STRUCTURED FINANCE

SPECIAL REPORT

Moodys Approach to Evaluating and Assigning

Operations Quality Ratings to Hedge Funds
AUTHORS:

CONTENTS

Gary Witt, Ph.D.

Managing Director
(212) 553-4352

Motivation

Operational Risk in Hedge Funds

Rating Description

Rating Process
o Initial Rating
o Ongoing Monitoring

Rating Content
o Valuation Process
o Internal and External Administration
o Audit
o Prime Brokerage
o Regulatory Compliance
o Human Resources
o Risk Reporting and Control

Summary

Appendix: Staff Biographies

Gary.Witt@moodys.com

Kevin L. Gaines, CFA

VP/Senior Analyst
(212) 553-4513
Kevin.Gaines@moodys.com

Courtenay Sturdivant,
CPA
Analyst
(212) 553-1044
Courtenay.Sturdivant
@moodys.com

Michael T. Ryan
Senior Associate
(212) 553-1418
Michael.Ryan@moodys.com

CONTACTS:
Gary Witt, Ph.D.
Managing Director
(212) 553-4352
Gary.Witt@moodys.com

Brett Hemmerling
Investor Liaison
(212) 553-4796
Brett.Hemmerling@moodys.com

WEBSITE:
www.moodys.com

A MOODYS OPERATIONS QUALITY RATING DOES NOT ADDRESS MARKET

RISK. RAPID LOSS IN HEDGE FUND INVESTMENTS CAN OCCUR EVEN WHEN
OPERATIONAL RISK IS LOW. PORTFOLIO LOSSES CAN OCCUR FOR MANY
REASONS INCLUDING PRICE VOLATILITY IN FUND ASSETS WHICH MAY BE
COMPOUNDED BY LEVERAGE, ILLIQUIDITY AND OTHER MARKET FACTORS.

MOTIVATION
Due to their proprietary and sometimes complex nature, hedge fund portfolios are
not usually transparent and often difficult to value. Further, fund managers tend to
be entrepreneurs properly focused on portfolio management rather than on the
details of day to day administration. For these and other reasons, investors in
hedge funds are rightly concerned about operational risk.
Originally electronically published on June 27, 2006,
but due to minor changes republished on October 19, 2006

October 19, 2006

Among institutional investors, this concern manifests itself in an extensive and time consuming due diligence
process. Each investor repeats the same process and information is shared only by the fund and its representatives. We believe that as institutions increase their allocations to hedge funds, an objective, independent thirdparty that is in the business of assessing risk can add value to this market. Consequently, as an aid to hedge
fund investors in their initial and on-going due diligence process, Moody's Investors Service has assembled a
strong team of professionals1 (see Appendix I: Biographies) and now offers a public, monitored Operations
Quality (OQ) rating.

OPERATIONAL RISK IN HEDGE FUNDS

"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 "2
This definition from the Basel Committee on Banking Supervision of operational risk in financial institutions is
widely quoted. As the content of our Operations Quality rating will illustrate, some special features need to be
considered when assessing operational risk in hedge funds3.
As the following citations illustrate, both at smaller, start-up hedge funds and at larger funds with proven track
records for growing NAV, regulatory authorities have expressed concerns on behalf of hedge fund investors
about operational risk.
"A further control environment concern related to hedge fund start-ups is the trend for former star traders at investment banks to set up such firms, even where they may not have a track record of running a
company, man management etc. It is also likely that the standard performance/reward model of
hedge fund managers may discourage investment in core management support systems and the control environment. Furthermore, as these firms are frequently small start-ups they sometimes only have
minimal staff training, relying on the background of their staff in other regulated entities - thereby creating a cultural and educational risk"4.
Regarding larger funds, the Financial Services Administration published the following comment:
"As successful hedge fund managers have a tendency to grow extremely rapidly (increased numbers of
funds, strategies, AUM, investor base, jurisdictional spread etc), growth beyond their control capacity is
an extremely real risk. This risk is particularly acute in relation to middle and back office functions which
may be made a lower priority for expenditure relative to profit centre sections of the business"5.

1
2
3
4
5

In addition to the rating team listed in the appendix, other specialist in areas such as accounting, corporate governance, financial institutions, insurance, energy, managed funds and securitization will be available on an as needed basis to consult on methodology, attend rating committees and
answer strategy specific questions in the course of each rating review.
Basel Committee on Banking Supervision, (June 2004), International Convergence of Capital Measurement and Capital Standards, section 644 on
Operational Risk.
Operational risk is most simply defined by what it is not. Hedge fund investors are exposed to both market risk and operational risk. Losses resulting
from the deliberate investment decisions of the fund manager reflect market risk. Losses from other sources reflect operational risk.
Financial Services Authority, (June 2005) Discussion Paper 05/4, Hedge Funds: A discussion of risk and regulatory engagement section on 3.50 on
Control Issues.
Ibid, section 3.51 on Operational issues.

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Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds

OPERATIONS QUALITY RATING DESCRIPTION

An Operations Quality rating expresses Moody's opinion of the quality of a specific hedge fund's operational environment. The rating opinion is derived from assessments of the fund's valuation process, accounting controls,
regulatory compliance effort, risk reporting and control, legal and financial structure, human resources and other
fund specific issues. Special attention is paid to gain a thorough understanding of the role played by key service
providers such as administrators, auditors and prime brokers. The rating process includes periodic on-site visits,
additional communications with the fund and its service providers, and background checks of key personnel.
Moody's offers qualitative risk assessments of mortgage and asset-backed servicers in its SQ Servicer Quality6
ratings, of asset managers in its MQ Investment Manager Quality7 ratings and of Structured Investment Vehicle
managers in its SIV MQ ratings8. Like the MQ, SQ and SIV MQ ratings, the hedge fund focused OQ Operations
Quality rating has five levels as shown below.
2ATING
,EVEL

/12ATING$ESCRIPTION

/1
%XCELLENT

&UNDSATTHISLEVELMUSTHAVEAVERYSTRONGVALUATIONPROCESSTAILOREDTOTHEIRINVESTMENT
STRATEGY/PERATIONSPOLICIESANDPROCEDURESAREEXTENSIVELYDOCUMENTEDPRECISELYEXECUTED
ANDSTRONGLYENFORCED!LLKEYSERVICEPROVIDERSAREJUDGEDTOBEINDEPENDENTOFTHEFUND
HIGHLYPROFICIENTANDWELL QUALIFIED#OMPLIANCERISKISJUDGEDTOBEMINIMAL4HEINVESTMENT
MANAGERSINTERNALRISKREPORTINGANDCONTROLISINDEPENDENTOFPORTFOLIOMANAGEMENT
COMPREHENSIVEANDAPPROPRIATETOTHESTRATEGY"ACKGROUNDCHECKSREVEALEDNOUNRESOLVED
ISSUESOFCONCERN

/1
6ERY'OOD

&UNDSATTHISLEVELHAVEASTRONGVALUATIONPROCESSAPPROPRIATEFORTHEIRINVESTMENTSTRATEGY
/PERATIONSPOLICIESANDPROCEDURESAREWELLDOCUMENTEDWELLEXECUTEDANDENFORCED!LLKEY
SERVICEPROVIDERSAREJUDGEDTOBEINDEPENDENTOFTHEFUNDPROFICIENTINTHEIRCONTRACTEDAREAS
OFRESPONSIBILITYANDWELL QUALIFIED#OMPLIANCERISKISJUDGEDTOBELOW4HEINVESTMENT
MANAGERSINTERNALRISKREPORTINGANDCONTROLISINDEPENDENTOFPORTFOLIOMANAGEMENTAND
APPROPRIATETOTHESTRATEGY"ACKGROUNDCHECKSREVEALEDNOUNRESOLVEDISSUESOFCONCERN

/1
'OOD

&UNDSATTHISLEVELHAVESOUNDOPERATIONSTHROUGHOUTANDAVALUATIONPROCESSTHATISCREDIBLE
GIVENTHEIRINVESTMENTSTRATEGY+EYSERVICEPROVIDERSAREJUDGEDTOBEOFGENERALLYGOODQUALITY
ANDNOTDEPENDENTONTHEFUNDINANYDISCERNABLEWAY#OMPLIANCERISKISNOTJUDGEDTOBE
HIGH4HEINVESTMENTMANAGERHASANINTERNALPROCESSTOSYSTEMATICALLYREPORTANDCONTROLRISK
"ACKGROUNDCHECKSREVEALEDNOUNRESOLVEDISSUESOFCONCERN

/1
&AIR

4HEVALUATIONPROCESSOFFUNDSATTHISLEVELISADEQUATEBUTMAYHAVESOMEDEFICIENCIES+EY
SERVICEPROVIDERSAREJUDGEDTOBEOFGENERALLYACCEPTABLEQUALITYANDARENOTDEPENDENTOFTHE
FUNDINANYOBVIOUSWAY#OMPLIANCERISKMAYBEMODERATELYHIGH4HEINVESTMENTMANAGERS
INTERNALRISKREPORTINGMAYLACKINDEPENDENCEORMAYNOTBEPRACTICEDSYSTEMATICALLY
"ACKGROUNDCHECKSREVEALEDNOUNRESOLVEDISSUESOFCONCERN

/1
0OOR

&UNDSATTHISLEVELMAYHAVEANINADEQUATEVALUATIONPROCESS3OMEKEYSERVICEPROVIDERS
COULDBEOFLOWQUALITYANDORDEPENDENTOFTHEFUND#OMPLIANCERISKMAYBEHIGH2ISK
REPORTINGMAYBELACKINGORABSENT"ACKGROUNDCHECKSCOULDHAVEREVEALEDUNRESOLVEDISSUES
OFCONCERN

Note: Where appropriate, a "+" or "-" modifier will be appended to the OQ2, OQ3, and OQ4 rating category
and a "-" modifier will be appended to the OQ1 rating category. A "+" modifier indicates the fund ranks in the
higher end of the designated rating category. A "-" modifier indicates the fund ranks in the lower end of the designated rating category.
This paper describes the process and content of Moody's formulation of its Operations Quality rating opinion
and the qualifications of our rating team. We believe that the resulting opinion will add substantial value to investor's due diligence; however, as no such assessment can uncover and measure all risks, we can make no guarantee that our OQ ratings will reflect all the operational risks of the rated funds. Further, Moody's Operations
Quality rating does not address market risk in hedge funds.
6
7
8

See Moody's Rating Methodology, "Updated Moody's Servicer Quality Rating Scale and Definitions", Jason Groholtoski and Wen Zhang, May 2005.
See Moody's Special Report, "Moody's Approach to Evaluating and Assigning Investment Manager Quality Ratings to Asset Management Companies", Henry Shilling and Roger Stein, August 2005.
See Moody's Rating Methodology, "SIV Management Quality Ratings", Henry Tabe and Mark Abbott, January 2006.

Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds

Moodys Investors Service 3

OPERATIONS QUALITY RATING PROCESS

Figure 1

Rating Process
2ATING
2EQUEST

/N SITE
2EVIEW

$OCUMENT
2EVIEW

#ONSULTWITHRATINGTEAMANDIN HOUSEEXPERTS


&OLLOW UPQUESTIONSWITH&UND



#ONTACT3ERVICE0ROVIDERS


#ONDUCT"ACKGROUND#HECKS

2ATING
#OMMITTEE

/N GOING

-ONITORING

Initial Rating Process

As Moody's does not plan to issue unsolicited OQ ratings, the first step in the rating process is a specific
request from the fund manager to rate the fund9. After the rating team has been assigned, a request for documentation and general information is made to the management of the hedge fund. The document request
includes such items as the investment management agreement, offering memorandum, subscription/redemption documents, internal control procedures, administration agreement, previous audit reports, organizational
charts, systems flow charts and the compliance manual. Under supervision of the lead analyst, the Moody's
rating team evaluates the requested documents and discusses them with the appropriate personnel at the
fund.
Prior to the on-site review, the lead analyst co-ordinates the interaction between members of the rating team
and personnel from the hedge fund. To maximize the value of time spent on-site, interviews are scheduled
between specific individuals on specific topics. Time is also allocated for questions and feedback.
When necessary the rating team will ask the manager to allow direct contact with third party service providers.
These contacts will be more extensive when we encounter an auditor, administrator or prime broker that is
unknown to us. For administrators, the purpose of these communications is to ascertain their understanding of
their role in the fund's operations, especially as it pertains to the fund's valuation process. For administrators
and prime brokers, weight will be given to evidence of independent review such as SAS 70 reports10. Discussions with the auditor will focus on previous audit reports and the current status of the relationship between the
audit firm and the hedge fund client. More generally, development of opinions about the quality and capacity of
service providers will be an ongoing part of the rating process. Where possible, these opinions will be developed from direct communications and occasional visits and by cross referencing information gained in different
fund ratings.
After the review process is completed, the lead analyst will prepare a rating committee memo to be circulated to
the members of the rating committee. Part of the committee memo will be a numerical scorecard that has been
created for OQ ratings. This very detailed scorecard is used to calculate a single rating score that will be used
as a basis for discussion at the committee but it is not anticipated that specific scores will translate into specific
ratings. For qualitative ratings, it is useful to have a numerical guide to promote consistency between ratings but
some aspects of operational risk assessment will always be difficult to quantify. As with other Moody's ratings,
the formal rating committee culminates with a vote on the rating recommendation of the rating team. After its
final determination, the public Operations Quality rating will be posted on the Alternative Investments area of
Moody's website, Moodys.com11 along with a Rating Report describing the rationale for the rating.

10

11

This could be a request for an indicative rating. As a service to hedge funds, Moody's offers an informal indicative rating on a confidential basis. The
indicative rating has several benefits. It can be used to motivate specific improvements to a fund's operational infrastructure. Any such upgrade to
operational infrastructure would of course tend to improve the fund's public OQ rating should it subsequently choose to obtain one. Also, the indicative rating fee can be applied to the fee for a subsequent public rating.
Statement on Auditing Standards (SAS) 70 is an international auditing standard developed by the AICPA (American Institute of Certified Public
Accountants) that was issued/published in April 1992. It relates to the evaluation of a Service Organization's 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.
Managed Funds are listed on the home page of Moodys.com. Alternative Investments are a subcategory of Managed Funds. Rating reports are
available only to accredited investors.

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Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds

Ongoing Monitoring
The rating process does not end with the issuance of the rating. In fact, the initial issuance of the rating is the
beginning of the ongoing monitoring process. Moody's monitoring process for OQ ratings will primarily be the
responsibility of the lead analyst. The fund and its administrator will send monthly NAV reports and appropriate
investor communications such as key-man changes to Moody's for review. The lead analyst will be available for
communications with investors, service providers and other appropriately interested parties. Typically on an
annual basis, or more frequently if necessitated by fund-related events12, a formal review process will be conducted by the lead analyst that may involve an on-site visit with the fund and submission of an internal monitoring report to a review committee.

OPERATIONS QUALITY RATING CONTENT

There are several broad and often over-lapping categories of operations risk that are considered by Moody's in
its OQ rating process and rating scorecard. The most important are the valuation process, internal administration, human resources, risk reporting and control, regulatory compliance and the role of the service providers13.
The intent of this section is to discuss the most important categories focused on during the OQ rating process14. Each category sub-section that follows contains an overview of risks and best practices illustrated with
one or two examples.

Valuation Process
"Conflicts of interest arise when the
remuneration of the manager
through
performance
creates
strong incentives for hedge fund
managers to overstate valuations,
raising performance and improving
fees"15.

Conflicts of Interest
A conflict of interest is a situation in which someone in a position of trust,
and in the case of hedge fund advisers, a fiduciary duty to a client, has a
competing personal or professional interest. A conflict of interest itself
does not imply any wrongdoing and in many cases is normal in the
course of business. Problems arise when this conflict of interest is not
disclosed to the adviser's clients and an individual or the firm as a whole
influences a decision for their own benefit disregarding their commitments to the advisory client. In the hedge fund industry a conflict of
interest such as trading through an affiliated brokerage arm can and
does exist in many cases. Moody's evaluation of the level of disclosure
and impact of present conflicts of interest is an important and essential
part of the rating process. Throughout the analysis of an individual fund
manager, Moody's is identifying, questioning and gauging the overall
effect of each possible conflict on the operational risk of the fund.

To address the conflict of interest

described by the FSA in the above
quote, a strong hedge fund valuation process16 will be independent
from the portfolio management
function, transparent to all parties
responsible for its application and
consistently applied over time. For
the large majority of funds, independence can be promoted by having an outside administrator value the portfolio; however, this can be problematic for some strategies depending on the liquidity or complexity of the positions held. In any event, the review of the valuation process will be conducted from the perspective that it is the
fund manager that has the ultimate responsibility and overall control of valuation17.
If valuation is performed within the fund, then personnel separate from portfolio management should play a
decisive role; regardless of who has direct responsibility for calculation of reported NAV, the process by which
the valuation is obtained should be documented and understood by everyone responsible for its implementation. For instance, a comprehensive pricing policy will contain a review process so that the portfolio manager,
as the party most knowledgeable about the individual positions, can review each trade valuation and suggest
corrections. A good written review process will require that any adjustments that result from the portfolio manager review are recorded and available for scrutiny along with explanations where necessary.
12
13
14
15
16
17

For example, depending on the particular circumstances, a change of auditor or administrator or the loss of a "key man" will usually necessitate a
formal rating review.
For each service provider, its relationship with the fund will be examined to assess the degree of its formal or implied financial dependence on the
fund.
Categories not covered in this report but considered in the OQ rating process include systems architecture, legal and financial structure, marketing
and internal tax risk.
Financial Services Authority, (March 2006) Feedback Statement 06/2, Hedge Funds: A discussion of risk and regulatory engagement, section 2.3.
Moody's will opine on the valuation process not on the values assigned to specific transactions.
The manager retains ultimate responsibility and control over valuation even when it has delegated that responsibility to an administrator or other outside service providers.

Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds

Moodys Investors Service 5

Another feature of a written review process is the formal categorization of positions into different degrees of
liquidity requiring different types of outside sources for pricing18. The most liquid instruments will have an obvious source for valuation such as a settlement price on an exchange. Slightly less liquid positions may be valued
with reference to a Bloomberg or Reuters page. Illiquid instruments may require broker or counterparty quotes;
more complex instruments may require model derived prices or independent appraisals. For the most illiquid
instruments traded in certain strategies, the concept of value itself begins to shift away from a realizable price
toward commercially acceptable best practice.19 Notice that for these most difficult to value positions, the
importance of independence, transparency and consistency is heightened.

External and Internal Administration

An operational rating review will assess the administrative function within a hedge fund, including all outsourced
service providers directly involved in valuation, especially the administrator. The review will entail a thorough
examination of internal and external administration processes and procedures.
The review of the administrative procedures will focus on completeness, meaning every trade, fee or interest
accrual related to the fund will ultimately affect the final Net Asset Value of the fund. The review will place an
emphasis on the policies and procedures that govern the NAV calculation process, as well as the checks and
safeguards to assure that during the trade flow process all transactions are appropriately recorded and classified. The review will also entail an analysis of several middle and back-office functions including trade confirmation, settlement, financial reporting and investor relations. Wire transfers are a sensitive area and strong
controls and procedures are necessary to prevent fraudulent and inappropriate use of cash.
The review will be tailored to the size of the organization. A small firm may have a concentrated reporting process that effectively processes all transactions, while a large firm may be highly de-centralized with multiple specialized groups handling particular items or tasks in the administrative process.
The administrator and other independent third party vendors directly involved in valuation or transfer of funds
will be assessed on the strength of their internal controls and safeguards to protect client assets. An overall
structural assessment will examine the underlying relationships of each vendor, to assist with identifying conflicts of interest or items that require more careful monitoring. Each independent vendor's management and
staff should possess the appropriate skill-set, experience and competency to effectively perform the level of
service contracted. In sum, the full review of the administrative function covers multiple areas of focus in detail
to generate a fair and concise assessment of the operational strength.

Auditors
An important part of the operational review is an assessment of the independent audit function and the audit
firm employed. The review will focus on the frequency of auditor changes and the opinions rendered on each
audit. Clear, credible explanations will be sought whenever the previous auditor has declined engagement for
the next annual audit. As with all service providers, an opinion will be formed as to the ability and diligence of
the auditor in performing its contracted duties for the fund.

Prime Broker
Prime brokerage consists of a host of special services that brokerage houses provide to clients, specifically
hedge funds and other investment pools. The services provided under prime brokering are custody, securities
lending, leveraged trade executions, and cash management, among other things.
A Moody's Operations Quality Rating assesses the prime broker(s) itself and the specific services these brokers
provide in addition to clearing trades on behalf of the adviser. Understanding the scope of the brokerage relationship, identifying possible conflicts of interest and the general credit quality of the prime broker(s) are important inputs to our analysis. Moody's will also scrutinize soft dollar arrangements, record keeping, margin
lending agreements, quality of systems and connections to the fund manager and other crucial service providers during our review.
18
19

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 recognized or otherwise appropriate sources.
See the Alternative Investment Management Associations (AIMA) publication, Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry, Executive summary, p.8 "Understanding the Limitations of NAV information"

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Regulatory Compliance
While the scope and depth of Moody's Operations Quality Rating review is not sufficient to precisely determine
all aspects of compliance risk, our goal is make a general assessment of the fund manager's overall compliance
program. In the United States, the primary regulatory bodies that require registration by managers of certain
alternative investment vehicles are the Securities and Exchange Commission (SEC) and the Commodities and
Futures Trading Commission (CFTC). While many exemptions to registration with both these federal commissions remain, in December 2004 the SEC adopted new rules that substantially increased the number of hedge
fund managers required to register with the SEC. As part of its review of fund managers claiming exemption
from registration, Moody's will assess the fund manager's exemption rationale based on applicable rules and
regulations20. Funds that are registered as Investment Advisors with the SEC are required to implement the necessary compliance policies and procedures and should be able to demonstrate that commitment to their implementation.
Some important aspects of compliance risk that will be considered are the fund manager's internal controls, the
content of its compliance policies, its demonstrated commitment to its compliance policies and the experience,
qualifications and effectiveness of its Chief Compliance Officer and other compliance personnel, including any
third-party regulatory service providers. To give a specific example, investment advisors are required to develop
and maintain a written compliance manual21 and conduct an annual review of the adequacy of their policies and
procedures and the effectiveness of their implementation22. Consequently, Moody's will review both the written
compliance manual and associated documentation that substantiates the adherence to and effectiveness of
these policies. Formulation of our opinion may therefore include examination of management reports, compliance checklists, exception reports, internal audits and other pertinent documents.

Human Resources
An important part of conducting an operations review on a fund is to ascertain the knowledge, experience and
integrity of its investment professionals and principals. Our assessment of the human resources of the firm will
address the following [and other related] questions. Are the employees qualified to perform their assigned
tasks? Are any key personnel wearing too many hats? Is compensation structured to retain support staff and to
align incentives between senior staff and investors? How much turnover has the fund experienced? What is the
degree of key man risk?
Furthermore, background checks can potentially mitigate certain risks associated with investment in hedge
funds. In order to corroborate critical aspects of hedge fund managements' qualifications, background checks
will be performed. Our goal is that these checks will include, but not be limited to, confirmation of post high
school education, licenses (i.e. C.P.A., Series 63, Esquire), designations (i.e. C.F.A), work experience, and material legal infractions. While we will make best efforts to use all our available information sources, background
checks are more of an art than a science and there is no guarantee that we will uncover all actual discrepancies
and issues of concern.

Risk Reporting and Control

"..for many hedge funds, risk management can be especially demanding since their targeted returns may imply
high levels of risk taking."23
Our operations review includes assessment of the implementation and execution of the fund's internal risk
reporting and control processes. As stated previously, Moody's Operations Quality rating does not seek to
address the appropriateness of the overall level of the fund's market risk but it does address how well market
risk is controlled within the fund's self-prescribed risk limits. The assessment will focus on three areas of the
fund's risk reporting and control processes: (1) its degree of independence from the portfolio management, (2)
20
21

22
23

For example, some funds with two year lock-ups for new investments claim exemptions under Rule 203 (b) (3) -1(d)(1)(ii) often referred to as the private fund exemption because such funds are not private funds as defined by the SEC in this context and so can avoid a registration requirement.
Excerpt from a speech by SEC Staff: Remarks before the Managed Funds Association Educational Seminar Series 2005 Guidance on the SEC's
New Regulatory Framework for Hedge Fund Advisers by Paul F. Roye, Director, Division of Investment Management, U.S. Securities and Exchange
Commission, Key Biscayne, Florida, February 9, 2005 "One word of caution, however: many advisers may be tempted to adopt so called "off the
shelf" compliance manuals or codes of ethics as their own. This can be a dangerous practice. Be careful to tailor your policies and procedures
and your codes of ethics to the individualized circumstances of your own firms."
See Rule 206(4)-7 under the Investment Adviser's Act.
Toward Greater Financial Stability: A Private Sector Perspective, The Report of the Counterparty Risk Management Group II, July 27, 2005, Appendix B, Section C.3

Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds

Moodys Investors Service 7

its usefulness in the identification and monitoring of the portfolio's risk exposures and (3) the level of commitment of the relevant individuals at the fund to the risk control process.
The fund should have a designated risk manager or someone within the fund with clear responsibility for oversight of risk reporting and control procedures. This individual (or group) should not be directly associated with
portfolio management and should have access to and support from the management of the fund. Our discussions with the risk manger will cover the fund's risk metrics and why they best quantify the exposures in the
fund. Each of the risk metrics will be assessed for relevance and validity. For funds that make extensive use of
leverage, on or off-balance sheet, additional discussions with the risk manager will include the quality and diversification of the fund's counterparties. Funds using extensive leverage from any source will be assessed on their
control of funding risk using appropriate reports and limits24.

SUMMARY
Moody's OQ rating provides our opinion of the quality of a fund's operations infrastructure and is informed by
our focus on the following operational surveilance tasks.
Assess the role and scope of service providers: administrators, auditors, and prime brokers
Examine the quality of controls over NAV calculation, reviewing procedures employed by both the manager
and relevant external service providers.
Assess the quality of key controls over the daily trade flow process, reconciliation and accounting
Assess regulatory compliance risk.
Check the backgrounds of key personnel within the organization.
Evaluate other sources of potential risks such as the legal and financial structure, systems architecture and
implementation and the adequacy of risk reporting and control.
For a variety of reasons, investors have legitimate concerns about operational risk in hedge funds. Moody's
Operations Quality ratings supply hedge fund investors with objective, public assessments of operational infrastructure of rated funds. Consequently, monitored Operations Quality ratings are a valuable supplement to
investor's individualized initial and ongoing due diligence.
On the home page of Moodys.com, choose the Managed Funds > Alternative Investments section to
view all ratings and associated research on alternative investments. Operations Quality Reports may only
be accessed by accredited investors. To view Operations Quality Reports simply 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 view Operations Quality rating reports and other alternative investment research.

24

For instance, funds that use securities as collateral for borrowing should produce reports that describe their exposure to increases in collateral haircuts from their lenders.

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Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds

APPENDIX I: BIOGRAPHIES OF MOODY'S TEAM

Gary Witt, Ph.D., Team Managing Director
Gary Witt is a Managing Director working at Moody's Investors Service in the Structured Finance Group. He
heads the Structured Credit Product Development Team focusing on rating products offered to hedge funds
investors. Prior to his current assignment, Gary was one of three Team MD's managing Moody's NY CDO
group. As part of Moody's CDO rating group, Gary published several rating methodologies pieces including
"Moody's Approach to Rating Collateralized Funds of Hedge Fund Obligations."
Before joining Moody's in September 2000, Gary traded derivatives for ten years at Citibank, General Re Financial Products, and Sakura Global Capital, including five years as head trader at Sakura Global Capital in London
where he was one of two executive board members overseeing the operation of the thirty-five person London
derivatives subsidiary. He also worked in research at Citi and CDO structuring at Prudential Securities.
Gary holds a Ph.D. in Statistics from the University of Pennsylvania's Wharton School and undergraduate
degrees in Math, Physics and Economics from Southern Methodist University.
Kevin L. Gaines, CFA, Vice President & Senior Analyst
Kevin L. Gaines is a Vice President - Senior Analyst working at Moody's Investors Service in the Structured
Finance Group. He has joined Moody's Investors Service to help develop a new product, the Hedge Fund
Operational Quality (OQ) Ratings.
Before joining Moody's in February 2006, Kevin was employed by ACAM Advisors LLC for eight years. He was
a Senior Investment Analyst and Controller, responsible for conducting due diligence on hedge fund managers
across all trading strategies. In addition, he also maintained oversight of the financial reporting and product
structuring functions for the ACAM suite of funds. Prior to entering the alternative investment space, Kevin
spent five and a half years as a municipal broker/trader for J.J. Kenny Drake, in lower Manhattan. He was
responsible for trade execution and relationship management. Kevin worked as and analyst/auditor for BEA
Associates, an ERISA asset manager, for two and a half years. Mr. Gaines entered the financial industry as an
accountant with The Dreyfus Corporation and later with Chase Manhattan Bank. Kevin Received a Bachelor's
of Science degree in Accounting from Norfolk State University. Mr. Gaines received his CFA charter in 2005.
Courtenay Sturdivant, CPA, Analyst
Courtenay Sturdivant is an Analyst working at Moody's Investors Service in the Structured Finance Group. She
joined Moody's to assist in the development of the new product, Hedge Fund Operational Quality (OQ) Ratings.
Before joining Moody's in December 2005, Courtenay worked for New York Life Insurance Company performing due diligence on fund of hedge fund managers across all trading strategies. She monitored and performed
operational and performance based reviews on numerous funds with AUM ranging from $25 million to $12 billion. During her tenure New York Life Insurance Company, she participated in an M.B.A. Management program
where she rotated through the High Yield, Chief Investment Officer, and Corporate Financial Department areas.
Prior to this, Courtenay was a licensed Certified Public Accountant for a former Big Four Accounting firm. She
also worked in the private industry as a corporate Tax Accountant.
Courtenay holds a Masters of Business Administration from, Fuqua of School of Business, Duke University and
an undergraduate degree in Accounting from James Madison University
Jim Leahy, Esq, VP/Senior Credit Officer
Jim Leahy is a Vice President working at Moody's Investors Service in the Structured Finance Group. He assists
the Alternative Investment Ratings Group focusing on rating products offered to hedge funds investors. Jim also
acts as legal analyst on a wide variety of cash flow and synthetic collateralized debt obligations (CDOs). He has
assisted with the development and publication of rating methodologies for ABS, Distressed Debt, CFO, Bank/
Insurance TRUPS and REIT CDO transactions.

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Before joining Moody's in March 1998, Jim was a lawyer at Skadden Arps and Millbank Tweed in New York
City. Jim's legal practice involved corporate, securities and financing transactions. Prior to practicing law, Jim
was a Naval Officer serving aboard the USS John F. Kennedy CV67, USS Independence CV62 and USS Samuel Elliot Morrison FFG13. He was also a Master Training Specialist and assisted in the development of the initial
curriculum at the Navy's Gas Turbine Engineering School in Newport, Rhode Island.
Jim holds an honors law degree from Boston College and an undergraduate degree in English from Dartmouth
College.
Michael T. Ryan, Senior Associate
Michael Ryan is a Senior Associate in the Structured Finance Group at Moody's. He has played a vital role in
the development of the operations quality rating methodology. He is responsible for monitoring monthly trends
of securitized funds of hedge funds (CFOs), review of associated transactional documentation as well as performing operational reviews on fund managers.
Before joining Moody's in 2004, Michael worked at several Internet start-ups in various capacities over a six
year period. At Interland, Inc. (INLD), Michael managed a web development team and presented during investor and venture capital due diligence meetings to secure additional funds for business operations prior to IPO.
Michael is currently pursuing an MBA in Finance at Fordham University and holds an undergraduate degree in
Economics from the University of Hartford.
Nawal K Roy, Vice President
Risk Management Specialist
Nawal K Roy is a Vice President in Moody's Investor Services as a risk management specialist in the Financial
Institution Group. He assists the Financial Institution Team focusing on risk management issues. Nawal also
acts as an analyst on a wide variety of derivatives products.
Before joining Moody's in January 2006, Nawal was a consultant at KPMG Financial Management Practice in
New York City. In that capacity, he has advised clients, both financial institutions and corporates, globally in risk
management and treasury issues. Prior to consulting at KPMG, Nawal has spent time as trading strategist and
global risk manager at CSFB and Deutsche Bank. He has worked in New York, London, Zurich and Tokyo.
Nawal holds dual masters (MA in Economics and MS in Quantitative Finance) from University of Cincinnati,
Ohio. In addition, Nawal has a MA (majoring in Econometrics and Mathematical Economics) and BA (majoring in
Economics and Statistics) from University of Bombay, India.
Bill Harrington, VP/Senior Credit Officer
Mr. Harrington is a Vice President - Senior Credit Officer in the Structured Finance Group of Moody's Investors
Service in New York City. Within this Group, he is Team Leader for Structured Finance Operating Companies,
which encompasses ISDA-based operating companies, such as interest-rate and credit-based Derivative Product Companies. Bill is also leading a global initiative within Moody's to develop and standardize hedge criteria
for use in cashflow structured finance products. Additionally, Bill rates and monitors a broad portfolio of cash
and synthetic CDO's, Derivative Product Companies and other structured vehicles.
Prior to joining Moody's in 1999, Bill worked in the Global Fixed-Income Group at Merrill Lynch, structuring and
trading derivatives in the international interest-rate, bond and currency markets. Bill worked from 1987 to 1990
as an International Economist at The WEFA Group, forecasting and analyzing OECD FX, interest rate and bond
markets.
Bill holds an MBA from The Wharton School, University of Pennsylvania and a BA in Economics from The University of Pennsylvania.

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Doc ID# SF77845

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