Hedge Fund Due Diligence

Hosted by Garrity Graham and co-hosted by PRMIA:

Hedge Funds and Fraud: The Future of Due Diligence

11:00 -12:30, March 19th, 2009

Webinar


Introduction

Welcome and Session Instructions

Order of Presentations:The Psychology of the Gullible Investor

Stephen Greenspan Ph.D., Clinical Professor of Psychiatry, University of Colorado

The Profile of a FraudsterJames Tunkey, I-OnAsia

Current Legal and Regulatory Requirements for Hedge FundsPhilip Thomas, Esq., Garrity Graham

A Hedge Fund Insider's ViewSamuel Won and Greg Ivancich, Global Risk Management Advisors, Inc.

The Regulatory Future for Hedge FundsPhilippa Girling, Esq., FRM, Garrity Graham

Q & A

Session Ends


The Psychology of the Gullible InvestorPresenter: Stephen Greenspan, PhD

Presenter: Stephen Greenspan, PhD

Affiliations: Emeritus Professor Educational Psychology, U of Connecticut

Clinical Professor of Psychiatry, U of Colorado Med. School

Website: www.stephen-greenspan.com

Contact: [email protected]

Steve

Presentation: The Psychology of the Gullible Investor

New book:

ANNALS OF GULLIBILITY

Published Jan 09, Praeger Publishing

Available at amazon.com ($36)

In the Jan 3 issue of the WALL STREET JOURNAL “Why We Keep Falling for Financial Scams”

Headline: “Intelligent people have long been ruined by frauds. Psychologist Stephen Greenspan, who specializes in gullibility, explores why investors continue to be swindled -- and how he came to lose part of his savings to Bernard Madoff”

Link: http://online.wsj.com/article/SB123093987596650197.html

________________________________________________

Cover Illustration

My four-factor explanatory model of gullible (induced socially foolish) behavior

Three types of “foolish action”—Practical; Noninduced-Social; Induced-Social (Gullibility)______________________________________________________

Gullible Act Situation Cognition Affect &

State Personality+ + +=

FOOLISH ACTION

INDUCED (GULLIBLE)

NON-INDUCED

SOCIALLYFOOLISH ACTION

PRACTICALLY FOOLISH ACTION

FIGURE1 – TYPES OF FOOLISH ACTION

Situational (External) factors contributing to investor gullibility:

• Robert Shiller’s “feedback loop” (people telling other people about their gains) lies at the heart of all Ponzi schemes and investment manias

• Social feedback loops apply to fund managers as well as investors (smaller funds taking their cues from the behavior of larger funds)

• Investments seem safer when they are within fund families that have good reputations (such as the Rye/ Tremont “feeder fund” that I invested with)

• Scam artists are skilled manipulators who engage in tricks such as playing hard to get, and they understand the basic trusting nature of most people

• Investors often lack other around who can protect them (for example, widows who formerly relied on their husbands)

• This factor also explains the affiliation angle (why so many victims tend to be from the same religious community, for example)

WITHIN-PERSON (INTERNAL) FACTORS

…………………………………………………………………….

Cognitive factors contributing to investor gullibility:

• Investors often lack any knowledge of investments or any ability to evaluate the risks and rewards of a proposed investment

• Investment schemes (especially fraudulent ones) are often mysterious and difficult to understand

………………………………………………………

Personality factors contributing to investor gullibility:

• Some people are extremely impulsive and quick to take risks

• Some people are too trusting of people and reluctant to check them out

• Obsessional personality can lead to resisting diversity

……………………………………………………………

Emotional factors contributing to investor gullibility:

• Greed (wanting far more than one needs) is a big motivator

• Fear of losing ground (need for assurance) ironically can make one vulnerable to loss

HOW INDIVIDUAL INVESTORS CAN BECOME LESS GULLIBLE

• Diversify, diversity, diversify (don’t put your entire future at the hand of one scheme or one individual)

• Take your time (hasty decisions are more likely to be foolish)

• Seek alternative sources of advice

• Recognize the limits of one’s expertise (smart people often think they are smart about everything)

• Be satisfied with enough and don’t try to make more just because others seem to be doing better

• Take responsibility for your investments and don’t be too passive

• Recognize that while gullibility will always be with us, you don’t have to be a victim

Website: www.stephen-greenspan.com

Contact: [email protected]


The Profile of a FraudsterPresenter: James Tunkey, I-OnAsia

ABOUT I-ON & SPEAKER JAMES TUNKEY

AmmanBangkokBeijingGuangzhouHong KongKuala LumpurLondonJohannesburgMelbourneMumbaiNew YorkRomeShanghaiShenzhenSingaporeTokyoVancouverWarsaw

I-OnAsia (www.ionasia.com.hk) is an international business intelligence and security consultancy serving the hedge fund and investment community. Founded in Hong Kong in 2001, I-OnAsia has grown as an international boutique with 18 offices worldwide. I-On’s team of over 100 full-time professionals have military, intelligence, and law enforcement backgrounds. I-On’s principals have worked together for more than a decade.

Mr. Tunkey has over 15 years of experience in due diligence as a business intelligence specialist, a financial journalist, and U.S. government analyst. He is often involved in transactions requiring both a strong understanding of the steps necessary to determine an individual or team’s activities and motivations, and of the complex global financial system within which his subjects conduct business. He has advanced law enforcement training in the conduct of interviews, government experience, unique education in corruption control, and has managed deal investigations teams working on many of the world’s largest transactions.

Mr. Tunkey also helps companies establish internal security and fraud departments, and benchmark performance against industry best practices. He is the volunteer Regional Director of the PRMIA New York chapter. His PRMIA blog on risk is found at www.prmia.org/Weblogs/General/James_Tunkey. Mr. Tunkey also serves on the boards of the International Council for the Life Sciences and the World Water Center. He is a member of the Council on Foreign Relations and the International Institute for Strategic Studies, amongst other organizations.

CONTEXT6 Feb: Federal Reserve Bank of New York President and CEO William C. Dudley states at CFR he expects the hedge fund universe to be reduced by 50% in the near future. We are in a period of redemptions and low trust in counterparties. Madoff, Stanford et al don’t help market confidence.

Earlier in the week, AIG repeatedly described in press as operating as an internal hedge fund. Operates outside of regulatory tent. Allegedly assists European banks dodge Basel capital reserve requirements. BofA investigating Merrill hidden losses and non-transparency. Meanwhile in US Congress: SEC and NY insurance regulators admonished for missing Madoff, AIG, others.

Housing bubble full of perverse incentives. “AAA” and models for valuing firm and transaction creditworthiness in tatters.

INCENTIVES, STRUCTURES, CONTROL SYSTEMYes, (best of present and) the future of due diligence does include profiling for fraud.

Fear may likely be the driver for fraud for next 2-3 years with deleveraging and redemption pressures affecting management judgment. Tier 1 long established teams and particular individuals may also be motivated to fraud (perversely) by honor, and there are many sacred cows. Greed always a problem, and was the primary motivator in the boom.

Current fraud prevention best practice is to identify key risk indicators on operational risk / background check and compare with other assessments of level of transparency and risk disclosures. Rigorous profiling is essential, as is the need to revisit individual assessments annually or bi-annually.

But… it this due diligence must be placed in its proper context. Missing in the prior period was a realistic understanding of the control system’s faults. What are the levers of control over the subject? How have they been tested? What are the terms of accountability? These affect the profile. Redemptions (and market failure in general) unlikely to halt until these market and government regulatory weaknesses are addressed directly.

Also… there must be greater attention paid to internal weaknesses. This goes beyond often weak bench strength (e.g. publicized reports of pre-allocation decisions in Madoff funds). It also addresses the vulnerabilities to fraud caused by internal staff.

“How much money do you need?... You could get a million dollars. And you could get it in cash… I know where it could be gotten… I mean its not easy, but it could be done… But, uh, the question is who the hell would handle it?... Let me say there should not be a lot of people going around getting money.”

… Richard Nixon

“Don’t come to the table with the same worn arguments and tired ideas that helped to create this crisis.”

… Barack Obama


Current Legal and Regulatory Requirements for Hedge Funds

Presenter: Philip Thomas, Esq., Garrity Graham


A ‘relentless SEC’ and Angry Investors: Uncovering and Managing Hedge Fund Legal Risk

Former SEC Chairman Christopher Cox. "Hedge funds are by no means unregulated when it comes to fraud. Those who commit fraud at the expense of investors will always be the target of a relentless SEC.“ http://www.sec.gov/news/press/2008/2008-115.htm


The Legal Environment

Private litigationBear, Stearns & Co./ Manhattan Investment Fund Ltd.

Banc of America

Madoff…

SEC Enforcement Actions:MedCap Management & Research (Fiduciary Duty)

Thompson Consulting Inc. (Misrepresentation)

WealthWise LLC (Undisclosed Conflicts of Interest)


Hot Regulatory Topics

Disclosure

Potentially Manipulative Practices

Valuation


Tools for uncovering legal and regulatory risk (but are they enough?)

GoodThe DDQ

Form ADV

Interviews with manager

Obtain customer references

BetterBackground investigation of principals and PMs

Check state and federal criminal and civil cases

Credit check if possible

Google!

Private Investigators?


Best

1. Never take the fund manager’s word for anything.

2. Be suspicious of managers’ limiting access to information.

3. Create state of the art legal documents and structures.

4. Consult specialist professionals who will be able to spot irregularities.

5. Pay attention to what the industry leaders are saying and doing about best practices.


What a simple background check might have uncovered…

MAR/Hedge (RIP!) No. 89 May 2001

…(Google is still free!)


Resources

Alternative Investment Management Association. www.aima.orgProvides industry standard due diligence questionnaire to its members (somewhat tailored to UK funds). Offers specialized DDQs (e.g. for FOHF managers, for single funds etc.)

FINRA BrokerCheck. Run report, including disciplinary history, on FINRA-registered individuals and firms.

http://brokercheck.finra.org/Investment Adviser Association. http://www.investmentadviser.org

Provides a number of risk assessment guides and charts (all free)Investment Adviser Public Disclosure website. Pull potential investee’s Form ADV Part I(if RIA).

http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspxManaged Fund Association. http://www.managedfunds.org/

Provides both the “Sound Practices for Hedge Funds” guide and a fillable DDQ (both free)http://www.managedfunds.org/downloads/Sound%20Practices%202007.pdfhttp://www.managedfunds.org/downloads/Due%20Dilligence%20Questionnaire.pdf

OFAC Search Tool. Determine if investor or counterparty is listed in the Office of Foreign Asset Control’s Sanctions Program Listings.

http://apps.finra.org/rulesregulation/ofac/1/Default.aspxThe President’s Working Group on Financial Markets, Asset Managers’ Committee Report.

www.ustreas.gov/press/releases/reports/amcreportapril152008.pdfhttp://www.investmentadviser.org/eweb/dynamicpage.aspx?webcode=PublicDocs_Websites

The SEC has published its enforcement manual for the first time.www.sec.gov/divisions/enforce/enforcementmanual.pdf


A Hedge Fund Insider's ViewPresenters: Samuel Won and Greg Ivancich,

Global Risk Management Advisors, Inc.

Risk Management at Hedge FundsIssues and Challenges

March 19, 2009

Webinar Presentation

Samuel K. WonFounder/Managing DirectorGlobal Risk Management Advisors, [email protected]

Gregory M. IvancichCOO/Managing DirectorGlobal Risk Management Advisors, [email protected]

GlobalRiskManagementAdvisors

Why Hedge Fund Due Diligence Failed

Understand the Secular Context

Breadth and Depth of the Due Diligence

Background and Experience of the Due Diligence Team

Formality vs. Investment Process

Global Risk Management Advisors, Inc. [email protected] 212-230-1610 [email protected] 212-230-1661


mailto:[email protected]


Why Infrastructure and Processes Matter

Unprecedented and Historic Events

Sea Change in Regulatory Environment

Institutional Requirement

Competitive Differentiator

Emerging Best Practice Standards





The Need for Independence

In-house versus OutsourcedEconomies of scaleAdvantages and disadvantages

Value of Third Party Review: Pricing and valuation of Illiquid InvestmentsInfrastructure, processes and controlsReview of investment style and process






Global Risk Management Advisors, Inc (“GRMA”) specializes in investment management advisory to asset managers and asset owners and in product development and strategic marketing for software companies and other service providers to the financial services industry.

Our mission is to provide unparalleled independent advice to our clients that leverages our extensive industry experience and allows our clients to take advantage of our many proprietary applications and processes. Our aim is to assist our clients to meet their strategic business objectives and achieve sustainable competitive advantage in their respective markets. Every aspect of our advisory services to our clients has a strong embedded proprietary risk management element that distinguishes our approach from all others.

Who we are:





The Regulatory Future for Hedge FundsPresenter: Philippa Girling, Esq., FRM, Garrity Graham


Global political reaction to current crisis will impact hedge fund regulation

British Prime Minister Gordon Brown met with President Obama at the White House March 3rd and the two discussed reform of financial regulation

Finance ministers to meet in London on March 13th.

G20 to meet in April in London to discuss global regulatory frameworkGermany and France have pushed for deeper regulation than the U.S. on hedge funds and private-equity firms.

Britain, which chairs the G-20 this year, generally has sided with the U.S.

IMF pushing for more regulation, including hedge funds

EU commissioners are set to endorse a regulatory restructuring plan. The proposal includes setting up a pan-EU systemic risk regulator attached to the European Central Bank.

European leaders agreed in February that hedge funds must be regulated.

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US reaction

Treasury Secretary Timothy Geithner has promised more oversight over hedge fundsIncluding a registration regime

Hedge Fund Transparency ActIntroduced by Sens. Chuck Grassley (R., Iowa) and Carl Levin (D., Michigan) in an effort to boost regulation.

Recent fraud cited as a reason to support the bill

Demand that hedge, private-equity and venture-capital funds with $50 million or more in assets register with the SEC, reveal key bank relationships and give the value of their holdings.

Anti-money laundering and suspicious activity requirements

CT proposed legislation Minimum requirement from $1 million up to $2.5 million, with institutions needing at least $5 million in assets.

Greater transparency by disclosing fees and other information about management or investment strategy.

Obtain a state license as well as have an independent annual financial audit performed.

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US reaction (Cont.)

Credit Default SwapsPossible clearing house for CDS

Rep. Collin Peterson's bill and NY state proposed legislation to restrict, regulate or prohibit naked CDS

Supplemental Anti-Fraud Enforcement ("SAFE") Markets Act Introduced by Sens. Charles E. Schumer (D-NY) and Richard Shelby (R-AL)

Add hundreds of new investigators and prosecutors to nation’s financial fraud units

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Other changes

Possibility of a Hedge Fund SROCredibility issues

The Alternative Investment Management Association proposalsU.K. trade group with members in many countries, including the U.S., said it plans to propose that hedge-fund managers agree to changes that many U.S. funds have resisted. The measures include registering with regulators and having regular contact with authorities about their businesses.

US Managed Fund AssociationOn Jan 29th expressed its support for the announcement of new legislation by Senators Charles E. Schumer and Richard Shelby, constructed to uncover and clean up financial fraud.

March 5th announced its support for “establishing a systemic risk regulator to restore investor confidence and ensure the proper functioning of capital markets”.

Market pressuresPrime brokers classifying hedge funds and limiting access to services

Due diligence requirements by investors impacted by recent fraud events

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What to do?

Anticipate regulatory requirements

Anticipate increased due diligence requirements from investors

Get involved with Managed Fund Association

Put appropriate protections in place to meet regulatory requirements and build confidence of investors

Evaluate risk on a regular basis

Ensure compliance risks are well managed

Ensure AML and suspicious activity procedures are in place

Conduct fraud risk assessments and training

Review current documents for compliance and best practice

Implement procedures and test them

Be ready for an SEC visit

Be ready for an enhanced due diligence visit

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Q & A


Thank You

Thank you for attending our session today.

Send an email if you are interested in learning more about any of these topics.

Email: [email protected].


Appendix: Presenter ProfilesPhilippa Girling is head of the Banking and Financial Services Practice at Garrity, graham, Murphy, Garofalo & Flinn PC. Ms. Girling joined Garrity, Graham, Murphy, Garofalo and Flinn, P.C. from Nomura where she was Global Co-Head of Operational Risk Management. At Nomura, Ms. Girling was responsible for the development of the global operational risk strategy to meet Japan FSA's Basel II requirements and for the implementation of that strategy in the Americas and Europe under local regulatory requirements. Previously, she was a founder and Program Director of the firm wide Operational Risk Department at Morgan Stanley. Ms. Girling also served as COO of the Global Financial Control Group and CAO of the Retail Brokerage Controllers Group at Morgan Stanley. She has 14 years experience in the global securities industry, working in the fields of operational risk, change management and project management. Ms. Girling has also designed and led many training programs, including an Operational Risk Executive Education program for Columbia University, NYC. Ms. Girling emigrated from the UK to the US in 1996. She has an English law degree, is a New York attorney and is a certified Financial Risk Manager (FRM).

Stephen Greenspan is a developmental psychologist who is Emeritus Professor of Educational Psychology at the University of Connecticut and Clinical Professor of Psychiatry at the University of Colorado. An expert on social incompetence and foolish behavior, Steve wrote the first comprehensive scholarly book on human gullibility (susceptibility to being duped or manipulated through deceptive means). The book—ANNALS OF GULLIBILITY—came out around the same time that Steve learned that he had been duped out of part of his retirement assets by Bernard Madoff through one of the so-called feeder funds. As a scholar, Steve thought this would be a good teaching case, so he immediately got a lengthy essay published in the Wall Street Journal explaining his own and others’ investor gullibility, using his four-factor theory of foolish behavior. Since then, Steve has gotten many invitations to speak to finance and other groups interested in better understanding how to help individuals and institutions to make more rational investment and other life-affecting decisions.

Philip Thomas is a securities and regulatory attorney specializing in investment adviser compliance issues. He spent six years at Merrill Lynch in New York, and in 1996 was a key member of the team that brought to market Merrill’s first fund of hedge funds. From 2006-2008 he was Chief Compliance Officer and Deputy General Counsel of SB Schonfeld Fund Advisors LLC, the New York asset management firm. At Schonfeld, Philip was the lead attorney on the formation of nine private investment funds and created and maintained the compliance program at three investment advisers. He has led the organization of private funds in the US, Cayman and Bermuda. As a consultant, he has served household name hedge funds, PE funds, VCs and investment banks on regulatory and legal matters. Philip is a decorated former US Navy officer. He is a graduate of the US Navy Supply Corps School; a 1995 graduate of Rutgers School of Law-Camden; and received an AB from Hamilton College, with honors, in 1992. He is a member of the New York Bar.

James Peter Tunkey is Chief Operating Officer of I-OnAsia, a global investigations and security consultancy headquartered in Hong Kong. James and his firm specialize in the conduct of due diligence on behalf of manufacturers and financial investors, including Tier 1 financial institutions, pension, hedge, and private equity funds. Using law enforcement investigation and advanced intelligence gathering techniques to collect information on the backgrounds and activities of key principals, James also supports firms recover from fraud and mismanagement. James is the volunteer Regional Director of the PRMIA New York chapter and former RD of PRMIA's Hong Kong chapter. His PRMIA blog on risk is found at www.prmia.org/Weblogs/General/James_Tunkey. James serves on the boards of the International Council for the Life Sciences and the World Water Center. He is a member of the Council on Foreign Relations and the International Institute for Strategic Studies, amongst other organizations.


Appendix: Presenter Profiles

Gregory M. Ivancich is Chief Operating Officer/Managing Director at Global Risk Management Advisors Inc. He has over 17 years experience in investment management advisory. He was most recently Executive Director in the Investment Banking Division of Morgan Stanley where he advised Morgan Stanley Real Estate on private and public real estate investment strategies, as well as advisingnumerous third party clients, including REITs, private equity firms and hedge funds on transactions totaling in excess of $10 billion. Prior to Morgan Stanley, Mr. Ivancich was at Credit Suisse (previously Donaldson, Lufkin & Jenrette) where he also advised private and public companies in the real estate sector and was involved with launching the firm’s private fund raising business, where he was responsible for performing due diligence on new fund manager clients for the firm. While at Credit Suisse, Mr. Ivancich also served as the Chief Operating Officer of the Real Estate Investment Banking Group. Mr. Ivancich began his career at Kidder, Peabody & Co. where he was involved in groundbreaking transactions for public REITs and early commercial mortgage securitizations. He was also involved with assignments for the Resolution Trust Corporation including bulk asset sales and restructurings. He has a Bachelor of Science in Foreign Service from Georgetown University and an MBA from Harvard Business School. He is a member of the National Association of Real Estate Investment Trusts, the International Center for Shopping Centers and is on the board of advisors for MetRock Capital Group.Samuel K. Won is Founder/Managing Director at Global Risk Management Advisors Inc. He has over twenty years of risk management experience at major financial institutions in both the private sector (buy side and sell side) and the public sector, Mr. Won was Chief Risk Officer and Managing Director for Brencourt Advisors, LLC. He was responsible for overseeing investment risk management, risk architecture and analysis, hedging, quantitative portfolio strategies and for playing key roles in asset allocation, new product development and investor relations. Before joining Brencourt, Mr. Won was Chief Risk Officer for Ospraie Management, LLC, where he oversaw investment risk management for over $8 billion in hedge funds and private equity funds. Prior to Ospraie, Mr. Won served as Director of Investment Risk Management for Citigroup Alternative Investments, where he oversaw market, credit and operational risk management for the multi-strategy hedge funds, private equity funds and real estate investment funds for Citigroup’s $44 billion global alternative investment business. Before moving to the buy-side at Citigroup, Mr. Won was Director of Global Equity Risk Management for Citigroup Global Markets. He was directly responsible for global market risk management for customer and proprietary equity trading and equity capital markets for Citigroup’s investment bank. Mr. Won served in several posts in the public sector. He was the Risk Manager at the Federal Home Loan Bank Board, where he wasresponsible for risk management, capital markets and mergers/acquisitions for the bail-out of the savings and loan industry. In addition, Mr. Won served as a Senior Risk Management Adviser to the Resolution Trust Corporation and as a Senior Negotiator at Fannie Mae. Mr.Won has also held senior positions working in risk management, corporate finance, mergers/acquisitions and strategic planning at various major financial institutions including: Dresdner Kleinwort Benson, Goldman Sachs & Company, Bear, Stearns & Company and GreatWestern Financial Corporation. Mr. Won is on the Executive Steering Committee for the Chief Risk Officer’s Group at the Managed Funds Association. Mr. Won played a leading role in developing and writing the MFA’s ‘Sound Practices Guidelines for Risk Management’ for the hedge fund industry. He is a member of the Global Association of Risk Professionals and of the Professional Risk Managers’ International Association. He is a frequent speaker at major investment conferences and has advised regulatory agencies, such as the SEC, theFederal Reserve Bank, the Office of the Comptroller and the FSA on major risk management issues and policies. Mr. Won completed a BA at Northwestern University, attended the Tuck School of Business at Dartmouth College and received a Masters degree from Columbia University with a concentration in International Finance and Economic Policy Management.

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Hedge Fund Due Diligence

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