2. INVESTMENT PROCESS AND PORTFOLIO RISK MANAGEMENT
This chapter deals with the sound practices relating to the creation of an investment process and portfolio risk management framework. Some of these practices may be very intuitive for individual portfolio managers and small teams, but it is important to recognise that investment processes evolve over time and as a FoHF ManCo grows and staff change, clear communication about the investment process, both to staff involved in its implementation and to investors, will help in the avoidance of misunderstandings and reduce the potential legal risk and risk of errors.
These processes should be tailored to individual FoHFs and the style of investment undertaken. If single investor portfolios (“SIPs” hereafter) are also operated, then the process and controls should be consistent with the commingled FoHFs (see appendix 1).

2.1 Due Diligence, Manager Selection and Monitoring
One of the goals of due diligence is to try to avoid investing in underlying hedge fund frauds or failures. The process of underlying hedge fund selection by FoHF ManCos must involve defined and thorough due diligence where invested funds will have passed through a due diligence process. There is no precise definition of what is to be included in hedge fund due diligence and no international regulatory standard exists to specifically address due diligence or the selection of underlying hedge fund managers by FoHF portfolio managers. Some jurisdictions have rules or regulations governing certain aspects of best practice on these topics and, normally, these rules and best practices are imposed by the jurisdictions where the FoHFs are incorporated or operate and where the FoHF ManCo is domiciled. However, they typically focus on the organisational and procedural aspects, including the marketing of the FoHFs, rather than on the content of the required due diligence or manager selection process.

2.1.1 Due Diligence Steps
Due diligence is the process of gathering and evaluating information about a hedge fund manager, as well as the investment vehicle itself, in order to assess whether a specific hedge fund is an appropriate candidate for investment by a FoHF ManCo. The due diligence process can vary depending on the style of the underlying hedge funds for example, a hedge fund which employs a systematic trading strategy will require some different due diligence analysis compared to a long/short equity, research-driven hedge fund.

The due diligence process can be split into 2 time frames:

a. prior to investing – during the selection process; and
b. ongoing monitoring – after initial investment, during the investment period.
The due diligence process during these time frames should be a combination of both quantitative and qualitative criteria. It is essential that once an investment is made into an underlying hedge fund it is regularly monitored in order to capture any investment style drift, changes in the risk profile; changes in key management personnel and changes in the levels of transparency of large and unusual inflows or outflows of assets.

And into 5 stages:
a. research and sourcing;
b. strategy and investment process due diligence;
c. operations due diligence;
d. legal documentation analysis; and
e. reputational checks.

The FoHF ManCo may consider the delegation of any of the above stages to an external service provider. In that situation, the FoHF ManCo should be expected to have procedures and processes in place to appropriately evaluate the service provider(s) and their compliance with industry best practice.

2.1.2 Eligibility Criteria
This thorough, and often time-consuming due diligence process involves checking that a potential underlying hedge fund investment meets certain basic criteria, such as the following:

a. custody of assets should be handled by an independent and financially sound entity;
b. custody of assets should be segregated from the custodian’s own assets, and/or re-hypothecated trades should be held in a segregated account in the name of the underlying hedge fund at the prime broker;
c. independent and reputable administrator;
d. minimum monthly valuation, by an independent third party;
e. mandatory annual (minimum) audit of the fund accounts by independent auditors, with hedge fund expertise;
f. independent lawyers;
g. legally enforceable ownership rights;
h. hedge funds should be based in reputable and well regulated jurisdictions, which have been the subject of favourable International Monetary Fund (IMF) and Financial Action Task Force (FATF) reviews;
i. liquidity profile of underlying funds should not differ significantly to the liquidity terms of the FoHF; and
j. adherence to industry standards such as the Hedge Funds Standard Board (HFSB).

2.1.3 Research and Sourcing
The selection process begins with the available universe of hedge funds. FoHF ManCos can select hedge funds to include in their due diligence process through a number of sources. Hedge fund databases provide a good starting point however, they do not capture the entire universe of hedge funds and the information reported on them is usually limited. Other useful sources include capital introduction teams, conferences, trade journals and industry contacts.
Screening and identification amongst the universe or peer group and the manner in which the fund was selected, either through visits, questionnaires or conference calls, should be documented. Information regarding the process of selection, how decisions were guided by information gathering, verification, qualitative and quantitative analytics and assessment, should also be documented, in a consistent format.

2.1.4 Strategy and Investment Process Due Diligence
In order to evaluate the capability of a manager to perform any investment management activities for an underlying hedge fund, the main areas requiring attention or action in the due diligence process are:

a. quality and experience of the management team, including any key-person risks;
b. investment strategy and associated investment research capability;
c. evaluation of risks associated with the portfolio (e.g., leverage, concentration, counterparty selection, type of instruments);
d. hedge funds risk management process, risk and control culture, and discipline including any risks associated with the delegation of any activity to an external service provider;
e. process and organisation of the execution and trading;
f. analysis of the track record of the hedge fund manager (if any); its feasibility (particularly with respect to back tests and pro-formas); its corroboration with the claimed strategy and stated risk levels; comparison to peers who operate using the same strategy; and capability to operate and perform successfully in varying market environments;
g. quantitative analysis which may provide a systematic and independent assessment of a hedge fund manager’s risk profile;
h. review of possible conflicts of interest; and
i. rebates (if any) provided by underlying hedge funds should accrue to the FoHF and not to the FoHF ManCo (thus ensuring the due diligence process is not influenced by financial considerations).

2.1.5 Operations Due Diligence
This is an essential element to the due diligence process and should be performed by separate personnel from the investment analysts within a FoHF ManCo. Detailed reviews of the organisation of an underlying hedge fund’s management company; of any of its service providers; its technology and systems and of documents (e.g., audited statements) are undertaken in order to evaluate non-investment type risks, before an investment is made into the hedge fund investment vehicle.

The analysis includes, but is not limited to:

a. analysis of the management company structure (such as capital base composition and review; experience of operational staff; segregation of duties; IT infrastructure; valuation process and accounting; valuation policy and corporate culture) and assessment of any associated risks;
b. review of valuation process of OTC, illiquid or non-exchange tradable securities;
c. review of any tasks delegated to service providers and an assessment of their ability to perform those tasks;
d. evaluation of potential conflicts of interests at the operations level;
e. quality and structure of the governing body;
f. strength and reputation of the independent administrator, auditors, prime broker and custodian;
g. custody and/or prime brokerage of hedge fund assets handled by independent entities, appropriately regulated;
h. cash controls approval and investment;
i. process and organisation of the execution and trading;
j. evidence that a proper reconciliation process is in place including, at least, daily trades, cash and holdings, pending transactions and settlement processes;
k. analysis of the life cycle of a trade, including trade input to the IT system;
l. adequacy and appropriateness of financing arrangements;
m. counterparty risk, including: concentration of risk within counterparty; evaluation of quality and reputation of counterparty; re-hypothecation risk; conflicts of interest; and terms of contracts between the hedge fund and the counterparty.
n. disaster recovery/business continuity review.

2.1.6 On-Site Visits
In order for a FoHF ManCo to obtain a genuine understanding of an underlying hedge fund, it is essential that on-site visits take place. This offers the FoHF ManCo the opportunity to see the environment that the hedge fund is operating within. Whilst other forms of communication with underlying hedge funds managers are still valuable and necessary, there is no replacement for face-to-face meetings where reactions to questions and the general substance of the business can be observed. These on-site meetings should take place at least annually.

2.1.7 Legal Documentation Analysis
A review of the legal documents of an underlying hedge fund (offering documents, memorandum and articles of association, and all agreements with service providers, including the management/advisory agreement, etc.) should take place in order to assess issues such as:

a. potential risks in the legal structure (e.g., lack of ring-fencing, contagion risk, inappropriate segregation of different investor classes, investors rights, side letters, fund domicile and past changes in structure) that may potentially impact investors;
b. coherence of all the documents;
c. legal relationship between the fund and its service providers;
d. quality of the governing body;
e. any potential conflicts of interests in the structure; and
f. procedures regarding changes in liquidity terms for investors.

FoHF ManCos should establish a routine process to receive communications from hedge funds including notices to investors, as described in 3.8.1, as well as updated offering documents. As with proxy matters, changes to offering documents should be fully understood and, if inconsistent with the FoHF ManCo’s expectations of the offering, the portfolio manager must speak immediately to the underlying hedge fund to gain acceptable explanations of the changes. When required, side letters also may be negotiated, for instance, in order to either clarify meaning in the legal documents, obtain better terms (i.e., tailored client reporting, fees, etc.) or to receive enhanced transparency.

2.1.8 Reputational Checks
Processes should be in place to check the background of an underlying hedge fund manager and/or of any important team members. These should include:

a. reference checks of portfolio/investment managers by other managers/previous colleagues;
b. background reviews by external business intelligence professionals covering: criminal activity, general relevant information etc., of portfolio/investment managers and key employees; and
c. periodic/specific evaluation of the quality and organisation of any service providers (existing or new).

2.1.9 Procedures, Policies and Data Management
FoHF ManCos should have documented policies and procedures covering the selection and monitoring of their hedge fund investments, including elements such as strategy, business risk, operational and reputational matters. As well as forming a clear framework to work within, these policies and procedures can assist clients of FoHF ManCos and regulators in understanding how the portfolio manager builds and operates its FoHFs platform.

Once an underlying hedge fund has been selected for investment, a FoHF ManCo should be expected to prepare and maintain information and data in respect of:

a. the underlying hedge fund’s portfolio construction process;
b. the underlying hedge fund’s portfolio governance arrangements
c. the rationale and philosophy behind investment decisions;
d. correspondence, calls, meetings and on-site monitoring visits with the underlying hedge fund manager;
e. information on asset allocation and weighting of underlying hedge funds in different portfolios; and
f. risk management considerations.
Subsequent to this process, upon investment, it should be expected to observe:
a. clear segregation of duties between investment and execution;
b. control over the process of notification of investment decisions to underlying hedge fund managers in order to avoid possible mistakes with custodian banks (see 3.1);
c. clear lines of communication and authority with regards to subscriptions or redemptions from an underlying hedge fund; and
d. active consideration of portfolio management components such as bridge financing, leverage and foreign exchange (“FX” hereafter) exposure.
The relationship between the redemption terms of a FoHF’s liquidity and the liquidity of the underlying hedge funds holdings should be monitored and appropriately managed.
The force majeure clause embedded in almost all FoHFs’ offering documents allows it to suspend redemptions or, sometimes, to redeem in kind. Less liquid redemption terms permit a hedge fund to invest in less liquid instruments or with a longer investment horizon. Less liquid investment, however, does not permit active management and active liquidity management is consequently essential to successfully manage investment risk in a FoHF.

2.6.1 Liquidity Terms
FoHF ManCos should have documented internal policies governing liquidity management of their portfolios. They should incorporate the liquidity terms of the underlying hedge funds into their overall investment portfolio construction and portfolio management processes. These policies and processes should be consistent with the FoHF’s constitutive documents.

2.6.2 Liquidity Management Process
The best practice at a FoHF ManCo is to ensure that the portfolio construction process reflects a reasonable balancing of the following factors:

a. liquidity actually available from the portfolio of hedge funds (including possible gates, lock-ups, restructurings or side pockets) as well as any preferential liquidity terms;
b. implications of cash flow from any FX hedging activities, taking into account available banking facilities;
c. consideration of known liquidity restrictions (gates, lock-ups, restructurings, side pockets and liquidations) of underlying hedge funds;
d. actual liquidity of the assets in an underlying hedge fund; and
e. consideration of any other factors such as availability of “emergency” clauses, including, but not limited to, the potential for the suspension of the investors’ redemption rights, in kind distribution and extended lock-up periods.

2.6.3 Transparency on Liquidity Profiles
In managing a FoHF, the FoHF ManCo should ensure that its shareholders and investors have a clear understanding of the liquidity profile of their investments. In order to accomplish this, FoHF ManCos should be able to provide clear and understandable/standardised liquidity measurements of their portfolios taking into account gates, lock-ups, restructurings and side pockets. This should assist both investors and the FoHFs to achieve the most efficient match of assets and liabilities whilst taking into account both the risk profile of the portfolio and an analysis of the investor base of the FoHFs. Some measure of liquidity profile reporting by FoHFs permits a clearer assessment by investors of comparable performance between FoHFs when adjusting for liquidity and should permit investors to make informed redemption decisions.