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The mysterious case of the missing due diligence

When it comes to the subject of due diligence, family offices allocating to alternatives in general, and hedge funds specifically, face a number of challenges in the post-Madoff environment.

These challenges come on many fronts which are both internal and external to a family office. The recent slew of hedge fund Ponzi schemes and failures has left many family offices questioning whether the benefits outweigh the seemingly massive risks associated with hedge funds.

While occurrences like the Madoff scandal certainly create cause for hesitation and self-reflection, they generally do not stop the train. After all, no one thought another large scale hedge fund fraud would occur after Sam Israel's Bayou, yet here we are – hedge funds survived the crisis as too, unfortunately, did a series of fraudsters. So assuming hedge fund investing will remain desirable to family offices, how are they to confidently proceed without fearing they may be giving away the store? A good starting point is to evaluate the due diligence processes that led them to this current hedge fund quandary.

Any family office that makes direct hedge fund investments should view the current hedge fund crisis as an opportunity to evaluate their own internal due diligence processes. This is a natural first step, particularly in light of the recent economic climate. It is worth pausing for a moment to clarify exactly is meant by the term due diligence in a hedge fund context. In practice, there are a number of definitions for the term. A wide range of factors can be classified under this heading, sometimes misleadingly so, and this has been a point of confusion for many hedge fund investors. On a broad basis, family offices should think of the due diligence in terms of the specific areas or risks which are being vetted.

These risks, in a hedge fund context, can be broadly classified into two distinct areas: those risks that are directly related to a hedge fund's investments, and all others. It is these other risks which were the primary red flags of many of the recent hedge fund frauds, and they can be thought of as the operational risks or non-investment related factors, which should be covered as part of the hedge fund due diligence process.

Operational due diligence is the process of collecting operational data about a hedge fund. Once these data are collected, an investor can then make a determination as to the levels of operational risk present at a particular hedge fund. But what exactly are these operational risks? In part they include, on a high level, a review of the internal policies and procedures at a hedge fund to evaluate whether there are sufficient checks and balances in place to ensure that fraudulent activity cannot take place.

A proper operational due diligence review will also include a review of a hedge fund's service providers (ie, administrator, custodian, auditor) to ensure not only quality but also independence. In many of the recent hedge fund frauds, there was a lack of independent oversight of traditional operational factors such as custody and valuation. Furthermore, a host of lesser known and arguably lower quality service providers were utilised. For example, Madoff Investment Securities LLC utilised a three-person "auditor" Friehling & Horowitz, CPA's, PC, who for the past 15 years had been informing the American Institute of Certified Public Accountants that they do not actually perform audits.

Such questionable practices should certainly raise at least one red flag during a thorough due diligence review process.
 
Furthermore, as a general rule, red flags travel in packs and this was certainly the situation in Madoff's case. So what happened? How did so many investors and family offices miss these now obvious red flags which individuals such as Madoff whistleblower Harry Markopolos had suspected for years?

The answer lies in part with family offices looking to outsource their responsibility when it comes to due diligence. In many cases, a family office may have been introduced to a hedge fund via a financial advisor, third-party marketer or a consultant.

Family offices that have relied on the advice of such advisors may be surprised to learn that in a recent survey conducted by Corgentum Consulting, an operational due diligence consultancy, of approximately 65 such independent financial advisers, approximately 75% of those surveyed stated that they were not confident that they possessed the necessary skills to fully vet all the risks associated with allocating to alternative investments.

In addition to relying on advisors, family offices may also allocate to alternative investment managers such as funds of hedge funds, in part, to lighten the due diligence burden on themselves. Based on the recent poor performance of many funds of hedge funds, this niche industry is currently undergoing an upheaval, particularly in light of the extra layer of fees they add to the hedge fund investing process.

Further adding to fund of hedge funds woes are the questionable levels of due diligence some of these organisations have performed. Exemplifying some of the frustration with the fund of funds industry, Yale's endowment manager, David Swensen, recently called fund of funds a "cancer on the institutional-investor world."

As part of the self-evaluative due diligence process, family offices must also look externally to vet the due diligence processes of their advisors. In the case of both financial advisors and funds of hedge funds, family offices should consider what steps they have taken to vet the due diligence process of these third-party firms. This review should cover a number of different factors ranging from resource allocation to process ownership.

 Of course, these same areas should be covered during the self-assessment of a family office's own internal due diligence framework as well. Firstly, a family office should consider whether sufficient resources such as staffing levels and budgets are committed to due diligence as compared to other functions such as client service or investment management. Another point of consideration is the scope and scale of an advisor's or fund of hedge funds' due diligence process. Other questions which a family officer may want to ask of their advisors include:

•    How does your advisor document the due diligence process?
•    Does your advisor have a consistent minimum standard of due diligence they perform on?
•    Is separate operational due diligence performed on operational risk, or is all due diligence – investment and operational – lumped together?
•    After the initial due diligence process is complete, does your advisor perform any on-going due diligence?
•    Does your advisor outsource any part of the due diligence process, such as background investigations, to other firms or is all due diligence performed in-house?
•    Can your advisor cite recent examples of hedge fund managers they have ever not hired (or fired) because of items uncovered during the due diligence process?
 
Returning to the results of the Corgentum survey, 63% of advisors stated they have no documented due diligence process. Furthermore, approximately 55% stated that they did not have a minimum consistent due diligence standard. Similar results have been found in larger studies of financial advisors as well. Clearly, based on these trends, many family offices should take steps to more carefully evaluate the due diligence processes in place at their advisors.    

When it comes to performing a self-evaluation of their own due
diligence processes, family offices may want to look at some of the recent hedge fund frauds and knowing what they now know, see if their process would have detected some, if not all, of the operational red flags. For example, in Madoff's case there were a significant number of his relatives working at his firm, including his brother Peter, nephew Charles Wiener, his two sons Mark and Andrew, and his niece Shana.

There is nothing inherently wrong with family members working together, but having such a heavy family presence in an investment firm is certainly unusual. As such, any investor performing due diligence of the Madoff firm should have vetted this particular issue very carefully to ensure that proper checks and balances as well as third-party oversight existed to prevent anyone from seizing the opportunity for fraudulent activity. Unfortunately, in Madoff's case such independent oversight was lacking allowing a massive fraud to perpetuate.

Family offices should take steps to perform a self-evaluation of where their specific thresholds lie in relation to certain issues, both investment and operational. Not every situation can be anticipated in advance, but by establishing an internal threshold in relation to a set of core issues which frequently come up, a family office will be much better positioned to address such issues when presented with them.

One approach that is gaining traction among hedge fund investors is to compromise between entirely outsourcing the due diligence process and working with external advisors. This compromise approach allows investors to outsource the aspects of the due diligence process while maintaining ownership of the process. Such an approach also enables family offices to outsource only those areas of the due diligence process which may require specialised skills or expertise. This is particularly important when it comes to certain areas of operational due diligence such as reviews of a hedge fund's legal documents or audited financial statements.

Ultimately, regardless of the approach taken, the onus for ensuring that comprehensive due diligence is performed on the hedge funds in which they invest, lies squarely with a family office. By carefully designing its due diligence process, a family office can create a thorough and efficient process which can reduce the likelihood of investing in the next hedge fund fraud.

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