IMDDA hosted an on-line workshop with Rajiv Jaitly, a hedge fund due diligence specialist who draws from high profile case studies and 18+ years of specialist experience in hedge fund investigations during the recording.
One of the key points he makes is the acknowledgement that not all hedge fund due diligence investigations can be conducted to a perfect textbook standard. The main driver here is limited resources available for operational due diligence. Luckily Jaitly had some great practical recommendations for how to do the best possible job with the resources you have available in your real world scenarios.
The full recording of the on-line workshop “Case Studies of Hedge Fund Failures and Lessons to be Learned” is available for members to download now, or you can dive into some of the key takeaways on how to budget for a hedge fund due diligence investigation below:
Step 1: Identify a risk appetite & spend accordingly
Your risk appetite comes from first establishing your risk capacity, i.e how much risk you can absorb. From this point you set your risk tolerance, which should be substantially lower than your total capacity for risk. Jaitly gives the example of a diverse portfolio with a 5% share in 20 holdings and volatility tolerance of 10%. Drawing on his own experience, he’d expect 2 of those 20 holding to blow up on average, which still puts you inside your 10% volatility tolerance. He says in this case, you could argue that no due diligence is necessary.
He goes on to say that obviously this would be the wrong attitude, but the example illustrated the point that where resources are constrained, you need to direct them first to the areas where the potential risk outweighs your risk tolerance.
Step 2: Mirror risk to experience
In a team where you have a variety of seniority in hedge fund operational due diligence personnel, you should allocate your most experienced people to investigate the areas of highest perceived risk. It may sound like basic common sense, but Jaitly has observed it is not always implemented. In this way you are able to do more with the same limited pool of resources.
Step 3: Bring in expertise where the risk is high
It is a hard reality that most organizations face tough choices as a result of constrained resources. This can be a difficult environment to justify spend on bringing in external expertise to supplement your internal hedge fund operational due diligence.
Whilst acknowledging the difficulty of this, we also advocate building a business case for doing so in the areas of greatest risk. Ultimately, the spend will be minimal when compared with the prospective loss.
Step 4: Build a diverse team
If your operational due diligence budget won’t stretch to senior team members or hiring in expertise from third parties, a good way to mitigate the risk posed by a more junior team is to ensure that they come from diverse backgrounds.
Blending people from different disciplines (legal, accounting, etc.) allows you to build a broader range of knowledge and a broader range of perspectives and ways of looking at things. This means that your investigations will be more rounded, even though they are carried out by junior people.
Step 5: Always cover the hygiene factors
No matter how small your hedge fund due diligence budget is, you cannot afford not to do the basics well. Reviewing all publicly available information, all supplied documentation from the hedge fund on policies and procedures and verifying the identity of all suppliers and counterparties is the bare minimum that should happen for every investment, regardless of constraints in resources.
Step 6: Collaborate with your investment team
Your investment manager is a mine of useful specialist knowledge that you can use to help shape your hedge fund operational due diligence investigation. And even better, they are a freely available resource to you that can be used in lieu of hiring in that knowledge either as a senior due diligence person or via a third-party specialist.
Want more insights into hedge fund operational due diligence? The full webinar recording is available now, complete with details of three high profile hedge fund failures and the lessons learned from each.
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