Study shows operational risk is key factor in hedge fund failures

Operational risks are broadly defined as risks associated with supporting the operating environment of the fund. The operating environment includes middle and back office functions such as trade processing, accounting, administration, valuation and reporting

A surprisingly low 38 per cent of hedge funds failed as a result of investment risk alone.

It is estimated that there some US$600 billion is invested in approximately 6,000 hedge funds worldwide. At the same time 700 hedge funds around the world closed in 2002 and 800 are predicted to close this year according to hedge fund consultants, Tremont Advisers.

Christopher Kundro and Stuart Feffer, partners at Capco and co-authors of the research study, said:"Structural problems with hedge funds have contributed to substantial investor losses. These could have been prevented or avoided with more comprehensive due diligence and monitoring."

They said: "As the hedge fund industry continues to grow, the market will demand better structures, increased performance, expansion of investment strategies and new forms of regulation. For the hedge fund investor, reducing the potential of catastrophic losses will be key to improving long term investment results."

While all large hedge fund investors (fund of fund managers, pension funds) conduct due diligence on hedge funds prior to making an investment, most focus on the investment side (who the managers are, track records, etc) and pay little, if any attention, to the operational side which accounted for half of all failures.

Even more alarming was that of the ‘operational failures’, misrepresentation (reports and valuations with false or misleading information), misappropriation of funds (fraud) and unauthorised trading was implicit in 85 per cent of cases.

Other operational risks included staff processing errors, technology failure, and poor data.

The report stated: "These problems have contributed to substantial investor losses in hedge funds that could possibly have been prevented or avoided with a more comprehensive due diligence and monitoring approach.  For example, in the case of last year’s failure of the Lipper convertible arbitrage funds, had investors scrutinised and monitored the funds’ valuation practices closely, there is a good chance that they would have recognised their limited use of objective third parties to verify the pricing of illiquid securities and avoided investing in these funds."

It continued: "The misrepresentation of fund investments and activities is clearly a major problem in both its prevalence among failed funds and its relationship to other issues and risks.  Although most managers do not set out to defraud investors from day one….we have found numerous occasions where on the back of poor investment performance, managers ‘modified’ the valuation of their funds and/or their investment results to buy time until actual results hopefully improved."

"Although it may be impossible to foresee which managers will attempt to defraud investors of their funds, it is critical that investors understand to what extent the opportunity exists to manipulate and misrepresent fund investments should their managers feel the urge. This can be accomplished through more complete scrutiny of a hedge fund’s operations and technology capabilities and a detailed understanding of the information flows between a fund and its supporting service providers that typically include prime brokers and administrators."

"Knowing that a fund has very tight controls over cash flows and seeks third party verification of a valuations to ensure they are current and appropriate will not eliminate the risk of fraud, but will go a long way in limiting the manager’s opportunity to do so."

"Relying solely on a fund’s administrators and auditors is not enough. For example, to hide substantial investment losses, the Manhattan fund allegedly created fictitious account statements that materially overstated the value of the fund. These statements were provided to investors, potential investors as well as the funds’ administrator and auditor for more than 3 years with neither the administrator nor the auditor catching the problem."

The report noted that traditional approaches to operational reviews fall short of the mark. It said "for the most part they are:
* an ancillary component of the overall investment due diligence process
* based on a generic view across multiple managers, fund types and strategies
* focused on specific functions
* focused on specific aspects of the operating environment
* focused internally
* often reduced to a background check and character assessment of fund managers."

"As a consequence, information about the efficiency, effectiveness, capacity and control of hedge funds is rarely assessed in sufficient detail to inform investment decisions and identify appropriate mitigation opportunities."

Capco has defined 5 key characteristics of an effective operational due diligence approach for hedge funds, defined as follows:

1) Provides a comprehensive view of the structure, quality and control of the people, operations, technology and data supporting the fund

2) Covers internal processes, systems and information flows

3) Covers the processes, systems, information flows and interfaces provided by external parties such as prime brokers, administrators, custodians, etc.

4) Analyses the unique requirements of each fund/strategy as they can vary considerably depending upon fund objectives and investment style

5) Assessments are updated on a periodic and event driven basis.

The report concludes: "Despite lukewarm performance results for 2002, the hedge fund industry is expected to maintain its steep growth trajectory. We expect that the anticipated growth in hedge fund investing will be accompanied by increased performance and operational demands as the number of new managers grows, the breadth and complexity of investment strategies expands and new forms of regulation are considered and eventually adopted."

"All of this suggests that the operational risks associated with these investments will only grow more important. For the hedge fund investor, effective operational due diligence and monitoring will be key to reducing the potential of catastrophic losses and improving long term investment results in this sector."

Background Note: Capco (www.capco.com) is a services and technology solutions provider. It focuses on improving clients’ financial and operational performance, risk profile, and return on IT investments by seamlessly integrating business strategy and process with technology implementation.

The firm has integrated capabilities in thought leadership, business strategy, technology services, software components, insourcing, and ventures. These are augmented through an alliance network – providing comprehensive, scalable solutions and reduced project risk. Capco has offices in the major financial centres around the globe and focuses on capital markets, private client services, asset management, and banking clients.

Capco is a registered trademark of The Capital Markets Company N.V.

The study is based on a proprietary database of 100 hedge fund failures over the past 20 years that looks at losses, litigation and root causes. For this study, failed funds have been defined as those that have been forced to cease investment operations for reasons outside of management’s control as distinguished from discretionary fund closures that are more frequent and driven by the business or market expectations of the fund manager.

The study is ongoing; the initial findings are not expected to change significantly as it progresses.