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FRM Part II · FRM Exam Part II · Performing Due Diligence on Specific Managers and Funds

An allocator is performing operational due diligence on a hedge fund manager. Which finding about the fund's service providers would be the strongest red flag requiring escalation?

A tiny, unknown auditor for a very large fund is the strongest red flag because the audit's credibility is doubtful given the fund's size and complexity. An independent administrator, major prime broker and local counsel are standard, acceptable arrangements.

  1. AThe administrator is an independent firm that strikes the NAV and reconciles it to the manager's records
  2. BThe fund's auditor is a small, unknown firm with no other hedge fund clients, while the fund holds billions in assetsCorrect
  3. CThe prime broker is a large global bank that also provides custody
  4. DThe legal counsel is based in the same jurisdiction as the fund's domicile

Explanation

An auditor that is small, unknown and inexperienced relative to the fund's size raises doubts about the reliability of audited financials, as seen in the Madoff case. Independent administration, a reputable prime broker and local counsel are normal or positive features.

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