A widely-quoted study once estimated that more than 50% of hedge fund losses were due to operational issues (Capco 2003, re-quoted Edhec 2004). These are losses you can control. The investor’s business plan drives the choice of fund strategy, and individual integrity and performance drives the choice of fund manager. Similarly, early and regular due diligence into the quality of a fund’s operational structure can prevent or mitigate future headaches.

Research in this area should be as comprehensive as that conducted into strategy and manager selection. A strong operational structure, managed by an independent third party, can help mitigate operational risk and provide transparency about the manager adhering to the agreed investment principles.

Our statistics confirm that investors, enlightened by the recent financial turbulence, increasingly consider a fund’s administrator as their partner. Trends we are seeing in the fund administration space include:

• A 30% increase in due diligence requests in 2009
• A parallel increase in the sophistication and the number of questions asked
• Pricing, asset verification and payment wire controls are key concerns
• An increased demand for additional detail and supporting data
• On-site investor visits doubled in the last 18 months.

In the spirit of solutions and best practice, below are 10 operational areas where investors should conduct personal, demanding and thorough due diligence:

1. Read ALL legal documents. Check there is no conflict between the terms of the private placement memorandum (PPM) and other documents.
2. An authorised written valuation policy should be available for review.
3. Conduct personal, detailed due diligence on all counterparties, including prime brokers, derivatives counterparties and the administrator. Check the creditworthiness of the administrator.

The following points to consider relate specifically to administration due diligence:

1. The administrator should be truly independent, and free from conflict created by other trading, lending or custody activity.
2. The size of the fund manager mandate must be appropriate for the administrator.  Mandates exceeding 10 - 15% of current assets under administration (AuA) can increase the risk of single client domination, and of significant impact from any uncapped litigation related to the fund.
3. Technology should be a source of innovation and a target of continuous investment – the market will continue to require robust, scalable new solutions.
4. Processes must be subject to a controlled environment. Is real-time transparency accessible to investors and administrator management? Always ask for a demonstration. 
5. There must be a clear program to develop domain experience and scale in the administrator’s human resource pool.
6. Visit off-shore teams and operations. Ensure they are all integral and adding value to operations.
7. Ask for a personal presentation of the SAS 70 Type II audit. This should cover the entire year and include all the services, controls and company offices the investor and fund manager require.

The rigorous operational due diligence which today’s sophisticated investors demand requires far more than the historic checklist approach. Collectively their mantra has become 'Trust but Verify'. Due diligence research more frequently involves face-to-face meetings.  Instead of asking 'Do you do...?', today the investor requirement is 'How do you do … ?' These due diligence questions are not only being asked pre-investment, but now also at regular intervals – as often as every quarter in some cases.

Today, the issue of operational risk management ranks among the foremost of investor priorities. That’s a very good place for it to stay.

Vernon Barback is president & COO of GlobeOp Financial Services