Hedge fund operational_due_diligence_insights_corgentum_january_2013

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  1. 1. January 2013Operational Due Diligence Insights In This IssueWelcome to Our January- Regulatory Focus: Can Operational Due Diligence Prevent Exposure to 2013 Edition Hedge Fund Insider Trading? Welcome to the January 2013 issue of Corgentum Consultings Operational- Business Continuity Corner: A Post-Due Diligence Insights. This newsletter serves as a resource for news,Sandy Analysis of Hedge Fund BCP/DRopinions and insights focused on issues related to operational risk andPlanning?operational due diligence on fund managers including hedge funds, private equity funds, real estate and traditional managers.- Private Equity: Will the ComingPrivate Equity Data Storm Influence LPOperational Due Diligence? Can Operational Due Diligence- IT Hub: Evaluating Hedge FundTechnology Consultants Prevent Exposure to Hedge- Service Providers: Analyzing FundFund Insider Trading?Legal Counsel - Does It Matter AsLong As Its Legal?There has been much news recently with regards to high profile hedge fund insider trading cases such as Raj Rajaratnams Galleon. As there seems to be a-Term of the Month: Audit Holdback continuing strong interest from the government in prosecuting insider trading, investors may be increasingly asking themselves what they can do to minimize,- Fraud Spotlight: The Preposterousor perhaps even completely reduce, their exposure to hedge funds that eitherFraud of Andrey C. Hicks and Locustmay be accused of insider trading, or even worse guilty of it.Offshore Management Before we can answer this question however, it is first useful to make sure we- Accounting Spotlight: Interpreting understand what is meant by insider trading. To boil it down to its most simpleFund Expense Disclosures form, insider trading relates to people utilizing so-called "insider" information- On the Calendar ...continued on next page www.Corgentum.com
  2. 2. 2 | Operational Due Diligence InsightsInsider Trading - Continued from page 1... Information, often referred to be the acronym MNPI, and how the analyst obtained this information.which they either: Following the Information Flow: a Four Step Process(i) misappropriated (i.e. - stole) This is all well and good, but investors generally do not (ii) obtained by legal means, or even by have the transparency or the ability to follow aroundaccident, but: the analysts of the hedge funds to determine how theya) shouldnt have acted upon; or are obtaining research. Therefore, the question couldb) had a duty to disclose it be posed, what are investors supposed to do?Of course there are a number of nuanced complexities The answer lies in understanding the nature of thewhen it comes to analyzing the actual insider trading control environment surrounding both the investmentlaws themselves. An example of this is whether the so- research process, as well as a funds ability to act oncalled duty to disclose was pro-actively requested by research obtained. But, how should an investor gothe person obtaining the information or instead was about assessing this environment? Detailed operationalimposed upon them. However, such legal intricacies are due diligence can provide a number of valuable insightsof little use to investors seeking to evaluate the overall in this regards.potential for insider trading to occur. Step 1: Determine research sourcesOne of the big problems with insider tradingprosecutions from anOne area which an investor caninvestors and fundevaluate during the operationalmanagers perspective, isdue diligence process relates tothat it is an area in whichfirstly understanding the ways inany bright line rules thatwhich a hedge funds analystsmay have existed are nowconduct research. In particular,seemingly in flux. Recentwhat research sources do theylegal decisions haveutilize? Do they primarily readseemingly increased theindustry journals and go onscope of the type ofBloomberg? What about attendinginformation that is nowconferences? Do the analystsconsidered illegal to tradeperhaps meet with theupon. management of any particular companies? Do they talk to analysts at other hedge funds? What about analystsAdditionally, insider trading is inherently in particular sectors at other firms outside of the hedgecounterintuitive in some regards to what hedge funds fund industry? Are third-party expert networks utilized?are paid to do - conduct research and utilize thisresearch to make investments. Insider trading rules, it Step 2: Evaluate research oversightcan be argued, stymie the efforts of analysts to collectthis information. It stands to reason that a hedge fund After an investor makes a determination as to whatanalyst may be able to devote more time to collecting research sources a hedge fund utilizes, the next step isresearch, and be more skilled at it, then let us say a to determine what actions the fund is taking to monitorregular retail investor. Is this insider trading for the such relationships. This oversight can come in a numberhedge fund analyst to act on this better information? of different forms, but is primarily driven by the compliance function. During the operational dueWell the answer, the insider trading rules explain, diligence process an investor can ask a number ofdepends on a number of factors including whether theinformation is so-called Material Nonpublic continued on next pageCorgentum Consulting 2013 Corgentum Consulting, LLC
  3. 3. January 2013 | 3Insider Trading - Continued from page 2... Are there sufficient prohibitions or limits on the way gifts are given, and received, in order todifferent questions to make an assessment as whether prevent any potential conflicts or bribery withor not the compliance function is actively policing the regards to information sharing?analyst research process or not. Examples of the typesof questions investors can ask in this regard include: Step 3: Evaluate trading oversightThird-party expert networks: It is worth noting at this point that just because a hedge Has the compliance function vetted a firms fund may come into possession of so-called materialrelationship with third-party expert networks? nonpublic information, they are not necessarily guilty ofIf so, what did this assessment entail? anything if they do not act on it. Has the hedge fund communicated its policies This is where an analysis of the oversight of a hedgewith regards to material nonpublic information fund trading procedures comes into play. After a hedgeand insider trading to the third-party network? fund has done its research and makes a determination that it would like to trade in a certain security, investors If so, has the network agreed in writing tomust determine what oversight is in place. Onecomply with these policies?common way hedge funds seek to prevent trading on securities on which they may possess material If hedge fund research personnel would like to nonpublic information about is via a so-called restrictedutilize such a network, must pre-approval be list. In general, securities on the restricted list cannot beobtained from the compliance function first? traded by the firm. However, not all restricted lists are created equal, and not all hedge funds maintain What research does the compliance function restricted lists. In addition to determining whether orperform before granting pre-approval?not such a restricted list is actually in place, investors can ask a number of questions to determine the Once approved, has compliance taken anyoversight and effectiveness of such lists including:additional measures to ensure compliance withthe hedge funds policies? (i.e. - such as reading How are securities put on the list? Is there seta disclaimer before the call begins) criteria or does one person make the determination in their discretion? Additionally, do compliance personnel listen inon calls? If a security is placed on the restricted list, is trading activity suspended for a certain pre- Is a log kept of the use of such third-party defined period? (i.e. - 30 days)networks? How do securities come off of the restrictedResearch sources in general: list? Does the hedge fund have any bans on speaking to individuals who either work at public Who maintains the restricted list? companies or have recently worked at such companies? If so, what are the details of this How often is it updated? ban? How is it monitored and implemented? How is the list shared throughout the firm? Are any conflict checks performed to make surethat a hedge fund analyst is not discussing acompany with someone with whom the hedgefund may have already been conflicted out of continued on next page(i.e.- passing along tips)?www.Corgentum.com
  4. 4. 4 | Operational Due Diligence InsightsInsider Trading - Continued from page 3...operational or otherwise, can completely preventexposure to hedge fund with insider trading issues.That being said, investors that conduct due diligence to Are names of securities contained in theunderstand the ways in which research is conducted,restricted list hard-coded into any tradinghow trades are executed, and the internal oversight ofsystems or instead is it up to employees tosuch processes will be more informed about the risksmonitor the list?involved . As with all operational due diligence,investors that dive deeper will be making more Are employees allowed to trade in names of theinformed investment decisions. Additionally, a hedgerestricted list for their own personal securities fund with robust oversight of the research and tradingaccounts? process will likely have a much lower likelihood of beingplaced into situations where insider trading could beStep 4: Is oversight provable and tested? alleged.After taking measures to evaluate any internal hedgeConclusion:fund oversight on the way in which a hedge fundcollects research and then trades on that data, are In conclusion, investors that take the time to askinvestors finished? questions and evaluate research and trading oversightduring the operational due diligence proces