
 Operational Risk in Private Equity    compliance web that both funds and investors must navigate. From the funds
 and Real Estate Funds                 perspective, these new rules apply to many different fund manager types
                                       across asset classes including hedge funds, private equity funds, real estate
-Analyzing Fund Administrators         funds and more traditional fund managers. For investors performing
 During Due Diligence - Valuation      operational due diligence, one of the key challenges to evaluate is whether a
 Independence                          fund not only has taken a pro-active

-Operational Risk Calendar                                                                 ...continued on next page

                                                                                                www.Corgentum.com
2 - Operational Due Diligence Insights
                                                              levels of compliance. Another less obvious added
Regulatory - Continued from page 1...                         benefit for investors may also be knowledge about how
                                                              seriously a fund manager takes the concept of
approach to comply with the new rules and regulations,        compliance.
but whether they have done so intelligently. One of the
                                                              Said another way - if a fund manager takes the bare
key challenges many fund managers have recently faced
                                                              minimum approach towards internal compliance
is the registration requirements recently enacted by the
                                                              oversight, where else might they be cutting corners?
SEC. In addition to the registration requirements, many
                                                              Without comprehensive operational due diligence, the
fund managers may have to comply with additional
                                                              answer might not be as clear as investors might like.
reporting disclosure requirements, including those
contained in the revised Form ADV and Form PF. Fund
managers seeking to initially comply with the SEC's           Backup Power
February 14, 2012 registration deadline, likely took a
number of different approaches in their path towards          Generation: Are
compliance. Many fund managers engaged one of the
bevy of third-party compliance consultants. These third-      Fund's Prepared for
party firms have realized a recent boon to their
businesses, based on increased compliance                     Blackouts?
requirements. Other fund managers, instead, likely
worked with law firms to assist them with this process.
                                                              Business continuity planning and disaster recovery,
Still, others may have utilized internal legal and
                                                              often abbreviated as BCP/DR, is one area which is
compliance resources. In any case, now that we are past
                                                              typically covered, or at least should be covered, during
the registration deadline, investors may be tempted to
                                                              the operational due diligence process. Reviews of a
consider the approach taken by a particular fund to
                                                              fund's BCP/DR infrastructures however, are a bit
comply with registration requirements to be a moot
                                                              counterintuitive. The goal of evaluating a fund's BCP/DR
point. After all, the only point is that a fund has met the
                                                              plans seems simple enough on its’ face - can a fund
requirements, isn't it?                                       continue operations in the event of a disaster? However,
Such an approach seeks to put the cart before the             from this simple enough question comes a myriad of
horse. With the registration deadline now behind them,        quite complex technology, process and planning
fund managers still have an enhanced series of ongoing        considerations. One such area that we will focus on in
reporting and compliance monitoring requirements.             this article relates to backup power generation.
Perhaps the most notable example of these ongoing
                                                              The concept behind a fund manager's backup power
requirements includes, the new disclosure
                                                              generation capabilities may seem to boil down to a
requirements of Form PF.                                      singular goal - can a fund manager keep the lights on if
During the operational due diligence process, investors       the power goes out? From an operational due diligence
can likely gain a number of useful insights into a fund       perspective, the question of how a fund manager
manager’s attitude towards compliance, by evaluating          approaches this issue can actually be further distilled
the way in which a fund manager worked to meet the            into two distinct questions.
initial registration requirements. By incorporating an
                                                              First, does a fund manager have backup power
ongoing review of a fund manager’s compliance
environment in their operational due diligence process,
investors will be able to monitor the way in which a
fund attempts to meet mandated regulatory minimum                                            ...continued on next page

Corgentum Consulting
February 2012 | 3

Power - Continued from page 2...                            While UPS' range in price and capabilities, it is generally
                                                            considered best practice for a fund manager to have
capabilities to allow for an orderly shut-down or           dedicated UPS's for both their desktop computers and
protection of the firm's hardware? Second, can the firm     servers. Additionally, it is important for fund managers
continue operations, and perhaps most importantly,          to perform ongoing testing of UPS's to ensure that they
investing activities in the event of a prolonged power      are appropriately holding battery power.
outage? Let us consider each of these questions
                                                            We can now turn to the second primary concern most
individually.
                                                            investors have to backup power generation - the ability
When considering backup power which provides an             of a fund manager to continue operations in the event
orderly system shutdown, we first have to understand        of a prolonged power loss. This area is most likely the
exactly what hardware is being turned off. On its most      more common of the two major investor concerns
basic level, fund managers generally have two primary       related to backup power generation. To clarify, a
types of hardware: desktop computers and servers.           prolonged power loss generally refers to a loss of power
When the power is suddenly cut to either of these types     which extends for more than a few minutes.
of equipment, bad things could happen if they were to
                                                            Depending on the fund manager’s geographic location,
immediately just shut down. First, important data that
                                                            inclement weather such as snow storms or hurricanes,
was not saved properly before the shut down could be
                                                            may potentially cause power outages which can extend
lost. Besides the loss of data, a sudden power loss could
                                                            for a number of days. The problem, of course, is that
potentially cause actual physical damage to the
                                                            the entire world does not lose power all at once, and
hardware itself.
                                                            the markets remain open.
To combat these problems, a fund manager can
                                                            A fund manager who cannot continue trading
typically install a piece of hardware known as an
                                                            operations for an extended period of time is likely to be
uninterruptible power supply, which is commonly
                                                            at a severe disadvantage and may potentially pile up
referred to as a UPS. On their most basic level, a UPS
                                                            serious losses. As an aside, for the purposes of this
provides protection from a power loss. It does this by
                                                            discussion it should be noted that while a fund
automatically switching on when the power is cut. Once
                                                            managers approach to continuing operations may
switched on, a UPS will minimally provide sufficient
                                                            encompass a number of concepts not directly related to
battery power to the computer or server so that it may
                                                            backup power generation including securing alternative
be properly shut down without data loss or hardware
                                                            work locations and maintaining backup phone lines and
damage.
                                                            internet connections. Returning to the issue at hand
The length of battery power provided by a UPS can be        though - what approaches is an investor likely to
relatively short (i.e. - 15 minutes) or may even extend     encounter during the operational due diligence
up to a number of hours. A UPS may not only serve as a      process?
backup to power loss. These devices can also protect
                                                            The most common solution that fund managers take to
equipment against power surges, spikes, and high
                                                            address this issue is a backup generator. Backup
frequency power oscillation from other equipment. All
                                                            generators are different from UPS's in that they actually
UPS's are not created equally, and there are many
                                                            have the ability to generate power for an extended
different types including offline / standby UPS, Line-
                                                            period of time. Emergency backup generators come in
interactive UPS, double-conversion online UPS, double
conversion on demand, ferro-resonant UPS and diesel
rotary UPS.
                                                                                            ...continued on next page
                                                                                               www.Corgentum.com
February 2012 | 4

multiple types including, natural gas powered and diesel
powered. Depending on the type of generator                 Financial Statement
employed, a number of different ongoing maintenance
requirements may be in place. With diesel generators,
                                                            Risk: The Master-
for example, it is important to ensure that the
generator has an appropriate supply of diesel gas in its’
                                                            Feeder Conundrum
tank. Additionally, diesel generators often need to be
                                                            A commonly employed fund legal structure, which is
started several times throughout the year to ensure
                                                            popular among both hedge funds and private equity
that the equipment continues to function properly.
                                                            funds, is the master-feeder structure. Under this type of
Depending on their location, a fund manager may have
                                                            two-tiered structure, a master fund sits above a feeder
a dedicated generator or one which is shared with
                                                            fund. Investors typically allocate capital to a feeder
multiple tenants in the same office building. Often
                                                            fund, which then takes this capital and makes an
times such large generators, which may be able to
                                                            investment in the master fund. Ultimately, it is the
generator power for periods of multiple days, can
                                                            master fund that makes the investments on behalf of
require a significant investment of capital from a fund
                                                            the whole fund complex.
manager. Depending on the nature of the fund
manager’s strategy, some investors may consider the         The master-feeder fund relationship is one which is
importance of such extended generator capabilities to       replete with operational intricacies. When one gets into
be more or less important.                                  the operational nuts and bolts of the ways in which
                                                            these different fund vehicles interact, the complexity of
For example, some investors might be of the opinion
                                                            such relationships may at first be overwhelming. Putting
that a high frequency trading hedge fund would likely
                                                            aside the legal pros and cons of such a fund,
suffer greater losses by having an extended power
                                                            arrangements aside, during the operational due
outage than a low frequency event driven manager.
                                                            diligence process a number of other operational
Regardless, of the particular specifics associated with
                                                            complexities may surface regarding this structure.
each manager, it is generally considered best practice
for a fund manager to have both UPS's and a dedicated       Many of these additional layers of detail typically center
emergency backup power generator.                           around accounting procedures. Examples of these items
                                                            can include the allocation of trades among the funds,
Investors that take the initiative to evaluate the way in
                                                            distribution of profits and losses among the funds, the
which a fund manager approaches loss of power issues,
                                                            allocation of management and incentive fees, the tax
lessens the risk of being left out in the dark when the
                                                            allocation implications of multiple fund arrangement,
power goes out.
                                                            and tracking of the fund’s inflows from the master and
                                                            feeder funds.

                                                            While each of these considerations could merit their
                                                            own separate discussion, in this article we instead want
                                                            to focus on a different aspect of the master feeder
                                                            relationship as reflected in the audited financial
                                                            statements of funds. During the operational due
                                                            diligence process, one of the key documents investors

                                                                                            ...continued on next page

                                                                                              www.Corgentum.com
February 2012 | 5

Master-Feeder - Continued from page 4...                         •   Can you track the allocation of fund expenses
                                                                     from the master to the feeder funds?
may seek to collect are the audited financial statements         •   What about the allocation of profit and losses?
of the fund(s) under consideration. Typically an investor        •   At which level are fees such as management fee
is considering allocating capital towards one fund                   and performance fee charged? The master
vehicle in particular. In a master-feeder situation, there           level? The feeder level? Do the financial
are typically at a minimum, fund vehicles that are                   statements accurately reflect your
appropriate for onshore or domestic investors and one                understanding of this arrangement?
which is more appropriate for offshore or foreign                •   Have the fund's always been organized in this
investors. From a U.S. perspective, the onshore vehicle              manner?
is typically organized via a limited partnership or "L.P."
structure where the offshore vehicle is via a Limited        Making the situation more complex can be situations in
Liability Company or "Ltd."                                  which feeder funds invest in multiple masters or when
                                                             investors make investments directly into the master
Investors may tend to focus the bulk of their due            fund skipping the feeders altogether.
diligence efforts on a particular fund vehicle which is
most appropriate for them. This is a dangerous trap that     Analyzing the relationship among master-feeder funds
can lead many investors astray. Not only is it considered    is a good example of an area where investors should
best practice that investors consider all other pari passu   coordinate their reviews of the fund’s legal documents,
funds in the same complex (i.e. - a domestic investor        such as the offering memoranda, and the review of the
should review the offshore fund as well), but also to        audited financial statements. By taking the time to
consider the role of the master fund.                        understand the way in which a master fund and feeder
Continuing our example, when collecting and reviewing        fund interact via audited financial statement analysis,
audited financial statements; investors should request       investors will likely be able to better target the focus of
both the onshore and offshore audits. It is also             their operational due diligence reviews to ensure that
advisable for investors to collect and review the master     they fully vet the intricacies of these relationships.
fund's financial statements as well. Once all of these
statements have been collected, how is an investor to
go about reconciling these statements? What exactly
should investors look for?

While the analysis of fund audited financial statements
can be a complex and time consuming exercise, there
are a number of basic checks investors can perform as
part of the operational due diligence process, to ensure
the basics of the master-feeder relationship are
functioning properly among the multiple funds. These
checks can include:

    •   Do the feeder funds own 100% of the master
        fund?
    •   If not, are there other fund vehicles for which
        you have not reviewed the audited financial
        statements for?
                                                                                                 www.Corgentum.com
February 2012 | 6

                                                            analyzing fund legal documents and financial
New Book Provides                                           statements, as well as methods for evaluating
                                                            operational risks concerning valuation methodologies,
Tools to Evaluate                                           pricing documentation and illiquidity concerns.

Operational Risk in                                         Filled with case studies, this book is required reading for
                                                            private equity and real estate investors, as well as fund
Private Equity and                                          managers and service providers, for performing due
                                                            diligence on the operational risks associated with
Real Estate Funds                                           private equity and real estate funds. This book also
                                                            includes case studies in operational fraud and a
                                                            companion website to the book includes sample
Operational due diligence reviews on
                                                                               checklists, templates, spreadsheets,
private equity funds has been an area of
                                                                               and links to laws and regulations
increased investor focus. Despite the
                                                                               referenced in the book.
numerous benefits of performing such
reviews, some investors may still not be                                      Private Equity Operational Due
convinced of the benefits of performing                                       Diligence: Tools to Evaluate Liquidity,
operational due diligence on private                                          Valuation and Documentation will be
equity funds. Still, others may be unsure                                     published by Wiley Finance and be
as to how to best begin an operational                                        released on April 10, 2012. The book
risk review of a private equity fund. In                                      is currently available for pre-order on
particular, investors which already                                           Amazon.com.
perform operational due diligence on
other asset classes, such as hedge
funds, may not have a clear
understanding of the unique
operational challenges presented by
private equity.

To address these issues, Jason Scharfman (Managing
Partner, Corgentum Consulting), has written a follow up     Diagnosing
to his first book, Hedge Fund Operational Due Diligence:
Understanding the Risks, which focuses on private           Information Security
equity. This new book, Private Equity Operational Due
Diligence: Tools to Evaluate Liquidity, Valuation and       Risk
Documentation, addresses the unique aspects and
challenges associated with performing operational due       Information technology is a quickly evolving area of
diligence reviews of both private equity and real estate    operational risk. Fund managers are often undertaking a
asset classes.                                              number of different technology projects at once. These
                                                            can range from mundane software updates, to full scale
Private Equity Operational Due Diligence seeks to
                                                            hardware upgrades. Additionally with the increased
provide readers with the tools to develop a flexible
                                                            acceptance of virtual work environments and increased
comprehensive operational due diligence program
                                                            cloud usage, many fund management organizations are
customized for private equity. It includes techniques for

                                                                                               www.Corgentum.com
February 2012 | 7

Security Risk - Continued from page 6...                     approach towards protecting data is often focused
                                                             almost exclusively on external threats. For example, it
eschewing further investment in more traditional             would be concerning if a hacker was able to log onto
technologies and ramping up the resources allocated to       the fund manager's internal network and steal data.
these emerging technologies.                                 This is certainly an important concern. During the
                                                             operational due diligence process investors can take a
With all of these changes taking place, investors may be     number of steps to evaluate the quality of a hedge
tempted to focus their efforts during the operational        fund's information security defenses from external
due diligence process on these more cutting edge             threats including:
advances, in lieu of spending appropriate time and
effort reviewing technology basics. These basics can             •   Has the firm performed any penetration
typically include an evaluation of the appropriateness               testing? If yes:
and quality of software systems utilized across a                             - has the firm employed a third-party
number of operational functions including order                      firm to conduct an evaluation or did they
management, settlement and reconciliation and fund                   perform the testing themselves?
accounting. Other traditional items which may be                              -what were the results of the
covered during an operational due diligence review                   penetration testing?
include, hardware related items such as understanding            •   If not, does the firm have any plans to perform
the types and number of servers utilized and the type of             such testing in the future?
network connections in place. A common item which
may become lost in the due diligence shuffle between             •   What are the firm's standard information
an increased focus on a fund manager's use of new                    security procedures to prevent external
technologies and more traditional technology concerns                attacks?
is information security.                                         •   What types of firewalls are in place?

A fund manager is not like a traditional factory - they do   Another often overlooked area of information security
not manufacture anything an end-user can touch.              due diligence relates to segregating and protecting data
Rather, a fund manager is in the investing business - and    within the fund management firm itself. Often,
this is a field that is centered around information. Funds   particularly in a larger fund management organization,
deal with all types of information- not limited solely to    different employees will have access to certain pieces of
investment data. For example, they typically maintain        information.
data related to daily operational procedures (i.e. - books
                                                             This can be both to protect the confidentiality of certain
and records, data from accounting systems, trade
                                                             employees (i.e. - the administrative assistant does not
confirmations etc.) as well as information about their
                                                             have access to everyone's personnel files in the same
employees (i.e. - employee addresses, payroll figures
                                                             way a human resources professional would) as well as
etc.), and data about who their clients are. During the
                                                             more likely to implement checks and balances
operational due diligence process, a key question to
                                                             throughout the firm. In this regard, a fund manager who
consider is how does a fund manager go about
                                                             takes measures to protect or limit access to certain
protecting this data? Perhaps the more appropriate
                                                             pieces of information would do so among the firm's
preceding question should be, who is this fund manager
                                                             employees itself. Some key considerations investors
protecting this data from?
                                                             may want to consider when evaluating the way in which
The most common consideration that first comes to the
                                                                                             ...continued on next page
minds of most investors is that a fund manager’s

                                                                                               www.Corgentum.com
8 - Operational Due Diligence Insights

Security Risk - Continued from page 7...                     the words and terms which investors may have not
                                                             previously encountered, or which tend to get
a fund manager protects data internally include:             overlooked in operational due diligence reviews.

                                                             This issue's word: Reserves
    •   Are IT consultants utilized? If so, how does the
        firm monitor consultant gain access to and use       Defined: Reserves refers to a cushion of cash that a
        proprietary data?                                    fund can set aside typically, so that there is sufficient
    •   Can employees utilize remote storage devices,        capital to deal with unforeseen events.
        such as zip drives?
                                                             What investor's should know: Reserves are one of the
    •   If employees can access the firm's systems
        remotely, are equivalent data protection             many landmine terms which can be buried in a fund's
        procedures in place to system access from            offering memorandum, which may be activated when
        within the office?                                   an investor least expects it. Often times the language
                                                             covering reserves will be in the form of a small,
A fund manager that does not take measures to                seemingly innocuous sentence in the fund offering
appropriately protect data from threats, both internal       memorandum which reads to the effect of, "the fund
and external, can have critical information literally walk   may establish reserves for contingencies." The problem
out the door. From an investors perspective, putting         is that many times, the term "contingencies" is either
aside any loss of competitive advantage from loss of         completely undefined or loosely defined at best.
investment related data, a fund manager that does not
protect data may be exposing their client's information      What this means in practice is that, as with most things
to others and run the risk of future fraudulent activity     related to fund offering memoranda, the fund manager
                                                             (or the General Partner or Board of Directors etc. as
or even identity theft. By asking the right questions, an
                                                             applicable) basically has broad discretion to put capital
investor can effectively diagnose whether a fund
                                                             aside. Investor's may think of reserves as a fund's rainy
manager approaches this subject seriously.                   day fund.


Understanding Fund                                           If the fund manager sets reserves aside that are too
                                                             large, and depending on the other terms of the offering

Terms: Reserves                                              memorandum, the fund manager could potentially halt
                                                             redemptions entirely or not fully pay them out.
                                                             Investor's may want to inquire if their fund managers
Operational due diligence is a multidisciplinary subject.    ever established reserves for their funds- if so, when
An investor beginning the operational due diligence          and why?
process for the first time may encounter subjects with
which they have little to no familiarity. As the scope of    It is also worth considering if a fund manager replies
operational due diligence has become broadened in            that they have no intention of ever establishing
recent years, even seasoned operational due diligence        reserves, but this is just boilerplate language that their
professionals may encounter terms which they may be          legal counsel made them put in - then perhaps an
unfamiliar. The purpose of this section of Operational       investor can have this language removed from the
Due Diligence Insights is to cast a spotlight on some of     offering memorandum altogether or limited in a side
                                                             letter.




                                                                                                 www.Corgentum.com
February 2012 | 9


                                                            example the valuation work performed by
Analyzing Fund                                              administrators. Many investors may be unaware of this
                                                            fact, but in determining the valuations of particular
Administrators                                              positions most administrators typically have a small
                                                            degree of discretion.
During Operational                                          This discretion typically comes into play, when an
Due Diligence -                                             administrator attempts to price a fund's positions
                                                            independently of the fund. For example, let's say a fund
Valuation                                                   manager's records indicate that a certain security,
                                                            which is typically priced via broker quotes, was
Independence                                                purchased and was worth $60.23 a share. Let's say that
                                                            the administrator reaches out to other brokers
                                                            independent of the fund manager and determines the
Several years ago, certain investors may not have felt
                                                            price is $0.01 less than the fund manager's price, or
the need to actively evaluate a fund's service providers.
                                                            $60.23. The administrator may have the discretion to
As the importance of the duties performed by fund
                                                            override the fund manager's price and utilize their own.
service providers has gained greater acceptance, so too
                                                            Most administrators typically operate within acceptable
has the level of attention paid to them. In the current
                                                            valuation difference bands. That is a certain amount of
environment, it is considered standard practice during
                                                            discrepancy between the price determined by the
operational due diligence to expand a fund review to
                                                            administrator and the fund manager is acceptable as
include not only the fund management organization
                                                            long as it is within predefined ranges. In most cases, the
itself, but external service providers with which the
                                                            administrator's price (which is typically more
funds interact. One of the most important such service
                                                            conservative), is the one which is utilized. Indeed, fund
providers is typically the fund administrator.
                                                            administration agreements and offering memoranda
The role that fund administrators play in the               may dictate as such. However, as there is discretion in
operational due diligence process is often a conflicted     the process, in practice a negotiation often occurs
one. On the one hand, an administrator wants to             between the administrator and the fund manager with
convey to investors their independence in the valuation     regards to what the final price should be. In certain
and fund NAV calculation process. On the other hand,        cases, depending on the nature of the security and the
administrators are typically hired by the fund              specifics of the administration arrangement, the fund
management companies themselves, the same entities          manager may have final say over the administrator.
and individuals they are supposed to act independent
                                                            Some fund managers are actively engaged with their
of.
                                                            administrators and speak to them several times a week.
As such, during the fund administrator review process,      Others may only talk to their fund administrators at
investors may find it beneficial to review not only the     month-end when fund NAV's are being calculated. An
actual operational processes and procedures in place        investor which takes the time to evaluate not only the
for typical administration services such as fund            nuts and bolts of fund administration procedures but
accounting and shareholder services, but to also gauge      also, the degree of interaction and control exerted by a
the level of involvement and control which a fund           fund manager in practice may gain useful insights which
manager exercises on this relationship. Consider for        other investors may not uncover during the operational
                                                            due diligence process.

Corgentum Consulting
10 - Operational Due Diligence Insights




 On the Calendar
 Please see below for a list of upcoming operational risk items of note and events:

     •    Hedge Fund Operation Risk and Due Diligence Class - (New York, NY)
          Begins on February 8, 2012. Jason Scharfman to lecture on hedge fund operational risk and due diligence.
          New York University SCPS.


     •    Investment Education Symposium - (New Orleans, LA)
          February 15 - 17, 2012. Jason Scharfman to moderate Investing in Alternatives panel.
          Presented by Opal Financial Group.


     •    2012 Investment Consultants Forum - (New York, NY)
          March 2, 2012. Jason Scharfman to speak on Hedge Fund Opportunities
          Presented by Opal Financial Group.


     •    6th Annual Private Equity Summit for Institutional Investors - (San Francisco, CA)
          March 26 - 27, 2012. Jason Scharfman to moderate Risk Management panel
          Presented by Opal Financial Group.


     •    Release of Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation and
          Documentation
          April 10, 2012. More information available at: http://www.corgentum.com




         About Corgentum Consulting
         Corgentum provides investors with the industry's most comprehensive operational due diligence
         reviews of hedge funds, private equity funds, real estate funds and traditional funds. Corgentum
         partners with investors to improve upon the efficiency and effectiveness of the operational due
         diligence process. Our proprietary due diligence methodologies and innovative original research allows
         our clients to continually manage and mitigate their operational risk exposures. Corgentum's unbiased
         and time-tested approach creates a substantial competitive advantage that enhances the risk
         management functionality of our clients. More information is available at www.Corgentum.com.

         Email: Info@Corgentum.com
         Main Tel. 201-918-5201

         ©2012 Corgentum Consulting, LLC


         Corgentum Consulting

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Operational due diligence_insights_corgentum_feb_2012 (2)

  • 1. Operational Due Diligence Insights In This Issue Welcome to Our First Issue - Increased Fund Regulatory Welcome to the inaugural issue of Corgentum Consulting's Operational Due Requirements Complicate Diligence Insights. This newsletter will serve as a resource for news, opinions Compliance Diligence and insights focused on issues related to operational risk and operational due diligence on fund managers including hedge funds, private equity funds - Backup Power Generation - Are and traditional managers. Fund's Prepared for Blackouts? - Diagnosing Information Security Increased Fund Regulatory - Business Continuity and DR - Financial Statement Risk: Requirements Complicate The Master-Feeder Conundrum Compliance Diligence -Focus on Private Equity In the context of investors attempting to evaluate the sum total of operational -Term of The Month: Reserves risk in fund managers, no area is currently more rife with changes than the legal and compliance area. The passage of Dodd-Frank and the subsequent -New Book Provides Tools to Evaluate flurry of governmental rules and regulations have metastasized into a complex Operational Risk in Private Equity compliance web that both funds and investors must navigate. From the funds and Real Estate Funds perspective, these new rules apply to many different fund manager types across asset classes including hedge funds, private equity funds, real estate -Analyzing Fund Administrators funds and more traditional fund managers. For investors performing During Due Diligence - Valuation operational due diligence, one of the key challenges to evaluate is whether a Independence fund not only has taken a pro-active -Operational Risk Calendar ...continued on next page www.Corgentum.com
  • 2. 2 - Operational Due Diligence Insights levels of compliance. Another less obvious added Regulatory - Continued from page 1... benefit for investors may also be knowledge about how seriously a fund manager takes the concept of approach to comply with the new rules and regulations, compliance. but whether they have done so intelligently. One of the Said another way - if a fund manager takes the bare key challenges many fund managers have recently faced minimum approach towards internal compliance is the registration requirements recently enacted by the oversight, where else might they be cutting corners? SEC. In addition to the registration requirements, many Without comprehensive operational due diligence, the fund managers may have to comply with additional answer might not be as clear as investors might like. reporting disclosure requirements, including those contained in the revised Form ADV and Form PF. Fund managers seeking to initially comply with the SEC's Backup Power February 14, 2012 registration deadline, likely took a number of different approaches in their path towards Generation: Are compliance. Many fund managers engaged one of the bevy of third-party compliance consultants. These third- Fund's Prepared for party firms have realized a recent boon to their businesses, based on increased compliance Blackouts? requirements. Other fund managers, instead, likely worked with law firms to assist them with this process. Business continuity planning and disaster recovery, Still, others may have utilized internal legal and often abbreviated as BCP/DR, is one area which is compliance resources. In any case, now that we are past typically covered, or at least should be covered, during the registration deadline, investors may be tempted to the operational due diligence process. Reviews of a consider the approach taken by a particular fund to fund's BCP/DR infrastructures however, are a bit comply with registration requirements to be a moot counterintuitive. The goal of evaluating a fund's BCP/DR point. After all, the only point is that a fund has met the plans seems simple enough on its’ face - can a fund requirements, isn't it? continue operations in the event of a disaster? However, Such an approach seeks to put the cart before the from this simple enough question comes a myriad of horse. With the registration deadline now behind them, quite complex technology, process and planning fund managers still have an enhanced series of ongoing considerations. One such area that we will focus on in reporting and compliance monitoring requirements. this article relates to backup power generation. Perhaps the most notable example of these ongoing The concept behind a fund manager's backup power requirements includes, the new disclosure generation capabilities may seem to boil down to a requirements of Form PF. singular goal - can a fund manager keep the lights on if During the operational due diligence process, investors the power goes out? From an operational due diligence can likely gain a number of useful insights into a fund perspective, the question of how a fund manager manager’s attitude towards compliance, by evaluating approaches this issue can actually be further distilled the way in which a fund manager worked to meet the into two distinct questions. initial registration requirements. By incorporating an First, does a fund manager have backup power ongoing review of a fund manager’s compliance environment in their operational due diligence process, investors will be able to monitor the way in which a fund attempts to meet mandated regulatory minimum ...continued on next page Corgentum Consulting
  • 3. February 2012 | 3 Power - Continued from page 2... While UPS' range in price and capabilities, it is generally considered best practice for a fund manager to have capabilities to allow for an orderly shut-down or dedicated UPS's for both their desktop computers and protection of the firm's hardware? Second, can the firm servers. Additionally, it is important for fund managers continue operations, and perhaps most importantly, to perform ongoing testing of UPS's to ensure that they investing activities in the event of a prolonged power are appropriately holding battery power. outage? Let us consider each of these questions We can now turn to the second primary concern most individually. investors have to backup power generation - the ability When considering backup power which provides an of a fund manager to continue operations in the event orderly system shutdown, we first have to understand of a prolonged power loss. This area is most likely the exactly what hardware is being turned off. On its most more common of the two major investor concerns basic level, fund managers generally have two primary related to backup power generation. To clarify, a types of hardware: desktop computers and servers. prolonged power loss generally refers to a loss of power When the power is suddenly cut to either of these types which extends for more than a few minutes. of equipment, bad things could happen if they were to Depending on the fund manager’s geographic location, immediately just shut down. First, important data that inclement weather such as snow storms or hurricanes, was not saved properly before the shut down could be may potentially cause power outages which can extend lost. Besides the loss of data, a sudden power loss could for a number of days. The problem, of course, is that potentially cause actual physical damage to the the entire world does not lose power all at once, and hardware itself. the markets remain open. To combat these problems, a fund manager can A fund manager who cannot continue trading typically install a piece of hardware known as an operations for an extended period of time is likely to be uninterruptible power supply, which is commonly at a severe disadvantage and may potentially pile up referred to as a UPS. On their most basic level, a UPS serious losses. As an aside, for the purposes of this provides protection from a power loss. It does this by discussion it should be noted that while a fund automatically switching on when the power is cut. Once managers approach to continuing operations may switched on, a UPS will minimally provide sufficient encompass a number of concepts not directly related to battery power to the computer or server so that it may backup power generation including securing alternative be properly shut down without data loss or hardware work locations and maintaining backup phone lines and damage. internet connections. Returning to the issue at hand The length of battery power provided by a UPS can be though - what approaches is an investor likely to relatively short (i.e. - 15 minutes) or may even extend encounter during the operational due diligence up to a number of hours. A UPS may not only serve as a process? backup to power loss. These devices can also protect The most common solution that fund managers take to equipment against power surges, spikes, and high address this issue is a backup generator. Backup frequency power oscillation from other equipment. All generators are different from UPS's in that they actually UPS's are not created equally, and there are many have the ability to generate power for an extended different types including offline / standby UPS, Line- period of time. Emergency backup generators come in interactive UPS, double-conversion online UPS, double conversion on demand, ferro-resonant UPS and diesel rotary UPS. ...continued on next page www.Corgentum.com
  • 4. February 2012 | 4 multiple types including, natural gas powered and diesel powered. Depending on the type of generator Financial Statement employed, a number of different ongoing maintenance requirements may be in place. With diesel generators, Risk: The Master- for example, it is important to ensure that the generator has an appropriate supply of diesel gas in its’ Feeder Conundrum tank. Additionally, diesel generators often need to be A commonly employed fund legal structure, which is started several times throughout the year to ensure popular among both hedge funds and private equity that the equipment continues to function properly. funds, is the master-feeder structure. Under this type of Depending on their location, a fund manager may have two-tiered structure, a master fund sits above a feeder a dedicated generator or one which is shared with fund. Investors typically allocate capital to a feeder multiple tenants in the same office building. Often fund, which then takes this capital and makes an times such large generators, which may be able to investment in the master fund. Ultimately, it is the generator power for periods of multiple days, can master fund that makes the investments on behalf of require a significant investment of capital from a fund the whole fund complex. manager. Depending on the nature of the fund manager’s strategy, some investors may consider the The master-feeder fund relationship is one which is importance of such extended generator capabilities to replete with operational intricacies. When one gets into be more or less important. the operational nuts and bolts of the ways in which these different fund vehicles interact, the complexity of For example, some investors might be of the opinion such relationships may at first be overwhelming. Putting that a high frequency trading hedge fund would likely aside the legal pros and cons of such a fund, suffer greater losses by having an extended power arrangements aside, during the operational due outage than a low frequency event driven manager. diligence process a number of other operational Regardless, of the particular specifics associated with complexities may surface regarding this structure. each manager, it is generally considered best practice for a fund manager to have both UPS's and a dedicated Many of these additional layers of detail typically center emergency backup power generator. around accounting procedures. Examples of these items can include the allocation of trades among the funds, Investors that take the initiative to evaluate the way in distribution of profits and losses among the funds, the which a fund manager approaches loss of power issues, allocation of management and incentive fees, the tax lessens the risk of being left out in the dark when the allocation implications of multiple fund arrangement, power goes out. and tracking of the fund’s inflows from the master and feeder funds. While each of these considerations could merit their own separate discussion, in this article we instead want to focus on a different aspect of the master feeder relationship as reflected in the audited financial statements of funds. During the operational due diligence process, one of the key documents investors ...continued on next page www.Corgentum.com
  • 5. February 2012 | 5 Master-Feeder - Continued from page 4... • Can you track the allocation of fund expenses from the master to the feeder funds? may seek to collect are the audited financial statements • What about the allocation of profit and losses? of the fund(s) under consideration. Typically an investor • At which level are fees such as management fee is considering allocating capital towards one fund and performance fee charged? The master vehicle in particular. In a master-feeder situation, there level? The feeder level? Do the financial are typically at a minimum, fund vehicles that are statements accurately reflect your appropriate for onshore or domestic investors and one understanding of this arrangement? which is more appropriate for offshore or foreign • Have the fund's always been organized in this investors. From a U.S. perspective, the onshore vehicle manner? is typically organized via a limited partnership or "L.P." structure where the offshore vehicle is via a Limited Making the situation more complex can be situations in Liability Company or "Ltd." which feeder funds invest in multiple masters or when investors make investments directly into the master Investors may tend to focus the bulk of their due fund skipping the feeders altogether. diligence efforts on a particular fund vehicle which is most appropriate for them. This is a dangerous trap that Analyzing the relationship among master-feeder funds can lead many investors astray. Not only is it considered is a good example of an area where investors should best practice that investors consider all other pari passu coordinate their reviews of the fund’s legal documents, funds in the same complex (i.e. - a domestic investor such as the offering memoranda, and the review of the should review the offshore fund as well), but also to audited financial statements. By taking the time to consider the role of the master fund. understand the way in which a master fund and feeder Continuing our example, when collecting and reviewing fund interact via audited financial statement analysis, audited financial statements; investors should request investors will likely be able to better target the focus of both the onshore and offshore audits. It is also their operational due diligence reviews to ensure that advisable for investors to collect and review the master they fully vet the intricacies of these relationships. fund's financial statements as well. Once all of these statements have been collected, how is an investor to go about reconciling these statements? What exactly should investors look for? While the analysis of fund audited financial statements can be a complex and time consuming exercise, there are a number of basic checks investors can perform as part of the operational due diligence process, to ensure the basics of the master-feeder relationship are functioning properly among the multiple funds. These checks can include: • Do the feeder funds own 100% of the master fund? • If not, are there other fund vehicles for which you have not reviewed the audited financial statements for? www.Corgentum.com
  • 6. February 2012 | 6 analyzing fund legal documents and financial New Book Provides statements, as well as methods for evaluating operational risks concerning valuation methodologies, Tools to Evaluate pricing documentation and illiquidity concerns. Operational Risk in Filled with case studies, this book is required reading for private equity and real estate investors, as well as fund Private Equity and managers and service providers, for performing due diligence on the operational risks associated with Real Estate Funds private equity and real estate funds. This book also includes case studies in operational fraud and a companion website to the book includes sample Operational due diligence reviews on checklists, templates, spreadsheets, private equity funds has been an area of and links to laws and regulations increased investor focus. Despite the referenced in the book. numerous benefits of performing such reviews, some investors may still not be Private Equity Operational Due convinced of the benefits of performing Diligence: Tools to Evaluate Liquidity, operational due diligence on private Valuation and Documentation will be equity funds. Still, others may be unsure published by Wiley Finance and be as to how to best begin an operational released on April 10, 2012. The book risk review of a private equity fund. In is currently available for pre-order on particular, investors which already Amazon.com. perform operational due diligence on other asset classes, such as hedge funds, may not have a clear understanding of the unique operational challenges presented by private equity. To address these issues, Jason Scharfman (Managing Partner, Corgentum Consulting), has written a follow up Diagnosing to his first book, Hedge Fund Operational Due Diligence: Understanding the Risks, which focuses on private Information Security equity. This new book, Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation and Risk Documentation, addresses the unique aspects and challenges associated with performing operational due Information technology is a quickly evolving area of diligence reviews of both private equity and real estate operational risk. Fund managers are often undertaking a asset classes. number of different technology projects at once. These can range from mundane software updates, to full scale Private Equity Operational Due Diligence seeks to hardware upgrades. Additionally with the increased provide readers with the tools to develop a flexible acceptance of virtual work environments and increased comprehensive operational due diligence program cloud usage, many fund management organizations are customized for private equity. It includes techniques for www.Corgentum.com
  • 7. February 2012 | 7 Security Risk - Continued from page 6... approach towards protecting data is often focused almost exclusively on external threats. For example, it eschewing further investment in more traditional would be concerning if a hacker was able to log onto technologies and ramping up the resources allocated to the fund manager's internal network and steal data. these emerging technologies. This is certainly an important concern. During the operational due diligence process investors can take a With all of these changes taking place, investors may be number of steps to evaluate the quality of a hedge tempted to focus their efforts during the operational fund's information security defenses from external due diligence process on these more cutting edge threats including: advances, in lieu of spending appropriate time and effort reviewing technology basics. These basics can • Has the firm performed any penetration typically include an evaluation of the appropriateness testing? If yes: and quality of software systems utilized across a - has the firm employed a third-party number of operational functions including order firm to conduct an evaluation or did they management, settlement and reconciliation and fund perform the testing themselves? accounting. Other traditional items which may be -what were the results of the covered during an operational due diligence review penetration testing? include, hardware related items such as understanding • If not, does the firm have any plans to perform the types and number of servers utilized and the type of such testing in the future? network connections in place. A common item which may become lost in the due diligence shuffle between • What are the firm's standard information an increased focus on a fund manager's use of new security procedures to prevent external technologies and more traditional technology concerns attacks? is information security. • What types of firewalls are in place? A fund manager is not like a traditional factory - they do Another often overlooked area of information security not manufacture anything an end-user can touch. due diligence relates to segregating and protecting data Rather, a fund manager is in the investing business - and within the fund management firm itself. Often, this is a field that is centered around information. Funds particularly in a larger fund management organization, deal with all types of information- not limited solely to different employees will have access to certain pieces of investment data. For example, they typically maintain information. data related to daily operational procedures (i.e. - books This can be both to protect the confidentiality of certain and records, data from accounting systems, trade employees (i.e. - the administrative assistant does not confirmations etc.) as well as information about their have access to everyone's personnel files in the same employees (i.e. - employee addresses, payroll figures way a human resources professional would) as well as etc.), and data about who their clients are. During the more likely to implement checks and balances operational due diligence process, a key question to throughout the firm. In this regard, a fund manager who consider is how does a fund manager go about takes measures to protect or limit access to certain protecting this data? Perhaps the more appropriate pieces of information would do so among the firm's preceding question should be, who is this fund manager employees itself. Some key considerations investors protecting this data from? may want to consider when evaluating the way in which The most common consideration that first comes to the ...continued on next page minds of most investors is that a fund manager’s www.Corgentum.com
  • 8. 8 - Operational Due Diligence Insights Security Risk - Continued from page 7... the words and terms which investors may have not previously encountered, or which tend to get a fund manager protects data internally include: overlooked in operational due diligence reviews. This issue's word: Reserves • Are IT consultants utilized? If so, how does the firm monitor consultant gain access to and use Defined: Reserves refers to a cushion of cash that a proprietary data? fund can set aside typically, so that there is sufficient • Can employees utilize remote storage devices, capital to deal with unforeseen events. such as zip drives? What investor's should know: Reserves are one of the • If employees can access the firm's systems remotely, are equivalent data protection many landmine terms which can be buried in a fund's procedures in place to system access from offering memorandum, which may be activated when within the office? an investor least expects it. Often times the language covering reserves will be in the form of a small, A fund manager that does not take measures to seemingly innocuous sentence in the fund offering appropriately protect data from threats, both internal memorandum which reads to the effect of, "the fund and external, can have critical information literally walk may establish reserves for contingencies." The problem out the door. From an investors perspective, putting is that many times, the term "contingencies" is either aside any loss of competitive advantage from loss of completely undefined or loosely defined at best. investment related data, a fund manager that does not protect data may be exposing their client's information What this means in practice is that, as with most things to others and run the risk of future fraudulent activity related to fund offering memoranda, the fund manager (or the General Partner or Board of Directors etc. as or even identity theft. By asking the right questions, an applicable) basically has broad discretion to put capital investor can effectively diagnose whether a fund aside. Investor's may think of reserves as a fund's rainy manager approaches this subject seriously. day fund. Understanding Fund If the fund manager sets reserves aside that are too large, and depending on the other terms of the offering Terms: Reserves memorandum, the fund manager could potentially halt redemptions entirely or not fully pay them out. Investor's may want to inquire if their fund managers Operational due diligence is a multidisciplinary subject. ever established reserves for their funds- if so, when An investor beginning the operational due diligence and why? process for the first time may encounter subjects with which they have little to no familiarity. As the scope of It is also worth considering if a fund manager replies operational due diligence has become broadened in that they have no intention of ever establishing recent years, even seasoned operational due diligence reserves, but this is just boilerplate language that their professionals may encounter terms which they may be legal counsel made them put in - then perhaps an unfamiliar. The purpose of this section of Operational investor can have this language removed from the Due Diligence Insights is to cast a spotlight on some of offering memorandum altogether or limited in a side letter. www.Corgentum.com
  • 9. February 2012 | 9 example the valuation work performed by Analyzing Fund administrators. Many investors may be unaware of this fact, but in determining the valuations of particular Administrators positions most administrators typically have a small degree of discretion. During Operational This discretion typically comes into play, when an Due Diligence - administrator attempts to price a fund's positions independently of the fund. For example, let's say a fund Valuation manager's records indicate that a certain security, which is typically priced via broker quotes, was Independence purchased and was worth $60.23 a share. Let's say that the administrator reaches out to other brokers independent of the fund manager and determines the Several years ago, certain investors may not have felt price is $0.01 less than the fund manager's price, or the need to actively evaluate a fund's service providers. $60.23. The administrator may have the discretion to As the importance of the duties performed by fund override the fund manager's price and utilize their own. service providers has gained greater acceptance, so too Most administrators typically operate within acceptable has the level of attention paid to them. In the current valuation difference bands. That is a certain amount of environment, it is considered standard practice during discrepancy between the price determined by the operational due diligence to expand a fund review to administrator and the fund manager is acceptable as include not only the fund management organization long as it is within predefined ranges. In most cases, the itself, but external service providers with which the administrator's price (which is typically more funds interact. One of the most important such service conservative), is the one which is utilized. Indeed, fund providers is typically the fund administrator. administration agreements and offering memoranda The role that fund administrators play in the may dictate as such. However, as there is discretion in operational due diligence process is often a conflicted the process, in practice a negotiation often occurs one. On the one hand, an administrator wants to between the administrator and the fund manager with convey to investors their independence in the valuation regards to what the final price should be. In certain and fund NAV calculation process. On the other hand, cases, depending on the nature of the security and the administrators are typically hired by the fund specifics of the administration arrangement, the fund management companies themselves, the same entities manager may have final say over the administrator. and individuals they are supposed to act independent Some fund managers are actively engaged with their of. administrators and speak to them several times a week. As such, during the fund administrator review process, Others may only talk to their fund administrators at investors may find it beneficial to review not only the month-end when fund NAV's are being calculated. An actual operational processes and procedures in place investor which takes the time to evaluate not only the for typical administration services such as fund nuts and bolts of fund administration procedures but accounting and shareholder services, but to also gauge also, the degree of interaction and control exerted by a the level of involvement and control which a fund fund manager in practice may gain useful insights which manager exercises on this relationship. Consider for other investors may not uncover during the operational due diligence process. Corgentum Consulting
  • 10. 10 - Operational Due Diligence Insights On the Calendar Please see below for a list of upcoming operational risk items of note and events: • Hedge Fund Operation Risk and Due Diligence Class - (New York, NY) Begins on February 8, 2012. Jason Scharfman to lecture on hedge fund operational risk and due diligence. New York University SCPS. • Investment Education Symposium - (New Orleans, LA) February 15 - 17, 2012. Jason Scharfman to moderate Investing in Alternatives panel. Presented by Opal Financial Group. • 2012 Investment Consultants Forum - (New York, NY) March 2, 2012. Jason Scharfman to speak on Hedge Fund Opportunities Presented by Opal Financial Group. • 6th Annual Private Equity Summit for Institutional Investors - (San Francisco, CA) March 26 - 27, 2012. Jason Scharfman to moderate Risk Management panel Presented by Opal Financial Group. • Release of Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation and Documentation April 10, 2012. More information available at: http://www.corgentum.com About Corgentum Consulting Corgentum provides investors with the industry's most comprehensive operational due diligence reviews of hedge funds, private equity funds, real estate funds and traditional funds. Corgentum partners with investors to improve upon the efficiency and effectiveness of the operational due diligence process. Our proprietary due diligence methodologies and innovative original research allows our clients to continually manage and mitigate their operational risk exposures. Corgentum's unbiased and time-tested approach creates a substantial competitive advantage that enhances the risk management functionality of our clients. More information is available at www.Corgentum.com. Email: Info@Corgentum.com Main Tel. 201-918-5201 ©2012 Corgentum Consulting, LLC Corgentum Consulting