Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers
Hedge Fund Law Report
The old paradigm of hedge fund due diligence focused on the hedge fund manager and the new paradigm focuses on hedge fund service providers. That is, the purpose of hedge fund due diligence used to be (broadly, pre-2008) to ensure that the hedge fund manager itself had, internally, sufficient people, process and plant to maintain its return and risk profile. However, the credit crisis that began in 2008, and the frauds it brought to the fore, highlighted the franchise risk posed by service providers to hedge funds and managers. Consequently, post-crisis hedge fund due diligence has focused more squarely and thoroughly on service providers. For example, in a June 2010 study, hedge fund operational due diligence consulting firm Corgentum Consulting analyzed data from over 200 hedge fund allocators and concluded that hedge fund “investors are focusing the bulk of their due diligence efforts on legal, compliance and regulatory risks.” The primary reason for this shift in focus – from managers and performance (then), to service providers and operations (now) – relates to the estimated harm from adverse outcomes. In relative terms, most investment losses are high probability, low magnitude events, while most operational failures are low probability, high magnitude events. The chief goal of due diligence is to avoid low probability, high magnitude events; and, moreover, the credit crisis taught that the probability of some operational failures may not be so low after all. Lehman Brothers provides the most sobering example. Hedge funds that used Lehman’s U.S. or U.K. brokerage entities as their only prime brokers and that did not perform adequate due diligence on Lehman’s custody and cash management arrangements – or that did perform such diligence but did not incorporate its lessons – wound up with significant investor assets tied up for long periods in bankruptcy, SIPA or administration proceedings. The purpose of service provider diligence is to identify operational issues that can have a material adverse effect on investment outcomes – issues such as the commingling of hedge fund customer assets by certain Lehman brokerage entities. With the twin goals of providing guidance to investors conducting due diligence on hedge fund service providers, and to hedge fund managers and service providers anticipating such diligence, this article: identifies key hedge fund service providers; details ten specific areas on which investors should focus when conducting service provider diligence; highlights areas of diligence specific to certain service providers; discusses strategies for accessing the data necessary to perform adequate due diligence; and incorporates recommendations regarding the timing and frequency of service provider due diligence.