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Explain the means of appraising both the fraud risk and the business model risk of a hedge fund.

FRM® Part II · Risk Management and Investment Management · Performing Due Diligence on Specific Managers and Funds · FRM2.IM.12.f

The idea

Fraud risk and business model risk are assessed differently. Fraud cannot be spotted from performance statistics alone, so the investor looks for warning signs. These include smooth returns that do not fit the strategy, an unknown or tiny auditor, no independent administrator or custodian, one person controlling trading, valuation and cash, reluctance to allow verification, and undisclosed past legal or regulatory problems. Background checks and independent third-party confirmation are the main tools. Business model risk asks whether the manager's firm is viable, and management fees should cover operating costs. The level of assets that does so follows from one ratio, Breakeven = annual costs ÷ management fee rate. Other concerns are dependence on performance fees, investor concentration, redemption exposure and key-person dependence. Economic stress pushes managers to take extra risk or cut spending on controls. The exam point is that small, thinly funded firms are not safer.

Formulas

Breakeven assets under management for a hedge fund manager

Breakeven AUM = annual costs ÷ management fee rate

annual costs
the management company's yearly operating costs
management fee rate
the management fee as a fraction of assets

Ignores performance fees. Below breakeven the firm depends on performance fees or outside capital, which can push it to take extra risk or cut spending on controls.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which combination is most characteristic of a fraud warning sign in due diligence?

  1. Returns that are volatile and correlated with the market, with open access to the administratorWhy not: Volatile returns with open verification are signs of an ordinary directional strategy.
  2. Smooth returns that do not fit the strategy, plus reluctance to allow verification - correct
  3. A large audit firm and an independent administrator with full position reportingWhy not: These are controls that reduce fraud risk.
  4. A manager who invests personal capital and publishes a detailed monthly letterWhy not: These suggest alignment and transparency, the opposite of a warning sign.

Returns that are implausibly steady for the strategy, with resistance to verification, are classic fraud indicators. Statistical analysis alone cannot prove fraud, but these call for caution.

A harder one

A manager's firm has annual operating costs of USD 2.4 million and charges a 1.5% management fee. Ignoring performance fees, what level of assets under management is needed to break even?

  1. USD 120 millionWhy not: Divides costs by 2%, a typical headline fee rather than this fund's 1.5%.
  2. USD 1.65 millionWhy not: Multiplies the fee by an assumed AUM of 110 million instead of solving for AUM.
  3. USD 50 millionWhy not: Subtracts an assumed AUM from the breakeven figure and so reports a shortfall rather than the breakeven level.
  4. USD 160 million - correct

Breakeven AUM = costs / management fee rate = 2.4 / 0.015 = USD 160 million. Below that level, the firm depends on performance fees or outside capital.

The hardest tier

A manager's firm has annual costs of USD 2.0 million, assets of USD 90 million, a 1.5% management fee and a 20% performance fee on gains with no hurdle. Treating management fees as fixed, what gain on assets is needed for performance fees to cover the cost shortfall?

  1. About 0.72%Why not: Divides the shortfall by assets without grossing it up for the 20% performance fee share.
  2. About 3.61% - correct
  3. About 11.11%Why not: Ignores management fee revenue and requires performance fees to cover all the costs.
  4. About 2.22%Why not: Uses the cost ratio of costs to assets as the required gain, ignoring both the management fee and the 20% share.

Management fee = 90 x 1.5% = 1.35. Shortfall = 2.0 - 1.35 = 0.65. Gain needed = 0.65 / 0.20 = 3.25, which is 3.25 / 90 = 3.61% of assets.

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