LO 72.6: Explain how a fund’s business model risk and its fraud risk can be

LO 72.6: Explain how a funds business model risk and its fraud risk can be assessed.
In addition to the previous due diligence, potential investors need to closely examine the fund to ensure that the risks associated with its business model and potential fraud are not excessive.
Business Model Risk
Evaluating business model risk requires assessing whether managers know how to operate the business as well as generate high returns. Typical risks, potentially leading to failure and closure of the fund, include a lack of cash and working capital, a lack of a succession plan, and excessive redemptions in a short period of time.
A funds business model risk can be assessed by performing the following tasks: Examining the nature of the revenues and expenses. For example, are revenue
items stable, recurring, or one-time? Can costs be reduced or are they increasing uncontrollably?
Calculating the percentage of revenues derived from variable incentive or performance
fees (that may not materialize in market downturns).
Assessing the significance of the gap between management fees (revenue) and operating
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Topic 72 Cross Reference to GARP Assigned Reading – Mirabile, Chapter 12
Considering the sufficiency of the amount of working capital (especially cash) in place to
cover revenue shortfalls and/or expense overages for a reasonable period of time.
Determining how frequently budgets are created and for what period of time. Determining the funds breakeven points in terms of assets under management and
required performance level. Comparing those amounts to current (actual) and future (projected) amounts.
Ascertaining if there is sufficient personnel or capacity to increase the funds investment

asset base. .Ascertaining the existence of key person insurance on relevant individuals and the existence of a succession plan.
Fraud Risk
Fraud risk can always exist even though extensive due diligence has been performed on the manager and fund prior to investing. A funds fraud risk can be assessed by determining the existence of the following factors:
Frequent related-party transactions, including trading through a broker or using a Frequent related-party transactions, including trading through a broker or using a valuator who is a related party. Frequent instances of illiquidity, including significant concentrations of illiquid investments (especially those that are valued by the manager only). Frequent litigation as a defendant, especially regarding claims of fraud.

Unreasonably high (stated) investment returns.
Frequent personal trading by the manager of the same or similar securities as those held by the fund. Frequent shorting transactions.
Fraud risk may be mitigated by performing the following actions: Check the SEC website for any prior regulatory infractions. Check court records for any prior litigation and bankruptcy records for examples of
financial irresponsibility. Inquire with service providers for assurance over their competence and independence from the manager. Perform extensive background checks on the manager.

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