Part 1: A Comprehensive Approach to Operational Due Diligence

A Primer on Fund of Hedge Fund Risk Management* Part 1: A Comprehensive Approach to Operational Due Diligence

Part 1: A Comprehensive Approach to Operational Due Diligence Introduction Since the launch of our first fund of hedge funds in 1988, Aurora Investment Management L.L.C. (Aurora or the Firm) has sought to build diversified portfolios of the world s best hedge funds. We distinguish ourselves by our process, where we retain critical judgments at the most senior level. In both the initial and ongoing due diligence process, the Firm s Portfolio Managers and Managing Director of Operational Due Diligence meet directly with their principal counterparts at the underlying hedge fund managers. These regular, direct, high-level contacts not only provide us with the most accurate and meaningful qualitative information, but also allow us to establish valuable long-term relationships. By having our most senior professionals consistently interact with their decision-making counterparts who manage the underlying hedge funds, we believe that we attain the highest and most timely level of vigilance, thereby reducing the risk that important information will be misinterpreted or overlooked. A key part of our overall due diligence is the work of Aurora s Operational Due Diligence Team (Ops Team). The Ops Team is dedicated to assessing the risk of loss from an investment in a hedge fund because of inadequate or failed internal processes, people, and systems, or problems with external service providers on the part of the hedge fund or the entity that manages the hedge fund (collectively, a Manager). This paper describes how we assess the operations of a Manager, and how that process, we believe, adds significant value to our portfolios investments. The role of our Ops Team is best understood in the context of the Firm s Investment Committee. The Firm s Portfolio Managers and other investment professionals who serve on the Investment Committee have a deep appreciation that strong operations are critical for any Manager to be considered for investment. Our experience in reviewing Managers for over twenty-three years has consistently confirmed the value placed by the Investment Committee on the analysis of operational risk. The Ops Team must analyze, review and report on a Manager s operations before Aurora will invest. Acting independently of the Firm s Research Team, the Ops Team assesses whether a Manager s organization has operational integrity and risk controls suitable to support the Manager s trading opportunities and our objectives and expectations as an investor. As this paper explains, the Firm s operational due diligence process is distinct in the following respects: the seniority and experience of our front-line professionals dedicated to the process; the Ops Team s focus on intangible factors in addition to more readily observable characteristics; and the Ops Team s commitment to collaborate with the Manager, when appropriate, to add value to the overall process. * This Primer on Fund of Hedge Fund Risk Management has been prepared for educational purposes only for clients of Aurora Investment Management L.L.C. and their consultants and professional advisors. It is intended for the person to whom it was given and such person s consultants and professional advisers. It may not be forwarded or otherwise distributed by such person.

Part 1: A Comprehensive Approach to Operational Due Diligence 3 Summary of the Process The Firm s operational due diligence process includes analysis of the key operational elements of a Manager. Areas of focus include asset valuation, compliance, legal and regulatory factors, trade execution and settlement, fund administration and accounting, audit and tax, information technology, operational controls (including cash controls), key service providers, and operational risk management. As investors focus on operational quality has increased over the past several years, our operational assessment must go beyond simply minimizing the risk of a possible allocation to a fraudulent operation. Operational problems can arise from a number of sources, including: inexperienced operations personnel; inadequate internal controls; lack of compliance standards and enforcement; and errors in analyzing, trading, or recording positions. Because Managers typically engage in active, complex, and sometimes leveraged trading, a failure of operational functions may have significant consequences. While fraud detection is a vital element, operational due diligence needs to go much deeper. The Aurora Approach and Team The senior members of the Firm s Ops Team also lead the onsite in-person operational due diligence discussions with Managers: The Firm s Managing Director of Operational Due Diligence is a partner of the Firm who has over 20 years experience with hedge fund operations including serving as the Chief Financial Officer of Aurora from 2005 to 2010. The Firm s Director of Operational Due Diligence has managed the operations of a direct-trading investment manager with an affiliated broker dealer (where she served as Chief Operations Officer) and also brings over 20 years experience in the industry. Because of their deep experience in the industry and because their respective experience and knowledge base is different and complementary, this senior team has insights that allow it to assess both the forest and the trees of a Manager s operations. The Firm s entire Ops Team consists of professionals with diverse experience within the investment management industry, including prior experience in investment firm accounting, public accounting, finance, audit, operations, and information technology. The breadth of the team s knowledge and experience allows the team, which is dedicated exclusively to operational due diligence of Managers, to collaborate on the assessment of the overall operational effectiveness of an organization. Our process, described in more detail below, culminates in a collective evaluation of each Manager by our Ops Team. Each Manager that is presented for consideration is evaluated on critical tangible and intangible aspects of its operations that concludes with the Ops Team s written report on the Manager that is provided to our Investment Committee. As a partner of the Firm and a member of the Investment Committee, the Managing Director communicates the Ops Team s findings and opinions and has veto power over any proposed or existing portfolio investment. Post-investment, the Ops Team monitors and evaluates our investments by continuing to inquire and gather information from each Manager, making on-site visits at least once per year. Additionally, the Ops Team shares information with the Firm s Research Team regularly so that the Firm s perspective on each Manager remains complete and up to date.

4 Part 1: A Comprehensive Approach to Operational Due Diligence Some of the Ops Team s recurring activities include: Financial statement reviews Counterparty exposure evaluation Monitoring of changes to controls, policies, procedures, service providers Asset and internal capital confirmation Asset valuation reviews process and FAS 157/ASC 820 categorization Operational expense reviews and manager comparisons Regular calls with each manager alongside our Research analysts Regular interaction with our Research analysts on manager status and events The Firm s proprietary database facilitates this process, allowing more informed and timely decisions. When the Ops Team assesses the key elements of a Manager s operations, we focus on both the tangibles and the intangibles. Example 1: Service Provider Review When a Manager made the decision to retain a new independent third party administrator, it proposed to engage a smaller firm that was unknown to us. The Ops Team visited the administrator s offices and concluded that the administrator, while competent in some areas, lacked the depth and breadth of expertise necessary to provide administrative services at the level appropriate for our Manager. After we communicated our conclusions, the Manager changed course, asked for recommendations and engaged a more experienced independent third party administrator. What We Look For The Tangibles The tangible elements that the Ops Team reviews are the clearly observable characteristics (e.g., strong policies and procedures, experienced and adequate staffing, competent third party service providers) of a Manager. At the outset, we assess these with the help of proprietary surveys and questionnaires, but the process then advances to deeper analysis. The Ops Team s process analyzes key criteria in the following general categories: 1. Firm structure 2. Fund structure and liquidity 3. Trading and settlement 4. Soft dollars / directed brokerage 5. Fund administration 6. Valuation and pricing policies and controls 7. Audit and tax 8. Controls and oversight 9. Compliance and regulatory 10. Corporate governance 11. Information technology 12. Service provider evaluation and confirmation 13. Asset confirmation 14. Background checks 15. Financial statement reviews 16. Periodic on-site due diligence review of third party administrator The Appendix to this paper provides a more detailed description of our review process for a single area noted above Fund administration. What We Look For The Intangibles The intangible elements are the less objectively measureable qualities, for example: Whether there is a culture of compliance throughout the organization Whether the CFO has adequate experience with the trading and other operational practices Whether the non-investment staff of the Manager who review and approve valuations have personal familiarity with the Manager s valuation and other key policies Whether the personal characteristics of the senior operational managers (CFO, CCO) suggest that they will have the strength to advocate for the proper outcome with the Manager s investment professionals

Part 1: A Comprehensive Approach to Operational Due Diligence 5 Example 2 : Strong Culture of Compliance With one Manager that was a skilled investor, our Ops Team put a hold on the investment process because it concluded that the Manager lacked a sufficiently broad commitment to operational excellence, having failed to devote sufficient time and resources to developing a culture of compliance. While the Manager s valuation processes and cash controls were strong, the Manager had not updated its offering materials for several years, and the chief compliance officer responsibilities had been assigned to an individual who also served as CFO who seemed to approach his compliance responsibilities as things to attend to in his spare time. Because we were not able to identify a strong culture of compliance instilled by the most senior executives of the firm, we communicated our concerns to the Manager and put our investment plans on hold. Example 3: Review of Personnel While meeting with the CFO of a large Manager in which we were already invested, the Ops Team s Managing Director noted certain potential weaknesses with regard to the CFO s personal ability to manage the increasingly complex functions at the growing, dynamic organization. The concern was that the CFO might be creating bottle-neck issues, as reports were not being issued on a timely basis, and our observation was that the individual had difficulty with delegation of responsibilities. After these concerns were communicated to the Firm s Investment Committee, the Firm arranged a call with the Manager s key professionals. Upon first learning of our observations, the Manager s senior team was defensive and challenged us for details and examples, which we provided. They then acknowledged that they also saw evidence of our impressions. Soon thereafter, the CFO was reassigned to a more suitable role, and a new, stronger CFO was retained. Since that time, the principals of the Manager have expressed appreciation to the Firm for helping them recognize and address the issue, noting that no other investor had observed what we had. Not measurable through a checklist, the intangibles are best measured through human interaction. While both tangibles and intangibles are important, we believe that our Ops Team differentiates itself by its ability to identify the intangible qualities necessary to support consistent and superior operational results. In advance of the conversations with the key operational staff during our on-site visits, our Ops Team prepares by reviewing the Manager s written information. This not only makes the meetings more efficient by avoiding a check the box approach, but also allows us to conduct a discussion addressing the why s (rather than the what s ), leading to a more open and candid dialogue that is more likely to reveal the information most critical for the assessment of operational risk. The expertise and experience of our front-line Ops Team leaders also make it more likely that we will develop a deep understanding of the most critical matters. Two-way, open-ended discussions create a basis for trust and can also lead to a Manager s CFO or CCO getting comfortable enough to share operational details that might otherwise not have been discussed. Our approach, driven by the expertise and effectiveness of our team, is key to our acquiring more and better information. The Aurora Ops Team as Consultant While operational due diligence in many cases will be effective in steering investment away from a Manager with weak infrastructure, in other cases it can help a Manager implement change to achieve higher operational quality for the benefit of the Manager, the fund and the investors. With a Manager that is generally strong but has limited weaknesses in operations, the Firm s Ops Team often will identify the weakness and make suggestions for improvement. Depending on the circumstances, the change may be a simple suggestion, a requirement that will be a condition to our investment, or part of a decision by the Firm to postpone the decision whether to invest until more time has passed and we can observe successful implementation. Part of the recipe for success is to be able to determine whether the area needing improvement is a sign of fundamental operational weakness or simply an area requiring improvement within an overall sound operation. Conclusion Well-executed operational due diligence requires expertise and resources, and should produce a thorough understanding and analysis of a Manager prior to rendering an investment opinion. To perform this assessment on any single Manager can require hundreds of hours of work involving research, interviews, review of policies, procedures and financials, analysis and written reporting. Additionally, once a Manager is in the portfolio, continuous monitoring and communication is required to assess whether the Manager continues to maintain high operational integrity. The broad investment freedom enjoyed by most Managers only adds to the challenge of operational risk monitoring. There are possible shortcuts, but each brings limitations and adds risk. To monitor a portfolio of hedge funds, an investing firm may elect either to perform pre-investment work followed by a single annual check-up using a survey or to outsource the operational due diligence function to a third party. But each of these approaches may not provide sufficient insight into the intangible elements. By approaching due diligence in this manner, an investor risks being late in identifying any problems and (more significantly) late to act on them. Redeeming from a troubled hedge fund in a timely manner can be much more critical than getting in. Because it is so important to maintain a regular dialogue with the underlying Managers, operational due diligence often is difficult for an investor to perform itself or to outsource effectively.

6 Part 1: A Comprehensive Approach to Operational Due Diligence A deep and experienced operational due diligence team offers significant value when it has the skills and experience to identify subtle clues and look through the information barriers to find critical information relevant to an investment decision. The Firm s Ops Team develops a professional collaborative rapport with each Manager while remaining resolute in their independence. As a result, the team develops a better understanding of each Manager s operations and, we believe, elicits and discovers more and better information, putting it in a better position to identify indicators or events that signal potential problems. When carried out this way, operational due diligence can play an active role in creating top quality portfolios of hedge funds. Appendix Example of the Process Fund Administration For the purpose of illustration, taking just the topic of Fund Administration as an example, our Ops Team focuses on whether a Manager s third party administrator is a good fit for the Manager s hedge funds and how the Manager seeks value from the relationship. Additionally, we evaluate the controls and functions assigned to the administrator and to assess whether the administrator is likely to exercise independent judgment in the execution of its role. Here are some questions we frequently ask in this analysis: What criteria were used in selecting the administrator? In entering into the administrative agreement, did the Manager have the mindset of adding value through the relationship or was the Manager more tolerating the presence of a third party administrator simply to meet investor expectations? Did the Manager conduct a formal selection process that identified areas where the administrator could help? How did the Manager assess whether the administrator s infrastructure, technology, experience and staff assigned to the account were appropriate for the Manager s investment style and structure? Are there potential conflicts of interest? Can the administrator exercise independent judgment? What assurances are there with regard to the independence of the third party administrator? Does the administration agreement clearly specify the areas where the administrator has final say or the ability to appeal to others (e.g., the fund s board, the fund s auditors)? Does the Manager have any seeding or other extraneous affiliations with the administrator? Does the Manager conduct on-going due diligence of the administrator? How does the Manager evaluate its administrator s performance on an ongoing basis? Do the Manager s CFO and COO have regular meetings with the senior staff of the administrator to review service and operational issues? Are these visits at the office of the administrator where the services are provided? How has the Manager gained comfort regarding the administrator s processes and controls? Does the Manager review the administrator s SAS 70 report each time it is issued and has the Manager considered potential weaknesses identified and how those may impact the Manager s operations? Example 4: Third Party Administrator Review The Firm s Ops Team was evaluating a potential Manager that was under active review by the Research Team. The Manager, relatively small in size, was using a middle tier administrator that we knew only by name. When a Manager uses an administrator that has not previously been evaluated by our Ops Team, we will conduct initial due diligence on the administrator. In this case, we went to the administrator s office to meet with both the administrator s senior management and the team assigned to the Manager s account. Going into the meeting, we expected to assess the firm s depth, experience and ability to staff and retain the type of professionals necessary to offer high quality administrative service to this potential Manager. We first spent several hours with the administrator s senior management, discussing the administrator s formation, philosophy, culture and vision for the future. We learned of situations where the administrator had turned down business with potential Managers based the Manager s apparent lack of appreciation for independence in pricing or unwillingness to allocate certain controls to the administrator. They gave an account of their effectively firing a client when they became uneasy with the client s business practices. We viewed it as a positive that they were willing to turn away business and accept only the clients that they thought were a good fit for them. We observed that the administrator s management had defined goals and appeared to be managing their growth prudently. Our conversations gave us comfort with regard to the culture and philosophy of the administrator and its leadership. Continued on next page. Does the Manager know and understand the mechanics of how and where the administrator performs critical services provided to the Manager (NAV calculation, shareholder services)? Has the Manager kicked the tires with regard to how the administrator performs valuation and calculates the NAV? Are the key administrative services being performed from a suitable office location with working hours and business culture that will allow for appropriate levels of support?

Part 1: A Comprehensive Approach to Operational Due Diligence 7 Example 4, continued: We then spent several hours with the team specifically assigned to service the prospective Manager s account. In considerable detail, they walked us through the NAV production process, anti-money laundering practices, subscriptions and redemptions, shareholder services, valuation and pricing, and internal controls. We reviewed their monthly book which had complete documentation of the monthly NAV process. We observed strong policies and procedures, and noted that the team had appropriate academic and professional credentials. They had purchased well-established third-party systems to support their operations. We discussed in detail the evaluation and monitoring of fund expenses, and the team gave accounts of questioning a different client on certain research expenses that were being charged to the fund. They ultimately convinced that Manager that the charges in question were management company rather than fund expenses. They gave another account of a case where they questioned a Manager s expenses and did not get the same response. As a consequence, they called the auditor and discussed the issue with the Manager s auditor, because as part of their administrative agreement they require the ability to contact the Manager s auditor. We were impressed with the administrator s professionalism and the integrity with which the employees operated the business. We concluded that this administrator was professionally sound and appropriate for the Manager. Are proper controls exercised by the administrator? Is the administrator charged with actively reviewing fund expenses and vendor relationships? Does the administrator control cash movements related to subscriptions and redemptions from the Manager s funds? Does the administrator receive trade and position data for each Manager directly from prime brokers? Does the administrator have independent systems that the Manager cannot access to input or alter data (apart from front office capabilities designed to allow the administrator to collect information from the Manager)? Does the administrator maintain independence in Valuation and Pricing? To what extent is the administrator independently pricing the book? All independent pricing mechanisms need to start with the viewpoints of the Manager s investment team, but then what happens? The administrator should be evaluating all prices that they can obtain independently and questioning the Manager while investigating and documenting the differences. How does the Manager communicate to the administrator proposed pricing and the rationale behind it? When there is a lack of agreement between the Manager and the administrator on pricing, how is the difference resolved? Does the administrator s team have a copy of the Manager s valuation policy and is it well versed in this policy? What expertise does the administrator have to understand the specific products and asset classes in which the manager transacts? Is that expertise sufficient? Does the administrator have the proper systems and infrastructure? Which and how many of the administrator s processes are carried out on a stable system? Which and how many are carried out on simple spreadsheets not part of a system? What risks does that create? Does the administrator offer reporting software or systems that will help the manager s operations? Is the Manager taking advantage of those? Are communications between the Manager and the administrator and between the administrator and the shareholders made using secure electronic delivery? Do the administrator s data intake processes provide for straight-through-processing that avoids dual entry of data to the greatest extent possible? Has the Manager reviewed the administrator s redundancy and business continuity preparations to assess whether those are consistent with the Manager s own service expectations and requirements? Service level agreement As part of the administrative agreement, has the Manager negotiated a service level agreement (SLA) that reflects the Manager s business needs? Does the SLA specify service commitments on the timing and quality of key deliverables, including the timing and frequency of posting NAV and the response time and hours of support from the administrator s staff? Does the SLA specify what happens if the minimum service levels are not met? General Disclosure: This Primer on Fund of Hedge Fund Risk Management is not intended as an offer to sell, or a solicitation to buy, an interest in any hedge fund or fund of hedge funds, including any investment fund managed by Aurora Investment Management L.L.C. An offer to sell, or a solicitation to buy, an interest in any hedge fund or fund of hedge funds may be made only to qualified investors and must be preceded or accompanied by the confidential offering memorandum for the relevant fund (which contains important information about the risks of investing in funds of hedge funds). There are substantial risks associated with an investment in hedge funds and funds of hedge funds. Only investors that are sophisticated and understand the risks of investing in hedge funds, including the risk of loss of their entire investment, should consider investing in hedge funds. All investors are urged to consult with their professional advisers prior to making investments, including investments in hedge funds and funds of hedge funds.

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