LO 72.5: Explain how due diligence can be performed on a funds operational

LO 72.5: Explain how due diligence can be performed on a funds operational environment.
Investors should focus on several key areas when performing operational due diligence on a fund. The focus areas are internal control assessment, documents and disclosure, and service provider evaluation.
Internal Control Assessment
A starting point in due diligence is examining the qualifications and attitudes of the personnel. For instance, does the CEO believe in controls and compliance with the rules? An analyst must also assess whether the internal control staff have sufficient technical and work experience to perform their compliance duties properly. Have they been properly trained and do they continue to expand their skills in compliance? Some assurance may be required regarding whether the back and middle office managers are sufficiently experienced in performing supervisory duties. Finally, background checks on critical internal control staff members might be required.
Examining the funds policies and procedures may also be useful. Related documents may cover areas such as trading, derivatives usage, and transaction processing. One drawback is that these documents tend to be general and only demonstrate the intention to have a strong control environment. In other words, merely reading the documents provides little assurance that the policies and procedures are actually being followed or are effective. It is
Page 156
2018 Kaplan, Inc.
Topic 72 Cross Reference to GARP Assigned Reading – Mirabile, Chapter 12
usually a good sign if a fund has been proactive and obtained an audit report and opinion on the effectiveness of its controls. If this report is available, it should be reviewed.
The due diligence process should include an examination of the in-house or outsourced compliance system that is in place. Examples of specific items to consider include the code of ethics (if one exists) and any restrictions on employee trading and related-party transactions.
There should be an investigation into how the funds deal with counterparty risk arising from OTC derivatives and other counterparties. Is such risk mitigated by dealing with more than one counterparty? Are the counterparties monitored for risk on a daily basis?
Finally, there should be an assessment as to the effectiveness of corporate governance. Is it pervasive throughout the organization? Are examples of internal control breaches followed up with appropriate actions to remedy and prevent future recurrence?
Documents and Disclosure
As part of the due diligence process, investors must confirm with the funds legal counsel its involvement in preparing the original version of the fund documents as well as any subsequent revisions. The investor should also confirm if the law firm remains as the funds legal counsel. A physical check of the documents should be made to look for any changes made after the date indicated on the documents.
The investor should corroborate the terms of the offering memorandum by examining other documents such as the Form ADV, subscription agreement, and investment management agreement. Consistency is important here. Terms relating to fees, redemption rights, liquidity, and lockups should be examined closely and clarified with the manager if required.
Conflicts of interest that are disclosed in the offering memorandum should be scrutinized carefully. Lack of clarity in the disclosure may be a red flag and warrant further discussion with the manager and/or require independent information.
Similarly, lack of clarity or sufficiency in the disclosure of risks may warrant further investigation. The discussion of very general or irrelevant risk factors may be cause for concern.
The focus of any due diligence should be on the manager. As a starting point, the potential investor should determine the extent of the managers authority. Are the provisions very broad (potentially more risky) or quite specific? Is the manager subject to limitations on the amount of leverage employed or on the percentage of the fund invested in specific securities, sectors, or industries? Can the manager be indemnified for his actions outside of fraud, gross negligence, or malicious intent? Additionally, there should be a consideration of the managers reporting duties to investors (e.g., audited financial statements, disclosure of the tax treatment of the funds income and transactions).
In analyzing the financial statements, the investor should begin by ensuring the audit opinion is unqualified (i.e., the auditor believes the financial statements contain no material misstatements). The balance sheet and income statement should be examined for
2018 Kaplan, Inc.
Page 157
Topic 72 Cross Reference to GARP Assigned Reading – Mirabile, Chapter 12
consistency with the funds investment strategy (e.g., a high leverage fund should have high interest expense on the income statement and high liabilities on the balance sheet). Any inconsistencies should be discussed with the manager on a timely basis. In addition, the footnotes (which are also audited) should be examined carefully since they provide more detailed information on key items (e.g., contingent liabilities, related-party transactions) than the corresponding financial statements.
Fees paid to the manager by the fund should be scrutinized and recalculated. They should be corroborated with the offering memorandum. Specifically, there should be a check of any incentive fees paid in loss years.
Finally, there should be a check for the level of net contributions to the fund by the general partner. .Any fund withdrawals should be questioned.
Service Provider Evaluation
Third-party service providers may be hired by a fund for trade execution, information technology, valuation, verification, and asset safeguarding purposes.
A starting point for assessing the actual service providers is to examine the internal control letters issued by its auditors and its audited financial statements. Further due diligence could be performed through in-person discussions regarding the service providers role.
Bu s in e s s M o d e l a n d Fr a u d Ris k

Write a Comment