CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

CHAPTER 40

Operational Due Diligence

This section examines operational due diligence in the context of hedge fund investments. Operational due diligence is an extremely important part of any institutional-grade investment process. This due diligence process should highlight and document potential areas of operational risk. The International Association of Financial Engineers (IAFE) defines operational risk as “losses caused by problems with people, processes, technology, or external events.”

An investor must understand the operational risk prior to committing to an investment decision, as operational risk is as important as investment risk. Operational due diligence should be an ongoing process thereafter, as organizational structures and businesses change over time, and investors need to be vigilant in defining, monitoring, and accessing their operational risk exposures.

The strength of a hedge fund's operations often follows the fund's level of assets under management (AUM). Larger hedge funds have much more resources to invest in risk management and reporting systems and to hire world-class chief operating officers, chief compliance officers, business development managers, back-office and middle-office personnel, lawyers, accountants, and so on. Smaller hedge funds are more limited in their abilities to hire such qualified staff. In any event, one of the key points of performing operational due diligence will be to understand the hedge fund manager's state of mind in regard ...