WIXLIB

What is Operational Due DiligenceIdentifying and assessing non-investment risks for asset managersAon Retirement & InvestmentInvestment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. an Aon CompanyNothing in this document should be construed as legal or investment advice. Please consult with your independent professional for any such advice. To protectthe confidential and proprietary information included in this material, it may not be disclosed or provided to any third parties without the approval of Aon Hewitt.

Four Key Areas of Non-Investment RiskBlow-UpFraud Purposeful misappropriation Collusion Employee theftReputational Headline risk Costs or losses associated with business deterioration Counterparty riskAsset – Liability mis-matchInappropriate or poor understanding of leveragePotential for style driftAlpha Degeneration Lower level risks that contribute to slippage Trade errors Sub-optimal implementation of core or ancillaryprocesses“50% of all hedge fund failures are related to operationalfailures.”Aon Retirement & InvestmentProprietary & Confidential May 20172

How Operations and Operational DueDiligence are evolvingAon Retirement & InvestmentProprietary & Confidential May 20173

Evolution of Operations and Operational Due Diligence2005Half of all hedge fundfailures are related tooperational failuresAon Retirement & InvestmentProprietary & Confidential May 20172017Are half of all hedgefund failures are relatedto operational failuresany longer?4

Evolution of Operations and Operational Due Diligence20052017Pre – MadoffPost - MadoffCurrent EnvironmentOperations Limited regulation Nascent technology Internal administrationOperations Increasing regulation Developing technology External administrationOperations Material increase in regulation Straight through processing External administrationODD Best practice:Comprehensive ODD Focus on hedge fundsODD Market practice:Comprehensive ODD onhedge funds Best practice: Attentionto other asset classesODD Best practice: ComprehensiveODD on all asset classesAon Retirement & InvestmentProprietary & Confidential May 20175

What is Operational Due DiligenceAon Retirement & InvestmentProprietary & Confidential May 20176

Audience Question:What are the biggest noninvestment risks faced by assetmanagers today?“50% of all hedge fund failures are related to operational failures.”Aon Retirement & InvestmentProprietary & Confidential May 20177

What is Operational Due Diligence?Topics we coverCorporate andOrganizationalStructureMiddle/BackOffice andValuationTrade andTransactionExecutionAon Retirement & InvestmentProprietary & Confidential May 2017ComplianceandAudit/TestingInvestment andCounterpartyRisk OversightKey ServiceProvidersTechnology andBusinessContinuityFund StructureandAdministration8

What is Operational Due Diligence?Topics we cover: Key AreasCorporate andOrganizationalStructureAon Retirement & InvestmentProprietary & Confidential May 2017 Corporate Structure – control, decision making, andoversight Organizational Structure – segregation of duties andstaffing adequacy/competency Key person exposure and succession planning Employee Retention and Turnover Background checks9

What is Operational Due Diligence?Topics we cover: Getting in the Weeds1.2.3.4.5.6.7.8.9.10.Corporate 19.20.21.22.23.24.25.26.27.28.29.30.Aon Retirement & InvestmentProprietary & Confidential May 2017Compliance can trade and actively doesComplete absence of background checking (in most scenarios)Historical/pending regulatory or litigation issues that are materialSenior non-investment functional heads that are clearly not skilled, experienced, or empoweredGoing concern risks sufficient to cause involuntary liquidation (profitability, contingent liabilities, litigation, regulation issues)Under resourced control or support functions; inadequate compliance or finance functions as exhibited by minimal staffGut or similar cues whether onsite (empty desks, noticeable disarray, nervousness, etc.) or desk-side/pre onsite (lack oftransparency)Significant turnover among firm Board of Directors members (if applicable)Absentee controlling shareholder with limited expertise, conflicting business activities, etc.Manager / fund(s) set up in a jurisdiction that is not highly regulated or unusual location without reasonable businesssupport (eg, UK manager running a fund in Brazil)Segregation of duties issues that are less severe (CFO is CCO, trading is segregated by employee but reports throughoperations, CCO reports to COO rather than CEO, CEO has investment responsibilities)Individual has multiple roles that challenge ability to conduct each/all of them effectively (COO is also CCO and head ofHR) or with appropriate level of skill/competence.Lack of appropriate representation on the committees (cross functional for example)Lack of committee meeting consistencyMaterial firm level/firm-wide initiatives (changes in ownership, senior leadership changes, re-locations, systems, etc.)Other org chart deviations or inhibitive reporting lines or backgrounds (say, IT reports through investment team or head ofops/risk is a former investment professional)Limitations in background checking (not all personnel, no recurring checks, etc.)Concentrated decision making (lack of committee structure; majority owner/controller of firm)Limitations in firm external oversight or governance (lack of independent oversight, particularly in a firm that is not private)Overly complex legal structure- jurisdictional mismatchKey Person risk, particularly when combined with lack of succession planning (functional or control)Limited employee turnover (less senior level)Client concentrationOther Employee turnover issues or lack of tracking/spikes in turnoverInappropriate levels/lack of insurance (currently Yes/No)Rapid growth or decline in assets, product extensions, etc., (even if well supported) but especially if not well supported.Inconsistent employee compensation or review processTrading occurs in offices or at times when operations/compliance/risk management personnel or guidelines are notpresent/availableRecent inception date; no operating historyIsolation of staff / multiple locations (i.e. compliance and ops team in a diff building to the IM team)10

Audience Question:How do we determine what is“riskier”?“50% of all hedge fund failures are related to operational failures.”Aon Retirement & InvestmentProprietary & Confidential May 201711

What is Operational Due Diligence Not?AuditAon Retirement & InvestmentProprietary & Confidential May 2017LegalReviewInvestmentDiligence12

The 3 “A’s” of operational risk gapsAptitudeAon Retirement & InvestmentProprietary & Confidential May 2017AttitudeAffordability13

Things we’ve heard in ODD reviews“Cyber security is not abig threat for us”Aptitude“Our data has notbacked up in months”Aon Retirement & InvestmentProprietary & Confidential May 2017“We’re not anenterprise”Attitude“Don’t want toslow down ourdecision-making”“We don’t like tomeddle”Affordability“We’re too small”14

Aon Hewitt’s Operational Due Diligence ProgramAon Retirement & InvestmentProprietary & Confidential May 201715

Overview of Aon Hewitt’s Operational Due Diligence TeamOur Operational DueDiligence (ODD) processis a multi-faceted review of Written responses to DDQs Supporting documentation Interviews Service providersTeam of specialistsresponsible for ODD Team of 10 Experienced, senior professionals Supported by data gathering andprocessing team Process demonstrationsGlobal OperationalDue Diligence Team Capabilities All new managers and/orproducts reviewed Authority to veto based onoperational risk concernsAon Retirement & InvestmentProprietary & Confidential May 201716

Examples of Failing ODD GradesFailing Rating: Material operational concerns that introduce the potential foreconomic or reputational exposure; we recommend that investors do not investand/or divest current holdings.Aon Retirement & InvestmentProprietary & Confidential May 201717

Fixed Income Manager – Fail RatingManager profile Small, 20-person firm runningseveral billion in traditionalequity and fixed incomestrategies Majority owned by employees;Private equity firm maintains aminority stake Low trade volumeRisks IdentifiedOrganizational Structure Chief Operating Officer (‘COO’) also PMTrading and operations report to the COOCOO married to another PMCFO also reports to the COOManual Processes Traders utilize physical (paper) trade ticketsHandwritten allocationsTrade information entered by operations personnelPortfolio manager codes mandate restrictionsTechnology Infrastructure 4 – 6 week recovery of electronic trading capabilitiesAon Retirement & InvestmentProprietary & Confidential May 201718

Hedge Fund Manager – Fail RatingManager profile Small, 20-person firm runningseveral hundred million intraditional equity and longshort equity strategies Recent regional expansion toAsian market Privately ownedRisks IdentifiedOrganizational Structure Back up trader does settlement and investor reporting Traders report through operations PM for Asian office is also the local compliance officerTechnology and Cyber Security “Pre-trade” compliance is implemented post execution.No password changes or complexity requirementsRemote access without secondary authenticationNo penetration test of network.Fund Governance and Administration No independent governance No external review of cash movementsAon Retirement & InvestmentProprietary & Confidential May 201719

Examples of Conditional Pass ODD GradesConditional Pass Rating: Specific operational concerns that the firm hasagreed to address in a reasonable timeframe; upon resolution, AH will review thefirm’s rating.Aon Retirement & InvestmentProprietary & Confidential May 201720

Real Estate Manager – Conditional Pass RatingManager profile Small, 20-person firm runningseveral hundred million privatereal estate, managed inclosed-end funds with multiyear lock-ups Privately owned, equally byemployees and a largeexternal corporate parentcompanyStrengths Appropriately leverages corporate parent, includinggovernance structures and internal audit Highly diversified decision making structure Outsources fund administrationRisks Identified No use of LPAC for funds All commingled investment funds should have somelevel of independent oversightAon Retirement & InvestmentProprietary & Confidential May 201721

Fixed Income Strategy – Conditional Pass RatingManager profile Large, multi-nationalinvestment firm of nearly 3000employees. Managing several hundredbillion, primarily in traditionalstrategies Publicly traded company Low trade volume strategyAon Retirement & InvestmentProprietary & Confidential May 2017Strengths Large, global financial services firm with operations andcontrols infrastructure that generally supports a firm ofits profile.Risks Identified Specialty strategy not subject to the same levels ofcontrol and oversight (as well as operational expertise)of firm’s core business:— Operations analyst is also an authorized trader— Ability to trade with new dealers and to authorizenew trading relationships without review by others.— Manual monitoring of guideline compliance22

Some current challengesODD as AuditSupportLagging AssetClasses ODD hasgotten broaderin scope, buthas it gottenbetter? Private marketsstandards lag— Internaladministration— Limitedregulation— Seller’s marketmentality Resourcecommitmentsto core versusnon-core risksAon Retirement & InvestmentProprietary & Confidential May 2017Relative RiskAssessment What is riskier?— Example: Internaladministration vs.password changes Risk tolerancedifferences— Client or assetclass23