CAIA - 33 - Hedge Fund Operational Due Diligence

Question 1

Hedge Funds typically differ from private equity in 2 primary ways with regards to operational due diligence:

1. ___ ___
2. ___ ___

Answer 1

Hedge Funds typically differ from private equity in 2 primary ways with regards to operational due diligence:

1. Frequent trading

2. Liquid positions

Question 2

___ refers to the process of completing a securities trade.

Answer 2

Execution refers to the process of completing a securities trade.

Question 3

It is best practice to keep investment and trading activities ___.

Answer 3

It is best practice to keep investment and trading activities separate.

(To reduce conflicts of interest)

Question 4

Trading software systems create ___ ___, which are records of trades made in a trading day.

Answer 4

Trading software systems create trade blotters, which are records of trades made in a trading day.

Question 5

___ refers to the process of logging trades internally at a fund either through order management or fund accounting systems

Answer 5

Posting refers to the process of logging trades internally at a fund either through order management or fund accounting systems

Question 6

___ refers to the process of reconciling third-party trade confirmations for executed trades with the firm’s internal systems and trade blotters, and transferring the cash and securities to complete the trade.

Answer 6

Settlement refers to the process of reconciling third-party trade confirmations for executed trades with the firm’s internal systems and trade blotters, and transferring the cash and securities to complete the trade.

Question 7

The allocation most commonly used is ___ ___allocation, which allocates shares based on preset proportionate amounts.

Answer 7

The allocation most commonly used is pro rata allocation, which allocates shares based on preset proportionate amounts.

Question 8

___ refers to the process of a hedge fund conducting an internal review to ensure that the trade’s internal details are consistent with those provided by the fund’s counterparties.

Answer 8

Reconciliation refers to the process of a hedge fund conducting an internal review to ensure that the trade’s internal details are consistent with those provided by the fund’s counterparties.

Question 9

Most reconciliations are ___-___. However, best practice to perform ___-___reconciliations with a ___ ___ ___.

Answer 9

Most reconciliations are two-way. However, best practice to perform three-way reconciliations with a third party administrator.

Question 10

A ___ ___is the failure of a trade to execute.

Answer 10

A trade break is the failure of a trade to execute.

Question 11

Regarding the frequency of reconciliations, the best practice is to conduct reconciliations ___.

Answer 11

Regarding the frequency of reconciliations, the best practice is to conduct reconciliations daily.

Question 12

Liquid securities are generally reconciled on a ___ basis.

Answer 12

Liquid securities are generally reconciled on a T+1 basis.

Question 13

During the ODD review, investors examine operational risks in each step in the trade life cycle. There are 2 key areas of focus:

1. Independent oversight of ___ ___
2. Independent oversight of ___ ___

Answer 13

During the ODD review, investors examine operational risks in each step in the trade life cycle. There are 2 key areas of focus:

1. Independent oversight of internal departments
2. Independent oversight of third parties

Question 14

What are the 4 reasons hedge funds hold cash:

1. ___
2. ___
3. ___ ___ ___
4. ___

Answer 14

What are the 4 reasons hedge funds hold cash:

1. Expenses

2. Trading

3. Investor Cash Flow

4. Unencumbered

Question 15

Paying expenses should require ___ of ___and oversight by a ___ ___ ___.

Answer 15

Paying expenses should require separation of duties and oversight by a third party administrator.

Question 16

Cash balances from trading should be ___ ___instead of ___a ___with the counterparty.

Answer 16

Cash balances from trading should be swept frequently instead of leaving a balance with the counterparty.

Question 17

___ ___is cash that is not currently being used for trading.

Answer 17

Unencumbered cash is cash that is not currently being used for trading.

Question 18

___ ___ ___ ___ are institutions that facilitate trading for hedge funds by aggregating some or all of their cash and securities, and provide services such as ___ and ___ ___.

Answer 18

Hedge fund prime brokers are institutions that facilitate trading for hedge funds by aggregating some or all of their cash and securities, and provide services such as leverage and short selling.

Question 19

During the hedge fund operational due diligence process, investors should evaluate a prime brokers ___ as well as its ___. Investors should also see if the hedge fund ___its hedge broker exposure.

Answer 19

During the hedge fund operational due diligence process, investors should evaluate a prime brokers operations as well as its solvency. Investors should also see if the hedge fund diversifies its hedge broker exposure.

Question 20

In contrast to private equity funds, hedge funds typically use third-party fund administrators that perform two key functions: ___ ___ and ___ ___.

Answer 20

In contrast to private equity funds, hedge funds typically use third-party fund administrators that perform two key functions: fund accounting and shareholder services.

Question 21

For valuation of securities, the best practice is for hedge funds to give TPAs the ___ of valuation committee meetings.

Answer 21

For valuation of securities, the best practice is for hedge funds to give TPAs the minutes of valuation committee meetings.

Question 22

Delays in NAV production have an ___ ___ ___, since they may represent operational issues between the hedge fund and the administrator.

Answer 22

Delays in NAV production have an operational signaling effect, since they may represent operational issues between the hedge fund and the administrator.

Question 23

When verifying operational data, ODD should verify ___and ___ with third parties.

Answer 23

When verifying operational data, ODD should verify assets and positions with third parties.

Question 24

There are three areas typically overseen by a hedge fund’s compliance department:

1. ___ ___
2. ___ ___
3. Monitoring and managing ___of ___

Answer 24

There are three areas typically overseen by a hedge fund’s compliance department:

1. Personnel training
2. Testing implementation
3. Monitoring and managing conflicts of interest

Question 25

An indication of poor operational oversight of personal account dealings is ___ ___, which involves placing trades for personal accounts before the firm.

Answer 25

An indication of poor operational oversight of personal account dealings is front running, which involves placing trades for personal accounts before the firm.

Question 26

Employees who want to execute trades for their personal accounts must submit ___-___requests and engage in a ___-___process.

Answer 26

Employees who want to execute trades for their personal accounts must submit pre-clearance requests and engage in a post-clearance process.

Question 27

A company with material nonpublic information about a security places the security on a ___ ___, and prohibits employees form trading any securities on the list.

Answer 27

A company with material nonpublic information about a security places the security on a restricted list, and prohibits employees form trading any securities on the list.

Question 28

Hedge funds may override minimum holding periods with a ___ ___that permits the employees to sell a security at a loss if it will prevent the employees from suffering significant losses.

Answer 28

Hedge funds may override minimum holding periods with a hardship exemption that permits the employees to sell a security at a loss if it will prevent the employees from suffering significant losses.

Question 29

___ ___refers to employees using matrial non-public information (MNPI) when making investments.

Answer 29

Insider trading refers to employees using matrial non-public information (MNPI) when making investments.

Question 30

___ ___are made up of professionals and academics who serve as consultants to hedge funds. Compliance should monitor interaction with experts to make sure MNPI is not acted on.

Answer 30

Expert networks are made up of professionals and academics who serve as consultants to hedge funds. Compliance should monitor interaction with experts to make sure MNPI is not acted on.

Question 31

It is considered best practice for hedge funds to use ___-___ ___ to supplement the internal compliance team.

Answer 31

It is considered best practice for hedge funds to use third-party consultants to supplement the internal compliance team.

Question 32

The last part of the ODD process is the ___ ___.

Answer 32

The last part of the ODD process is the operational decision.

Question 33

___ ___involves comparing market operational best practices to a fund’s actual procedures.

Answer 33

Operational benchmarking involves comparing market operational best practices to a fund’s actual procedures.

Question 34

An ___ ___ ___ refers to an issue that must be addressed before an investor continues to consider an investment in a hedge fund.

Answer 34

An operational threshold issue refers to an issue that must be addressed before an investor continues to consider an investment in a hedge fund.

Question 35

___ ___ ___ (or background checks) has traditionally been considered a separate part of the due diligence process.

Answer 35

Investigative due diligence (or background checks) has traditionally been considered a separate part of the due diligence process.

Question 36

The ___ ___model of investigative due diligence does background checks on all owners and is typically for small hedge funds.

Answer 36

The equity ownership model of investigative due diligence does background checks on all owners and is typically for small hedge funds.

Question 37

The ___ ___ ___ ___ model of investigative due diligence performs a background check on all individuals with the ability to make investment decisions or place trades.

Answer 37

The investment decision making authority model of investigative due diligence performs a background check on all individuals with the ability to make investment decisions or place trades.

Question 38

The ___ ___model of investigative due diligence does background checks on all individuals who control risk.

Answer 38

The risk control model of investigative due diligence does background checks on all individuals who control risk.

Question 39

There are 5 areas covered during the background investigation process:

1. C___
2. C___
3. R___
4. M___
5. F___

Answer 39

There are 5 areas covered during the background investigation process:

1. Criminal

2. Civil

3. Regulatory

4. Media

5. Factual

Question 40

___ ___ ___ confirm education and previous employment.

Answer 40

Factual information searches confirm education and previous employment.

Question 41

___ investors outsource the background investigation and other ODD processes to a third-party ODD consulting firm.

Answer 41

Most investors outsource the background investigation and other ODD processes to a third-party ODD consulting firm.

Question 42

There are 4 approaches to allocating resources for ODD:

1. ___
2. ___
3. ___
4. ___

Answer 42

There are 4 approaches to allocating resources for ODD:

1. Dedicated

2. Shared

3. Modular

4. Hybrid

Question 43

A ___ operational due diligence approach involves an investor with at least one full-time employee responsible for vetting the operational risks of hedge fund managers.

Answer 43

A dedicated operational due diligence approach involves an investor with at least one full-time employee responsible for vetting the operational risks of hedge fund managers.

Question 44

A ___ operational due diligence approach involves the individuals responsible for investment due diligence splitting the responsibility.

Answer 44

A shared operational due diligence approach involves the individuals responsible for investment due diligence splitting the responsibility.

Question 45

A ___ operational due diligence approach involves classifying the ODD process into functional components and dividing them among specialists who also have other roles.

Answer 45

A modular operational due diligence approach involves classifying the ODD process into functional components and dividing them among specialists who also have other roles.

Question 46

Most funds implement a ___ or ___operational due diligence approach.

Answer 46

Most funds implement a dedicated or hybrid operational due diligence approach.

Question 47

___ ___refers to an interconnected system of controls and procedures that determine a fund’s independence, transparency, and oversight.

Answer 47

Fund governance refers to an interconnected system of controls and procedures that determine a fund’s independence, transparency, and oversight.

Question 48

There are 5 common operational hedge fund committees:

1. ___
2. ___
3. ___ ___
4. ___ ___
5. ___

Answer 48

There are 5 common operational hedge fund committees:

1. Operations

2. Valuation

3. Business continuity

4. Best execution

5. Compliance

Question 49

A hedge fund’s ___ of ___is another governance mechanism, which is responsible for fulfilling the fund’s regulatory obligations, exercising legal rights, and providing limited independent oversight.

Answer 49

A hedge fund’s board of directors is another governance mechanism, which is responsible for fulfilling the fund’s regulatory obligations, exercising legal rights, and providing limited independent oversight.

Question 50

Hedge Fund Board of directors typically have 6 common duties:

1. Oversee ___ ___
2. Review ___ ___ ___
3. Approve ___ ___
4. Approve ___
5. Review ___
6. Review ___ ___

Answer 50

Hedge Fund Board of directors typically have 6 common duties:

1. Oversee redemption gates
2. Review audited financial statements
3. Approve legal documents
4. Approve mechanisms
5. Review valuations
6. Review service providers

Question 51

An ___ ___involves a hedge fund manager keeping part of an investor’s redeemed capital until the hedge fund’s audit has been completed.

Answer 51

An audit holdback involves a hedge fund manager keeping part of an investor’s redeemed capital until the hedge fund’s audit has been completed.

Question 52

A ___ refers to a capital buffer created by a hedge fund from invested capital to meet potential expenses.

Answer 52

A reserve refers to a capital buffer created by a hedge fund from invested capital to meet potential expenses.

Question 53

Board members of offshore funds must have a majority in ___. This has created the issue of ___ ___.

Answer 53

Board members of offshore funds must have a majority in jurisdiction. This has created the issue of director capacity.