Saturday, March 31, 2007

Hedge Fund Due Diligence

The operational risks implicit in hedge fund investing are often greater than the risks associated with the investment strategies. The International Organization of Securities Commissions has developed a set of principles for valuing hedge fund portfolios, especially those whose strategies include illiquid or complex financial instruments. The principles address the conflicts of interest that may arise between hedge fund managers and their investors. Hedge funds can use significant leverage which makes appropriate valuation even more critical. The principles, outlined below, provide a good due diligence checklist in this area.

1.Comprehensive, documented policies and procedures should be established for the valuation of financial instruments held or employed by a hedge fund.
2. The policies should identify the methodologies that will be used for valuing all of the financial instruments held or employed by the hedge fund.
3. The financial instruments held or employed by hedge funds should be consistently valued according to the policies and procedures.
4. The policies and procedures should be reviewed periodically to seek to ensure their continued appropriateness.
5. The Governing Body should seek to ensure that an appropriately high level of independence is brought to bear in the application of the policies and procedures and whenever they are reviewed
6. The policies should seek to ensure that an appropriate level of independent review is undertaken of the individual values that are generated by the policies and procedures and in particular of any valuation that is influenced by the Manager.
7. A hedge fund’s policies and procedures should describe the process for handling and documenting price overrides, including the review of price overrides by an Independent Party.
8. The Governing Body should conduct initial and periodic due diligence on third parties that are appointed to perform valuation services.
9. The arrangements in place for the valuation of the hedge fund’s investment should be transparent to investors.

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