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

During operational due diligence on a hedge fund with USD 800 million in assets, an analyst finds that the fund's administrator is a small firm with no other clients, the auditor is an unknown firm that audits only this manager's funds, and the manager's principal also sits on the administrator's board. Which conclusion is most appropriate?

The service providers lack independence and appropriate scale for an USD 800 million fund, with a manager principal sitting on the administrator's board. This weakens independent checks on valuation and reporting and signals serious operational and fraud risk, so having providers in name is not enough.

  1. AThe structure is acceptable because the fund has an administrator and an auditor in place
  2. BThe main concern is that the auditor's fees are likely too low, which affects only costs
  3. CThe service providers appear insufficiently independent and lack capacity relative to fund size, which raises serious operational risk and fraud concernsCorrect
  4. DThe structure is positive because a single related group ensures better information flow

Explanation

Independent, reputable and appropriately scaled service providers are a key control against fraud and misreporting. A related-party administrator and a tiny auditor for a USD 800 million fund mean checks are weak, a pattern seen in cases such as Madoff. Merely having providers named does not satisfy the control objective.

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