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“Hedge Fund Operational Due Diligence” - Book Review & Giveaway at Trader’s Narrative





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Coming at the heels of such massive financial frauds as Madoff and Stanford, (as well as previous hedge fund collapses like Bayou) “Hedge Fund Operational Due Diligence” is well timed.

The recent batch of fraud dwarfs the largest trading losses in history, combined, and makes it crystal clear why all investors should take due diligence extremely seriously. The author, Jason Scharfman, previously at Graystone Research (a division of Morgan Stanley), is now at Corgentum, a full service hedge fund operational risk consultancy practice.

hedge fund operational due diligence scharfmanWhat is operational due diligence? Usually when we think of the risks involved with a hedge fund, the first we think of are related to the market. That is, how much an investment in them can depreciate as a result of trading losses. And although this is very important, there are two more areas of risk: credit and operational.

Credit is the risk associated with a counter-party being unable to meet their obligations (cough AIG cough). Operational due diligence encompasses a broad array of risks, including more ‘human’ frailties, such as internal controls, internal/external fraud, as well as business disruptions due to external or internal factors.

This is the risk that almost every single Madoff investor ignored - that says a lot because these were, by definition “sophisticated” but they ignored all the operational red flags and handed over millions of dollars.

Scharfman’s book explains not only how to diagnose and analyze the operational risks that may be present in a hedge fund, but how to continue to monitor them. This book is invaluable if you are running or thinking of starting a hedge fund, want to invest in one (or already have) or if you work in the field of asset management.

Because it is a thorough and exhaustive exposition, going through just about everything like a manual, it makes for an excellent reference resource. While the topic can be rather dry, Scharfman brings it to life by using nuanced hypothetical scenarios which read like stories (Chapter 5).

For example, would you or should you allocate money to a hedge fund if the head trader or manager has a criminal record? How would you treat this if the manager was pro-active in mentioning it? and not? what if it was not related to financial fraud?

If you’re impatient, you can skip to Chapter Six, which has the “Ten Tips for Performing an Operational Due Diligence”:

  1. Avoid meeting with the wrong people or the wrong group
  2. Get out of the conference room
  3. Little white lies can turn into big problems
  4. Be wary of phantomware
  5. Focus on documentation and negotiation
  6. Read the fine print (financial statement notes, etc.)
  7. Reference checking: importance of in-sample and out-of-sample references
  8. Credit analysis: are funds financially viable?
  9. Long-term planning: Key staff retention, succession planning, and more
  10. Growth Planning: is the manager proactive or reactive?

There has always been a struggle between hedge fund managers and investors. One side wants to disclose as little as possible, to protect proprietary strategies. And the other wants as much disclosure as possible to protect their assets. There has been an uneasy relationship between the two parties because of this. The trend is now shifting to more transparency not only because of the large fraud cases that have come to light but also because of a diminishing source of funds. Investors have a stronger position to make more demands for disclosure. And with Scharfman’s book, even the smaller investors have a blueprint to follow.

There’s a lot more in the book, of course, but that should give you enough to whet your appetite. You can purchase it at Amazon, or your favorite book seller (it is published by Wiley, a specialist in finance books).

Or be one of my lucky readers to win a free copy of Hedge Fund Operational Due Diligence. To enter for the chance to receive a copy of Jason Scharman’s book for free, just drop me a comment below. Make sure you write your email correctly (so I can contact you when you win the random draw!).

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29 Responses to ““Hedge Fund Operational Due Diligence” - Book Review & Giveaway”  

  1. 1 Zach H

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    Hey — love the blog, excited to see risk analysis texts reviewed. Hope I get to pick up a copy!

    Cheers, best of luck to you and the readers

  2. 2 Markus

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    Thanks for the review!

    Markus

  3. 3 BryanL

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    Love reading your emails in the morning!

  4. 4 Peter R

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    Due diligence is such a lost art and its coming back in style.

  5. 5 Michael Arold

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    Important topic! Thx for sharing.

  6. 6 Art Cooper

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    Scharfman seems to have done an exhaustive study of the inquiries hedge fund investors should make, but I wonder how fully investors with limited independent investigative ability will be able to utilize his inquiry guidelines. Very few potential investors have the resources at the disposal of a hedge fund consultant like Scharfman.

  7. 7 Aaron Schindler

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    Look out Madoff’s of the world, here comses Scharfman!

  8. 8 David Blair

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    Hedge Funds are clouded in such mystery and, thus, a timely book. Draw my name please.

  9. 9 PEJ

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    Alright, alright, since you are asking so nicely Babak, I would love to be included in the draw :-D
    Cheers mate.

  10. 10 Jean Levac

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    Thanks for the chance to win the book!
    J

  11. 11 RP

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    My hat is in the race!

  12. 12 Yesandnotyes

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    Thanks for the giveaway contest!

  13. 13 JB

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    i’m in! Thanks!

  14. 14 Justinvest

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    I would be particularly interested in reading the book for many reasons. ONE, is just having a better understanding of that big money that is in motion so that I can strategize more efficiently for my investors. TWO, in an enduring bear market, there are FEW investments that one can buy and hold as the fundamentals of most companies and municipalities is deteriorating. That creates the safest investments being inverse ETF funds - which the mainstream financial, both broker/dealers and regulators, are ill-equiped to understand, much less supervise and support. Their favorite word is BUY, and do very little to expose instruments facing poor future prospects. More and more, it is leading me to eploring having a “Hedge Fund” where I have an absolute return objective and one standard set of disclosures. With the market cascading downward and the best reassurance we get from Bernanke is that the markets should . . . essentially decelerate their collapse later this year, the safest investment are inverse funds as the markets work backwards in a BEAR market and the industry/regulations are only geared for BULL makets. I think that is a recipe for A LOT of retail investors being quite unamused particularly if they should see their statements drop another 30% from here.

    Thanks,

    Justin

  15. 15 ABell

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    Seems timely, and I need a weekend read after I finish this Wiley C# book!

  16. 16 Jiri Novotny

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    Hi, keep up the good work!

  17. 17 Nitin

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    Great review! I would love to get a chance to be included in the draw.
    Thanks

  18. 18 Ten Alley Rahman

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    Madoff and Stanford, (and collapses like Bayou) show that ethics are never high in business.

    when recent fraud dwarfs largest trading losses in history, combined, governements should take operational due diligence more seriously.
    Operational due diligence encompasses broad risks, including ‘human’ frailties, as internal controls, internal/external fraud, as well business disruptions due to external or internal factors.

    Madoff shows how easy it is for crooks to hide behind fake personas and business is so fast paced that we have to take many shortcuts to process more jobs in less time, just to survive.

    we need external monitors who can release public reports on such risks for external reliance. maybe an extended audit function is required to be legislated.

    Chapter Six, “Ten Tips for Performing an Operational Due Diligence” is probably the key to understanding the concepts:

    1. Avoid meeting with the wrong people or the wrong group
    2. Get out of the conference room
    3. Little white lies can turn into big problems
    4. Be wary of phantomware
    5. Focus on documentation and negotiation
    6. Read the fine print (financial statement notes, etc.)
    7. Reference checking: importance of in-sample and out-of-sample references
    8. Credit analysis: are funds financially viable?
    9. Long-term planning: Key staff retention, succession planning, and more
    10. Growth Planning: is the manager proactive or reactive?

    if dealing with crooks auditors should have priority to override the usual claims of business and irritation at oversight.

    it is essential that regulators insist on full transparency. large fraud cases prove that business cannot be trusted on its own to ensure effective transparency.

    it is unrealistic to expect small investors to have to do due diligence on every investment when regulators do not implement and enforce effective standards to ensure transparency and good ethics.

    do not need a copy.
    maybe something else

  19. 19 Edward Kim

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    Hey, there are some hedgies here on this blog!

  20. 20 Babak

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    Edward, yes, been known to happen ;-)

  21. 21 MJ

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    Great article. I would appreciate if you could include my name in the draw.

  22. 22 jeff pierce

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    Sign me up for the book drawing! Thanks for the useful reviews.

  23. 23 Jim

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    You have some good insights and data. I enjoy reading your blog. Thanks.

  24. 24 Tarun Saigal

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    Would love to be picked in the draw ….

  25. 25 Johnabi

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    “The illiterate of the 21st century will not be those who can not read and write, but those who can not learn, unlearn and relearn.” Alvin Toffler
    Thanks for providing us a site that helps us “learn, unlearn and relearn. :)

  26. 26 Misha

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    Great article! I would love to be included in the draw.
    Thanks

  27. 27 investor

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    hi nice analysis. I would like to become a successful trader and analyst of market movements. thanks fr including me for the draw.

  28. 28 Danni

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    Hi!! I’ve really appreciated your blog the last few months- it hasn’t turned me into a technical trader but it has been fascinating!! Keep it up!!

    Thks!

  29. 29 Ernest Rolfson

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    Good stuff here. Throwing my hat in.