Family Offices and Alternative Investments

Whitepaper Family Offices and Alternative Investments

Paul A. Ehrhardt

Managing Member Investment Business Advisors, LLC Washington DC

In the midst of a prolonged low interest rate environment, many mid and large sized Family Offices are going beyond the traditional 60- 40 equity/fixed income asset allocation framework for their investment portfolios. In search of higher expected returns through portfolio diversification and lower volatility, and seeking to tap true alpha uncorrelated to traditional equity and fixed income markets, many Family Offices are making initial allocations or increased allocations to “alternative investments” including hedge funds, funds of hedge funds, private equity, real estate and commodities funds.

How can Family Offices effectively and prudently pursue this trend? What are the specific lessons to be learned by Family Offices from the 2008-09 financial crisis regarding alternative investments? What additional lessons need to learned from the Madoff Ponzi scheme and other recent alternative investment frauds and failures? And what lessons can be learned from institutional investors (such as university endowments) whose portfolios have included significant allocations (>50%) to alternatives for many years?

This White Paper posits that, as Family Offices pursue “alternative investments”, it is critical to their success that they undertake broader, deeper and more robust initial and ongoing due diligence assessment programs for these alternative investments. Traditional alternatives due diligence programs have had two major components: “Investment Due Diligence” and what has been termed “Operational Due Diligence” (“Ops DD”). This White Paper recommends expanding that framework to include 3 additional explicit categories of due diligence assessments regarding: “Alternatives Fund/Account/Investment Vehicle” due diligence, “Alternatives Manager Firm” due diligence and “Investment Business Process” due diligence. And to consider all 5 key areas under a new framework/heading called “Alternatives Investment Business Management Due Diligence”.

Investment research shows that overall asset allocation decisions can be a very important driver of investment performance; explaining as much as 90% of the variability of portfolio returns. Research also shows clearly that “performance dispersion” among alternative investments (the difference between the highest and lowest performing funds/managers in a given alternatives strategy) varies much more widely than the performance dispersion in, e.g., long-only equity strategies. As a result, manager/fund selection is even more important in the alternatives arena than in the long-only world. This heightened importance of alternatives manager/fund selection further reinforces the importance of Family Offices adopting the broader, deeper and more robust due diligence programs as recommended in this White Paper.

The author also suggests that use of formally adopted alternatives industry “Best Practices” can guide and give confidence to Family Offices as they pursue alternative investments more extensively. Several sources of formal alternative industry “Best Practices” are highlighted and the author also describes how these “best practices” should be customized to Family Offices based on each Family Office’s distinctive overall investment program characteristics and operating model (mix of internal and outsourced assistance).

Attention is also drawn to a potential distinctive “sweet spot” for Family Offices investing in alternatives; i.e., by seeking to align the typical size of individual alternatives investments made by many Family Offices with the smaller and “younger” alternatives funds/ managers who have outperformed their larger peers.

Following a summary of recommendations, there are 3 Appendices: Appendix A: Bibliography with relevant website addresses; Appendix B Sample Model Due Diligence Questionnaires (DDQs) – one for assessing Hedge Funds and the other for assessing Private Equity investments, and finally, Appendix C: Table of Contents (for 16 different) Alternatives Industry “Best Practices” documents”.

I. Trends: Family Offices and Alternatives…………………………………………………………...... 4 a. Moving away from “60-40 Asset Allocation Model” b. Importance of Asset Allocation as “Return Driver” c. Rationale for Allocations to “Alternatives”

II. Types and Characteristics of Alternative Investments…………………………………………………………...... 7 a. Hedge Funds, Funds of Hedge Funds, Private Equity, Real Estate, Commodities b. Varied Strategies, Holding Periods, Liquidity & Other Terms c. Importance of Performance Dispersion and Manager Selection

III. Family Offices Take Note of Lessons Learned From…………………………………………………………...... 12 a. 2008-09 Financial Crisis: • Liquidity/Illiquidity • Enhancement of Risk Management Capabilities • Transparency • Alignment of Interests • PPM Terms • Credit Facility Issues • Portfolio Diversification Low/No Correlation • Downside Protection • Leverage • Firm Leadership, Management & Governance • Valuation of Assets • Increased Regulation b. Madoff Ponzi Scheme c. Other Alternatives Frauds and Failures d. Institutional Investors with Extensive Alternatives Experience

IV. Past/Present: Traditional Due Diligence…………………………………………………………...... 30 a. 2 Types: “Investment Due Diligence” &“Operational Due Diligence” b. Continuing Evolution of Due Diligence Programs

V. Future: Broader & Deeper “Alternatives Investment Business Management” Due Diligence…………………………………………………………...... 38 a. 5 Part Due Diligence Framework b. Add “Fund”, “Firm” and “Business Process” Due Diligence

VI. Alternatives Industry “Best Practices”…………………………………………………………...... 45 a. Government, Industry and Other Sponsors of Formal “Best Practices” b. Examples of “Alternatives Industry Best Practices”

VII. Customizing “Best Practices” to Family Offices…………………………………………………………...... 50 a. Meeting Family Office Specific Needs for Best Practices

VIII. Family Office Investment Management Models…………………………………………………………...... 51 a. “Insourced” And “Outsourced” b. Combination

IX. Family Offices & Alternatives Investment “Sweet Spot”…………………………………………………………...... 52 a. Performance Advantage of “Smaller” and “Younger” Alternatives Funds/Firms b. Alignment with Family Office Alternatives Investments

X. Conclusions & Recommendations…………………………………………………………...... 62 Appendix A: Bibliography…………………………………………………………...... 64 Appendix B: Sample Due Diligence Documents…………………………………………………………...... 73 Appendix C: Alternative Industry “Best Practices” Documents………………………………………...... 74

Family Offices (along with other institutional and ultra- Kaplan demonstrated that “asset allocation explains high net worth individual investors) are increasingly approximately 90% of the variability of portfolio returns moving away from the traditional “60-40 Asset Allocation over time.”1 So it is clear that Family Offices and investors Model”; meaning 60% allocation to equities and 40% to of all types need to focus on the need for an asset fixed income assets. Even within the “60-40” model in allocation policy and strategy that reflects the investors’ recent years there has been a trend for many investors appropriate asset–liability matching needs, cash flow to diversify the types of equities (growth, value, core) requirements, risk tolerance and other factors. the target capitalization category/size (i.e., small, mid and large cap) and the geographic focus of equity This trend among virtually all investors in recent investments, (i.e., US, international, regional, emerging years toward making initial or increased allocations to markets, and global). Similarly, many investors have “Alternative Investments” has been documented in a diversified the type and maturity of fixed income securities variety of studies and research reports. For instance, held in their portfolios (i.e., US government and corporate a Rothstein Kass study in June 2011 found that more bonds, high yield bonds, target date maturity bonds, than 85% of Family Offices investing in hedge funds foreign sovereign bonds, emerging market bonds, etc.). at that point were highly likely to increase hedge fund allocations.2 In July 2012 McKinsey & Company predicted These changes in asset allocation have been a factor that allocations to alternatives will increase to 28% of total of the general level of knowledge, sophistication and portfolio assets by the end of 2013.3 The main purpose in experience of each investor and related advisors, and a adding such allocations is in order to achieve increased factor of the prolonged low interest rate environment that diversification and to increase risk-adjusted returns and has been experienced in recent years. Similarly, investors limit losses in down markets, as described in a March are moving away from the 60-40 traditional allocation 2013 PIMCO article.4 model since, quite often, in recent years, their return objectives have not been met. This has been true whether Before proceeding further, it may be helpful to identify the investor is a corporate or public pension plan, a more specifically what types of investments are included foundation or endowment, a Family Office or an individual under the heading: “alternative investments” and why investor. are they called “alternatives”? Typically “Alternative Investments” include: hedge funds, funds of hedge funds, Investment industry research has demonstrated that private equity, real estate and commodities. For reference, getting overall asset allocation policy, strategy and the following are basic definitions/descriptions of each percentages right is an extremely important “return type of alternative investment. driver”. For instance, in a landmark study, Ibbotson and

1 Roger B. Ibbotson and Paul D. Kaplan, Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance?, The Financial Analysts Journal, January/February 2000; as quoted in The Case For Dynamic Asset Allocation, by Mellon Capital Management Corporation, February 2012. 2 Rothstein Kass Study on Single-Family Office Allocations To Alternatives, June 2011, page 9 3 McKinsey & Company: “The Mainstreaming of Alternative Investments”, July 2012 4 PIMCO: “It’s Time for Alternatives To Do Some Heavy Lifting”, March 2013

Hedge Fund “A pooled investment vehicle that generally meets the • Helping to grow a new business following criteria: (1) it is not marketed to the general • Bringing about operational change public (i.e., it is privately-offered); (2) it is limited to • Taking a public company private high net worth individuals and institutions; (3) it is not • Financing an acquisition”8 registered as an investment company under relevant laws (e.g., U.S. Investment Company Act of 1940); (4) Real Estate its assets are managed by a professional investment “A fund investing in the real estate market - can management firm that shares in the gains of the include investment in several types of real estate 9 investment vehicle based on investment performance including housing, hotels and commercial property.” Real estate investments may be made using equity of the vehicle; and (5) it has periodic but restricted or or debt limited investor redemption rights.” 5 Note recent changes in hedge fund marketing rules due to the “JOBS Act” approved by the SEC on July 10, 2013.6 Commodities “…products (futures contracts, physical commodities, ETFs, etc.) traded on an authorized commodity Fund of Hedge Funds exchange. The types of commodities include “A fund of hedge funds is an investment vehicle whose agricultural products, metals, petroleum, foreign portfolio consists of shares in a number of hedge funds. currencies and financial instruments and indexes…”10 The fund of funds strategy can be applied to any type of investment fund, from a mutual fund to a private equity All of these different types of investments typically are fund. The fund of funds – which may also be called a called “alternatives” since they are alternative asset collective investment or a multi-manager investment – classes to the traditional equity and fixed income asset simply holds a portfolio of other investment funds instead classes. As will be discussed later in this White Paper, of investing directly in securities, such as stocks, bonds, it will be key for Family Offices to focus on specific commodities or derivatives.”7 “alternative investment” opportunities which not only fit under the name of “alternatives” but also actually have Private Equity low correlation to the characteristics and performance “In its broadest sense, private equity is an ownership drivers of equity and bond markets so that the chosen interest in a company or portion of a company that is not alternative investments actually will provide for portfolio publicly owned, quoted or traded on a stock exchange. diversification and help Family Offices reach their goal However, from an investment perspective, private equity of higher expected returns with lower risk as a result of generally refers to equity-related finance that is designed having a truly well-diversified portfolio. to bring about some sort of change in a private business, such as:

5 Managed Funds Association, Hedge Fund Glossary www.managedfunds.org/industry-resources/hedg-fundglossary/ 6 Bloomberg: July 10, 2013: http://www.bloomberg.com/news/2013-07-09/sec-set-to-lift-80-year-old-ban-on-advertising-by-hedge-funds.html 7 BarclayHedge.com: Glossary : http://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-definition/hedge-fund-strategy-fund-of-funds.html 8 Blackrock Q&A: http://www2.blackrock.com/us/individual-investors/products-performance/alternative-investments/private-equity?cmp=alternatives&chn=PPC_Mobile&c=bing&kw=private%20equity 9 Preqin Glossary: https://www.preqin.com/itemGlossary.aspx?pnl=QtoT 10 National Futures Association Glossary: http://www.usafutures.com/commodityglossary.htm

There are multiple types of strategies pursued under alternative. See the next section of this White Paper each of the different types of “alternatives” and there are and Appendix A: Bibliography for more information on variable and distinctive features regarding the structure specific characteristics of different types of “alternative and funding processes for each type of investment, as investments”. well as varied terms and timeframes for each type of

In order to have the desired impact on overall portfolios, reduce the risk profile of the balance of an investor’s it is critical that the “alternative investments” chosen by portfolio. Family Offices, whether they be hedge funds, private equity, real estate and commodities or some mix of As illustrated in the following chart, alternative these investments, achieve, in fact, low correlation to investments offer many choices of investment strategy standard equity and fixed income markets. In addition, that can be tailored to the characteristics of a Family it is of key importance that these investments by Family Offices’ liability stream, risk tolerance, cash flow needs Offices represent a truly differentiated alpha source and, and other factors. See “Appendix A” For Links to as needed, can serve as a hedge against inflation, and glossaries and definitions/descriptions.

The appropriate choices of alternative investment regarding hedge funds and private equity investments are strategies for a particular Family Office can be assessed as follows: in terms of the Family Office’s specific profile and take into account such factors as: sound asset/liability matching, Both hedge funds and private equity funds are private timing of cash flow needs, risk tolerance, duration of investments for “accredited investors” and “qualified investment period, management and performance fees, purchasers”11 with investments being made subject and other factors. to private placement memoranda and subscription agreements which spell-out all relevant terms and It is also very important for Family Offices to be aware obligations of various parties. Some typical key structure of the different investment structures and terms that differences and differences in terms are highlighted in typically are employed by the different categories of the following table. Note: Due to the long-term and illiquid alternative investments. While it is beyond the scope of characteristics of certain hedge fund strategies, some the White Paper to provide an exhaustive description of hedge funds can have structures and terms that are quite the differences, some key points for Family Offices to note similar to typical private equity funds.

11 “Accredited Investor”: based on US Securities Act of 1933 as amended; generally, a natural person with net worth exceeding $1million or a charitable organization with total assets in excess of $5 million. See SEC full definition at: http://www.sec.gov/answers/accred.htm; “Qualified Purchaser”: based on Investment Company Act of 1940, as amended; Typically individual/family owning not less than $5 million in investments and company owning not less than $25million in investments., See SEC full definition (page 18): www.sec.gov/about /laws/ica40.pdf

While there are multiple differences that also are Importance of Manager Selection most often associated with Real Estate Funds and To this point, this White Paper has noted the well- Commodities Funds, depending on their subject matter established trend regarding Family Offices, Foundations, focus and investment strategy employed, for the purposes Endowments and other institutional investors continuing to of this White Paper, it is sufficient to highlight that the make increased allocations to alternative investments as structure of most Real Estate private investment funds a time-tested way to achieve true portfolio diversification is most similar to the characteristics noted above for and to achieve higher expected risk-adjusted returns with Private Equity and private investment commodities funds lower overall portfolio volatility. In addition, this White are most similar to the characteristics noted for hedge Paper has noted the importance of asset allocation as a funds. That being said, investors also can get access to key driver of achieving such desired portfolio results. some more highly liquid Real Estate funds via Real Estate Investment Trusts (REITS) which trade similarly to mutual Not surprisingly, key investment decisions do not stop with funds. Conversely some commodities funds are structured top-down generic asset allocation policies and asset class very similarly to hedge funds with initial lock-up periods weightings. As important as asset allocation decisions and periodic redemption terms subject to lead time are, they represents a necessary but not sufficient set notices. Also, some hedge fund exposure can be gained of decisions to achieve desired portfolio characteristics, by Family Offices via more liquid vehicles such as “hedge diversification benefits and risk adjusted higher returns fund replication products”. Further, there is an increasing that are potentially available through use of alternative trend to provide some hedge fund strategies in mutual investments. The remaining steps require effective fund format 12 with daily calculation of Net Asset Values investment strategy selection and individual manager (NAV) and daily liquidity terms. See the June 2013 SEI selection decisions. study entitled: “The Retail Alternatives Phenomenon”.13 While these hedge fund strategies in mutual fund format The importance of specific alternatives manager selection offer Family Offices and other investors some hedge fund is also highlighted by the fact that historically, the range of exposure, the nature of these products limits the number performance achieved by various alternatives managers and types of hedge fund strategies that can be pursued pursuing the same strategy type is significantly wider due to liquidity requirements. As a result of liquidity than the range of performance generated, for example, requirements, typical hedge fund strategies in mutual by long-only equity managers such as growth and value fund type product structures include: equity/long short managers. A June 2013 White Paper by Jon Sundt, strategies and global macro strategies.

12 Eurekahedge (data provider to the alternatives industry): http://www.eurekahedge.com/news/07_apr_EDHEC_Hedge_Fund_Replication.asp, http://www.eurekahedge.com/news/07_apr_EDHEC_Hedge_Fund_Replication.asp 13 SEI “Knowledge Center”: “The Retail Alternatives Phenomenon” June 2013; http://www.seic.com/enUS/about/11943.htm

President & CEO of Altegris (subsidiary of Genworth Financial) provides a thorough and helpful treatment The importance of manager selection in the alternatives of topics related to the link between “performance arena was also highlighted in a June 2012 report dispersion” and manager selection.14 published by Blackrock:

As documented in Sundt’s report, the range of “A key aspect of alternatives, particularly hedge funds performance dispersion of value oriented mutual and private equity, is the wide dispersion among funds returns (the distance between the top and successful and poorly performing funds. This feature bottom performers) is tightly clustered in comparison places heightened importance on the manager to alternative investment funds. Specifically, in 2012, selection process and increases the benefits of owning 16 the performance dispersion for value equity managers a diversified portfolio.” was 7.9% (based on bottom quartile managers who achieved an averaged 10.68% gain while the top quartile Similarly the dispersion of hedge fund performance in value managers averaged a gain of 18.57%. At the 2011 is highlighted in the following chart. This chart, 17 same time, the performance dispersion for equity long/ from “Pension and Investments Online” highlights the short managers in 2012 was 33% with bottom quartile performance dispersion of top and bottom decile hedge managers losing 6.94% and the top quartile equity long/ fund managers for each of more than 10 different hedge short managers achieved a gain of 26.12%.15 And this fund strategies and demonstrates the comparison of the relative range of performance dispersion holds true in the performance dispersion across the different hedge fund Sundt’s analysis for the 3 and 10 year periods as well. strategies as well.

14 “Performance Dispersion, Implications for Manager Selection”, June 2013, Jon Sundt, President & CEO, Altegris 15 IBID. Sundt page 3 16 “Weighing the Alternatives: How Five Non-Traditional Investments Stack-up” by Jason Malinowski, Nicholas Miller Smith and John Pirone, June 2012, Blackrock Volume 15 Issue 1, page 7. 17 “Pension and Investments”: online: http://www.pionline.com/article/20120206/CHART01/120209929/graphic-global-hedge-fund-performance-dispersion-for-2011

Dispersion of Global Hedge Fund Performance 2011 By Hedge Fund Strategy Type

As a result, Family Offices need to focus not only on for Family Offices to focus significant attention on the customized asset allocation strategies that are well- manager and fund selection process. suited to their particular set of liabilities and investment objectives. The existence of a wide range of “performance As will be seen later in the White Paper, manager size dispersion” results among different categories of (AUM under management and the number of different “alternative investments” and a wide range of performance strategies being managed) as well as the “age” of an dispersion results among individual sub-strategies and alternatives firm/fund (years since fund inception) can be individual managers both provide powerful motivation also be very important to Family Office manager selection. See pages 52 to 56 below.

Now that Family Offices are increasingly pursuing initial/ risk management and the need for increased regulation increased allocations to various alternative investments, and supervision by banking and securities regulators how should they proceed? In general terms the main world-wide. answer is “Very carefully”! More specifically, Family Offices will be well-advised to take into account the It is beyond the scope of this White Paper to go into lessons learned from 4 sources: detail regarding the causes of and lessons learned from the 2008-09 global financial crisis in an overall global 1. 2008-09 Financial Crisis context. Those topics have been addressed in some 2. Madoff Ponzi Scheme detail in financial and government publications as noted 3. Other alternatives frauds and failures, and in reports such as a Goldman Sachs presentation at a 4. More positively, lessons learned from the meeting of the Trilateral Commission in Tokyo in April, extensive experience of institutional investors, in 2009.18 See Appendix A. But it is very much in scope to particular, university endowments with alternatives focus on a refined understanding of the lessons learned investing. from this crisis as these lessons specifically relate to Family Offices and other institutional investors who invest 2008-09 Global Financial Crisis in various types of alternatives investments. This section The major themes and overall lessons learned from the of this White Paper is designed to highlight some key 2008-09 financial crisis include issues related to the issues and lessons learned that have specific relevance to mortgage crisis, to global financial systemic risk, the Family Offices as they initiate or continue to expand their concept of “too big to fail” and related bailouts, negative allocations to “Alternative Investments” including hedge impacts of overuse of leverage in investment portfolios, funds, funds of hedge funds, private equity, real estate lack of transparency at many levels, lack of appropriate and commodities.

18 “Causes and Lessons Learned from The Financial Crisis”, Presentation by E. Gerald Corrigan Managing Director, Goldman Sachs, The Trilateral Commission, April 25, 2009, Tokyo, Japan www.trilateral.org/.../annual_meeting/Corrigan_financial_crisis.pdf

Lessons Learned for Family Offices The following are some of the key lessons learned • Imposing “gates” to limit the percentage of invested from the 2008-09 global financial crises that can serve capital that could be requested for redemptions on a Family Offices well with regard to monitoring their current given date (both “fund level gates” and/or “investor alternatives investments and in terms of their future level gates”) consideration of making future alternative investments. • Making “payments-in-kind” of underlying securities (or 1. Liquidity/Illiquidity holdings of underlying managers in the case of funds One of the harshest lessons learned from the 2008-09 of hedge funds) global financial crisis involves portfolio liquidity, or more to the point, portfolio illiquidity during times of severe • Or, managers simply liquefied their most marketable market stress. And this illiquidity was exacerbated, for securities leaving remaining investors with an even example, by the rush to redeem hedge funds during the more constrained and illiquid portfolio crisis. As noted above (p. 9) hedge funds typically have provisions for monthly, quarterly or other set term for In other cases, the underlying authorizing documents may periodic redemptions under “normal market conditions” not have provided for such measures, but some were with the frequency and amount of redemptions being adopted by managers as a way of dealing with the extent limited by the nature of the underlying investment strategy of redemption requests. As can be readily imagined, and by the specific investments held in a portfolio. The whether provided by the underlying fund/account financial crisis of 2008-09 put enormous pressure on the documents or not, investors typically viewed these extent of redemptions sought from some hedge funds and restrictions on redemptions and getting access to cash managers were not able to meet the demand. This led to with grave concern as being very investor unfriendly. a very negative experience, whereby investors learned that [depending on fund vehicle type and the terms of the Given these different experiences during the latest governing “Private Placement Memorandum” (PPM) and financial crisis, it can be very valuable for Family Offices related subscriptions agreements] liquidity was not going to inquire of any candidate manager, what specific steps to be available at time it was needed most. they took to deal with the liquidity squeeze in the 2008- 2009 period. And it can be very helpful to learn what In some cases, the relevant manager and fund/account changes, if any, these candidate managers made as a legal documents provided for metering-out redemptions result of dealing with the most recent severe liquidity through means such as: crunch. Put another way, Family Offices, could do well to inquire of candidate managers, how they would deal • Suspending redemptions (open-ended or deferred on “today”/“tomorrow” with market conditions similar to the a stated schedule) 2008-09 period.

2. Transparency to be very familiar with all key terms for an alternatives A second lesson that alternatives investors learned from investment. Again, “Know Thy Documents” is a very the recent global financial crisis involves “transparency”, important motto. These terms are typically captured in the or the lack of transparency regarding alternatives fund product “Private Placement Memorandum” (PPM) and and alternatives manager policies, processes and Subscription Agreement. These documents should not operations. Overall Family Office alternatives investors be regarded by Family Office investors as only relevant are advised to “Know Thy Documents”, meaning that it for their lawyers. Rather, Family Office investors need to is critical to be thorough at the early stages of screening be fully knowledgeable about all key terms that govern and choosing an alternatives investment strategy and their investments, because, when things go wrong, it will an alternatives manager to have complete and accurate be these terms that play a major role in how a manager material information about multiple aspects of a fund’s/ acts under conditions of market stress. As a result, Family manager’s key terms and provisions. Offices and other alternatives investors are well –advised to understand thoroughly what the material governing And it is critical to be sure that the manager is explicitly terms are for their millions of dollars committed to a given committed to initial and ongoing transparency throughout alternatives manager. the life of the fund/investor’s account regarding all material aspects of investor funds and portfolios. This Key terms to be clearly understood include fees, means that transparency is a high priority concern on performance calculation methodology (including, use topics such as investment strategy, investments made, of “Hurdle Rates” and “High Water Marks”, “Clawback” portfolio holdings, changes in holdings, risk profile of provisions, existence of “Most Favored Nation” (MFN) portfolio and changes in risk profile, leverage allowed and clauses, policy and practice on use of “Side Letters”, actually used and other topics. valuation policies and practices including the potential use of “Side Pockets”, liquidity terms, redemption notice Once again, Family Offices will be well-advised to inquire dates, effective dates and payment dates, existence of of candidate alternatives managers how the managers investor level or fund level “Gates” to limit ability to make have very specifically improved transparency in all redemptions when requested, provisions for “Payments- material aspects since the 2008-09 crisis. in-Kind” (and criteria for exercising such payments) and other key terms that might vary by the specific investment 3. Private Placement Memorandum (PPM) and strategy under consideration or the specific fund/account Subscription Agreement Terms under consideration. Another lesson that has to be learned from the financial crisis is that Family Office alternatives investors need

Family Office investors in alternatives need to take all investments as well as to long–only investments in their due care to be assured that they understand all these respective portfolios. After all, the key reason for pursuing terms regarding how a fund/investor account is intended “alternative investments” is to seek out investment to operate under “normal market conditions” and under opportunities that have performance drivers and other different scenarios of “stressed market conditions”. characteristics that are truly different from traditional While not every downside scenario can be predicted or equity and fixed income investments and to be assured modeled, a Family Office investor will be well-served to of an alternative source of alpha (and possibly of beta) so understand how their investment might be treated under that risks are diversified and higher risk adjusted returns multiple downside scenarios as well as upside scenarios. can remain a reasonable potential objective.

And, while the pursuit of understanding certainly includes During the recent financial crisis, in many portfolios such complete familiarity with the business operations diversification was reduced and correlations among aspects of the terms defined in the Private Placement various equity markets and between equity markets and Memorandum and Subscription Agreement, such Family some investments in alternatives increased markedly Office investor due diligence also needs to be extended and both types of investments moved sharply downward to include a thorough review of all relevant documents in unison. While there were a myriad of reasons for (printed or provided on-line) such as: a firm’s “capabilities this increase in correlations, one material factor was brochure”, all marketing materials and client reports as due to extensive selling across multiple investments well as to responses to “Requests for Proposal” (RFPs) and asset classes as investors sought to reduce risk, and Due Diligence Questionnaires (DDQs). reduce leverage and increase liquidity. For more detailed information on the various causes of the increase in 4. Portfolio Diversification/ Low/No Correlation To market correlations during the financial crisis, See the Equity and Fixed Income Markets referenced article in the March 3, 2011 edition of Forbes19 Another key lesson for Family Office alternatives investors to learn from the 2008-2009 financial crisis is the importance of paying attention to the profile of alternative

19 Understanding the Recent Rise in Correlations…,” Forbes March 3, 2011

This experience highlights the need for initial and ongoing 5. Leverage monitoring of a manager’s investment strategy and target The excessive use of leverage throughout the global profile and any material variations or “style drift” from the financial system has been identified as one of the key expected profile. Similarly Family Offices should be sure factors in the recent global financial crisis. This over to monitor portfolio holdings on an ongoing basis to see use of leverage was undertaken by governments, that these holdings are in line with the stated strategy global, regional, national and local banks, investment and have not been changed due to changes in traditional managers and households and was facilitated by financial beta when such investments seem to be outperforming innovation such as the securitization of mortgages and by the chosen alternative investment strategy. Since portfolio persistently low interest rates. Some observers have gone diversification and correlations between markets are so far as to indicate that the excessive use of leverage dynamic realities, Family Offices must be attentive to was the root cause of the financial crisis. One advocate of the need to assess these factors on an ongoing basis this position is Norman Chan, Chief Executive of the Hong and to make appropriate periodic adjustments in order Kong Monetary Authority (HKMA) and he articulated these to avoid repeating some of the harsh downside impacts issues in a speech at a Hong Kong Economic Summit resulting from the loss of true portfolio diversification and in 2012.20 Chan also highlighted that the wide spread the increase in correlations between/among various asset negative impacts and stress in the financial system classes and global markets during the recent financial caused by over-leveraging were further exacerbated crisis. by the painful process of deleveraging and the related impacts on asset depreciation. In addition, it can be very instructive to learn from a candidate manager what the firm’s experience was Use of leverage in alternative investment portfolios can with regard to portfolio diversification and correlation be a bona fide component and positive contributor to the to standard beta markets during the 2008-09 financial outperformance of some alternatives investing strategies. crisis. And Family Offices should understand how each And investors can experience the benefits of the prudent candidate manager managed through this period, what use leverage in an upmarket. At the same time, excessive lessons the managers learned and what safeguards they use of leverage can have a major impact on losses in may have adopted and implemented (if any) as result of a severe down market as was experienced during the the lessons learned. recent financial crisis. Clearly, some alternatives investors

20 Norman Chan, Chief Executive of the Hong Kong Monetary Authority, “Excessive Leverage –root cause of financial crisis”, Hong Kong December 9, 2011; http://www.bis.org/review/r111215g.pdf

(and managers!) did not really understand the potential global financial system that go beyond the scope of impact that the use of excessive leverage can have on the this White Paper, there are also some key lessons downside risk in a portfolio….until they experienced the learned from the perspective of Family Offices investors pain first-hand. in alternative investments. Perhaps the most relevant overall lesson learned is that Family Offices should take A study by the US Government Accountability Office special care to be aware of any use of leverage in the (GAO)21 also examined how leverage and deleveraging investment strategy that is undertaken by their current by financial institutions may have contributed to the and/or proposed alternatives investment managers. financial crisis and reviewed then current regulations Family Offices should be comfortable that the use of by federal financial regulators to limit leverage and leverage makes fundamental sense as it relates to the reviewed the need for new regulatory approaches to particular strategy being pursued and Family Offices must restrict leverage. Recommendations were embodied recognize that such use of leverage has to be monitored in the Dodd Frank Wall Street Reform and Consumer on an ongoing basis as both market conditions and the Protection Act signed into law in July 2010 and included investment holdings in their portfolios (and the risk profile provisions for measuring and monitoring financial system- of such holdings) may change over time. wide leverage. The Dodd-Frank legislation authorized the Financial Stability Oversight Council (FSOC) which is And, as is the case with other key lessons learned focused on collecting and sharing information among US highlighted in this White Paper, Family Offices will be financial system regulators regarding the use of leverage well-served to inquire of their current and candidate among other matters related to systemic risk. Under this alternatives managers to learn the specifics of how these provision, the Securities and Exchange Commission managers dealt with leverage during the recent financial collects information from private fund advisers (e.g., crisis and what changes they have made in their use of hedge funds) regarding their assets under management leverage as a result of the lessons they learned regarding and use of leverage which is shared with FSOC to enable leverage. Such careful reviews on the topic of leverage an overall financial system risk assessment. should be baked into a Family Office’s initial and ongoing robust due diligence and monitoring processes in order to While there are extensive lessons learned from the avoid the significant negative impacts from the improper excessive use of leverage and from the painful process use of leverage in the future. of deleveraging that have relevance for the overall

21 U.S. Government Accountability Office Study, FINANCIAL MARKETS REGULATION “Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and across System”: July 2009 http://www.gao.gov/products/A86877

6. Valuation of Assets “Fair Value Hierarchy” for the consideration of appropriate Valuation of alternative assets (particularly private fair market valuation policies and practices as outlined equity, real estate and some more longer term and in the table below. This FASB hierarchy and previously illiquid hedge fund strategies such as distressed debt) dispersed FASB guidance on fair market valuation topics can be a challenging undertaking under “normal market were addressed in a consolidated fashion in the FASB conditions”, but is almost always even more challenging “Financial Accounting Statement No.157” so called “FAS during a financial crisis and the 2008-09 crisis was no 157” which was effective for financial statements issued exception. Guidance on fair market valuation is based for fiscal years beginning after November 15, 2007. on principles and policies established by the Financial Standards Accounting Board (FASB). FASB established a

22 FASB Accounting Standards Codification; Master Glossary; https://asc.fasb.org

Managers of alternative assets faced significant valuation market prices from fundamental values, distorted prices issues as the 2008-09 financial crisis unfolded. Pressure during a financial crisis, asset write-downs, downward on asset values increased as the mortgage crisis, overall valuation pressures, asset fire sales and the “contagion” credit crunch, and unprecedented levels of redemption that can impact one holder of a specific asset who does requests combined to create illiquidity problems for some not plan to sell that asset when another holder of the alternatives strategies. And these problems led to issues same/similar asset does in fact sell and other pertinent regarding how to value assets under such circumstances. issues. These issues were particularly problematic for managers of alternatives strategies that by design involve illiquid Clearly it is beyond the scope of this White Paper to assets such as hedge fund event driven strategies and delineate all the valuation issues arising from the recent distressed debt strategies, as well as most private equity financial crisis, but it also clearly in scope to address the strategies. But they were also experienced by hedge fund valuation lessons to be learned by Family Office investors managers whose strategies mostly involved publicly listed in alternative assets. These lessons include paying securities such as global macro strategies and equity careful attention to the type of holdings that the candidate long/short strategies. alternatives managers actually manage. How liquid are these holdings? Are they primarily listed equities and/or During and after the 2008-09 financial crisis there was a sovereign debt? Are the related to inherently less liquid good deal of discussion as to whether this emphasis on investment strategies such as hedge fund event driven “Mark to Market” valuation policy contributed negatively or distressed debt strategies? Do they involve private to the financial crisis. One such study,23 “Did Fair Value equity investments? …Or real estate development or Accounting Contribute to the Financial Crisis?” was infrastructure development assets? sponsored by the American Economic Association and was published in the Journal of Economic Perspectives by Additional topics for focus include whether the candidate Christian Laux (Professor of Finance, Goethe University- managers are knowledgeable regarding fair value topics Frankfurt) and Christian Leux (Professor of International such as FAS 157. And Family Offices will want to probe Economics, Finance and Accounting, University of and understand how alternatives managers classify Chicago Booth School of Business). This study provides portfolio holdings using the FASB 3 level hierarchy very a helpful summary of fair market value issues as regarding valuation principles. And Family Offices will they were experienced during the recent financial crisis want to be sure to monitor changes in classification as and addresses such topics as: causes of the deviation of market and investment characteristics change over time.

23 Christian Laux and Christian Leuz, “Did Fair Value Accounting Contribute to the Financial Crisis?”, National Bureau of Economic Research, published in Journal of Economic Perspectives, American Economic Association , 2010 http://www.nber.org/papers/w15515

And Family Offices will be well-advised to inquire of counterparties, some of whom were under extensive candidate managers what these managers did relative pressure when long-only firms as well as alternatives to valuation policy during the recent crisis. Do these firms sought to liquidate positions in the face of falling managers have the appropriate separation of duties markets and were unable to meet demand from selling relative to valuation policy e.g., portfolio managers investors and redeeming investors. Similarly, some not involved in the valuation process? Does the firm derivatives counterparties were not able to meet their have an appropriate Valuation Committee established commitments due to unforeseen and unprecedented with appropriate valuation policies and procedures to negative market moves. The lessons to be learned in address valuation issues? And finally, what changes have this case involve advance scrutiny of such potential candidate managers made since the 2008-09 crisis and counterparty risks under different scenarios of market how would they act under similar conditions of market conditions and the need for attention to risk management stress in the future? as market conditions change on an ongoing basis.

7. Enhancement of Risk Management & 8. Alignment of Interests Monitoring Capabilities Another key lesson learned from the recent global A central lesson to be learned by Family Offices investing financial crisis involves taking due care to understand in alternatives involves the need for enhancing risk whether the alternatives manager’s interests are well- management and monitoring capabilities at several levels, aligned with investor interests. Examples of such including the risk management related capabilities of the mis-alignment (including overvaluing assets to benefit broad global financial system itself and the capabilities manager compensation, masking the true value of assets of individual alternatives managers, as well as the risk in “side pockets”, not disclosing business done with management capabilities of investors such as Family related-parties et. al.) were highlighted in a December Offices. In some ways, it can be argued that the broad 2012 speech by Bruce Karpati, Chief, SEC Enforcement negative impacts of the global financial crisis itself were Division’s Asset Management Unit, Securities and due to failure of robust risk management capabilities. And, Exchange Commission.24 this was also true at the manager level as will be seen in several examples of alternatives fund failures and frauds In this speech, Mr. Karpati explains how the hedge fund highlighted in the next two sections on Madoff and other operating model can create misaligned incentives and alternatives frauds/failures (pp. 25-26). emphasizes “…various steps that [hedge fund] managers can take to insure that they fulfill their fiduciary duties.”25 One area of particular negative impact related to the These steps include setting the tone at the top and lack of attention to counterparty risk, e.g., trading

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 21 III. Family Offices Take Note of “Lessons Learned” (cont’d) creating a culture of compliance within the firm; adopting underlying investment strategy being pursued and how and implementing a compliance program and controls well these compensation program incentives are aligned geared to the risks and investment strategies of the with achieving particular outcomes that are well-aligned firm and the advice that managers need to be alert and with investor interests. prepared to be the subject of SEC exam inquiries. For instance, when the alternatives manager has a multi- Evidence of good alignment of management and investor year objective of beating a relevant index or achieving interests (beyond simple declarative claims regarding a particular level of absolute return, are compensation alignment in marketing materials) includes the following rewards similarly based on longer term achievements? key topics: And are payouts of bonuses appropriately deferred and subject to clawback provisions? • Manager Co-investments: What is the extent of manager co-investments in a given alternatives fund? Similarly, what is a manager’s policy on calculating And, very importantly, are managers invested on the fund/account performance for purposes of determining same terms as outside investors? payment of incentive/performance fees, so-called • Compensation Programs: What is the structure “crystallization policy”? Is a long term investment strategy of candidate alternatives manager compensation inappropriately linked to a quarterly crystallization policy programs? Are they well-aligned with investor or even an annual crystallization policy? If so, as noted interests? by a representative of the California Pension Fund (CALPERS), the deck is stacked in favor of the manager The topic of compensation programs is critically important and incentives are not well-aligned with investors.26 relative to alignment with investor interests. Beyond understanding the typical components of compensation For more detail on the alignment of investor and (base salary, bonus, longer term incentives, performance alternatives manager interests on compensation topics fee sharing, firm options and equity) Family Offices will and “performance crystallization” policy and an innovative want to understand the rationale for the particular mix deferred compensation program that closely aligns of compensation adopted by a particular firm. It will investor and manager interests see the OptCapital be instructive to learn whether and how a particular website.27 compensation program is well-attuned (or not) to the

24 “Enforcement Priorities in the Alternative Space” by Bruce Karpati; presented to the Regulatory Compliance Association in New York, December 18, 2012; http://www.sec.gov/news/speech/2012/spch121812bk.htm 25 IBID Page 4. 26 Craig Dandurand, Portfolio Manager, Absolute Return Strategies, CalPERS, as quoted by Opt Capital: http://www.optcapital.com/WhatWeDo/InvestmentFunds/MisalignmentProblem.aspx 27 http://optcapital.com

Other Potential Conflicts of Interest recent financial crisis, existing credit facility agreements Based on experiences with some managers during the were put under significant pressure due to the overall financial crisis, Family Offices need to be aware of and financial system cash crunch and hedge fund managers monitor their alternatives managers for other areas of found themselves unable to access such existing lines potential conflict of internet. Such areas could include: a and the prospect of entering new agreements were manager taking on more portfolio risk to achieve a key virtually impossible as terms tightened (loan to value threshold level that would trigger payment of performance ratios increased, and fees for stand-by facilities increased fees and/or to meet/exceed a prior “high water mark”. significantly or were simply not quoted). As a mirror of Additional examples include: policies and practices for the tightening of the entire financial system, alternatives the allocation of limited investment opportunities across managers could not get access to such credit facilities multiple portfolios; including cases where portfolios at the time when they were most needed. See a detailed where managers may have higher proportional/lower study regarding the availability of credit facilities during proportional participation in different funds. the financial crisis.28

Further, care is needed to assure that there a proper Once again, the lesson to be learned by Family Offices separation of duties, for example, to assure that portfolio is to have a very thorough understanding of the managers or traders are not involved in the process of credit facilities terms and fees in place with candidate valuing portfolios. Or, even more egregiously, as perhaps alternatives managers and have a good understanding of most infamously experienced in the case of Madoff, the steps that have been taken by alternatives manager’s Family Office investors need to assure themselves that to avoid the type of credit facilities related issues which managers use a third-party administrator/custodian for the were experienced in the 2008-09 financial crisis. calculation of the value of fund/account assets. 10. Downside Protection 9. Credit Facility Issues The need to attend explicitly to portfolio downside Typically, hedge fund managers have contractual protection was highlighted by the recent financial crisis. arrangements with one or more banks to provide for Of course, Family Offices and other investors generally credit facilities (short term lending) to manage liquidity are concerned with capital preservation, but their and smooth cash flows related to the timing of ongoing awareness was heightened by the actual occurrence of subscriptions and redemptions; for instance, to invest in what is typically assumed to be a rare but significant event one security prior to proceeds being available from the (“left tail risk”: return distribution of more than 3 standard sale of another security and related purposes. During the deviations from the mean).29

28 “Credit Line Use and Availability in the Financial Crisis: The Importance of Hedging” by Jose M. Berrospide, Federal Reserve Board, Ralf R. Meisenzahl, Federal Reserve Board, Briana D. Sullivan, University of Florida, Gainesville, April 17, 2012, www.federalreserve.gov/pubs/feds/2012/201227 29 Investopedia definition of “tail risk”: http://www.investopedia.com/terms/t/tailrisk.asp

Investment strategies which can be used explicitly to policies, performance reporting, client service, human provide for portfolio downside protection (as part of a resources, etc.) being provided by the overall investment single multiple purpose alternative investment or a as firm. As a result these alternatives managers may or may stand-alone special purpose investment) include: equity not have a similar level of high expertise and experience long-short strategies, market neutral strategies, use with governance, leadership and management of their firm of low-beta stocks, put options, managed futures and as a business enterprise. REITs among others. The point for Family Offices is to be sure to focus careful attention on having such downside On the one hand, the assessment of such firm protection features as part of their alternatives investment “investment business management” skills has always program and to include scrutiny of these topics as part of been a part of well-designed Family Office due diligence their alternatives management due diligence processes programs. On the other hand, the impacts of the financial going forward. crisis as noted above (liquidity/illiquidity, transparency, portfolio diversification, changes in correlations, use of In addition, Family Offices should elicit from alternatives leverage, enhancement of risk management capabilities, managers information specifically geared to understand alignment of investor and investment manager interests, what changes (if any) the managers have made in their avoiding conflicts of interest, and related topics) have overall offerings to incorporate such left-tail protection drawn more intense attention to the importance of into their products and whether these managers offer assessing candidate alternatives manager capabilities, not specific stand-alone downside protection products for only in terms of investment strategy and fund performance consideration as part of a Family Office’s overall allocation track record, but also in terms of all aspects of firm to alternatives. governance, as well as leadership and management of an alternatives business enterprise. 11. Alternatives Manager Firm Leadership, Management and Governance It is a major point of emphasis of this White Paper that Typically hedge fund managers, private equity managers one of the main lessons to be learned from the 2008-09 and other alternatives managers are highly experienced financial crisis is to undertake a comprehensive, robust in successfully carrying-out one or more investment assessment of candidate alternatives managers in terms strategies. And typically, their experience has often of these firm governance, leadership and management been gained within a major Wall Street “buy-side” asset points and to extend such assessment to include initial management firm or investment bank with all supporting comprehensive assessments and ongoing monitoring of business infrastructure functions (legal/compliance, all manager firm business processes (both processes that technology, finance and accounting, middle and back office operations, fund administration, custody, valuation

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 24 III. Family Offices Take Note of “Lessons Learned” (cont’d) are exclusively internal to the manager firm, and Without going into the details of all these new regulations, processes as they relate to investors, third party service suffice it to say at this point that Family Offices will need providers and regulators. More perspective and advice on to be particularly attentive to the changes that have these topics can be found below in Section V. “Broader already been made and continue to be made with regard & Deeper Assessment of “Alternatives Investment to alternatives investing. The specifics of such impacts will Business Management Due Diligence” (See pages understandably be shaped and will need to be customized 38-44) to the specifics of each Family Office’s overall mission and objectives and by each Family Office’s specific portfolio 12. Increased Regulation Resulting from the 2008- and portfolio objectives. 09 Global Financial Crisis As Family Offices and other investors are well aware, Simply keeping up-to-date with such comprehensive increased regulation has been a major theme in the wake and far-reaching changes in the regulatory environment of the 2008-09 global financial crisis. Global, regional and can be an extremely challenging task. Multiple law firms national banking authorities among others have been and other regulatory compliance and enterpriser risk very active to counter the negative impacts of stress and management firms offer services to keep assist Family failure witnessed in the recent crisis. This White Paper Offices with the most relevant regulatory information is not focused on these generic global financial system needed by Family Offices. One such firm, Regulatory oriented regulations. Rather the point here is the highlight Fundamentals Group (RFG), which is headed by CEO the significance for Family Offices to be attentive to the Deborah Prutzman, espouses a helpful 3 tiered system extensive statutory and regulatory changes related to of tracking all regulations and business risk management alternatives investors and alternatives manager related topics as they relate to: regulations put forth by the US Congress (e.g., Dodd Frank legislation) and by the US Securities and Exchange i. The Alternatives Fund/Account Commission (SEC), the Commodities Futures Trading ii. The Alternatives Manager Firm, and, Commission (CFTC), the revamped UK Financial Services iii. The Alternatives Investments30 Authority (FSA) into two complementary regulatory bodies (“Prudential Regulation Authority” (PRA) and the All of the above points should be viewed as key “lessons Financial Conduct Authority (FCA) effective April 1, 2013, learned” from the 2008-09 global financial crisis for Family and the European Union related regulations regarding Offices and other investors in alternatives going forward. “Alternatives Investment Fund Manager Directive” As already noted these topics are developed further in (AIFMD) effective July 2013. Section V regarding “Broader and Deeper “Alternatives Investment Business Management Due Diligence” (See below, pages 38-44)

30 Regulatory Fundamentals Group (RFG) www.regfg.com Note: the author of this White Paper has served as an RFG Advisory Board Member

Going beyond these global financial crisis related lessons, warnings signs and alerts regarding the components Family Offices can learn multiple other important lessons of a significantly more robust due diligence program (or have them reinforced) from a review of the Madoff can be found in a research paper by Professors Greg Ponzi scheme fraud as well as from lessons learned/ N. Gregoriou and Francois-Serge Lhabitant which was reinforced by other alternatives fund failures and frauds as published by the EDHEC Risk and Asset Management described in the following sections. Research Centre in January 2009.31

Lessons Learned from the Madoff Fraud As nicely summarized by Gregoriou and Lhabitant, some Virtually all investors and potential investors in alternatives of the key indicators that there were many things amiss in have at least a general understanding of the Madoff fraud the Madoff case included: and that Bernard Madoff was prosecuted for securities fraud, investment adviser fraud, mail fraud, wire fraud, • Access to the manager: very restricted money laundering, perjury, false filings with the SEC and • Access to the fund: very restricted, only via secretive theft among other violations. And it is commonly known referrals; mostly via “feeder funds” that Madoff is currently serving a 150 year sentence • Highly stable returns: 10%-12% per year; too stable in a federal prison. Further, most observers are aware given background market volatility; there were no that the main takeaway and lesson learned from this performance down years across the supposed 17 massive fraudulent experience involving many billions of year-long Madoff track record investor assets is the need for greater due diligence when • The Madoff legal entity (Bernard L. Madoff Investment choosing an alternatives investment manager. Securities, LLC, (BMIS) was a pure brokerage business, not an investment advisor Such a lesson learned is quite accurate, but let’s dig • End-investors were investors in various feeder funds, deeper and get a better understanding of what took not in BMIS; therefore investors could not directly place and what the major warning signs were that conduct due diligence on BMIS; Gregoriou and were missed by sophisticated high-net-worth investors, Lhabitant highlight that this was an essential feature wealth management platforms, funds of funds, and other of the Madoff scheme advisors and regulators. A very good summary of the

31 “Madoff: A Riot of Red Flags”, Greg N. Gregoriou, Professor of Finance, SUNY, Plattsburgh and Francois-Serge Lhabitant, Associate Professor of Finance at EDHEC Business School, Lille-Nice, France, January 2009

• Operational Red Flags: • Through multiple public allegations and entreaties • Lack of segregation among service providers; to the SEC, the currently well-known Madoff critic, i.e., investment manager, fund administrator, Harry Markopolos, in November 2005 claimed that custodian, prime broker; with Madoff all functions the Madoff fund was a fraud; his findings should have were provided internally and with no third party been a warning sign for investors and regulators. oversight • Use of a small, obscure auditing firm which • BMIS avoided SEC registration until 2006; there were claimed it did no auditing business no detailed SEC investigations following registration • Unusual fee structure: no management or until the massive fraud was exposed in December performance fee; according to the BMIS ADV, the 2008 only fee was a “market rate commission charged on each trade”32 • Conclusions: • Multiple family members played key roles; • Reported results were clearly too good to be true head of trading, chief compliance officer for the • Investors chose “faith over evidence” investment advisor and broker dealer; in-house • References to reputation and supposed track legal counsel; record should never be the sole rationale for • Marketing materials made no mention of Madoff investing or BMIS directly; and provisions were made to • In short, the Madoff scam was a very costly prohibit mention of Madoff or BMIS by name lesson in the importance of multi-level due • Very small staff: (5 members) managing $17bn in diligence assets is quite implausible • No operational transparency, no monthly performance attribution

• Investment Red Flags • Track record so good in terms of consistency and few down months should have generated suspicion • No plausible explanation of investment strategy and its success except to refer to a “black box strategy”; a red flag in itself • Avoidance of disclosure and SEC reporting by claiming that BMIS portfolios were mostly cash at the end of each quarter

32 IBID. Gregoriou and Lhabitant page 11

Other Alternatives Frauds and Failures • Insufficient attention to operational due diligence While the Madoff Ponzi scheme fraud is likely the best to detect fraud, insider trading, inadequate internal known and largest scale alternatives industry fraud in controls, lack of separation of duties, conflicts of recent years, it was not the earliest such fraud nor is it interest and Ponzi schemes (Bayou, Petters, Stanford the latest. And there have been multiple alternatives fund Financial Group; Weavering and Level Global)34 failures, perhaps not involving fraud, but misjudgments on markets and inattention to comprehensive alternative Of course, the point of this White Paper is not to ward-off investment risk management. potential investors in alternatives, but, on the contrary, is to help assure that such investors come at this tasks Some of the more well-known frauds and failures of the with their eyes wide open and to help assure that they are last 15 years include: Long-term Capital Management well-attuned to the egregious mistakes and behaviors of a (1998); Bayou Hedge Fund Group (2005); Amaranth few in the alternatives industry in order to avoid repeating Advisors (2006); Petters Group Worldwide (2009); such mistaken manager selection choices in the future. As Stanford Financial Group (2009); MF Global (2011); will be seen in section IV below, the lessons learned from Weavering Capital UK (2012); Level Global (2013). these frauds and failures will be best memorialized if they And there are continuing investigations by the SEC and are put into action by Family Offices and other alternatives litigation pending on other cases involving similar fund investors in terms of adopting a broader, deeper and more failure and fraud issues that persist to today.33 robust and inclusive program of “due diligence” as has been evolving among successful alternative investors in While each case has its unique features, facts and recent years. circumstances, some of the key themes and related lessons learned are as follows: Of course, not all of the valuable lessons to be learned come from negative business experience. Before moving • Over reliance on the capabilities of “name” on to the critical topic of alternative investment related alternatives managers (e.g., Long-Term Capital, due diligence programs, this White Paper addresses the Madoff, MF Global) more positive lessons to be learned from the very positive experience that some institutional investors, especially • Inadequate attention to risk profiles of portfolios and university endowments, have had over the past 15 to use of leverage (Long-Term Capital, Amaranth, MF 20 years with highly successful programs in alternatives Global) investments

33 “FBI and Hedge Fund White Collar Crime”: www.fbi.gov/about-us/investigate/white_collar/hedge-fund-fraud 34 Multiple sources of information on each fund failure or case of fraud can be found in Attachment A Bibliography, on the Wikipedia website and other websites under the name of each firm

Experience of University Endowments with The underlying objective of this model is based on the Alternative Investments ability of the endowment staff to achieve a more broadly Getting to the heart of the matter, top university diversified portfolio which also has a lower risk profile and endowment plans have not only moved away from the higher expected returns from investments in alternatives traditional 60-40 stock-fixed income allocation model, but which have low correlation to standard equity and fixed they have embraced significant allocations to alternatives income indices. as a key element of their investment allocations and expected return targets. “Large endowments, on average By utilizing such large allocations to alternatives, large have in excess of 60 percent of their assets invested in university endowments (>$1 bn in AUM) have generated alternative strategies, more than five times the exposure the largest average returns for the latest 3, 5 and 10 of small endowments”.35 year trailing periods (through 2012) compared to all other university endowments by size of AUM.37 David Swensen Yale University’s Chief Investment Officer has been a champion of high levels of allocations to It should be noted that the financial crisis of 2008 proved alternatives for more than 15 years. As a result, what to be an exception for the Yale Model when the Yale some have called the “Endowment Model” is quite endowment was down 24.6% compared to the average frequently referred to as the “Yale Model”. As reported in 18.7% loss for the endowments that year. But, as noted in the April 2012 issues of Forbes: the Yale Daily News online headline “Yale Model Back on Track”38, the Yale endowment had returned 21.9% for the “The Yale Model is an investment strategy named fiscal year ended June 30, 2011 compared to the average after the university endowment that popularized the return of 19.2% among 823 university endowments for the concept. The strategy produced superior returns over same period. And the Yale report further noted that over the past 15 years and made the Yale endowment the the prior decade the Yale endowment had an average envy of all institutional investors. It was developed annual return of 10.1% compared to the average of 5.6% and made famous by David Swensen, Yale’s Chief for the other endowments. As one analyst noted, “For Investment Officer, and Dean Takahashi, Senior individual investors and advisors, one task-away (from Director of Investments. They suggest that large the Yale experience during the 2008 financial crisis) is investors, such as endowments and pension funds that diversification works to increase risk adjusted returns can achieve superior returns by shifting a significant portion of investments away from traditional stocks over long periods, but it does not provide much market 39 and bonds and into carefully selected hedge funds, protection during severe market dislocations.” private equity, real estate and other alternatives.”36

35 National Association of College and University Business Officers (NACUBO) & Commonfund Institute Study, February 2013 36 Forbes, April 14, 2012 37 NACUBO Commonfund Study February 2013 38 Yale Daily News Online, January 31, 2012 39 Geoff Considine PhD; Advisor Perspectives, Inc. April 2010; www.advisorperspectives.com

Large endowments, of course, may have significant cash flow needs, risk tolerance, capabilities of internal advantages over smaller endowments and Family Offices. and consultant/advisor staff and the applicable investment These advantages may include factors such as: large, time horizon. high caliber professional staffs; access to top alternative managers; ability to negotiate favorable terms and pricing As one asset manager noted in May 2013, “…blindly power; very long term investment horizon; ability to take adding alternative investments just for the sake of on/tolerance for liquidity risk and other factors. adding alternative investments is a sure way to fail. The alternative strategies must be consistent with the But useful “lessons learned” for Family Offices from the overall goals of the portfolio.” And he added, “Upfront due experience of Yale and other large endowments include diligence is significant (and critical) [emphasis added] the potential advantages of making larger allocations to and one must ‘kiss a lot of frogs’ before finding the right alternatives. In the case of Family Offices these “larger manager and strategy”.40 allocations” to alternatives might mean moving from alternatives allocations of 5% to 15% or 20% or higher This reference serves as a useful bridge to the next depending on the specifics of a Family Office’s investment section of this White Paper, which addresses traditional objectives and strategy as well as factors such as the “Due Diligence” regarding the manager selection process Family Office’s needs regarding asset/liability matching, and ongoing monitoring process.

40 Charles Blankley, CFA, Chief Investment Officer, Gemmer Asset Management as quoted in www.advisorone.com; May 30, 2013

Some level of “Due Diligence” has always been an pursued based on a Family Office’s overall investment important feature of “manager selection” whether a program include: (Illustrative/Not Exhaustive): equity Family Office investor (or other investor) is selecting styles & capitalization: e.g., value, core, growth styles long-only equity managers, fixed income managers or and small, mid-cap and large-cap. There will also be a alternatives managers. The specific focus and the breadth question of choosing active versus passive management, and depth of such due diligence will vary by asset class as well as use of single stocks, stock indices, ETFs, and specific investment strategy among other factors, derivatives, etc. And Family Office investment due but the underlying due diligence process is the same in diligence focused on long-only equity investments will principle across all types of asset classes and strategies. involve decisions and diligence geared to the choice of Historically such “due diligence has typically been divided the geographic location(s) of the investment manager into two overall categories: “Investment Due Diligence” and of the investments being made, such as: US, global, and “Operational Due Diligence”. international, regional, emerging markets, and the currency and foreign exchange involved, (if any). “Investment Due Diligence” “Investment Due Diligence” naturally involves a wide In the case of Fixed Income, investment due diligence range of investment related topics to be undertaken by similarly addresses the type and geographic location of a Family Office investor and its advisors/consultants investment manager and investments being made as well (if any). Typical topics to be considered include: asset as the currency and foreign exchange (if any). Types of allocation, asset/liability matching, cash flow needs, risk Fixed Income investments can involve: sovereign debt, tolerance, investment time frame, investment strategy municipal, agency, corporate, high yield, money market, selection and other investment related functions such as: target date and other types of fixed income investments research, portfolio management, portfolio construction, and can be taxable or tax exempt. trading strategies, tools and systems, risk management capabilities, risk management programs and supporting When it comes to “Alternative Investments” investment technology tools, investment performance, etc. due diligence topics to be pursued by Family Offices include: allocations among different alternate investment In the case of long-only equity investment due diligence types: Hedge Funds; Funds of Hedge Funds; Private topics to be pursued include the identification, screening Equity; Real Estate; Commodities and other real assets and selection of equity strategies to be managed such as timberland, farmland, energy facilities and internally or via external managers. Equity topics to be infrastructure investments.

Additional investment due diligence for alternative management capabilities and practices. Assessing these investments involves the choice of strategy type under risk management capabilities includes understanding the each category of alternatives, such as for: roles and responsibilities of investment team members. Is there a separate risk team? Or are risk duties part • Hedge Funds of a portfolio manager’s duties? What authority does a • Varied Strategies: global macro, equity long/ risk manager have with regard to decisions to invest or short, event driven, market neutral, relative value, sell holdings? What risk analytics tools and measures distressed credit, convertible arbitrage, multi- are used? Are they specifically suited to the particular strategy, left-tail downside protection, etc. investment strategy being pursued? Does the risk team • Funds of Hedge Funds use multiple scenario stress testing and correlation and • Varied Strategies as above for hedge funds covariance analysis? Is the use of leverage modeled and • Private Equity monitored as an essential part of risk management? And • Varied types: growth capital, mezzanine capital, more broadly does the risk management program reflect venture capital, leveraged buy-outs, management any needed refinements or changes as a result of the buy-outs, distressed, Secondaries, etc. 2008-09 financial crisis or based on lessons learned from • Real Estate the Madoff fraud and any of the other hedge fund failures • Types: equities, mortgages, mortgage backed and frauds noted above? securities, commercial office, retail, residential, industrial Another area for investment due diligence for alternative • Commodities investments can involve a firm’s trading capabilities and • Types: precious metals (gold, silver, platinum), supporting technologies. Trading capability assessments energy (coal, natural gas and oil), agricultural are central to investment due diligence for most hedge (corn, soybeans, wheat, orange juice, cotton, fund strategies and commodities strategies but are less hogs and cattle, etc.) relevant for most real estate and private equity investment • Other Real Assets: strategies. And the focus, scope, and breadth of these • Ownership of/lending to owners of physical assessments are directly related to the underlying assets or interests in funds holding: Timberland, investment strategy. For example the assessment of Farmland, Infrastructure Projects, Infrastructure a quantitatively driven high frequency trading strategy Funds will have material differences from the assessment of a fundamentally-oriented, bottom-up buy and hold hedge Investment due diligence for alternative investments fund trading strategy. also involves an extensive assessment of a firm’s risk

In addition to investment research, portfolio management, focused primarily on the important but smaller impact investment risk management and trading capabilities, a aspects of middle and back office operations and at times proper investment due diligence program for alternative did not receive the level of attention that is required. investments will also involve consideration of additional Some operational due diligence programs tended to topics such as: a firm’s investment process; investment highlight only a few topics for assessment as part of the performance track record, regulatory registration status, initial screening program as well as ongoing alternatives review of any issues regarding investment style drift, manager monitoring programs. Typical elements of early undisclosed changes in investment process and related stage operational due diligence programs included topics/ topics. areas of assessment such as the following: operational aspects of trading, manager firm and administrator/ “Operational Due Diligence” custodian operations, assessment of business continuity Historically, as would be expected, the term “Operational and disaster recovery plans, and background checks on Due Diligence” focused on operational risks, but it also manager personnel. has served as a catch-all term for “everything else” not considered under “investment due diligence”. Operational due diligence has sometimes been associated with a “checklist” approach and/or a “tick the As has been noted in a well-known 2003 industry study box” approach to the process of assessing the capabilities of 100 hedge fund failures over the prior 20 year period of an alternatives manager. On the one hand, such (Capco)41 “… an alarmingly high number (50 percent) of checklists can be useful if they are comprehensive and hedge funds fail due to operational risk alone rather than well-focused on material operational risks. On the other bad investment decisions. Even more alarming, was that hand, Family Offices should be wary of overly simplified of the ‘operational failures’, misrepresentation (reports one page checklists of 5 to 10 topics to be pursued. and valuations with false or misleading information), Corgentum Consulting highlights this point in the following misappropriation of funds (fraud) and unauthorized trading quote: “By design operational due diligence processes was implicit in 85% of cases. Other operational risks which are driven solely by checklists and tick the box included staff processing errors, technology failure and approaches will inevitably overlook key operational risks poor data.” (including frauds) and will cost investors time, resources, and most importantly money.”42 Prior to the 2008-09 financial crisis and prior to the recent hedge fund and other alternatives fund frauds and failures, “Operational Due Diligence” was sometimes

41 Capco, Global Business and Technology Consulting Firm; www.capco.com 42 Corgentum Consulting: http://corgentum.com/blog/corgentum-consulting/operational-due-diligence-checklists-investors-beware-4/

Well-designed operational due diligence programs • Business Continuity and Disaster Recovery will be comprehensive in scope covering all relevant systems and capabilities; replication and back-up; areas of operational risk that need to be managed by disaster recovery space; designation of roles and an alternatives manager. Such risks to be assessed by responsibilities, and an ongoing process for testing alternatives investors should, for example, include an and refining such systems assessment of the staff capabilities, policies, practices and internal controls for the following topics. (See Another key characteristic for robust operational due Appendix C for comprehensive operational topics to be diligence programs is that they continue to evolve to covered in “Operational Due Diligence Programs”.) reflect new developments and address the shortcomings of recently experienced failures or frauds. In other words, • Cash Management/Movement of Cash; Authority, by definition, robust operational due diligence programs Roles and Responsibilities need to be dynamic on an ongoing basis. Since the financial crisis of 2008-09 and since the Madoff fraud and • Chief Compliance Officer, Code of Ethics, Compliance other alternatives industry frauds and failures, operational Manual; policies on personal trading, review of due diligence programs have, in fact, been continually quarterly brokerage statements, etc.; training of evolving and taking-up the topics often related to the manager personnel latest incidence of fraud or other fund failure. In effect, the lessons learned from the crisis and from the frauds • Separation of duties between investment and and failures (as noted above) have become elements of operational personnel; internal staff and service the work program for an expanded due diligence program providers carried-out by investors in alternatives.

• Selection and ongoing management of service As an example, the Madoff fraud importantly was providers (accounting, audit, legal counsel, facilitated by Madoff not having a third party administrator/ compliance consultant, fund administrator, custodian, custodian. Shortly after the fraud was uncovered, the credit facility provider(s), information technology SEC added to its standard examination program an providers, etc.) explicit check on the existence of cash and securities held in hedge fund accounts on behalf of investors.43 • Investor KYC/AML processes; Investment Consequently, having a third party administrator to Performance and other reporting calculate net asset values and a custodian to confirm the existence of investor holdings have both become • Accounting and Auditing policies and practices fundamental expected elements of alternatives due diligence processes.

43 “Strengthening Examination Oversight:: Changes to Regulatory Examinations”, Lori A. Richards, Director, Office of Compliance Inspections and Examinations, (OCIE), US Securities and Exchange Commission June 17, 2009

Some Family Offices have been becoming more and more consultants, have the capabilities to perform sophisticated in the breadth and depth of their hedge fund effective operational due diligence. This is in stark “operational due diligence programs”. At the same time, contrast with the 76% that stated that they actually according to a 2012 study by Corgentum Consulting,44 perform some sort of operational due diligence. Family Offices have a long way to go toward establishing robust and comprehensive hedge fund operational due • Only 18% of those surveyed indicated that their diligence programs. The authors of the Corgentum survey family office has begun to perform operational due study reached the following key conclusions from this diligence within the past two years. The remaining 2012 survey of 120 single family and multi-family office 82% indicated that they were not performing what members: they deemed to be operational due diligence two years ago. Conclusions • Only 21% of family offices maintain a documented Family Offices have begun to refocus on operational operational due diligence process risk in hedge funds. While they have made recent significant progress towards developing more robust • The majority of family offices (68%) feel that their hedge fund operational due diligence programs, there operational due diligence processes do not adhere is still a long way to go. The survey data suggests to minimum standards. This results in inconsistent a number of opportunities for fine-tuning the ways due diligence processes where some hedge funds in which they, and their investment consultants, receive light touch reviews based on perceived approach diagnosing and monitoring operational risk. lower risks. This was particularly true for more In summary the results of this survey indicate: liquid strategies such as long/short equity.

• Almost one-fourth of those family offices surveyed • Family Offices are still overwhelmingly concerned (24%) indicated that they, or their consultants do with fraud. 57% of them stated that it was the not perform any operational due diligence largest operational risk facing investors. Other risks considered to be important were regulatory • The majority of family offices (73%) indicated risks (21%) and counterparty risks (9%)45 that they do not feel confident that they, or their

44 “Family Office Study: Taking Aim at Hedge Fund Operational risk”, Corgentum Consulting 2012 45 Ibid., Corgentum Consulting Study 2012, page 12

A mid-year 2013 study of a wide range of hedge fund • Start-up managers need to invest in people institutional investors reinforces the theme of continued and process – Investment in human capital and investor attention and greater emphasis on hedge fund proper segregation of duties ranked as the top operational due diligence.46 This study, conducted by two operational recommendations for start-up and Deutsche Bank, involved a survey of 68 institutional emerging managers. investors with over $2.13tn of total assets and hedge fund allocations in excess of $724bn. Key findings included: • Managers should expect a thorough review of operations during the site visit – Almost 60% of Deutsche Bank 2013 Survey Highlights investors observe daily operations during a typical ODD review, using a “trust but verify” approach • Almost three quarters of those surveyed rank to validate what managers represent in their a hedge fund firm’s compliance and regulatory documentation.47 framework as the top priority for 2013 This well-established trend to more and more • Investors are placing greater emphasis on the comprehensive “Operational Due Diligence” (ODD) for depth and breadth of their Operational Due assessing alternative investments has produced very Diligence (ODD) team – 80% of respondents have detailed model ODD work programs. For example see a dedicated ODD team and investors conduct an Appendix C to view the detailed Table of Contents of average of 50 manager reviews a year. the Managed Fund Association’s publication: “Sound Practices for Hedge Fund Managers”48 (The link • Investors are increasingly focused on fund provides access to entire 278 page document.) This expenses – the majority of respondents have comprehensive document has 7 chapters on topics little or no tolerance for expenses such as such as: Disclosure and Investor Protection: Valuation; non-research related travel or employees’ Risk Management; Anti-Money Laundering Trading compensation being charged to the fund. 40% and Business Operations, Compliance, Conflicts accept charges such as regulatory reporting. and Business Practices; and Business Continuity Disaster Recovery Principles. Extensive appendices • Independent governance is expected – The are included on topics including: Model Due Diligence majority of respondents prefer at least three Questionnaires; Risk Monitoring; Compliance and a directors on the board including two independent Code of Ethics Checklist. directors. Nearly a quarter vetoed an investment due to lack of independent governance.

46 Deutsche Bank Study as reported by The Wall Street Journal, online July 1, 2013. http://online.wsj.com/article/PR-CO-20130701-905687.html 47 Ibid., 48 Managed Fund Association (MFA) “Sound Practices for Hedge Fund Managers”, 2009 Edition ; https://www.managedfunds.org/hedge-fund-investors/sound-practices-for-hedge-fund-managers/

And this MFA document also includes sample investors. Key topics usually include profiles of the provisions for Fund Administrators, Investor manager’s entity(ies) and organizational structure, its Intermediaries and sample templates for Board personnel, staff turnover, supervisory structure, etc. resolutions. While this MFA document was prepared These manager DDQ’s also provide information on the for use by hedge fund managers, (and as noted range of service providers used (auditors, accounting below is an example of an alternatives industry “Best firms, law firms, valuation consultants, etc.) and about Practices”) the topics addressed in the chapters and the firm’s compliance policies, Code of Conduct, the appendices can serve a very useful purpose for internal controls, and topics related to registration Family Offices just by using the topics addressed in with regulatory authorities and a wide range of other the table of contents as elements of an expanded due relevant topics. But, as helpful as these manager diligence work program. prepared due diligence documents can be, Family Offices are advised to treat these DDQs as a starting And Family Offices are not on their own in terms of point or as one element in their ODD assessment developing new or enhancing existing due diligence process. capabilities. They can access multiple sources of due diligence program assistance ranging from firms As highlighted (above and in more detail below - such as the Big Four accounting firms (Deloitte, Ernst see Section VI), there are also industry and other & Young, KPMG, PwC), with newly expanded ODD sources of “Best Practice”, such as the Managed Fund capabilities as well as specialty alternatives accounting Association, “Model Due Diligence Questionnaire” firms such as Anchin, Bloch and Anchin, Cohn which spell out key work program elements Family Reznick, Eisner Amper, Rothstein Kass and others. In Offices should expect to find in alternative manager addition specialty stand-alone consulting firms such DDQs. (See the full MFA “Model Due Diligence as Castle Hall Alternatives, Corgentum Consulting Questionnaire” in the link provided in footnote 49 and others also provide value added alternatives due below and as provided in Appendix B). diligence assistance. Beyond providing a road map for a Family Office’s Heightened interest in ODD assessments has also assessment of an alternative investment manager’s led alternatives managers (and their consultants) to operational risks and mitigation program, it should be create special purpose “Due Diligence Questionnaires” noted that the subjects addressed in a typical DDQ (DDQs) for use by potential investors and their can also serve as a work program for the Family consultants. These DDQs typically address a broad Office’s own due diligence and alternative investment range of topics of interest to Family Offices and other business management risk assessment programs.

49 Managed Fund Association (MFA) “ Model Due Diligence Questionnaire”, June 2011; www.managedfunds.org/.../2011/06/Due-Dilligence-Questionnaire.pdf

Before moving on from this section, it should be noted, Chief Investment Officer (OCIO) or a mix of internal as would be expected, that Family Office investment and external resources and the range of advisors / due diligence programs (staffing, expertise, structure, consultants that may be used on a project specific scope, etc.) for both “investment due diligence” or ongoing basis. For more information on different and “operational due diligence” will be significantly Family Office investment models, see below, section impacted by the investment model it currently VIII. “Family Office Investment Management Models”, follows, i.e., internal investment staff, Outsourced (p. 51)

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 38 V. Future: Broader & Deeper: “Alternatives Investment Business Management Due Diligence”

As noted above, the scope and depth of “Due This White Paper suggests that investors in alternatives, Diligence” programs, both “Investment Due Diligence” including Family Offices will be well-served by expanding and “Operational Due Diligence” have been evolving that 2 part conceptual framework to include 3 additional and becoming more comprehensive in recent years. key areas of due diligence assessment and to create And such dynamic evolution is expected to continue and adopt a 5 part robust due diligence framework into the future, if for no other reason than the fact under a new substantive heading that the author of this that new alternatives fund failures and frauds, as White Paper calls: “Alternatives Investment Business well as new regulatory actions, provide the occasion Management Due Diligence”. for expanding the reach of robust investment and operational due diligence programs. As a result, As presented below, this new, broader framework includes Family Offices are advised to be continually on the all the elements of the traditional 2 part framework and alert and committed to maintaining an ongoing and adds significant emphasis and attention to fund/account/ dynamic process of continual refinement of what investment vehicle due diligence, manager firm due constitutes a comprehensive alternative investment diligence and adds another key element that is designed due diligence program. to involve an assessment of investment and business processes that are undertaken by all parties involved Over and above this “continuous improvement”, in alternatives investing across the multiple strategies ongoing, evolutionary and dynamic refinement embodied under the typical alternatives headings of: approach to strong due diligence programs, this White hedge funds, private equity, real estate, and commodities. Paper also suggests that it will be useful for Family Offices to think about alternative investment manager due diligence in a different conceptual framework than has been typically used in the past. The typical framework has had two major elements as described above:

1. Investment Due Diligence, and 2. Operational Due Diligence.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 39 V. Future: Broader & Deeper: “Alternatives Investment Business Management Due Diligence” (cont’d)

The new recommended overall “due diligence” framework 3. Classic “Investment Due Diligence” is as follows: a. Investment Strategy b. Research “Alternatives Investment Business c. Portfolio Management Management Due Diligence” d. Risk Management e. Trading 1. Fund/Account/Investment Vehicle Due f. Performance Record Diligence g. Etc. a. Constitutional Documents b. Governance 4. Classic “Operational Due Diligence” i. Directors a. Operational Risks ii. Roles and Responsibilities b. Business Continuity and Disaster c. Fund/Account Terms Recovery Plans d. Fund Vehicle “Operations” c. Background Checks e. Other d. Service Provider/Counterparty Risks

2. Firm/Manager Due Diligence 5. Investment Business Process Due Diligence a. Governance a. All Investment Processes b. Business Topics b. All Business Processes i. Business Strategy c. All Fund, Firm, Investor, Service Provider ii. Business Plans and Counterparty Processes iii. Business Results c. Compensation Policies As can be readily seen, there are many topics in the d. Legal & Compliance broader recommended due diligence framework Family e. Technology Offices will want to assess in detail that are not really f. Other “investment topics” or “operational topics”.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 40 V. Future: Broader & Deeper: “Alternatives Investment Business Management Due Diligence” (cont’d)

The rationale for recommending this new broader basis and not just as a partial subset of both Investment framework is based on the belief that by undertaking the and Operational Due Diligence categories. Further such “new elements” of this expanded due diligence process a separate consideration of Firm/Manager due diligence Family Offices (and other alternatives investors) will be framework and process would by definition cover the better equipped to conduct meaningful assessments important topics of firm governance, firm leadership and of candidate alternatives investment products/offerings management, business strategy, current and projected and alternatives manager firms. To some extent, existing staffing, annual operational planning, new initiative strong alternatives due diligence programs do address planning (e.g., new products, new geographic office plans, both fund/investment vehicle and manager firm topics, upgraded technology platform,) etc. which otherwise but the author of this White Paper suggests that such might not be highlighted in the current two category due diligence assessments will be broader, deeper and framework. more effective if such topics as firm governance and fund governance (among other topics) are focused on explicitly In addition, regulators such as the US SEC, and Cayman and are separately assessed and ranked for various Islands regulators as well as UK and European regulators candidate alternative investment strategies, products and have called for greater focus on fund and firm governance managers, rather than as a subset of “Operational Due topics including: Board of Directors, expertise, roles and Diligence”. responsibilities, method of selection and replacement, transparency and other related matters. This suggested Further this broader framework is suggested since the broader due diligence framework will help Family Offices author of the White Paper believes that it will be beneficial and other investors assure themselves that they have for Family Offices and other alternatives investors to probed deeply into these hot button topics and make consider, for example “Fund/Account/ Investment vehicle” their own assessments of how well candidate alternatives issues comprehensively, as a whole and on a stand-alone managers have addressed these very important topics.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 41 V. Future: Broader & Deeper: “Alternatives Investment Business Management Due Diligence” (cont’d)

The fifth element of this broader and deeper due o Firm Management Committee Processes diligence framework (“Investment Business Process o Processes for Addressing Potential Conflicts of Due Diligence”) bears some further explanation and Interest clarification. The intent here is for Family Offices to get o Firm Board of Directors Processes (if any) as much information as possible regarding a description o Firm Valuation Committee Processes and business workflow process graphic picture of how key o Etc. investment processes, marketing processes, indeed all business function processes actually take place. Many of • Fund/Firm and Investor Processes these processes will be described in legal documents and o Fund/Account Marketing, PPM, and Subscription business operations documents, but it can be very helpful Document Processes for a variety of reasons (noted below) to require candidate o Investor KYC and AML Processes managers to document and develop workflows of all these o Investor/Client Reporting Processes process for review and assessment by Family Offices o Etc. and other investors. As will be seen from the following examples, such processes involve firm internal processes, • Fund/Firm and Third Party Processes firm and investor interactive processes, firm and third o Fund/Fund Administrator/Firm Processes party service providers and regulator processes. • Subscriptions • Redemptions • Internal Manager Firm Processes • Calculation of Net Asset Value (NAV) o Investment Process(es) • Etc. • Research o Fund Custodian Processes • Portfolio Management • Risk Management • Fund/Firm and Regulator Processes • Trading/Portfolio Management o Initial Registration Processes o Business Strategy, Planning and Reporting o Updating Form ADV as needed Processes o Responding to regulatory “sweep” and individual o Annual and Multi-Year Staff Goal Setting and examinations Assessment Processes o Etc.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 42 V. Future: Broader & Deeper: “Alternatives Investment Business Management Due Diligence” (cont’d)

There are also multiple direct and indirect benefits to be seen below in the “Best Practices” section (pages 37 to obtained from having a robust set of important business 40), such documentation of key investment and business processes documented by alternatives managers. For processes is increasingly being seen as being valuable in instance, once documented, best practice calls for itself for managers and the effectiveness and efficiency of periodic testing and refinements as may be needed their firms and funds/accounts. due simply to the passage of time and/or due to the introduction of new features to a given process. In In addition, a candidate alternatives manager’s willingness addition, such documented workflows can serve as to undertake such work and share it with potential very effective training tools for new staff being hired or investors can be a very concrete and specific indication transferred within an alternatives firm. And such workflows that the manager is truly committed to operating in a can also serve as the basis for both transparency and transparent way with Family Offices and other investors. accountability in a manager’s dealings with investors, Until such business process/workflow documentation trading counterparties, derivatives counterparties, fund and sharing becomes more widespread practice, Family administrators, custodians, prime brokers, and other third Offices can decide for themselves the highest priority party service providers. areas that they wish to identify and insist on getting such workflow documentation as part for their robust Furthermore, if a manager has developed at least some “Alternatives Investment Business Management Due subset of documented workflows and related roles and Diligence” regime. responsibilities, they can provide very specific evidence of whether or not an alternatives manager has truly “Set the So far, this section of the White Paper on “Family tone at the top” and very specific evidence of a manager Offices and Alternative Investments” has focused on truly having a “culture of compliance” as called for by the Due Diligence in the context of the correct topics to SEC.50 be covered. A new broader, more inclusive conceptual framework for conducting assessments of alternative At this point, there are likely to be few alternatives investment opportunities has been identified and managers who have a complete set of all relevant recommended for consideration, namely what is called business processes fully documented and available for an “Alternative Investment Business Management Due potential investor review. At the same time, as well be Diligence framework.

50 “Enforcement Priorities in the Alternative Space” by Bruce Karpati; presented to the Regulatory Compliance Association in New York, December 18, 2012, Page 4: http://www.sec.gov/news/speech/2012/spch121812bk.htm

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 43 V. Future: Broader & Deeper: “Alternatives Investment Business Management Due Diligence” (cont’d)

As described above, this new conceptual framework In addition Family Offices are well-advised to vigorously highlights the continued importance of investment employ the familiar dictum from the due diligence (research portfolio management, risk management, world, i.e., “Trust But Verify”. This means, for example, trading, etc.) topics and espouses a significantly in addition to reading a firm’s capabilities brochure or broadened so called “Operational Due Diligence” website, and in addition to having a good understanding assessment. To these core elements, the White Paper of the manager’s investment strategy, investment process, suggests adding explicit attention to both fund/investment risk management capabilities and trading systems, Family vehicle and investment manager firm due diligence in Offices (or their representatives/advisors/consultants) terms of governance. And this White Paper highlights should also meet with key members of the alternatives the significance of Family Offices delving into the full management firm and verify in-person what they have range of “business processes” that support all investment read in the key product and firm documents including functions, internal firm business functions as well as the marketing materials, manager firm formation documents, interactions of investors and third party service providers SEC registration documents, Form ADV disclosures and with the alternatives fund/investment vehicle and firm all relevant policies and procedures. management entity (ies). And how should these “Trust But Verify” meetings be In addition to getting the framework and content of held? A suggestion from the author’s business experience alternative investment due diligence right, it is also is to hold multiple meetings with different firm principals recommended that Family Offices consider the most (or video or audio conference calls in the case of remote effective ways of carrying-out a comprehensive process managers). For instance, Family Office principals of alternatives due diligence. That is, very specifically, might meet with alternatives manager principals on how should Family Offices actually carry- out due one occasion for an overview of the firm’s investment diligence assessments? For sure, reviews of key fund strategy, investment process, risk management and and firm documents are critical to the due diligence trading capabilities. In addition, later the same day or on process for Family Offices. And these reviews should be another occasion, Family Office staff might meet with carried-out not only by lawyers (internal and/or external individual portfolio managers, risk managers or traders to counsel), but also Family Office principals and specific get their overall perspective as well as to probe and test business function heads should have a good working for the investment team members’ having a consistent understanding of these documents. understanding of the firm’s published descriptions of these topics.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 44 V. Future: Broader & Deeper: “Alternatives Investment Business Management Due Diligence” (cont’d)

This can yield a three-way triangulation on key topics, i.e., conversely, provide confidence that a manager has what do the documents say, what do firm principals say indeed established a robust business infrastructure and and what do front line participants say about the same key the Family Office can proceed confidently to make an topics. investment as long as all material aspects of this in-depth due diligence process produce similar results. Similarly, Family Office principals might conduct in- depth interviews regarding a firm’s trading platform with Another benefit of this approach to due diligence key traders and ask about key features of the trading assessments is that to the extent that material negative system as they relate to the firm’s investment strategy. issues are identified, the Family Office has a clear record Separately, Family Office staff can check this information of the reasons for deciding not to proceed, which, in itself not only with the underlying offering memorandum, but can be useful for internal Family Office management also with the manager’s technology staff, middle and back purposes, Family Office Board purposes and feedback to office staff as well as with the manager’s counterparties candidate managers as may be needed. And further, by and service providers such as trading clearance firm(s), adopting such a thorough due diligence process, a Family fund administrator and custodian. And this multiple step Office can gain a very positive reputation for its robust due process can and should be continued and focused on diligence capabilities and thereby send a message about fund and firm governance and all aspects of investor/ its expectations for considering alternatives managers in manager interactions as well. the future.

This type of multiple checking with key (internal and external) participants throughout a dynamic business process can find areas of potential concern or

In addition to all the sources of “lessons learned” and of helpful information on industry “Best Practices” for the recommendations for adopting a new framework alternatives investors and for alternatives managers. for thorough alternatives due diligence assessments Different organizations have sponsored and published which have already been covered in this White comprehensive information on different aspects of Paper, Family Offices can also benefit from becoming alternatives investing. Some of the most prominent and familiar with established alternatives industry “Best important sources of alternatives industry “Best Practices” Practices”. Fortunately for Family Offices there are information are as follows: already well-established and highly regarded sources

As can be seen from the table above, there are several documents provide very useful information to Family different kinds of organizations which have sponsored Offices as they consider their alternatives due diligence the creation of these alternatives industry “Best programs for the first time or are refining their existing Practices” documents. These organizations include alternatives due diligence programs. For easy reference, multiple agencies of the US Government: President’s the URL addresses for each of the 16 alternatives industry Working Group (PWG) with Investor and Manager “best practices” documents listed above are included in sub-committees), Washington, DC; associations of Appendix C. And each “Best Practices” document is just alternatives investors and managers: Managed Fund a “click away” using the URL links in the chart above. Association (MFA), Washington, DC; Alternatives Investment Management Association (AIMA) based in These documents on “Best Practices” and “Standards” London; a not-for-profit research organization: Greenwich represent an important body of knowledge that can Roundtable, Greenwich, CT; a specialized membership be of assistance to Family Offices and their advisors organization of limited partners in private investments: as existing alternative investments and managers are Institutional Limited Partners Association (ILPA), Toronto, monitored and potential new investments in alternatives ON, Canada, and a specialized association of hedge fund are considered. On the one hand, the point is not to try to investors and managers: Hedge Fund Standards Board make Family Office staff members experts on the status (HFSB), London. of “alternative industry best practices”. On the other hand, such documents can be very useful resources as Family Each organization has a different scope of topics covered Offices undertake the kind of robust broader and deeper in their “Best Practices” documents and each organization “Alternatives Investment Business Management” due utilized a different consultative process for the creation diligence and assessments as recommend in this White and ongoing refinement of the “Best Practices” which Paper. they have adopted and published. In each case, these

As an example of the help that “Best Practices” choose not to pursue this opportunity: More about documents can be, consider the Institutional Limited the Team; Operations; Business Continuity Plans; Partners Association (ILPA) Private Equity Principles Service Providers (Auditor, Marketing Relationships, which cover topics such as: Legal and Compliance, Other Providers); Declining an Opportunity Alignment of Interests: Management Fee and Expenses; Performance Fee; Term of Fund; General Due Diligence on Hedge Funds (similar to above Partner Commitments; Standards for Multiple Product plus): Risks to Consider: Management of Risk; Firms Measurement of Risk; Stress Testing; Trading; Liquidity Risk; Leverage; Transparency Counterparty Governance: Team; Investment Strategy; Fiduciary Risk; Prime Broker/Futures Clearing Merchant (FCM)/ Duty; Changes to the Fund; Responsibilities of the Custodian; Administrator; Pricing Limited Partners Advisory Committee; Due Diligence on Specific Hedge Fund Strategies: Transparency: Management and other Fees; Capital Equity Long/Short; Event Driven, Including Special Calls and Distribution Notices; Disclosure Related Situations and Merger Arbitrage; Interest Rate and to the General Partner; Risk Management; Financial Credit Arbitrage; Distressed; Convertible Arbitrage; Information; Limited Partner Information; Carry Global Macro; Managed Futures; Multi-Strategy Clawback Best Practice Consideration Due Diligence on Private Illiquid Investments: Also, consider the scope of the Greenwich Roundtable Strategy: Venture Capital; Buyout Firms; Buy-in Firms; publication on “Best Practices in Alternatives Investing: Mezzanine Capital; Distressed; Real Estate; Natural Due Diligence” Resources; Energy Funds; Mining Funds; Timber Funds; Track Record; Terms Due Diligence on Any Alternative Investment: Part A: Why we might want to consider this opportunity: The Market Opportunity; The Strategy; The Sponsoring Organization and its Team; Part B: When we might

Due Diligence on Fund of Funds: General Concerns: Commercial Terms Disclosure: Fees and Funds of Hedge Funds; Funds of Private Illiquid Funds expenses; Termination rights; Exit Terms; Changes to Redemption Terms, etc.; Changes to fees and In the Final Analysis: The Greenwich Roundtable expenses; Side letters; Other funds similarly managed, advises that it is important to… “Recognize that …all etc.; Performance measurement; Fund Administrator decisions about investment decisions are judgment Topics; Valuation; Segregation of Duties; Hard to Value calls. Judgments honed by proper due diligence, Assets however, should not only help us avoid mistakes but also identify opportunities likely to provide superior Additional topics covered under 28 categories/terms. returns.51 See Hedge Fund Standards Board link above.

Appendix: Document Review List: Offering Again, for those interested in exploring these alternatives Memorandum and Subscription Agreement; Governing industry “Best Practices” in more detail, the websites/ Documents; SEC Form ADV; Audited financial URL addresses for these documents are only a click statements, etc.; “SAS 70”type reports regarding away (See links in table above on pages 45-46). And systems of controls; Marketing materials; Material see examples of the full “Tables of Contents” for these written policies and procedures etc. best practices documents in “Appendix C: Tables of Contents of Alternatives Industry “Best Practices” Or similarly, consider the scope of the “Standards” Documents adopted by the Hedge Fund Standards Board:

Disclosure: Investment Strategy; Investment Instruments (e.g., derivatives); Use of Leverage; Target return; Target level of risk ; Historical track record, etc.

51 Greenwich Roundtable: “Best Practices in Alternative Investments: Due Diligence”, 2010, page 74

The real benefit for Family Offices will be to concentrate On the other hand, these documents can also be used on the most relevant of these alternatives industry best as a way to enhance the scope and range of a Family practices and to customize them to the specific nature Office’s alternatives due diligence program for considering and scope of each individual Family Office’s objectives first time or additional alternative investments. And further, and the nature and range of its alternatives investment depending on a particular Family Office’s “investment portfolio. For example, a Family Office which already has management model” (see next section below) and what it considers to be a sufficient portfolio of alternatives depending on the extent of internal versus outsourced in keeping with its objectives and risk profile, portions of functions, knowledge of these industry best practices can these “best practices” documents can serve as a specific also be used by Family Offices as part of the evaluation work program for conducting periodic and ongoing process for consultants/advisors to assist the Family monitoring of existing alternative investment managers Office with its alternatives investment management and their related alternatives fund/separate account program. investments.

What different investment management models are (investment research, portfolio management, asset typically in place for Foundations, Endowments and allocation, manager selection, risk management, etc.) Family Offices? What are some of the pros and cons of time availability and focus, access to appropriate these different models and which model is right for your investment solutions, oversight and monitoring, breadth Family Office? and depth of capabilities, cost, alignment of interests and accountability. This topic and some key factors for consideration are addressed in a June 2013 article by Lisette Cooper, What is the “right model” for your Family Office? This CFA, PhD, and CEO of Athena Capital Advisors.52 In this White Paper suggests that there is no single right answer article, Dr. Cooper provides useful information on the and each Family Offices has to assess its own unique characteristics of and pros and cons of five models for facts and circumstances in terms of the factors noted handling investment management responsibilities. These above along with considerations such as ability to manage models utilize the framework structure presented in a increasing complexity in the external environment. Commonwealth Fund report in 2009.53 The 5 investment management models highlighted are as follows: In addition, Family Offices can be well-served by evaluating the most appropriate investment management 1. Model 1: Solo Investment Committee model in light of its needs for assistance on key decisions 2. Model 2: Investment Committee + Investment such as asset allocation as well as specific investment Consultant strategy and manager selection since these decisions are 3. Model 3: Investment Committee +Internal Finance key drivers for achieving a well–diversified portfolio with Staff + Investment Consultant the target expected returns, downside protection and risk 4. Model 4: Internal CIO profile customized to each Family Office’s portfolio and 5. Model 5: Outsourced CIO cash flow needs. Consideration should also be given to which model not only fits a Family Office current situation, As can be seen these models progressively involve but which model is likely to meet future needs and then a movement from internal responsibility for key adopt the most appropriate model for “now” and identify functions to external/outsourced responsibility for these the specific threshold factors (such as AUM, further asset functions and different levels of mixing and matching class diversification, personnel changes, need for greater along the continuum. Key factors to be considered expertise, depth of resources, etc.) that would trigger a include: AUM size and portfolio complexity, expertise move toward a future more appropriate model. and experience of Family Office principals and staff

52 “Which Investment Management Model Is Right For Your Endowment, Foundation or Family?” June 19, 2013, Lisette Cooper, CFA, Ph.D. 53 “Rethinking the Management of Foundation Endowments”, Commonwealth Fund Annual Report 2009

In addition to the overall reasons for the attractiveness of healthcare and energy). Fund results were analyzed for alternatives investments that have been highlighted above the 2003-2012 ten year period and “Small Funds” were (e.g., portfolio diversification benefits, projected higher designated as having between USD $50 million and USD risk adjusted returns and downside risk protection) this $500 million in assets under management (AUM) and “Big White Paper also highlights what may well be a distinctive Funds” had AUM of greater than $500 million. additional reason for some Family Offices to consider allocations to alternatives. The distinctive additional Key findings of this 2013 study included: rationale involves a potential “mutual sweet spot” for Family Office investors in alternatives and small to mid- “Results demonstrate that hedge funds managed by sized alternatives manager. firms with $50 million to $500 million in AUMs have outperformed those run by larger peers over almost Important alternatives industry research suggests that any period. when it comes to outperformance among alternatives managers, fund/manager size and fund “age” (length • Five and ten year outperformance was 254 bps and of time a fund has been operating) can be extremely 220 bps per annum, respectively. important as described below. • Outperformance was most pronounced preceding and Manager Performance: Size Matters: following the crisis, especially during 2009. Alternatives industry research has shown that the size of assets being managed can matter when it comes • Overall risk was in line, with a beta of approximately to outperformance. And in these studies, there is a 1.09 relative to larger peers. clear advantage to the new/emerging small to mid- sized manager compared to large fund manager. One • Smaller funds show a higher dispersion in returns, recent study (February 2013) by Beachhead Capital which suggests that potential out-performance, is 55 Management pinpoints this manager size advantage quite higher with careful manager selection.” clearly.54 • The reasons given by Beachhead Capital for this out 56 In the Beachhead Capital study 2,327 equity long-short performance are summarized in the following table: hedge funds were analyzed in order to determine the impact of firm size on fund returns. The firms/funds studied both fundamental value and fundamental growth styles and 3 sector-specific categories (technology,

54 “Performance of Emerging Equity Long/Short Hedge Fund Managers, 2003-2012”, Beachhead Capital Management February 2013; http://www.beachheadcapital.com/index.php/articles 55 IBID., page 2 of PowerPoint presentation accessed via the above link 56 IBID., page 7 of PowerPoint presentation accessed via the above link

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 53 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

The following graphic from the February 2013 Beachhead Capital study clearly indicates the persistent outperformance of smaller equity long-short hedge fund firms compared to larger firms over the 10 year period to 2012 and the chart to the right provides additional relevant comparative information regarding “Small” and Big” firms.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 54 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

The author of this White Paper believes it can be Key findings of the PerTrac study regarding manager/fund particularly helpful to Family Offices to focus on the size for the period 1996-2011 are as follows: identification of the greater “opportunity set” available to smaller managers as a particularly key reason of this • “The average small fund outperformed the average outperformance. In addition to the two Beachhead points mid-size fund and average large fund in every year of analysis (stock market trading volume shrinkage with except for 2008, 2009 and 2011 size and low overlap in the holdings of small and large funds), the author suggests that some of the expanded • Since 1996, the cumulative return for the average opportunity set presents potential investments which are small fund has been 558%, mid-size 356%, and large simply too small to matter to managers of large funds 307% while at the same time, these smaller opportunities can be drivers of out-performance for the smaller manager. • The annualized compound ROR for the average small fund is 12.5%, for mid-sized 9.95%, and for large In addition to this Beachhead Capital study showing that 9.16%. smaller equity long short hedge fund firms outperform larger hedge fund firms over a 10 year period, other • The average standard deviation for the average studies also provide similar evidence of smaller small fund is 6.92%, for mid-size 5.94% and for large alternatives manager firms outperforming larger firms. 5.95%”58

One such additional study of note, also focused on hedge Another notable study regarding private equity funds, was conducted by PerTrac -- a leading provider of investments was conducted by the EDHEC-Risk Institute software solutions for investors and investment managers: (a division of one of Europe’s leading Business Schools). www.pertrac.com57 Some of the central findings of this This study involved 254 private equity investment firms study involve differentiating hedge fund performance world-wide and 7,500 private equity investments made by manager size of assets under management with the between 1971 and 2005. While not defining “size” by AUM following size designations: (as in the two studies above), the EDHEC study primarily focused on complexity and “scale” which are measured • Small: Less than $100million in AUM in terms of factors such as: the number of investment • Mid-Size: $100 million in AUM to $500 million professionals, the number of investments being managed in AUM simultaneously, the number of investment strategies being • Large: Greater than $500 million in AUM managed, the total AUM being managed, and the level of hierarchy and organization structure of the firm.

57 PerTrac: “Impact of Size and Age on Hedge Fund Performance: 1996 -2011”, 6th Annual Update, October 2012

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 55 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

One of the main conclusions of the EDHEC study is The key conclusions of this PerTrac study with regard to that smaller scale firms produce better returns than the age of hedge funds are as follows: larger scale firms or in the words of the study: “…Private Equity firm scale is a significant and consistent driver of • “The average young fund has outperformed the returns”.59 As measured by scale, the median IRR of the average mid-age and tenured fund in 14 out of 16 smallest scale decile was 36% versus an IRR of 16% for years since 1996, including every year after 2003 the largest scale players. The difference was attributed largely to the diseconomies of scale associated with larger • Since 1996, the cumulative return for the average firms and the number of different investment strategies young fund has been 827%, mid-age 446%, and and the number of different investments being managed tenured 350% simultaneously. Again, in the words of the EDHEC study: “…as the number of simultaneous [private equity] • The annualized compound ROR for the average investments rises, returns fall.”60 young fund is 14.93%, for mid-age 11.19% and for tenured 9.85% Alternatives Firm/Fund: Age Matters Hedge fund industry research shows that not only does • The annual standard deviation of the average young size matter when it comes to outperformance (smaller = fund is 6.37%, for mid-age 6.99%, and for tenured better) but also “age” matters as well, where age refers to 6.80% the length of time a hedge fund has been operating. Once again citing the PerTrac study on the Impact of Size and • The average young fund also generated the most Age on Hedge Fund Performance: 1996-2011”61 , hedge return per unit of risk based on its Sharpe and Sortino fund “age” categories are as follows: ratios”62

• “Young Fund” Start date within the last • “The most impressive feature of this strong track two years record is that the average young fund has generally • “Mid-Age Fund” Started within the last two outperformed its average mid-age and average to four years tenured peers, while keeping a lower volatility profile” • “Tenured Fund” Operating beyond four years (emphasis in original report)63

58 IBID. PerTrac page 55 59 EDHEC-Risk Institute: “Giants at the Gate: On the Cross-Section of Private Equity Investment Returns”, January 2011, p.76 60 IBID. EDHEC –Risk Institute page 38. 61 PerTrac: “Impact of Size and Age on Hedge fund Performance: 1996 -2011”, 6th Annual Update, October 2012, page. 3 62 IBID PerTrac page 55 63 IBID, Pertrac, page 44

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 56 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

What’s Next re: Family Office and Alternative alternatives. And Family Offices will also seek to diversify Investment “Sweet Spot?” their alternatives investments in different strategies. Having established this alternatives manager “sweet Again, for simplicity sake (and hopefully for the sake spot” regarding size/scale (in the case of hedge funds: of clarity) the following illustrative example reflects a managers with between $50mn and $500mn in assets Family Office having decided to allocate what can be who have achieved material outperformance over the characterized these days as a moderate 20% of assets to most recent 10 year period; in the case of private equity alternatives, and sub-allocations to hedge funds of 40%, managers, more generically “smaller scale is better”); private equity 15%, real estate 15% and Commodities and having demonstrated the importance of alternatives 30%. firm/fund age, the question now becomes: How do these alternatives managers and their offerings align with Family In the case of Family Offices with total portfolios of say Office allocations to alternative investments? $50 million to $500 million, and allocations to alternatives of 20%, that would mean an alternatives budget (all In this illustrative example, it is assumed that, for risk alternatives styles/categories; hedge funds, private management purposes, Family Offices would generally equity, real estate and commodities) of between $10mn seek to have their alternatives investment with a given and $100mn. For the sake of this example, assume that manager to be below 10% of assets being managed Family Office allocations of their alternatives budget in a given strategy. Similarly, it is assumed that initial follows the percentages identified in the chart below. investments in particular alternatives assets (hedge Again, in reality, actual Family Office allocations will vary funds, private equity, real estate and commodities) among alternatives asset classes depending on multiple would begin at 1% of a fund or less and then grow from factors including: asset liability matching, cash flow needs, both investment performance and potentially additional risk budgets, expected returns, experience of the Family allocations from the same Family Office to the 3% to 5% Offices with different types of alternatives, and market range of a fund’s AUM and ultimately to the 7% to 10% conditions among other factors. range.

Naturally, individual Family Offices will have different reason for different total allocations to alternatives and different sub-allocations to the subset types of

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 57 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

The following table shows an illustrative example of Family Offices with different levels of assets under management (AUM) and a 20% total allocation to all forms of alternative investments. For purposes of this illustration, assume the following sub-category asset allocations:

Under the given set of assumptions Family Offices strategies such as equity long/short, global macro and with $50mn in overall assets and a 20% allocation to event driven strategies. Similarly at each increasing level alternatives would generate $10mn for investments in of total assets, the 20% constant alternatives percentage all types of alternatives. In this particular example it is produces larger levels of allocations to each type of assumed that such an allocation is split between hedge alternatives with the expectation that these individual funds and commodities. And it is assumed that the hedge allocations will be diversified across more than one fund allocations might be diversified across two or more strategy type and more than one manager.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 58 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

Given this set of assumptions how do these Family Office illustrative allocations to different alternatives categories match-up with alternatives managers who manage varied levels of assets in their chosen investment strategy type(s)? To take the next step in this analysis, review the following table which identifies alternatives managers by AUM size and lists the size of investments that represent different percentages of total assets in a given strategy (from .5% to 10% as indicated above).

Illustrative Example Sizing Family Office Alternative Investments

The left hand column of the exhibit above lists (in portion of the chart is shaded in green to highlight the descending order) the assumed size of an alternatives alternatives managers “sweet spot” as indicted in the manager fund/level of assets managed according to a Beachhead Capital study cited above. The author of this particular investment strategy. The right hand portion White Paper suggests that the green shaded area forms a of the exhibit (6 columns) lists the incremental size of Family Office “sweet spot” that coincides with the smaller a potential investor’s investments in a given manager’s manager outperformance “sweet spot” highlighted in the fund/account managed in a similar strategy. The lower Beachhead Capital Management study cited above.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 59 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

Note the following key points for Family Offices to keep For instance, consider the Yale endowment with $19.3 in mind regarding the size of funds/investment vehicles in billion in assets under management and allocations to which they consider making investments: all alternatives in excess of 60% (i.e., $11.6 bn allocated to alternatives), and an allocation to hedge funds alone • Manager AUM in a given “investment strategy” in the range of 18% ($3.4bn). For efficiency reasons, matters, not just AUM in a given commingled fund these larger plans typically make allocations to individual or separate account. It is very important for Family managers in the range of $50mn, to $100mn or more. Offices to know the holdings that may be held in And that would simply be too large for a manager of common across multiple commingled funds, share $500mn in total AUM in terms of concentration risk from classes and separate accounts. And, it is also very the manager’s perspective as well as from the investor’s important for Family Offices to get a complete picture perspective. of manager exposures across similar strategies that may involve some common holdings. In some cases, such as CalPERS, very large pension plans and other investors will have a specific allocation • The “arithmetic” highlighted above in the illustrative dedicated to seeding new/emerging alternatives example is dynamic on an ongoing basis as a fund/ managers with an equity stake and/or make allocations account grows/shrinks from performance or additional to new/emerging funds.64 But for the most part these very investments/redemptions; large alternatives allocators typically make investments of $50mn to $100mn or larger individual alternatives To take this analysis another step, one can ask, if the investments. alternatives manager sweet spot of outperformance is in the range of managers with $50mn to $500mn in AUM, As a result, in the case of many large and super large why wouldn’t “all investors” focus on this portion of the pension funds, as well as large endowment investors, alternatives management industry? One reason why the manager outperformance “sweet spot” is too small very large institutional investors would not pursue these for these larger investors to consider and “too young” to smaller managers has to do with the size of allocations to consider as well due to the fact that many large investors alternatives which very large public and corporate pension require a minimum 3 year track record before a manager/ plans and university endowments typically have to put to fund would be considered for addition to their portfolios. work in alternatives.

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 60 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

These points regarding being “too small” and/or “too “smaller [alternatives] funds show a higher dispersion in young” are both additional pluses for “right sized” returns [than larger alternatives funds] which suggests Family Offices in that they are not subject to as much that potential outperformance is higher with careful potential “crowding-out” from these attractive alternatives manager selection.”66 investments by larger institutional investors. And, such Family Office individual alternatives investments in the Figuring-out and picking the right small to mid-sized range of $1.5m to $20m, potentially can have a positive manager, of course, can be a tough assignment; but one impact on a chosen manager in terms of being able way to “enrich the fishing pond” is to build on the key to negotiate on fees and terms perhaps measurably factors highlighted earlier in this White Paper. These key more than a similar amount invested with a much larger factors include answering questions such as: which firms manager who often may seek much larger allocations show that they have learned lessons of the financial crisis, before considering any negotiations on fees and terms. and lessons from the various alternatives industry frauds and failures; and which firms have adopted “industrial Other investors such as Larch Lane Advisors and Protégé strength” investment and business infrastructure which Partners specialize in making firm manager equity and not only meet the criteria of the broader and deeper level seed fund investments in smaller/emerging alternatives of “alternative investment business management due managers for the precise reasons noted above regarding diligence”, as recommended; but also which of these the potential for outperformance by these managers.65 small to mid-sized managers have adopted alternatives industry “Best Practices” which are attuned to their Heightened Importance of Manager Selection particular investment strategy, to the size of the firm, the Of course, this research on the outperformance of small level of assets being managed, the geography of the to mid-sized hedge fund managers does not mean that investor and the geography of the investments being for Family Offices success with hedge fund investing is made? a matter of picking any small, new manager with relative small level of assets under management. As highlighted Establishing a pool of alternatives managers who meet above (See pages 10-11), the dispersion of returns all or most of these suggested factors and criteria can among managers in the alternatives space is significantly help Family Offices create an enriched fishing pond for wider than the dispersion among, for example, value long- manager selection by Family Offices and offer Family only equity managers and among growth equity long-only Offices increased of odds of making sound selections managers. The issue becomes (not surprisingly) picking of alternatives managers who can deliver the desired the right small to mid-sized manager. And as noted by portfolio diversification and higher risk adjusted returns Beachhead Capital, this dispersion of returns is not only which are so fervently sought. found between long-only and alternatives managers, but

64 Pension & Investments Online: 11-28-2011 65 See Larch Lane Advisors website: http://larchlane.com/philosophy-strategies/our-philosophy.html; and Protégé Partners website: http://www.protegepartners.com/www2/Login.aspx?page=About Us 66 Beachhead Capital Management, “Performance of Emerging Equity Long/Short Hedge Fund managers, 2003-2012”, February, 2013 PowerPoint Presentation, page 2 http://beachheadcapital.com/images/ResearchPapers/Beachhead%20Emerging%20Manager%20Study.pdf

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 61 IX. Family Office and Alternative Investment “Sweet Spot” (cont’d)

It should be noted that while these smaller managers Family Offices who pursue these smaller managers and younger funds have attractive outperformance return and younger funds can feel more confident about their potential, at the same time they can present challenges manager assessment effort if they also adopt the new and concerns for Family Offices in terms of not having range of due diligence as highlighted above in Section a 3 year investment track record, not having a robust V. “Broader & Deeper “Alternatives Investment Business investment and business infrastructure and perhaps not Management Due Diligence” which calls for not only having as highly experienced investment and business robust “Investment Due Diligence” and “Operational professionals as larger firms and funds. As a result, the Due Diligence’ but also recommends undertaking 3 attention needed to conduct thorough due diligence new categories of due diligence, namely fund, firm and assessments becomes, perhaps, even more critical than business process due diligence. See pages 38-44 above. for established firms and funds.

This White Paper has addressed the trend of Family alignment of interests between investors and managers; Offices to move away from the traditional “60-40” credit facility issues; downside performance protection; allocation of assets to equities and fixed income manager firm leadership, management and governance investments and to toward making initial or increased and lessons learned from the increased regulation of commitments to “alternative investments” such as hedge alternatives following the financial crisis. funds, private equity, real estate and commodities. The increase in such allocations to alternatives has Other lessons to be learned by Family Offices regarding been based on using portfolio diversification as a way alternatives investing are drawn from some of the to achieve higher risk adjusted expected returns. The underlying causes and “red alerts” involved with the importance of making such allocations to alternative Madoff Fraud and with other alternatives frauds and investments which, in fact, have low correlation, or ideally failures such as Long-Term Capital Management, negative correlation, to traditional equity and fixed income Bayou Hedge Fund Group, Amaranth Advisors, Petters investments has been emphasized. Group, MF Global and others. Finally regarding lessons learned, emphasis is provided on the positive lessons The types and characteristics of various alternative to be learned from the experience of some university investments have been profiled and an introductory endowments which have achieved attractive risk adjusted overview has been provided to the variety of underlying returns by way of making very significant allocations strategies that are typically pursued in these different (>50%) to alternatives. types of alternative investments. Significant attention has been drawn to the importance of manager and Next, this White Paper provided information on the fund selection since there is wide dispersion in the typical historical approach to alternatives due diligence performance of alternatives managers, much wider assessment programs under the headings of “Investment dispersion than is typical in traditional equity and fixed Due Diligence and “Operational Due Diligence”. Further income investments. the author advocates that Family Offices and other investors broaden their due diligence programs to include Lessons to be learned by Family Offices are then 3 specific additional stand-alone categories, namely: highlighted. These lessons to be learned come from alternatives fund and firm due diligence and alternatives the recent financial crisis and involve topics such as: “business process due diligence”. The author also liquidity/illiquidity; transparency; understanding the stressed the importance of treating Family Office due formal documents involved with alternatives investing; diligence assessment programs dynamically and in the portfolio diversification and low/no correlation; use of context of a commitment to “continuous improvement”. leverage; enhancement of risk management capabilities;

An additional source of significant technical assistance for investments in smaller managers and “younger” funds Family Offices undertaking alternatives investing can be due to their documented record of outperformance found in a variety of reports which address “Alternatives compared to their larger peers. And the author notes Industry Best Practices”. These “Best Practices” that Family Offices can become confident in undertaking documents (16 different best practices documents such investments in smaller alternatives managers are profiled in the report) have been developed by and younger funds if they pay careful attention to the US government sponsors, associations of investors recommended ways to expand the breadth and depth of and alternatives managers, a not-for- profit research their alternatives due diligence programs and pay similar organization, and an association of private equity limited careful attention to adopting the most relevant features of partners. As impressive as these documents are in alternatives industry best practices and incorporate such themselves, the real value for Family Offices will be to best practices into their operating models. focus on and adopt as well as adapt the most relevant “best practices” which make sense for each Family Office Final Note: depending on the nature of its investment objectives and The Author of this White Paper hopes that the topics the range of its long-only and alternatives investment addressed will be helpful to Family Offices as they review portfolio. their current alternatives investment program or as they begin planning to make their initial investments in And exactly what those best practices are for each alternatives. Family Office will be highly dependent on the operating model that each Family Office is utilizing -- ranging For further information or discussion of topics addressed from 100% internal operating model to various hybrid in the White Paper or other alternatives investment models including: Investment Committee + Investment business management topics, the author’s contact Consultant, Investment Committee, Internal Staff and information is provided below. Investment Consultant; Internal CIO, Outsourced CIO and varied mix and match alternatives of these operating Thank you for your time and interest. model variables. Similarly, the operating model for each Family Office will be a significant factor in determining how best to pursue the recommended broader and more Paul A. Ehrhardt robust “Alternatives Investment Business Management” Managing Member due diligence program framework. Investment Business Advisors, LLC Washington, DC Finally this White Paper explored the “sweet spot” that potentially exists for Family Offices by considering [email protected]

Chan, Norman ,Chief Executive of the Hong Kong Monetary Authority, “Excessive Leverage –root cause of financial crisis”, Hong Kong December 9, 2011; http://www.bis.org/review/r111215g.pdf

Considine, Geoff, Ph.D., “Lessons from Yale’s Endowment Model and the Financial Crisis”; Advisor Perspective, April 20, 2010; http://www.advisorperspectives.com/newsletters10/Lessons_from_Yales_Endowment_Model_and_the_Financial_ Crisis.php

Cooper, Lisette, CFA, Ph.D., “Which Investment Management Model Is Right For Your Endowment, Foundation or Family?” June 19, 2013

Corrigan, E. Gerald, Managing Director, Goldman Sachs, “Causes and Lessons Learned from The Financial Crisis”, The Trilateral Commission, April 25, 2009, Tokyo, Japan www.trilateral.org/.../annual_meeting/Corrigan_financial_crisis.pdf

“Giants at the Gate: On the Cross-Section of Private Equity Investment Returns”, EDHEC-Risk Institute, January 2011

Gregoriou, Greg N., Professor of Finance, SUNY, Plattsburgh and Lhabitant, Francois-Serge, Associate Professor of Finance at EDHEC Business School, Lille-Nice, France, “Madoff: A Riot of Red Flags”, January 2009

Ibbotson, Roger B. and Paul D. Kaplan, “Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance? The Financial Analysts Journal, January/February 2000

Laux, Christian and Leuz, Christian, “Did Fair Value Accounting Contribute to the Financial Crisis?”, National Bureau of Economic Research, published in Journal of Economic Perspectives, American Economic Association , 2010 http://www.nber.org/papers/w15515

Malinowski, Jason, Miller Smith, Nicholas, and Pirone, John, “Weighing the Alternatives: How Five Non-Traditional Investments Stack-up”, Blackrock, Investment Insights, Volume 15 Issue 1, June 2012 Performance Dispersion 2011, “Pension and Investments”: online: http://www.pionline.com/article/20120206/ CHART01/120209929/graphic-global-hedge-fund-performance-dispersion-for-2011

Sundt, Jon, President & CEO, Altegris, “Performance Dispersion, Implications for Manager Selection”, June 2013

“Understanding the Recent Rise in Correlations…,” Forbes March 3, 2011

Alternative Investment Management Association (AIMA) “AIMA’s Roadmap to Hedge Funds, 2012 Edition”, December 2012

AIMA Research Committee Paper: “Methodological, Mathematical and Factual Errors in the “The Hedge Fund Mirage”, August 2012

“AIMA/KPMG Report on The State of the Global Hedge Fund Industry, April 2012

“A Guide to Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures”, May 2011

“Guide to Sound Practices for Hedge Fund Administrators”, September 2009 Joint project: AIMA and Irish Funds Industry Association (ifia)

“Guide to Sound Practices for Hedge Fund Managers”, London, 2009 (Requires purchase)

“Guide To Sound Practices for European Hedge Fund Managers”, London, 2007

“Guide to Sound Practices for Hedge Fund Valuation”, London, 2007 http://www.aima.org/ www.aima.org/en/education/aima-guides.cfm http://www.aima.org/en/education/guides-for-institutional-investment.cfm

Anchin, Block and Anchin “2013 Outlook” Acquisition International Magazine’s International Hedge Fund Awards Selects Anchin as

“U.S. Overall Accountancy Firm of the Year” 2013 www.anchin.com

BarclayHedge.com Glossary: http://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-definition/hedge-fund-strategy- fund-of-funds.html

Beachhead Capital Management “Performance of Emerging Equity Long/Short Hedge Fund Managers, 2003-2012”, February, 2013 PowerPoint Presentation http://beachheadcapital.com/images/ResearchPapers/Beachhead%20Emerging%20Manager%20Study.pdf

Bloomberg News Hedge fund Advertising; July 10, 2013: http://www.bloomberg.com/news/2013-07-09/sec-set-to-lift-80-year-old-ban-on-advertising-by-hedge-funds.html

Blackrock Q&A: Alternatives Investment Performance http://www2.blackrock.com/us/individual-investors/products-performance/alternative-investments/private- equity?cmp=alternatives&chn=PPC_Mobile&c=bing&kw=private%20equity

Capco Global Business and Technology Consulting Firm: www.capco.com

Castle Hall Alternatives “Redefining Corporate Governance, Towards a new framework for hedge fund directors”, April 10, 2013 “Hedge Funds in Asia, A Guide to Operational Due Diligence”, March 31, 2013 “Six Principles of Operational Due Diligence”, October 2012 “From Manhattan to Madoff: the Causes and f Lessons of Hedge Fund Operational Failure”, August 19, 2009 “The New Standard of Operational Due Diligence, Five Principles to guide best practice”, April 22, 2009 www.castlehallalternatives.com

CFA Institute Global Investment Performance Standards: www.gipsstandards.org

Commonwealth Fund Annual Report 2009: “Rethinking the Management of Foundation Endowments”

Corgentum Consulting, LLC “Family Office Study: Taking Aim at Hedge Fund Operational Risk” Based on 2012 survey of operational due diligence analysts www.corgentum.com

“Due Diligence Checklist” http://corgentum.com/blog/corgentum-consulting/operational-due-diligence-checklists-investors-beware-4/

Deloitte “2013 Hedge Fund Outlook” “2013 Private Equity Outlook” “Hedge Fund Succession Planning, Passing the baton” “Alternative Investment Fund Managers Directive Survey” http://www.deloitte.com http://www.deloitte.com/view/en_US/us/Industries/Private-Equity-Hedge-Funds-Mutual-Funds-Financial-Services/4 df45f0018eab310VgnVCM1000003256f70aRCRD.htm

Deutsche Bank “Deutsche Bank survey highlights greater investor emphasis on Hedge Fund operational due diligence”, July 1, 2013 https://www.deutsche-bank.de/medien/en/content/4238_4450.htm

Eisner Amper “The Pulse of Private Equity, Private Equity Executives Survey”, Spring 2012 4th Annual Survey www.eisneramper.com

Ernst & Young “Finding common ground, Global hedge fund and investor survey 2012” “Coming of Age, Global hedge fund survey 2011” Contents includes: Succession planning, Governance, Administration, Fees and Expenses, Capital raising and due diligence, Future landscape “Risk Management for Asset management, 2011 Survey” www.ey.com

Financial Accounting Standards Board (FASB) Accounting Standards Codification; Master Glossary https://asc.fasb.org

Financial Times/Towers Watson “Global Alternatives Survey 2012”, July 2012 Hedge Funds Private Equity Websites: www.towerswatson.com www.ft.com

Greenwich Roundtable “Best Practices in Alternative Investing: Avoiding Mistakes”, 2012 “Best Practices in Alternative Investing: Managing Complexity”, 2011 “Best Practices in Alternative Investments: Due Diligence”, 2010 “Best Practices in Alternative Investing: Portfolio Construction”, 2009 “Best Practices in Hedge Fund Investing: Due Diligence for Fixed Income and Credit Strategies”, Spring 2007 “Best Practices in Hedge Fund Investing: Due Diligence for Global Macro and Managed Futures Strategies”, Winter 2006 “Best Practices in Hedge Fund Investing: Due Diligence for Equity Strategies”, Spring 2005 www.greenwichroundtable.org www.greenwichroundtable.org/best-practices

Hedge Funds Standards Board (HFSB) “The Hedge Fund Standards”, February, 2012 http://www.hfsb.org/ http://www.hfsb.org/?section=11502

Hedge Funds Standards Board (HFSB) “Fair Value Best Practices and Implementation” “Best Practices for the Hedge Fund Industry” 2009 “Best Practices for the Hedge Fund Industry,” 2008 www.houlihan.com

Institutional Limited Partners Association (ILPA) “Updated Private Equity Principles” Principles and Standardized Industry Reporting Template Alignment of Interests Governance Transparency

“First Standardized Reporting Template”, January 2011 “Standardized Private Equity Due Diligence Questionnaire”, April 2013 http://ilpa.org http://ilpa.org/ilpa-private-equity-principles/

KPMG “The evolution of an industry: 2012 KPMG/AIMA Global Hedge Fund Survey Based on survey between October 2011 and February 2012 “Alternative Investments Practice”, June 2012 “Top 12 Actions to Achieve Better Risk Management” www.kpmg.com

Larch Lane Advisors: Alternatives Fund/Manager Seeding http://larchlane.com/philosophy-strategies/our-philosophy.html

Managed Funds Association (MFA) Hedge Fund Glossary: www.managedfunds.org/industry-resources/hedg-fundglossary/ “Sound Practices for Hedge Fund Managers”, 2009 Edition; https://www.managedfunds.org/hedge-fund-investors/sound-practices-for-hedge-fund-managers/

Managed Fund Association (MFA) “Model Due Diligence Questionnaire”, June 2011; www.managedfunds.org/.../2011/06/Due-Dilligence-Questionnaire.pdf

McKinsey & Company: Financial Services Practice “The Mainstreaming of Alternative Investments, Fueling the Next Wave of Growth in Asset management”, September 2012 http://www.mckinsey.com/insights/financial_services/how_alternative_investments_are_going_mainstream

Multilateral Investment fund, IDB Group “The Evolving Relationship Between LP & GPs”, September 5, 2012 “A Study Prepared for the Multilateral Investment Fund’s Fund Manager Meeting” www5.iadb.org/.../Publications/MIF2012_Evolving_Relationship_LP_GP.pdf · PDF file

National Association of College and University Business Officers (NACUBO) & Commonfund Institute Study, February 2013 http://www.nacubo.org/Research/NACUBO-Commonfund_Study_of_Endowments.html

National Futures Association (NFA) Glossary: http://www.usafutures.com/commodityglossary.htm

OptCapital Investor/Manager Alignment http://www.optcapital.com/WhatWeDo/InvestmentFunds/MisalignmentProblem.aspx http://optcapital.com

PerTrac “Impact of Size and Age on Hedge Fund Performance: 1996 -2011”, 6th Annual Update, October 2012

“Sizing the 2011 Hedge Fund Universe” April 2012 9th Annual Update www.pertrac.com

PIMCO “It’s Time for Alternatives To Do Some Heavy Lifting”, March 2013 http://www.pimco.com/EN/Insights/Pages/Its-Time-for-Alternatives-To-Do-Some-Heavy-Lifting.aspx

President’s Working Group “Principles and Best Practices for Hedge Fund Investors”, April 15, 2008 www.amaicmte.org/Public/Investors%20Report%20-%20Final.pdf

“Best Practices for the Hedge Fund Industry”, January 15, 2009 www.amaicmte.org/Public/AMC%20Report%20-%20Final.pdf

Preqin Glossary: https://www.preqin.com/itemGlossary.aspx?pnl=QtoT

“2012 Preqin Global Investor Report: Hedge Funds” www.preqin.com

Protégé Partners Alternatives Manager Seeding http://www.protegepartners.com/www2/Login.aspx?page=About Us

Rothstein Kass “Hedge Fund Managers Mixed on 2013 Outlook Despite Strong Performance Predictions” 7th Annual Survey April 2013 “Hedge Funds 2.0: Evolution in Action” 6th Annual Survey, April 2012 Rothstein Kass Study on Single-Family Office Allocations To Alternatives, June 2011 www.rkco.com

Russell Investments “Assessing investment managers’ business, operational and compliance risks”, August 2010 “Evolving due diligence to focus on non-investment risks” www.russell.com

SEI “Knowledge Center” “The Retail Alternatives Phenomenon” June 2013; http://www.seic.com/enUS/about/11943.htm “6 Ways Hedge Funds Need to Adapt Now” 6th annual survey conducted in November 2012; results published March 2013 www.seic.com

Sound Fund Advisors (SFA) “Fund Governance Redux: 2012 Industry Data, Hot Topics & Recommended Best Practices”, February 19, 2013 “Fund Governance at a Crossroads: Current Industry Data and Recommended Best Practices”, February 14, 2012 www.soundadvisors.com

US Government Agency Publications U.S. Government Accountability Office Study, FINANCIAL MARKETS REGULATION “Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and across System”: July 2009 http://www.gao.gov/products/A86877

“FBI and Hedge Fund White Collar Crime”: www.fbi.gov/about-us/investigate/white_collar/hedge-fund-fraud

Berrospide, Jose M., Federal Reserve Board, Meisenzahl, Ralf R., Federal Reserve Board, Sullivan, Briana D., University of Florida, Gainesville, “Credit Line Use and Availability in the Financial Crisis: The Importance of Hedging” April 17, 2012, www.federalreserve.gov/pubs/feds/2012/201227

Karpati, Bruce, “Enforcement Priorities in the Alternative Space”; presented to the Regulatory Compliance Association in New York, December 18, 2012; http://www.sec.gov/news/speech/2012/spch121812bk.htm

Richards, Lori A., Director, Office of Compliance Inspections and Examinations, (OCIE), US Securities and Exchange Commission, “Strengthening Examination Oversight: Changes to Regulatory Examinations”, June 17, 2009

SEC Definitions: “Accredited Investor” http://www.sec.gov/answers/accred.htm;

“Qualified Purchaser” www.sec.gov/about /laws/ica40.pdf

Model Due Diligence Questionnaires • Managed Fund Association (MFA): For Hedge Funds, 2009 www.managedfunds.org

• Institutional Limited Partners Association: For Private Equity Funds, April 2013 http://ilpa.org/ilpa-private-equity-principles/

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 74 Appendix C: Table of Contents of Alternatives Industry “Best Practices” Documents

Presidents Working Group on Financial Markets (PWG) Washington, DC • Principles and Best Practices for Hedge Fund Investors”, April 15, 2008 www.amaicmte.org/Public/Investors%20Report%20-%20Final.pdf

• “Best Practices for the Hedge Fund Industry”, January 15, 2009 www.amaicmte.org/Public/AMC%20Report%20-%20Final.pdf

Managed Fund Association (MFA), Washington, DC • “Sound Practices for Hedge Fund Managers”, 5th edition, March, 2009 www.managedfunds.org/wp-content/uploads/2011/06/Final_2009_complete.pdf

Alternative Investment Management Association (AIMA), London • “Guide To Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Structures” • “Guide To Sound Practices for Europeans Hedge Fund Managers” • “AIMA’s Guide To Sound practices for hedge Fund Valuation” www.aima.org/en/education/aima-guides.cfm

Greenwich Roundtable, Greenwich, CT • “Best Practices in Alternative Investing: Avoiding Mistakes”, 2012 • “Best Practices in Alternative Investing: Managing Complexity”, 2011 • “Best Practices in Alternative Investments: Due Diligence”, 2010 • “Best Practices in Alternative Investing: Portfolio Construction”, 2009 • “Best Practices in Hedge Fund Investing: Due Diligence for Fixed Income and Credit Strategies”, Spring 2007 • “Best Practices in Hedge Fund Investing: Due Diligence for Global Macro and Managed Futures Strategies”, Winter 2006 • “Best Practices in Hedge Fund Investing: Due Diligence for Equity Strategies”, Spring 2005 www.greenwichroundtable.org/best-practices

© 2013 Family Office Association and Angelo J. Robles Family Office Association / Whitepaper Family Offices and Alternative Investments 75 Appendix C: Table of Contents of Alternatives Industry “Best Practices” Documents (cont’d)

Institutional Limited Partners Association (ILPA), Toronto, ON, Canada • “Updated Private Equity :Principles”, Updated January 2011 • “First Standardized Reporting Template”, January 2011 http://ilpa.org/ilpa-private-equity-principles/

Hedge Funds Standards Board (HFSB), London • “The Hedge Fund Standards”, February, 2012 http://www.hfsb.org/?section=11502

Paul A. Ehrhardt

Paul A. Ehrhardt is an executive with 40+ years of experience; public sector (5 years), non-profit (3 years) and financial services experience (36 years). 28+ years of Paul’s experience have been in leadership and management positions in global asset management firms. Most recently Paul served as Managing Director & Chief Operating Officer of Arden Asset Management (fund of hedge funds) and he has experience in the long-only equity and fixed income businesses as well as with a range of “alternative investments” including hedge funds, private equity, real estate and commodities firms. His global asset management experience as Managing Director and Chief Operating Officer includes responsibilities for leadership and management support and regulatory compliance of investment teams located in: London, Tokyo, Hong Kong, Singapore, Melbourne, Sao Paulo, New York and multiple other cities/states in the USA.

In addition to his role at Arden, Paul’s experience also was gained at: Legg Mason International Equities (London & New York), Citigroup Asset Management (London), American Century Investment Management (Kansas City, MO), Aeltus Investment Management, and CIGNA Investment Management (Hartford, CT). Currently Paul is Managing Member of Investment Business Advisors, LLC, registered in Washington, DC and New York.

Paul A. Ehrhardt Managing Member Investment Business Advisors, LLC Washington, DC

[email protected]

Important Note: This document is for informational purposes only and is not and should not be construed as an offer to sell or a solicitation of an offer to buy any interest in any entity or investment vehicle. Any offer to sell or solicitation of an offer to buy can only be made pursuant to a confidential private offering memorandum of the applicable investment vehicle “Memorandum”). The information in this document is qualified in its entirety and limited by reference to any such Memorandum, and in the event of any inconsistency between this document and such Memorandum, the Memorandum shall control.

The Family Office Association (FOA) is an affinity group dedicated primarily to the interests of Single Family Offices. FOA is intended to provide members with educational information and a forum in which to exchange information of mutual interest. FOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, FOA does not provide tax, legal or financial advice.

Materials distributed by FOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation or recommendation by FOA. Any investment decisions you may make on the basis of any information provided by FOA is your sole responsibility.

The FOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of Family Office Association. All other product and service marks on materials provided by FOA are the trademarks of their respective owners. All of the intellectual property rights of FOA or its contributors remain the property of FOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the FOA web site.

The information presented by FOA has been obtained by FOA from sources it believes are reliable. However, FOA does not guarantee the accuracy or completeness of any such information. All of such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.

Angelo J. Robles of Family Office Association 203-570-2898 . [email protected]

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