Due diligence service offered to hedge funds

The hedge fund operational due diligence service provided by New York-based Conrad Capital Management (CCM) is attracting interest from institutional investors and regulators, according to the company's president and CEO Donald Conrad.

CCM, a registered investment advisory firm which also runs a fund of hedge funds, launched the service, known as IVOR (investment verification and operational review) in the fourth quarter of 2008. It is principally aimed at institutional investors like pension funds.

The review involves a half day on-site visit with the hedge fund manager. CCM staff review the operational processes and compliance, pricing and financing practices of the manager. They also confirm the role and services provided by third parties like administrators and prime brokers.

"We carry out a thorough operational review. This is not a passive, check-list based due diligence product," said Doug Pateka, a director at CCM. "We sit with the traders, portfolio managers and operational staff and verify that they are following best practices. We look at the full spectrum of operational and business processes from trade execution through to soft dollar issues," he added.

The results of the review are made available to investors in the form of a report. CCM also gives the report available to the hedge fund. It can be used to answer due diligence questionnaires and request for proposals from potential investors.

Hedge funds are showing some interest in commissioning due diligence reports on their operations to reassure investors, Conrad said.

"Hedge funds themselves can benefit from reviews by independent third parties. It can provide comfort to investors. In many cases we are able to highlight operational risk or cost issues that the manager may not be aware of," he said.

Conrad said in some cases managers may not realise that they are overpaying for services like prime brokerage compared to their peers.

He said an IVOR review is priced significantly lower than traditional due diligence services. CCM's fund of funds business only invests in managers that have been subject to an IVOR review.

CCM is working with the Hedge Fund & Private Equity Resource Center run by Paul Seader to develop the service.

Conrad said CCM has been in discussions with the US Securities and Exchange Commission (SEC), the Managed Funds Association (MFA) and the attorney general of Connecticut, Richard Blumenthal, about making IVOR reports available to regulators.

Rules that would require US hedge funds to register with the SEC and provide the regulator with information about their activities is expected to be implemented in the near future.

Lawmakers in Connecticut are already considering legislation which would require hedge funds to provide reports to the local State Banking Commission.

The SEC has also stepped up its probes of hedge funds following a string of revelations about investment frauds and Ponzi schemes. However, SEC chairwoman Mary Schapiro has admitted that the agency has historically lacked the resources to properly police the complex hedge fund industry.

Conrad said third parties such as CCM were well positioned to provide regulators with key information about hedge funds. He said companies like CCM often had more first-hand experience of the complex workings of hedge funds than staff at regulatory agencies. The discussions between CCM and regulators are ongoing.