Tag Archives: due diligence

Hedge Fund Operational Issues and Failures

Hedge Fund Due Diligence Firm Releases White Paper

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Auditors).  Today we are publishing a press release which announces a new white paper from Castle Hall detailing the various reasons which hedge funds fail.  The press release also describes a new web database called HedgeEvent which was created by Castle Hall and details a number of hedge fund operational failures over the last few years.

I found the white paper to be interesting.  I would imagine that some fund of funds and other types of hedge fund investors would find the information useful.  A couple of interesting facts from the whitepaper:

  • The most common causes of operational failure in hedge funds are (i) theft and misappropriation and (ii) existence of assets (i.e. Ponzi schemes).
  • Long/short equity and managed futures are the strategies which are most likely to be subject to operational failure.


Castle Hall Alternatives Publishes White Paper on Hedge Fund Operational Failures: Launches “HedgeEvent” Database

MONTREAL–(BUSINESS WIRE)–Castle Hall Alternatives, the hedge fund industry’s leading provider of operational due diligence, today published its latest White Paper, ‘From Manhattan to Madoff: the Causes and Lessons of Hedge Fund Operational Failure.’ The Paper’s analysis and findings are based on HedgeEvent, a comprehensive, web-based database of more than 300 operational events, now available to Castle Hall’s due diligence clients. HedgeEvent supplements HedgeDiligence, the firm’s existing client web portal.

The White Paper may be downloaded from www.castlehallalternatives.com/publications.php

Chris Addy, Castle Hall’s CEO, said “the colossal fraud perpetrated by Bernie Madoff, together with a number of other recent cases, has made investors acutely concerned by the risk of operational ‘blow ups’. However, there has been little systematic study of operational failure, meaning that investors have limited guidance as to the extent of this problem.”

“The creation of HedgeEvent, which has taken more than two years to compile, has enabled us to summarize key metrics related to hedge fund operational failure” said Addy. “From Manhattan to Madoff analyzes operational events by number, estimated loss, causal factor and by the strategy of the funds involved.”

HedgeEvent contains 327 cases of hedge fund operational failure through June 30, 2009. Madoff, with an estimated financial impact of $64 billion, is by far the largest; the remaining cases have an aggregate estimated financial impact of approximately $15 billion. Of the 327 operational events, 121 have an estimated impact of $10 million or more, and 31 of at least $100 million.

“While operational failures are material – Madoff spectacularly so – it does not seem that fraud is pervasive in the hedge fund industry” said Addy. “Investors should, however, be very focused on the lessons which can be learned from those hedge funds which did generate large losses. Many of these were well established firms which attracted capital from reputable investors.”

Across all Events, the most common causes of operational failure are theft and misappropriation followed by existence of assets (the manager claimed to own fake securities or operated a Ponzi scheme where reported assets did not exist). The most common strategies subject to operational failure are long / short equity followed by managed futures. It is notable that investors have traditionally viewed these strategies, holding largely exchange-traded securities, as straightforward with low operational risk.

“HedgeEvent is an invaluable tool for both Castle Hall and our clients” said Addy. “A lot can be learned from historical events: better knowledge can help investors avoid the losses, both monetary and reputational, of hedge fund operational failure.”

About Castle Hall Alternatives

Castle Hall Alternatives helps leading institutional investors, fund of funds, family offices and endowments identify and manage hedge fund operational risk. Castle Hall’s team draws on more than 30 years of direct due diligence experience and is the industry’s largest, dedicated provider of operational due diligence. More information is available at www.castlehallalternatives.com


Castle Hall Alternatives
Chris Addy, President and CEO, +1 450 465 8880
[email protected]


Other related hedge fund law and start up articles include:

For more information, please call Bart Mallon, Esq. at 415-296-8510

Investment Advisor Fraud

Another Investment Advisor Ponzi Scheme

In the wake of the Madoff scandal the SEC is taking out other fraudulent investment advisory firms.  The release below details a south Florida investment advisor who perpetrated a multi-million dollar ponzi scheme.  As we noted in Lessons in Hedge Fund Due Diligence, it is so important for investors to conduct proper due diligence on their investment advisors or hedge fund managers. Continue reading

Another Commodity Pool Operator Fraud – Lesson in Hedge Fund Due Diligence

We frequently discuss scams involving the investment management and hedge fund industry as a warning to potential hedge fund investors to take the hedge fund due diligence process seriously.  In the CFTC release posted below, we have a classic scam where the sponsors of a commodity/futures fund acted in a fraudulent manner and used the assets of the fund for their own personal reasons.  We have listed the items which the consent order found and how an experienced hedge fund due diligence team could have protected the investor from fraud. Continue reading

Hedge Fund Fraud – Prominent Hedge Fund Attorney is Wrongdoer

Usually our discussion of hedge fund frauds revolves around unscrupulous promoters who engage in some sort of fraudulent behavior against hedge fund investors.  Most of the time the fraud is based on some sort of ponzi scheme.  However, in the case reprinted below, the fraud was actually perpetuated against many hedge funds, including some funds with a significant amount of assets under management.  Even more incredible is that the fraud was perpetuated by a hedge fund attorney with a very impressive background.  While this is slightly different than hedge fund affinity fraud, it does show that frauds can be found on all scales and that hedge fund due diligence is important for both investors and hedge funds.  It is important, maybe now more so than ever, that hedge funds conduct proper due diligence on their counterparties when engaging in private placements and off-exchange transactions.  Please contact us if you have any questions on hedge fund due diligence. Continue reading

Hedge Fund Due Diligence – Affinity Fraud Alert

In these uncertain and volatile markets hedge fund due diligence is more important than ever.  We’ve discussed how hedge fund due diligence is likely to change, but it is also important to note that hedge fund frauds can be detected through simple due diligence procedures.  In this vein, the NFA has released a notice and an alert on “affinity fraud.”  The NFA alert points out that there are many ways a potential hedge fund investor can protect themselves from a fraud by conducting basic research on the investment advisor, commodity pool operator, or forex manager.  If you are a hedge fund investor and would like a referral to a due diligence firm, please contact us.  Continue reading

Hedge Fund Investors and Increased Due Diligence: GAO Report

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here. Continue reading

Hedge Fund Due Diligence Firm Releases Whitepaper on Hedge Fund Industry

Castle Hall Alternatives, a hedge fund due diligence firm, has just released a new white paper entitled “Hedge Fund Investing in a New World: Five Questions for Investors.”  We greatly respect the thoughts and opinions of Christopher Addy, President and CEO of Castle Hall, who has allowed us to repost some of his earlier blog posts (please see Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).

In this article, I have summarized the thoughts presented in the white paper and added my own thoughts as well.  The thesis of the white paper is that the hedge fund industry will change because of the recent market events.  The paper is broken up into five different questions and each answer discusses how the current industry trends and what the trends will likely (or should) look like in the future.  The issues the white paper raised are:

1.  Is 2 and 20 fundamentally flawed?

In this section Castle Hall believes that there may be more hurdle rates in the future, that performance fees periods will need to mirror lock-up periods and that performance fees on hard to value assets need to be reconsidered.

HFLB: We agree with some of the points made in this section.  While the fee structure will ultimately be decided by the market, whatever the manager decides upon can be implemented by the attorneys in the hedge fund offering documents.  A good hedge fund attorney should discuss the above issues with hedge fund managers who have hard to value assets or long lock-up periods.

2. Do Hedge Funds Need Better Corporate Governance?

In this section Castle Hall argues that hedge funds, especially offshore funds, have very low corporate governance standards and that there may need to be greater oversight in the future.  The paper states, “As an immediate priority, investors need a Board which can provide genuine, active oversight in two key areas: portfolio valuation and situations in which funds elect to impose gates or suspend redemptions.”

HFLB: We agree generally and in principle.  However, investors will ultimately pay for the expense of greater corporate governance.  If investors show themselves willing to pay for the added expenses then it seems there should not be a lot of push back from the hedge fund managers.

3.  Is there an ‘Expections Gap’ in the administration industry?

Castle Hall notes that “vigilant oversight from an independent administrator remains by far the most effective protection investors have against manager errors, be they honest or dishonest.”  CH then goes on to discuss how hedge fund administrators do not all provide the same services to hedge fund managers and many administrators provide “NAV Lite” services.  CH believes that administrators need to have clearly defined and delineated roles which should include real asset valuation (not just rubber stamping a manager’s good faith valutation).  CH notes that third party valuation specialists may be a solution but that this could be an expensive option for hedge fund managers and investors.

HFLB: We agree.  The term “hedge fund administrator” is one of the loosest terms in the industry right now.  Administrators may be full service, provide “NAV lite” or provide mid and back office support as stated in the paper.  Sometimes hedge fund offering documents do not thoroughly discuss the actual duties of the hedge fund administrator and we believe that disclosure in the offering documents will increase in the future.  In the future hedge fund managers may want to include the actual administration contract in the offering documents as an exhibit.

With regard to third party valuation specialists, we agree that these types of firms will provide valuable services to both hedge funds and administrators in the future.  Hedge fund managers should discuss this option with their hedge fund attorney.

4.  Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers.  Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program.  The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents.  However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.

5.  Is it possible to hold illiquid assets in an open ended vehicle?

Castle Hall questions whether funds which hold illiquid assets should have open contribution and withdrawal periods.  If there are open contribution or withdrawal periods then illiquid assets must be valued so that there can be a NAV calculation.

HFLB: We agree that hedge funds need to have valuation methodologies if a fund will hold illiquid or hard to value assets.  We do not necessarily agree that funds which hold illiquid assets need to be closed ended (i.e. have a private equity fund structure).  Hedge fund attorneys will usually address this issue in a couple of ways: (1) through specifically delineated valuation practices to be utilized on valuation dates or (2) side pocket or similar structures.   We do note that in certain instances the manager, as well as the investor, would be better served through a closed end or private equity fund structure.  These are issues which the manager will need to discuss with their hedge fund attorney.


Castle Hall concludes with the following statement: “Ultimately, challenge brings opportunity: we remain convinced that a better, stronger hedge fund industry can emerge from the difficulties of today’s markets.”

HFLB: We agree.  I have stated before that we think the hedge fund industry will come back strong.  As regulations are added and due diligence increases, hedge funds should continue to grow as investors grow more comfortable with hedge funds as an asset class.

The full white paper can be found here.  The press release reprinted below, can be found here.


November 03, 2008

Castle Hall Releases White Paper on Hedge Fund Investing in a New World

Castle Hall Alternatives, a leading provider of hedge fund operational due diligence, today published “Hedge Fund Investing in a New World: Five Questions for Investors and Managers.”

Chris Addy, Castle Hall’s President and CEO, said “the credit crisis and market events over the past year have challenged the hedge fund industry as never before. Alternative investments will remain integral to diversified, institutional portfolios, but there will unavoidably be a re-evaluation of the hedge fund model.”

Castle Hall’s focus on hedge fund operational risk has helped the firm identify five questions relevant to both investors and managers in this “New World”. The firm’s White Paper asks whether the typical “2 and 20” fee structure is fundamentally flawed; whether hedge funds need better corporate governance; and whether there is an “expectations gap” in the fund administration industry. The White Paper also questions whether the fund prospectus should be written to protect the manager or the investor and asks if it is possible to hold illiquid assets in an open ended vehicle.

“The structures and conventions accepted in the past may not be the best for the hedge fund industry going forward” said Addy. “We have highlighted a number of areas where current practices are weak and, in the New World, we expect investors to be more vocal and require greater protection and control when allocating to hedge funds. Investors will also focus more intently on operational, structural and business issues in addition to performance and strategy.”

Hedge Fund Investing in a New World, the first in a series of thought leadership papers to be published by Castle Hall, can be accessed on our Website, under the Publications section.

Please feel free to contact us if you have any comments or questions.  Other relevant HFLB articles include:

Hedge Fund Manager Fined and Banned for a Year for “Portfolio Pumping”

This is another example of a hedge fund manager acting with incredible audacity.

Last week the SEC issued a release detailing an action taken against a hedge fund manager for his “portfolio pumping” practices.  Bascially the manager was caught buying a large amount of shares through another fund he ran in order to boost the price of the thinly traded security.  The manager then charged higher management fees based on the inflated price of the securities.  The manager was fined $100,000 and ordered to disgorge the higher management fee of $80,000.

The end of the release states that the adviser will be allowed to reapply for association with an investment advisor for a year, but I believe the damage has been done.  If this manager does start another fund, proper hedge fund due diligence will show this SEC action which by itself should send investors running for the door.  In this case the hedge fund manager ruined his career for a few thousand dollars.

The release can be found in full here.

SEC Charges San Francisco Hedge Fund Adviser for “Portfolio Pumping”

Washington, D.C., Oct. 16, 2008 — The Securities and Exchange Commission today charged San Francisco investment adviser MedCap Management & Research LLC (MMR) and its principal Charles Frederick Toney, Jr. with reporting misleading results to hedge fund investors by engaging in a practice known as “portfolio pumping.”

The SEC alleges that Toney made extensive quarter-end purchases of a thinly-traded penny stock in which his fund was heavily invested, more than quadrupling the stock price and allowing him to report artificially inflated quarterly results to fund investors. Without admitting or denying the SEC’s allegations, MMR and Toney have agreed to settle the charges by paying financial penalties and agreeing to an order barring Toney from acting as an investment adviser for at least one year.

“Fund investors relied on MMR and Toney to abide by their fiduciary duties and put the fund’s interests ahead of their own,” said Marc J. Fagel, Regional Director of the SEC’s San Francisco Regional Office. “Instead, Toney engaged in trading activity which hid his poor performance.”

According to the SEC’s order, MedCap Partners L.P. (MedCap), a hedge fund run by MMR and Toney, was suffering from dramatic losses and facing increasing redemptions from fund investors by September 2006. Over the last four days of the month, Toney — through a separate fund that MMR managed — placed numerous buy orders for a thinly-traded over-the-counter stock in which MedCap already was heavily invested. Toney’s buying pressure caused the stock price to more than quadruple, from $0.85 to $3.72.

The SEC alleges that because the stock represented over one-third of MedCap’s holdings, the brief boost in its price inflated MedCap’s reported value by $29 million, masking what would otherwise have been a 40 percent quarterly loss for MedCap. Immediately after the quarter ended, Toney reported to MedCap’s investors that the fund’s investments had begun to “bounce” and that the fund’s performance was improving. Toney failed to disclose that this “bounce” was almost entirely the result of his four-day purchasing spree. Following MMR’s brief buying activity, both the stock price and MedCap’s asset value declined to their previous levels.

According to the SEC’s order, at the same time, MMR charged fees to the fund based on the inflated quarter-end asset value.

The Commission found that MMR and Toney breached their fiduciary duties to MedCap and to MMR’s other fund in which the penny stock was acquired. Toney and MMR, without admitting or denying the Commission’s findings, have agreed to cease and desist from violating the antifraud provisions of the Investment Advisers Act of 1940. MMR also will disgorge the higher management fees it received due to the inflated fund asset value, plus interest — an amount totaling $70,633.69 — and receive a Commission censure. Toney also has agreed to a bar from association with any investment adviser with the right to reapply after one year, and to pay a $100,000 penalty.

Other releated articles:

Please contact us if you have questions or if you would like to discuss.

Hedge Fund Due Diligence Firm Expands

This week we’ve seen a deluge of hedge fund press releases which indicate that the industry which supports hedge funds remains strong a growing.  The press release below provides details on a hedge fund due diligence firm which is expanding its operations.  In the coming months and years hedge fund due diligence is poised to become a central part of the hedge fund investing process.

October 14, 2008

Gillian Scott, CA CFA, Joins Castle Hall Alternatives as Managing Director; Castle Hall Opens Office in Halifax, Nova Scotia

MONTREAL – Castle Hall Alternatives, a leading provider of hedge fund operational due diligence, announced today that Gillian Scott, CA CFA, has joined the firm as Managing Director. She will lead the firm’s new presence in Halifax, Nova Scotia, where Castle Hall joins several leading administrators and other service providers to help establish a growing pool of hedge fund expertise in Canada.

Gillian previously held the position of Group Financial Controller of The Atlantic Philanthropies, a leading international philanthropy with an investment portfolio in excess of $4 billion. Gillian was a key contributor to the design and development of the group’s operational due diligence process, completing due diligence reviews for a significant portion of Atlantic’s portfolio. She was also responsible for Atlantic’s group audit and internal control environment. Prior to joining Atlantic in 2001, Gillian was an audit manager with the Bermuda office of PricewaterhouseCoopers, where she was responsible for a wide range of hedge fund and investment related audits.

Gillian is a member of the Canadian Institute of Chartered Accountants and is also a CFA (chartered financial analyst) charterholder.

Commenting on her new role, Gillian said “in the current markets, hedge fund investors face multiple challenges that, more than ever, involve operational risk. Investors must understand many new issues, including counterparty risks, the impact of FAS 157 and how to deal with funds which impose gates, suspend redemptions or restructure. Castle Hall helps investors enhance their due diligence program and better respond to these new challenges.”

Chris Addy, Castle Hall’s President and CEO, said “we are delighted to welcome Gillian to our firm and expand our presence to Nova Scotia. Castle Hall’s unique due diligence model enables us to provide the objective and fully independent advice that investors need to navigate today’s markets. We are particularly proud to have assembled what is now the industry’s largest and most experienced team dedicated solely to operational due diligence on behalf of the investor community.”

Overview of hedge fund short sale rules and likely fallout from recent events

I received a request today to talk about hedge fund short sales and the likely fallout from the recent market disruptions and the failed bailout bill.

Short Sale Ban

The SEC has banned short sales on 800 individual securities.  These securities are generally within the financial services industry.  The ban on shorting these securities ends at 11:59 p.m. ET on Oct. 2, 2008. The SEC may extend the ban beyond this date if it deems an extension necessary in the public interest and for the protection of investors, but the SEC will not extend the ban for more than 30 calendar days in total duration.  (The SEC press release can be found here.)

Short Sale Disclosure Requirements

For hedge fund managers who are subject to 13F filings (i.e. those managers who manage $100mm or more), such managers will need to disclose their short positions by filing Form SH with the SEC.  More information on this can be found at 13F questions and answers or at the SEC’s website here. Please click here to view form-sh

Likely Fallout

There is so much uncertainty in the air right now.  Congress is having trouble trying to find some way to unfreeze the credit markets and money managers are just trying to find a way to stay afloat.  Additionally, as I mentioned this morning, investors are getting worried and are pulling cash out of hedge funds.  They way I see it, there are many scenarios which are likely to play out in the next couple of weeks and months:

1. Hedge fund redemptions – many investors are scared and are looking for safety right now.  While some managers are doing phenomenal in this wildly votile market, most are not and have not been doing well for much of the year.  I think that we’ll see in the coming days stories of large amounts of redemptions.

2. Hedge fund closures – as I discussed previously, because of the problems with the hedge fund high watermark, you are going to see money managers face the difficult decision of whether or not to keep their fund running.  Undoubtedly many managers will choose to close down their funds because of lack of capital (from redemptions and/or losses) or because they are too far under to make any money in the coming year.

3. Hedge fund regulation – while hedge funds have not faced the front page criticisms that the large investment banks and other financial institutions have seen over the past few weeks, the lawmakers have already began calling for investigations into the cause of this mess.  These investigations are likely to focus on systemic risks and how hedge funds may have contributed to the current market crisis.  As these reports begin spilling out over the next few weeks and months, I believe hedge funds will be a prime target and you are likely hear lawmakers facing re-election calling for more regulation.  [Please also note, Congress has indicated that it is more than willing to require more regulation of the financial markets as evidenced by its willingness to allow the CFTC to begin regulating the retail spot forex market.  For more information, please see this note from the CFTC. ]

4. Hedge fund start ups – over the next couple of months as funds begin to close down, successful traders will decide to go and start up their own hedge funds.  For these traders the transition to hedge fund manager will be difficult, but they will be able to be successful if they can find investors willing to invest in a start up hedge fund manager.  These traders will need to talk with a hedge fund attorney in order to get started with the hedge fund formation process.

5. Hedge fund due diligence will increasehedge fund due diligence is one of the areas that is set to grow quickly.  I expect that investors, especially smaller institutional investors, will require greater risk management disclosure from hedge funds.  A simple manager back ground check is no longer going to be sufficient.

6. Hedge fund consolidations – while every now and again I will hear something about hedge fund consolidation, it never really seems to happen in any sort of large scale way.  This year may be different as smaller firms with decent track record decide to merge with more established funds with greater risk management procedures.

Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include: