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Moodys Global
Managed Investments
Rating Methodology
June 2009
Table of Contents:
Methodology Update
1
Overview
1
Moodys OQ Rating Definition and Scale
2
Moodys universe of OQ rated hedge funds 3
Operational risk in hedge funds
3
Moodys rating screening criteria
5
Framework for assigning OQ ratings
6
Operational Quality Rating Process
20
Moodys Related Research
22
Website Access
22
Analyst Contacts:
London
44.20.7772.5454
Odi Lahav
Vice President
Joanne Job
Analyst
New York
1.212.553.1653
The rating factors have been grouped into five key rating categories and
a rating scorecard has been introduced to communicate the relationship
of those assessments to the rating more clearly.
Daniel Serrao
Senior Vice President
Courtenay Sturdivant
Assistant Vice President - Analyst
Michael T. Ryan
Analyst
Joshua Gorelik
Senior Associate
Paris
33.1.5330.1020
Yaron Ernst
Team Managing Director
Business Development:
London
44.20.7772.5454
Andreas Naumann
Senior Vice President - Business Development
New York
1.212.553.1653
Bryan Johnson
Vice President - Business Development
Overview
The hedge fund industry landscape has changed dramatically in the past few
years, first with the rapid growth in the number of hedge funds and assets under
management. This was followed by the stresses caused by the economic
downturn which started in 2007 and were exacerbated in the latter part of 2008.
The extreme market dislocation of 2008 was characterised by the failure of
Lehman Brothers, the US governments intervention into AIG, Fannie Mae and
Freddie Mac, and the severe turmoil faced by other major financial institutions
resulting in an acute liquidity shortage.
Rating Methodology
Scale
The hedge fund OQ rating has five broad categories, with OQ1 as the highest and OQ5 as the lowest, as
depicted in the table below. A + modifier indicates that the fund ranks in the higher end of the designated
rating category, while a - modifier indicates the fund ranks in the lower end of the designated rating category.
Table 1
Definition
OQ1
OQ1-
Excellent
Funds rated OQ1 are judged to have excellent operational quality within their stated objectives and
investment strategy
OQ2+
OQ2
OQ2-
Very Good
Funds rated OQ2 are judged to have very good operational quality within their stated objectives and
investment strategy
OQ3+
OQ3
OQ3-
Good
Funds rated OQ3 are judged to have good operational quality within their stated objectives and
investment strategy
OQ4+
OQ4
OQ4-
Fair
Funds rated OQ4 are judged to have fair operational quality within their stated objectives and
investment strategy
OQ5+
OQ5
Poor
Funds rated OQ5 are judged to have poor operational quality within their stated objectives and
investment strategy
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This
definition includes legal risk, but excludes strategic and reputational risk. Basel Committee on Banking Supervision, (June 2004), International Convergence
of Capital Measurement and Capital Standards, section 644 on Operational Risk.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
Rating Methodology
Table 2
Est'd AUM
(US$)**
LTCM
1998
4.7 billion
Liquidity, concentration
Tiger Funds
2000
22 billion
Investment performance
Manhattan Fund
2000
575 million
Alleged Fraud
2002
365 million
Alleged Fraud
2002
300 million
Alleged Fraud
Lancer Group
2003
1.1 billion
Alleged Fraud
2005
450 million
Alleged Fraud
2005
1.3 billion
Investment performance
Marin Capital
2005
2 billion
Concentration, leverage
Aman Capital
2005
340 million
Investment performance
Amaranth Advisors
2006
9 billion
Concentration, liquidity
Archeus Capital
2006
3 billion
Operational error
2007
3 billion
2007
1.6 billion
Principles and Best Practices for Hedge Fund Investors, Report of the Investors Committee to the Presidents Working Group on Financial Markets,
January 15, 2009.
At the time of writing this report, the regulatory framework for hedge funds across a number of jurisdictions looked likely to change in future with an emphasis
on additional disclosure requirements.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Year of Failure
or Wind-up
Est'd AUM
(US$)**
2007
1.2 billion
Concentration
Drake Management
2008
5 billion
Investment performance
Peloton Funds
2008
2 billion
2008
670 million
2008/9
6.9 billion
Alleged Fraud***
2008/9
2.7 billion
Alleged Fraud***
Weavering Capital
2009
640 million
Alleged Fraud
Best Practices for the Hedge Fund Industry, Report of the Asset Managers Committee to the Presidents Working Group on Financial Markets, January 15,
2009.
Principles and Best Practices for Hedge Fund Investors, Report of the Investors Committee to the Presidents Working Group on Financial Markets,
January 15, 2009.
The PWG was established by Executive Order in 1988. The PWG was given the mandate to enhance the integrity, efficiency, orderliness and
competitiveness of US financial markets and to maintain investor confidence. In February 2007, the PWG released a set of principles to guide financial
regulators as they addressed the growth of hedge funds.
The Hedge Fund Working Group, Hedge Fund Standards, January 2008.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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1. Key Staff
An important driver of the quality of any organisation is the quality of its people. As an initial step in the
assessment of operational quality, Moodys obtains information about the background and experience of the
funds key staff and principals. While naturally limited in scope, we believe that this information may serve to
highlight any issues about the professional or educational track record of key personnel that could be relevant
to our assessment of operational quality.
2. Auditors
The examination of a hedge funds financial statements by independent auditors represents an important
source of comfort for investors and provides some information about the control environment as evaluating
internal controls is part of the audit process. Beyond considering the existence and contents of such audited
financial statements, and any associated internal control reports, Moodys also considers whether the profile of
the auditing firm suggests capabilities commensurate with the size and complexity of the fund.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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A. Rating Scorecard
As part of the rating assignment process, analysts complete a rating scorecard (see Table 3 below) which
summarises component assessments leading to the OQ rating. While some aspects of operational risk
assessment may be difficult to quantify, for qualitative ratings, it is nevertheless useful to have a numerical
guide to promote consistency between ratings. It is important to note that the scorecard is only a tool to help
Moodys analysts and rating committees in arriving at a rating decision. Other qualitative and quantitative
factors will likely be considered by the rating committee to determine the final rating outcome.
The rating scorecard contains a large number of underlying assessments, including some must have
features, which encompass the mechanics of a funds operational and control environment. The questions are
compiled into sub-categories and (major) categories and are then aggregated, using a weighted average, into
a single score which then maps to an indicated rating. Analysts then make rating recommendations based on
the results of the scorecard and other qualitative considerations. Rating decisions are then made by a Rating
Committee (see page 21 for more details).
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Default
weights
Operations
25%
Computed
Score
x
Adjusted
Score
x
Outline of Subcategories
1) Trading Infrastructure (Systems, people, process and documentation)
2) Trade Flow (Execution to settlement )
3) Wire Transfers (controls around cash/wire transfers)
4) Investor Relations
Valuations
25%
Corporate
Functions
20%
1) Governance
1) Asset Liquidity
2) Cash Management
3) Funding
4) Collateral Management
5) Communication to Investors
6) Redemption Terms
Service
Providers
10%
Other Considerations
- Overall Governance
Adjustment
- Weighting Consideration
Adjustment
Adjustment
Pass/Fail
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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4. Other Considerations
Other considerations, beyond the key rating elements, which are not well suited for an analysis of tangible
characteristics, include corporate governance (detailed below) and management quality (for instance,
experience and track record of management). While these factors are not explicitly rated as part of the
scorecard, they are overarching considerations and may have a bearing upon the rating outcome.
In the US, funds aimed at US investors are generally set up onshore, that is, in the form of limited
partnerships or limited liability companies, primarily for tax purposes. The manager typically acts as the
general partner and there is no separate board of directors of the fund.
For non-US investors and US tax-exempt investors, funds are generally domiciled offshore, typically in
low (or zero) tax jurisdictions. These funds are usually required to have a board of directors, which is
ultimately responsible for the fund.
Nevertheless, our view is that even if the fund has a board of directors, the way in which boards are typically
appointed for hedge funds, as well as the fact that investment decisions are effectively made by the Fund
Manager and, in some cases, the nature of the rules governing the activities of the board in offshore
jurisdictions, means that fund boards can be a less effective means of oversight than those of public
companies in major jurisdictions 8 . As such, our view is that governance and oversight are primarily the
responsibility of the fund Manager and its senior management. Thus, the focus of our review in this area will
be on the oversight structure and internal controls for investor protection, transparency and general use of
best practices at the Fund Manager level.
while independent board oversight may provide some benefit to investors, the level of investor protection provided by hedge funds boards of directors often
falls short of the protections provided by similar governing bodies, such as U.S. public company boards of directors, Principles and Best Practices for
Hedge Fund Investors, Report of the Investors Committee to the Presidents Working Group on Financial Markets, January 15, 2009.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Delegation
Advice
The Investment Manager
Management
Investment
Management
Trading
The Fund
(Master Fund)
Fund Governing
Body/Board of
Directors
Markets
US Feeder Fund
(Limited Partnership)
US Investors
Administrators
Middle and back office, transfer agency, investor reporting
Auditors
Audit services for the Fund's annual accounts
The nature and complexity of the oversight structure will also depend on the size and complexity of the fund.
For instance, it may be appropriate for smaller hedge funds to have a more informal set of governance
arrangements while in larger funds greater importance is placed on strengthening the fund governing body and
emphasising the independence between the latter and the Manager 9 .
At the senior management level (of the Manager) there can be different structures in place depending on the
size and complexity of the fund. This can range from one person being the ultimate point of escalation to
having internal committees in place. In Moodys opinion, the use of committees as the ultimate point of
escalation is positive and (assuming the committee composition is appropriate) ensures that the relevant
parties are involved in the decision-making and hence, is a beneficial control. However, having an appropriate
individual or smaller group as ultimate decision-makers, which can be achieved by having a committee
chairman and/or veto rights for the appropriate people, is regarded by Moodys as good practice.
Table 4 outlines some of the committee characteristics that we seek to confirm during our review (these apply
to both high-level, management committees, as well as functional line-level committees utilised within the
categories of our review):
Table 4
Mandate
It should be noted, however, that even in these circumstances at times of stress the nature of the relationship between the Manager, the fund governing
body and the investors can be tested. It may therefore be the case that a more robust, advanced governance model could be an advantage even for these
more informal types of hedge fund, Fund Governance, p. 87, The Hedge Fund Working Group, Hedge Fund Standards, January 2008.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Frequency of formal meetings is sufficient given the mandate, for example, weekly risk
committee meetings, annual disaster recovery/business continuity meeting
Other fund policies make reference to committees and are consistent with the mandates
Line managers may also have various oversight roles within their mandates, which have been delegated to
them by senior management or senior level committees. These are typically functional by nature and involve
oversight on day-to-day issues under the Managers purview. During our review, we look at the mandate and
presence of appropriate skill sets.
Moodys also establishes whether there is an internal audit-type function which, although not typical in many
hedge funds, is viewed positively and helps ensure internal quality control. This is particularly true for larger
funds where senior management is further removed from the many functions that may be performed daily.
Lastly, the Fund Managers oversight of third parties is also important. Of course in many cases the use of
independent third-party service providers, such as an independent administrator, is a positive control for
investors. However, outsourcing key functions performed on behalf of the fund poses certain risks to the fund
as the control of the function no longer rests with the Fund Manager. Hence Moodys reviews whether the
Manager monitors and ensures that the services and controls in place at the service providers are of high
quality. The greater the dependence of the Fund and the Manager on the service providers, the greater the
emphasis Moodys places on this oversight.
10
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Operations
Valuations
Corporate functions
Service providers
The purpose of this section is to discuss the categories and sub-categories of the OQ rating, outline why we
analyse each and provide some of the key characteristics that we look for in our analysis.
Category 1: Operations
Why it matters
The Operations function is crucial to a hedge fund (and thus to our analysis) as once the trading decision is
made, trades need to be executed efficiently, booked, reconciled and settled correctly so that the funds
positions are known and reported accurately. This information forms the basis of the funds activities and is
necessary for traders and portfolio managers to trade off the correct positions. The information is also
important in other key areas of our analysis such as valuations and risk management. Thus, the accuracy and
efficiency of the operations processes is essential.
Assessment areas
Trading Infrastructure
Trade Flow
Cash Transfers
Investor Relations
Our assessment
In this category, the Moodys OQ rating entails an examination of trade-flow (or trade life cycle) processes and
procedures, which also includes a review of all outsourced service providers who are involved in this function,
especially the administrator. Our approach looks through which party is responsible for actually performing
the various tasks, and focuses on the activities themselves. The positive effects of using an external
administrator, such as increased independence, will be captured in the Service Providers Category, Page 19.
Chart 2
Summary of the Trade-Flow Process
Trading
Decision
Trade
Capture
Trade
Execution
Entry &
Verification
Affirmation/
Confirmation
Trade feeds
Reconciliations
Settlement
Moodys carries out a detailed analysis of the controls and procedures surrounding the trade-flow process
summarised in Chart 2 above. This entails a review of all pre-trade and post-trade controls in place, including
the trade support system(s) used and the process for setting up new trading counterparties.
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June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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The procedures in place to ensure that all trades, positions and cash are reconciled
The process by which trade errors (or breaks) are identified and resolved
The escalation procedures in place to ensure that reconciliation differences are resolved promptly
Moodys also reviews the level of automation of operations functions and particular attention is paid to the flow
of information between the fund and its prime brokers and administrators. We also look at the procedures and
systems in place for handling trade confirmations to ensure that all trades are promptly confirmed and/or
matched with counterparties.
Additionally, the processing of cash transfers to/from the fund from/to third parties forms part of our analysis.
We look at the controls surrounding these transfers in order to assess the adequacy of the controls in place to
prevent fraudulent and inappropriate use of cash, including the use of authorised signatory lists and
appropriate checks and balances, typically built into the systems and reconciliation processes 10 .
The assessment also addresses shareholder activity, which typically falls under the purview of an Investor
Relations team (either at the fund or administrator). The review includes controls surrounding subscriptions,
redemptions, switches, anti-money laundering AML checks and procedures. Moodys also reviews the
investor communication processes, including investor documentation and reporting.
Our review is tailored to the size of the organisation, and focuses on the effectiveness of the function and the
controls in the context of the funds size and strategy. Expectations from smaller firms/funds, which in all
likelihood have concentrated functions that process all transactions, differ from larger firms, which may have
highly decentralised, specialised groups handling particular items or tasks in the trade-flow process.
Assessment areas
10
12
Valuation Oversight
See also: Trading and Business Operations, p.36, Best Practices for the Hedge Fund Industry, Report of the Asset Managers Committees to the Presidents
Working Group on Financial markets, January 2009.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Table 5
Level 2
Assets
Level 3
Assets
Those that have observable market prices, such as a stock traded on the NYSE
Although these are generally easy-to-value, Moodys will also ascertain whether price sources used are
verified against secondary sources and subject to various price tests designed to ensure accuracy
It may be obvious, but it is important to note that the valuation of exchange traded positions may be
uncertain as a price published by an exchange may be different from the price at which the trade may be
liquidated
Those that do not have an observable price but have observable inputs other than quoted prices, such as
interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks, and default rates
and inputs that are derived principally from or can be corroborated by market data, e.g. an interest-rate
swap where its components are observable data points like the price of a 10-year Treasury bond.
The valuation is generally derived from pricing models or counterparty valuations, broker quotations,
pricing specialists. Again Moodys will seek to ensure that the prices used are verified against a reputable
secondary source, which where possible, should include external broker quotations.
Assets where one or more inputs do not have observable values. This is the bucket that has sometimes
been described as a guesstimate, because it is reliant on management best estimates. Prices can only
be known upon sale/realisation of the asset.
Unobservable inputs/values are inputs that reflect the reporting entitys own assumptions about what
market participants would use to price the asset or liability (including risk), developed using the best
information available without undue cost and effort.
If there are no available sources, there is no verification requirement if the assumptions are in line with
those of market participants. However, we would still ensure whether the process is appropriate,
sufficiently independent from the traders and consistently applied.
In addition to the above, Moodys also assesses the checks in place to ensure the accuracy of pricing such as
price testing, stale prices and price variance reports. Particular attention is paid to period end policies and
procedures.
One of the key characteristics of a strong hedge fund valuation process 12 is its independence from the
trading/portfolio management function. If valuations are performed by the Fund Manager, then this would be
typically done by a dedicated fund accounting group, and senior personnel separate from portfolio
management would play a decisive role in the valuation process. For the majority of funds, independence is
promoted by having an outside administrator value the portfolio. In order to determine the appropriateness and
independence of the valuation process, Moodys closely reviews the role that any external administrator plays
in the NAV calculation process.
However, the presence of an administrator should not be construed as a solution to all the risks involved in the
valuation process and our review is conducted from the perspective that it is the Fund Manager who has the
ultimate responsibility and overall control of valuation. Moodys ascertains whether the fund has additional
steps in place towards ensuring that a high level of quality in the process is maintained, such as performing
shadow accounting of the funds books; this provides redundancy in the process and where an administrator
is used to increase independence, this ensures that all accounting entries are effectively checked.
11
12
13
For positions at all levels of liquidity, external pricing information should be obtained from sources demonstrated to be appropriate to the product type. The
same is true for any pricing models used in the valuation process. They should be from recognised or otherwise appropriate sources.
Moodys assessment of the valuation process does not involve verification of values assigned to specific investments, although these may be used as
supporting evidence.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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13
14
See Moodys Special Report Assigning Unsecured Credit Ratings to Hedge Funds, Joel Levine, April 2007.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Oversight
Asset Liquidity
Cash Management
Funding
Collateral Management
Communication to Investors
Redemption terms
Our assessment
Investment Risk Management
As previously stated, the OQ rating does not aim to address the level of market risk or any other investment
risk in the fund, nor the level of risk tolerance of the Fund Manager. What we look at is how well the
processes, controls, people and systems have been set up to try to ensure that the fund meets its risk
objectives and defined risk tolerances.
Our operational review includes an assessment of the funds internal risk reporting and control processes as
for many hedge fund managers, balancing this requirement with its investment goals can be challenging.
Additionally, these processes can vary substantially given a funds structure and strategy. Our approach and
the importance placed on various elements of risk management thus considers the differences between funds
and the relative merit of different structures of the control framework. It is important to note that the Moodys
OQ rating does not seek to address the appropriateness of the overall level of a funds market or investment
risks, but rather addresses how well these risks are controlled within the funds self-prescribed risk limits.
Moodys also establishes whether the fund has a designated risk manager or someone within the organisation
with clear responsibility for risk management oversight and control. Risk quantification, monitoring and
reporting is also analysed. The size of the team and level of expertise needed by these individuals would
depend on the nature and complexity of the fund. In each case, Moodys assesses whether the individual, or
group, is sufficiently independent from portfolio management, has access to (and support from) senior
management and whether the risk manager is sufficiently senior within the organisation to be able to carry out
their functions effectively. The level of commitment of the relevant individuals to the risk control process as
well as the Fund Managers overall risk governance approach is also assessed during the course of our
review.
A key focus of our review is on the effectiveness of the risk management function in identifying, quantifying
and monitoring the funds risk exposures, which include inter alia the risk tolerance definition and breadth of
the approach, flags and limit structures used. Our discussions with the risk manager cover the funds risk
metrics and how these best quantify the exposures in the fund. The use of stress-tests, where appropriate, is
also examined.
15
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Guidelines for distribution of risk mandates among individual sub-portfolio managers and the setting and
changing of risk limits;
Guidelines for risk monitoring and risk measurement during stressed periods; and
Routines for communication the above information to all relevant persons within the hedge fund Manager
in a clear and understandable manner 14
As is the case throughout the rating process, Moodys review of risk management controls is tailored to the
funds size, profile and to the type and complexity of investment strategies employed by the fund.
Figure 1
Poor performance may be an indication of process deficiencies in the funds operational framework which is
generally organised around avoiding losses. For example, it may highlight a weakness in the risk monitoring
function due to inappropriate quantification of risk;
Fund underperformance may lead to loss of investor confidence which in turn may lead to high redemption
requests and hence to the imposition of gates or suspensions of redemptions;
If the underperformance is due to market stresses, the reliability of valuations may be affected due to pricing
volatility and the inability to obtain independent marks because of market illiquidity;
Financial performance triggers in credit agreements may be activated which may result in increased liquidity
risk and decreased flexibility constraining the Managers ability to perform its functions effectively; and
Poor performance may also lead to resource constraints leading to headcount reductions, either voluntary or
involuntary or decreasing information technology spending, all of which may impact certain key operational
functions.
Therefore, during the course of our OQ review, we focus on whether any material underperformance may
reflect or ultimately lead to weaknesses in the funds operational framework.
14
15
16
Portfolio Risk Governance Standards and Guidance [11], Hedge Fund Standards: Final Report, January 2008 Hedge Fund Working Group.
See Moodys Special Report Market Turmoil Increases Stress on Hedge Fund Operations, January 2009.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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16
17
17
See also, Liquidity Risk, page 26, Best Practices for the Hedge Fund Industry, Report of the Asset Managers Committees to the Presidents Working Group
on Financial markets, January 15, 2009
For instance, funds that use securities as collateral for borrowing should also keep track of its exposure to increases in collateral haircuts from their lenders.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Complexity of
Compliance Regime
Hiring Process
Internal Accounting
Staffing
Staffing
Staffing
Taxation
Training
Compliance Monitoring
and Reporting
Compensation
Regulatory Compliance
Reporting
Anti-Money Laundering
Procedures
Our assessment
(a) Compliance and Legal
The objective of Moodys OQ rating review is to make a general assessment of operational aspects of the
Managers overall compliance framework and not to address all the elements of compliance risk.
Some important aspects of compliance that are considered are the complexity of the funds and Managers
compliance regime, compliance policies and manual (which typically include inter alia anti-money laundering
procedures, code of ethics, personal account dealing and market abuse checks), procedures and associated
documentation that substantiate the adherence to these policies and the firms demonstrated commitment to
its compliance policies. Formulation of our opinion may therefore include an examination of management
reports, compliance checklists, exception reports, internal audits and other pertinent documents. Moodys also
reviews the controls that the Manager has in place to ensure that the fund complies with all the relevant
regulatory authorities and legislation. We further consider the experience and qualifications of the firms Chief
Compliance Officer, in reference to the funds size and complexity.
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June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Our assessment
Moodys considers that the three main types of service providers to hedge funds are Administrators, Prime
Brokers and Auditors, each of which can provide the fund or Manager with a variety of different services and
service levels. Chart 1, on page 9, depicts a typical hedge fund structure including its primary service
providers.
As such, our review focuses on these three service providers, particularly their profile and reputation. Our
considerations include characteristics such as: size of the organization, track record, experience, market
standing and independence among others items.
The more detailed review of the services provided, particularly in the case of the administrator, including our
review of the processes and controls related to the fund, are addressed in the aforementioned categories,
primarily in Operations and Valuations.
Table 8
Prime Brokers
Auditors
The fund and Manager may also use a variety of other service providers, such as external counsels, marketing
companies, research houses, consultants, etc. Their profile and reputation are also considered as part of the
rating.
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June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Chart 3
Moodys OQ Rating Process
Rating
request
Document
review
Legal documentation
Internal policies and procedures
Onsite
review
3rd Party
review
Rating
decision
Rating
assignment
Document Review
After a rating analyst and team have been assigned, a request for documentation and general information is
made to the management of the hedge fund. The document request includes items such as the investment
management agreement, offering memorandum/prospectus, subscription/redemption documents, internal
control procedures, administration agreement, previous audit reports, organisational charts, systems flow
charts and the compliance manual. At the Managers request, more sensitive documents may be reviewed at
the Managers premises (as part of the on-site review, described below). Under the supervision of the lead
analyst, the Moodys rating team evaluates the requested documents and may discuss them with the
appropriate personnel at the fund during the on-site review.
On-Site Review
Once the documentation review is largely complete, the lead analyst and rating team conduct the on-site
review at the Managers premises. Meetings between key fund personnel and the rating team are scheduled.
The rating team generally focuses on discussions with the senior individuals responsible for specific areas that
form part of the OQ assessment, such as the Risk Officer for the Risk Management Framework category,
Chief Compliance Officer regarding the compliance function.
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June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
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Third-Party Review
During the course of the review, the rating team also asks the Manager to allow direct contact with third-party
service providers. The contact may be more extensive when an administrator, prime broker or auditor is
previously unknown to Moodys.
For administrators, the purpose of these communications is to ascertain their understanding of their role in the
funds operations, especially as it pertains to the funds valuation process. Where deemed necessary, Moodys
also conducts on-site meetings at the administrators premises.
Moodys interaction with the prime brokers primarily focuses on the confirmation of process descriptions
provided by the administrator and Fund Manager and confirmation of the continuing relationship between the
fund and the prime brokers. If a variety of services is provided by the prime brokers to the fund, and where
those services are relevant to the OQ rating, Moodys may then request more information from the prime
brokers. Typically where the fund has several prime broker relationships, Moodys may only select a sample
as part of the assessment.
For administrators and prime brokers, weight is given to evidence of independent review such as SAS 70
reports 18 .
Rating Decision
After the review process is completed, the lead analyst, in conjunction with the rating team, prepares the rating
scorecard, a rating recommendation and a summary memo to be circulated to the members of a rating
committee. All assignments and changes to OQ ratings result from a rating committee decision after
consideration of the analyst's rating recommendation.
Rating Assignment
After the funds rating is determined by the rating committee, a rating report and press release are
communicated to the Fund Manager. Should the fund elect to make the rating public, it will be subsequently be
posted on the Alternative Investments area of Moodys website, Moodys.com 19 , along with a Rating Report
describing the rationale for the rating.
Ongoing Monitoring
OQ ratings are monitored on an ongoing basis.
18
19
21
Statement on Auditing Standards (SAS) 70 is an international auditing standard developed by the AICPA (American Institute of Certified Public Accountants)
that was published in April 1992. It relates to the evaluation of a Service Organizations implementation and disclosures of its internal controls. Only
Certified Public Accounting Firms that comply with professional standards established by The American Institute of Certified Public Accountants can issue
the reports.
The Alternative Investments area of the Moodys website is a subcategory of Managed Funds, which is listed on Moodys homepage.
June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
Rating Methodology
Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds, October 2006
(SF77845)
Market Turmoil Increases Stress on Hedge Fund Operations, January 2009 (113953)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication
of this report and that more recent reports may be available. All research may not be available to all clients.
Website Access
On the home page of Moodys.com, choose the Managed Funds section to view all ratings and associated
research on Alternative Investments.
Operational Quality reports may only be accessed by accredited investors in accordance with US rules. NonUS individuals or entities are requested to also complete these online forms in order to gain access to the
reports. To view these, click on the Operations Report link on the right-hand side of the web page. You will
be prompted to submit an accreditation form in order to verify your accredited investor status. Once submitted,
you will receive further instructions on how to access OQ reports and other alternative investment research.
www.moodys.com/...managed funds/..alternative investments
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June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds
Rating Methodology
Odi Lahav
Joanne Job
Wing Chan
Ida Chan
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HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED,
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and Shareholder Affiliation Policy.
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June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds