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Moodys Global

Managed Investments

Rating Methodology

June 2009

Table of Contents:
Methodology Update
Moodys OQ Rating Definition and Scale
Moodys universe of OQ rated hedge funds 3
Operational risk in hedge funds
Moodys rating screening criteria
Framework for assigning OQ ratings
Operational Quality Rating Process
Moodys Related Research
Website Access

Analyst Contacts:


Odi Lahav
Vice President
Joanne Job

New York


Operational Quality Rating

Methodology for Hedge Funds
Methodology Update
This report provides an update to Moodys Approach To Evaluating And Assigning
Operations Quality ratings to Hedge Funds, which was originally published in
2006. This update does not reflect a significant change in approach, but does
contemplate recent market experience as well as other considerations including
the recent market turmoil, the evolution of best practice standards for the hedge
fund industry espoused by various industry bodies and Moodys desire to provide
greater clarity and transparency into our rating approach. However, somewhat
greater consideration is now given to certain aspects of our analysis and some
elements of our approach have been refined and updated, including:

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.

The key category weights have been fixed, with continuing

accommodation for analyst judgment in the assessment of the rating

Effective overweighting of rating factors where significant weaknesses

are identified.

Daniel Serrao
Senior Vice President
Courtenay Sturdivant
Assistant Vice President - Analyst
Michael T. Ryan
Joshua Gorelik
Senior Associate



Yaron Ernst
Team Managing Director

Business Development:


Andreas Naumann
Senior Vice President - Business Development

New York


Bryan Johnson
Vice President - Business Development

Moodys Operational Quality Rating does not

address market or investment risks. 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, liquidity and other
market factors.

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

Moodys Global Managed Investments

Operational Quality Methodology for Hedge Funds

This was followed by the massive fraud allegedly committed by Bernard L. Madoff. Many hedge funds, like
almost all financial market participants, have been materially impacted by these market events; however,
dispersion of performance has been wide across funds and across strategies, and as ever, it remains difficult
to draw general conclusions about the industry as a whole.
Operational risk in particular remains at the forefront of investors concerns about hedge funds, which among
institutional investors, manifests itself in an extensive and time consuming due diligence process. As a
complement to the analysis performed by hedge fund investors themselves in their initial and on-going due
diligence process, Moodys continues to offer published, monitored Operational Quality (OQ) ratings. Moodys
OQ ratings do not address market or investment risks, the managers risk appetite or the investment strategy,
all of which are certainly key considerations for investors. However, these factors do provide context for a
hedge funds operational infrastructure and thus will be considered when evaluating operational quality.

Moodys OQ Rating Definition and Scale

A Moody's hedge fund Operational Quality (OQ) rating expresses an opinion on the quality of a fund's
operations in the context of its stated objectives and investment strategy. The areas of review are: operations,
valuations, risk management framework, corporate functions and key service providers. Our definition of what
constitutes operational risk is similar to that used in Basel II 1 .

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

Moodys OQ Ratings Scale

Rating level




Funds rated OQ1 are judged to have excellent operational quality within their stated objectives and
investment strategy


Very Good

Funds rated OQ2 are judged to have very good operational quality within their stated objectives and
investment strategy



Funds rated OQ3 are judged to have good operational quality within their stated objectives and
investment strategy



Funds rated OQ4 are judged to have fair operational quality within their stated objectives and
investment strategy



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.
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Moodys Universe of OQ Rated Hedge Funds

The total assets under management of all the funds actively rated by Moodys totalled approximately US$80
billion as of 30 April 2009. Names and details of the specific rated funds can be accessed on Moodys website
(see page 22 for further details).

Operational Risk in Hedge Funds

Hedge funds do not represent a single asset class but are a type of investment
vehicle that provides exposure to a range of investment strategies. Hedge funds
come in different sizes and have different management strategies and styles 2 .
This statement highlights the diverse and fragmented nature of the hedge fund industry and some of the
problems associated with trying to draw general conclusions. Hedge funds are often characterised by trading
in complex strategies, dealing with large sums of money and often taking exposure to risks that are not typical
of traditional investment vehicles. Furthermore, unlike traditional investment vehicles, hedge funds are typically
only lightly regulated 3 as in many cases they either fall outside local regulatory rules related to investment
funds or are domiciled in offshore jurisdictions, and hence many funds have also historically offered limited
transparency to investors. All these characteristics lend themselves to the increased likelihood of operational
risks, in addition to idiosyncratic market risks.
Given the nature of operational risk and the specific considerations that need to be taken into account for each
individual hedge fund based on developments at both the fund and at the fund manager over time, investors
often seek to monitor and update their understanding of a funds operational quality. This is particularly
important in an industry which has been somewhat volatile recently, with periods of rapid growth followed by
declines and the possible changes in regulation, which can affect the nature of a funds strategy or
composition, its operational landscape and the managers flexibility, among other things.

Table 2

Some Notable Hedge Fund Failures and Their Causes*

Year of Failure
or Wind-up

Est'd AUM



4.7 billion

Liquidity, concentration

Tiger Funds


22 billion

Investment performance

Manhattan Fund


575 million

Name of Hedge Fund

Primary Causes of Failure

Alleged Fraud

Lipper Convertible Fund


365 million

Alleged Fraud

Beacon Hill Asset Management


300 million

Alleged Fraud

Lancer Group


1.1 billion

Alleged Fraud

Bayou Hedge Funds


450 million

Alleged Fraud

Bailey Coates Cromwell Fund


1.3 billion

Investment performance

Marin Capital


2 billion

Concentration, leverage

Aman Capital


340 million

Investment performance

Amaranth Advisors


9 billion

Concentration, liquidity

Archeus Capital


3 billion

Operational error

Sowood Capital Management


3 billion

Liquidity, investment performance

Bear Stearns Credit & ABS Funds


1.6 billion

Liquidity, leverage, concentration

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.
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Some Notable Hedge Fund Failures and Their Causes*
Name of Hedge Fund

Year of Failure
or Wind-up

Est'd AUM

Primary Causes of Failure

Dillon Read Capital Management (UBS)


1.2 billion


Drake Management


5 billion

Investment performance

Peloton Funds


2 billion

Liquidity, leverage, concentration

Carlyle Capital Corporation


670 million

Liquidity, leverage, concentration

Fairfield Greenwich Sentry Fund


6.9 billion

Alleged Fraud***

Kingate Global Fund


2.7 billion

Alleged Fraud***

Weavering Capital


640 million

Alleged Fraud

* Based on Moodys review of published accounts in the press

** The estimated AUMs figures are based on reported AUMs at peak or from estimated losses at time of failure as reported
in the press
*** These were feeder funds to Bernard L. Madoff Investment Securities, LLC (Madoff), an investment advisory business.
Madoff itself was not a hedge fund and came to light in December 2008, after allegedly running a massive fraud in the form
of a Ponzi scheme.

Industry Best Practice Standards

In addition to the above concerns, given the amount of interest generated by hedge funds, there has been a
significant drive towards developing best practices and improving the publics understanding of hedge funds and
the transparency of the industry. Over the years, there have been several initiatives by industry bodies, such as
The Alternative Investment Management Association Ltd (AIMA) in UK and The Managed Funds Association
(MFA) in the US, to promote sound practices and publish various guidelines within the sector.
In addition, in the US, the Asset Managers Committee 4 and the Investors Committee 5 of the Presidents
Working Group (PWG) 6 recently published a set of best practices for the hedge fund industry and hedge fund
investors in an effort to promote strong practices commensurate with the increasing role of hedge funds in
financial markets.
In 2007, the Hedge Fund Working Group 7 (HFWG), consisting of 14 leading European hedge fund managers,
was set up with the aim of improving disclosure to investors and developing best practice standards. The
group published its report on Hedge Fund Standards in January 2008; these standards are maintained by the
Hedge Fund Standard Board (HFSB). The HFWG report states that managing and mitigating operational risk
is important for a sound approach to risk management by hedge fund managers. Operational risk includes
breakdowns in internal controls, systems and corporate governance and unexpected disasters which can lead
to financial losses from failure to perform, error and fraud.
Moodys Operational Quality rating methodology details the key features that we consider in our assessment
of operational risk in hedge funds and incorporates some of the items that are detailed in the standards of
practice and research produced by AIMA, MFA, PWG and HFWG.

Best Practices for the Hedge Fund Industry, Report of the Asset Managers Committee to the Presidents Working Group on Financial Markets, January 15,
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.
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Initial Fund Screening

As a preliminary step in assigning an OQ rating, Moodys seeks a basic understanding of the nature of the
fund, with particular focus on the areas detailed below:

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.

3. Transparency and Fund Strategy

Another basic screening inquiry undertaken by Moodys analysts as part of the rating process is assessing the
managers ability and willingness to articulate the funds investment strategy. If the strategy is unclear and/or
appears to be inconsistent with the results that the fund has achieved, confidence in the quality of operating
processes may be difficult to attain. Moodys will also seek to confirm that the fund is prepared to provide
access to sufficient, relevant information so that a rating can be assigned and maintained.

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Framework for Assigning OQ Ratings

This section provides details of our approach in assigning OQ ratings. The section is divided into two parts: the
OQ rating scorecard (Part A below) and the key rating factors underpinning our assessment (Part B). In Part
A, we provide an overview of the scorecard and of our scoring mechanism and in Part B, we discuss why each
category is important to our ratings and the different factors we look at within each category. This methodology
is not an exhaustive treatment of all factors reflected in Moodys OQ ratings, but it should enable the reader to
understand the key considerations used by Moodys in the final rating determination.

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).

1. Key Rating Categories

The rating factors, and hence the scorecard are divided into five key categories of assessment, namely
Operations, Valuations, Risk Management Framework, Corporate Functions and Service Providers. Each
category has defined weights which have been set according to their perceived importance in a funds overall
operational framework and have been based on a large, moderately complex fund.
Three of the four core areas -- Operations, Valuations and the Risk Management Framework -- account for
70% of the total weights as in Moodys view, they represent the crux of the funds operational framework. The
Corporate Functions, which consists of the general internal functions of the firm (namely compliance and legal,
systems and business continuity, human resources and finance and taxation), represents a further 20% of the
overall weighting. The final category, which relates to the use of third-party external service providers,
represents 10%.
There are several sub-categories within each of these five categories, each having defined weights which
have again been set based on their perceived importance.

2. Consistency of the Rating Categories

Once the category scores are calculated, a number of adjustments may be made before the final rating is
determined. One of these potential adjustments is to ensure consistency between the ratings of the four main
categories (Operations, Valuations, Risk Management Framework and Corporate Functions) and the overall
score rating assigned. For example, if the Valuation category is rated as an OQ3+, and all the other rating
categories are awarded an OQ1 (i.e. the highest rating), then the rating committee may conclude that the
overall rating should be more closely aligned with the Valuation category ratings and the overall fund rating
could be OQ2, irrespective of the implied rating calculated using standard weightings. Moodys considers this
consistency adjustment to the overall rating as an important aspect of the OQ ratings, because operational
quality is not simply a composite characteristic but can be compromised by weakest link elements within the
overall operating structure.
The summary below provides an outline of the scorecard used.

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Table 3

Moodys OQ Rating Scorecard







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



1) Valuation Process and Controls

2) Valuation Policies and Documentation
3) Valuation Oversight

Risk Management 20%




Investment Risk Management

Liquidity Risk Management

1) Governance

1) Asset Liquidity

2) Tolerance and Identification

2) Cash Management

3) Monitoring and Controls

3) Funding

4) Ex-post Outcomes Analysis

4) Collateral Management

5) Communication to Investors

5) Counterparty Credit Risk Management

6) Link with Liquidity Risk Management

6) Redemption Terms

1) Compliance & Legal

2) Systems and Business Continuity
3) Human Resources
4) Finance and Tax



Use of Service Providers (level of external involvement/oversight):

1) Administrator
2) Prime Brokers
3) Auditors
4) Other 3rd-Party Service Providers

Other Considerations
- Overall Governance


- Weighting Consideration


Total (Overall Result)

Minimum Requirement Tests:


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3. Analyst Adjustments
In addition to the scoring described above (the Computed Score), there is also scope for the analysts
qualitative judgment which is summarised in the Adjusted Score column. The adjusted scoring is very
important to our analysis given that the rating is essentially qualitative in nature and therefore the analysts
input is an important component of the ratings process and captures items that could not otherwise be
captured in a generic scorecard.
Additionally, the analyst may recommend an adjustment to the rating if they determine that the category
weights are not appropriate in light of the fund's characteristics. For example, the relative importance of the
Operations section will be different for a multi-strategy fund characterised by high trading volumes than for a
concentrated long-short equity fund, such as an activist fund. This adjustment would be reflected in the
Weighting Consideration Adjustment section of the scorecard.
In any case, it is important to note that where the adjusted score for a particular rating factor deviates from the
computed score, the rationale for these adjustments will be explicitly discussed by the rating committee (a brief
overview of the Moodys rating committee process is provided in page 21).

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.

Corporate Governance and Oversight

Given the generally more lightly regulated and less transparent nature of hedge funds, it is reasonable to focus
on the funds overall governance culture and structure. However, this can vary depending on how the fund has
been set up and where it is domiciled. Typically, the highest level of a governance structure would be a board
of directors, however:

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.
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Chart 1

Typical (simplified) hedge fund structure

The Manager


The Investment Manager

The Investment Adviser



The Fund
(Master Fund)

Fund Governing
Body/Board of

Offshore Feeder Fund

(Offshore Company)


US Feeder Fund
(Limited Partnership)

Main Third Party Service Providers and Key Services

Prime Brokers
Custody, settlement, margining, funding, securities lending

US and non-US Tax

Exempt Investors

US Investors

Middle and back office, transfer agency, investor reporting
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

Internal Committee Characteristics



Involvement of all relevant parties

Appropriate independence particularly for key decision makers

Appropriate mix of expertise and functions of the committees (relevant backgrounds)

Appropriate mandate for committees

Comprehensiveness of the mandate, given its ultimate aim

Conflicts of interest, if any, are managed and kept to a minimum

Delegation to individuals or working level committees is reasonable and appropriate

Culture of open conversation between committee members

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.
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Internal Committee Characteristics

Frequency of formal meetings is sufficient given the mandate, for example, weekly risk
committee meetings, annual disaster recovery/business continuity meeting

Ad-hoc meetings during stressed periods.

Minutes of meetings are readily available, to illustrate proof of effectiveness

Executables are effected and recorded in the minutes

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.


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B. Key Scorecard Rating Categories
There are five broad categories assessment of a funds operational quality listed below that are considered by
Moodys in its OQ rating process and scorecard, each of which comprises a number of sub-categories which
are made up of a number of even more granular rating factors (see also Table 3, Page 7). The categories are:



Risk management framework

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



Entry &


Trade feeds



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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The review also encompasses the checks in place to ensure that during the trade-flow process all transactions
are appropriately recorded and classified. A critical part of the review is the assessment of the reconciliation
processes. Moodys examines, inter alia:

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.

Category 2: Valuation Process

Why it matters
The valuation process is integral to a hedge funds ability to function, as it underpins the calculation of the
funds net asset value (NAV), performance, trading position (daily p&l), risk management and among other
things, ensures that investor subscriptions and redemptions are fair and appropriate. The valuation process is
ultimately designed to ensure that the value assigned to each asset is as accurate as possible. This is
particularly important where the assets are not traded on an exchange and hence there is no easily identifiable
market value. Although it is clearly not possible to obtain an accurate market value for some assets with
absolute certainty, given the very nature of such assets, there are a number of procedures and best practices
that, if consistently applied, provide the Fund Manager and investors with confidence that the fund's positions
are marked as accurately as possible.

Assessment areas



Valuation Process and Controls

Valuation Policies and Documentation

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.
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Our assessment
A key feature of a strong valuation process is the formal categorisation of positions into different degrees of
liquidity requiring different types of outside sources for pricing . The Financial Accounting Standards Boards
(FASB) Statement of Financial Accounting Standards No. 157, Fair Value Measurement (FAS 157) which
took effect in November 2007, categorises assets into a three level hierarchy illustrated as per the table below.
As such, we look at the controls and processes in place within each category:

Table 5

Categorisation of assets as per FAS 157

Level 1

Level 2

Level 3

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

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
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.




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.
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It is important to note that even in the presence of an administrator, for strategies consisting of complex, illiquid
or hard-to-value positions, the Manager may have significant input into the valuation process. This may be
considered appropriate, given the specific instruments and where the Manager is better placed to value such
positions. However, even where the Manager is best-positioned and appropriately used to provide an estimate
for certain securities, such an arrangement is not optimal from an operational quality perspective, and hence
would need to be balanced by a number of controls. Our view is that a good, robust valuation process contains
a review by the portfolio manager/trader, who, as the party most knowledgeable about the individual positions,
would review each trade valuation and may suggest corrections to the back-office. In all such cases, Moodys
looks at the controls and checks which ensure sufficient independence from portfolio management and the
transparency and consistency of the process.
Regardless of who has direct responsibility for calculation of reported NAV, we assess whether the process by
which the valuation is obtained is documented and understood by everyone responsible for its implementation.
Moodys reviews the funds valuation policy, the methods utilised for valuing each type of asset it invests in,
any documented appeal procedures, and any evidence in place covering adjustments suggested by the
portfolio manager review to ensure that they are handled in a structured, consistent manner and are recorded
and available for scrutiny along with explanations where necessary. Moodys also examines any documented
procedure for resolving disagreements on pricing
The level of valuation oversight, typically in the form of a Valuation Committee (and/or potentially a different
control function), is another important element to consider when assessing the controls surrounding the
valuation process. Moodys looks at the role of the committee, its composition and where possible, any
documented evidence of resolutions of specific valuation issues.
Lastly, Moodys views positively the use of side pockets created for the purpose of holding illiquid investments
which have no readily ascertainable market value up until realisation, only when necessary. These
considerations are also discussed with the Manager during our review.

Category 3: Risk Management Framework

Why it matters
The Risk Management Framework is a key function in the investment decision-making process. Identifying
and ensuring that the portfolio risk position is provided to the key decision makers is crucial to the Managers
ability to meet the funds stated mandate. It is also important that suitable risk controls, which are best fitted to
the funds strategy, are in place and that the process around risk management decisions is sufficient to ensure
that risk considerations are given sufficient weight in the investment decision-making process.
Additionally, a hedge fund manager needs to know and understand the funds liquidity risk exposure and the
fund needs sufficient liquid assets to meet its obligations as they fall due; these include investor redemptions,
margin calls and means to pay creditors and expenses (funds also need some liquidity in order to be able to
capitalise on potential investment opportunities). The management of a funds liquidity is key to a funds
survival as the lack of liquidity can cause (and has in the past caused) the collapse of otherwise well-run
sustainable funds 13 .



See Moodys Special Report Assigning Unsecured Credit Ratings to Hedge Funds, Joel Levine, April 2007.
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Assessment areas
Table 6
Investment Risk Management

Liquidity Risk Management


Asset Liquidity

Tolerance and Identification

Cash Management

Monitoring and Control


Ex-Post Outcomes Analysis

Collateral Management

Communication to Investors

Counterparty Credit Risk Management

Link with liquidity risk management

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
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.


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Moodys ascertains whether the fund has a written risk policy in place that outlines its procedures and
approach and that is available to all relevant personnel. The HSFB provides a useful outline of items which
may be included in such a document:
in most circumstances the Risk Policy Procedures might, amongst other things, include:

Guidelines for distribution of risk mandates among individual sub-portfolio managers and the setting and
changing of risk limits;

Routines for risk reporting, exceptions reporting and escalation procedures;

Routines for reviewing and testing the risk measurement framework;

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

Investment Performance: Does it affect the OQ rating?

As stated previously, Moodys OQ rating does not address investment performance and of course actual
losses are not necessarily an indication of elevated operational risk. However, while there may be no
direct relationship between investment performance and operational quality as underperformance can
occur even when operational risk is low and quality of the management high, the impact of performance
on a funds operational profile can be significant, particularly under stressed market conditions as
highlighted by the recent market turmoil 15 . Some of the potential relationships between losses and
increased operational risk include the following factors:

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

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.



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.
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Liquidity Risk Management
Moodys looks at the different facets of liquidity risk in the fund and the process in place to capture, quantify
and manage these risks, and also, where necessary, how prevalent these considerations are in the decisionmaking process.
The type and degree of control needed depends on a number of factors, including (amongst others)
investment/asset liquidity, degree of leverage typically used or required by the strategy, the size and
complexity of the fund and the stability of the capital base of the fund (including redemption terms, investor
composition and financing arrangements).
Our assessment encompasses the Managers approach towards quantifying and managing liquidity risk and
the management of any asset-liability mismatch. We also review the funds cash management process, and
assess how cash requirements are monitored to ensure that the fund has enough liquidity to finance its
The way that the fund Manager diversifies and manages the funds sources of financing, such as prime broker,
repo, lending and margining arrangements are taken into consideration, in the context of the funds needs,
particularly where leverage is extensively used. Funds using extensive leverage from any source are assessed
on their processes and controls around funding risk 16 . It is important that financing arrangements and the
constraints that they impose on the fund are understood, are monitored actively and are considered as part of
the investment decision-making process.
Moodys reviews the collateral management/margin call process and key financing agreements. Particular
attention is placed on material terms contained within the agreements such as termination events, crossdefault and cross-collateralisation provisions as these terms may affect the availability of funding under certain
conditions 17 .
The funds counterparty credit risk management is also analysed with particular attention paid to diversification
of counterparties where appropriate (including prime brokers), ongoing monitoring of counterparties'
creditworthiness and counterparty exposure management.
Moodys focuses on the funds redemption terms in order to determine the presence of gates, suspension
provisions and lock-up periods and how well these correspond to the funds strategy, liquidity of the underlying
assets, other means of financing and their impact on the funds liquidity profile.

Category 4: Corporate Functions

Why they matter
The Corporate Functions are collectively the remaining primary internal functions that a hedge fund manager
typically performs to support the investment activities of the fund (and the aforementioned functions) as part of
the course of business. These include compliance and legal, systems and business continuity, human
resources and finance and taxation. These functions are important to the funds operational infrastructure as
they affect the smooth running and sustainability of the fund Managers operating environment, as well as
underpinning a number of the investment-related functions.




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.
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Assessment areas
Table 7
(a) Compliance and

(b) Systems and

Business Continuity

(c) Human Resources

(d) Finance and


Complexity of
Compliance Regime

IT & Systems Culture

Hiring Process

Internal Accounting





Compliance and Legal


Security, Access &



Compliance Monitoring
and Reporting

Business Continuity &

Disaster Recovery


Regulatory Compliance

Scalability & Growth



Anti-Money Laundering

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.

(b) Systems and Business Continuity

Systems are key to ensuring that the operational infrastructure can continue to operate in the event of a
significant business or environmental or possible security disruption. It is important that suitable information
technology and systems controls best fitted to the funds strategy are in place.
In our assessment we look at information technology security, access and permissions and how this is
managed from a control perspective. Business continuity and disaster recovery are also considered to be
important elements to ensure that the organisation is able to cope in any event without suffering any undue
stress. As such the business continuity plan, the role of information technology and its perceived importance
within the organisation, staffing, scalability and growth planning are also be taken into consideration.

(c) Human Resources

The majority of value added by a fund is derived directly from its human capital (i.e. its employees). Our review
of the various human resources functions of the Fund Manager entails hiring practices, staffing, training,
compensation and reporting, all in the context of the organisations size and complexity.
Large complex organisations would likely require a separate function and structured approach to managing
these processes, while smaller, less complex companies could perform many of these functions in more
flexible ways. As such, Moodys analyses how these functions are performed, that they are appropriate to the
organisation and that key criteria such as staff background checks are given sufficient attention.


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(d) Finance and Taxation
This section addresses the needs at the Manager level, not at the fund level, with regards to internal
accounting controls and financing activities. These include: budgeting, financing, forecasting, expense
approvals/allocations (which also directly affect the fund if certain expenses are allocated to the fund) and fee
calculations. Moodys assesses whether the Manager has sufficient access to taxation expertise, either
through an in-house professional or via a reputable third-party specialist, to meet its tax reporting requirements
and for tax efficiency purposes.
The finance/accounting function is paramount to ensuring that the investment manager remains viable and
profitable and that the day-to-day business of the firm operates as smoothly as possible; as such, the portfolio
managers/traders are more likely to be able to focus on the value-added services that they provide to the
fund. This in turn affects the long term viability of the fund and the operational stability of the Manager. Tax
efficiency and expertise are also important to the running of the firm as they affect the fund's overall results.
We also review the firms processes used to ensure that the fund and investors do not breach any
requirements, such as accurately reporting tax filings, which could result in fines or suspensions.

Category 5: Service Providers

Why they matter
The use of third-party (external) service providers for certain functions provides an additional layer of security
to investors by increasing the level of external (independent) scrutiny over the funds activities.

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
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

Typical Services Provided by Third Party Service Providers to

Hedge Funds

Trade Support (trade reconciliation, confirmations)

Fund Accounting (maintenance of accounting books and records, security pricing,

determination of monthly NAV)

Fund Administration/Transfer Agency (maintenance of shareholder registers, processing

subscriptions, redemptions, investor reporting and corporate secretarial services)

Prime Brokers

Custody, securities lending, executions, leverage facilities, margin facilities, cash

management, clearing, capital introduction, business consulting and research among others


Financial statement audit, auditing opinion

Companies affiliated to the auditors may also provide certain tax and accounting services

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


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Operational Quality Rating Process

Initial Process
The first step in the rating process is a specific request from the Fund Manager or other related party to rate
the fund.

Chart 3
Moodys OQ Rating Process

Approx. 6-8 Weeks


Rating Process Description


Legal documentation
Internal policies and procedures


Perform initial fund screening

Meetings with key fund personnel

3rd Party

Discussions with the funds administrator,

prime brokers and auditor


Analyst recommendation and Scorecard

presented to rating committee
Final rating decision made by committee


Rating and report communicated to client

Rating made public (at funds option)

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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Moodys also conducts meetings with the individuals responsible for the day-to-day functions in certain areas,
such as the fund accountants responsible for the calculation of the funds Net Asset Values or operations
managers which deal with trading requirement. Time is also typically allocated for follow-up questions and
feedback, and to confirm the details of any findings.
The rating team typically has a tour of the Managers premises, which may be accompanied by discussion
regarding any business continuity and disaster recovery plans and in certain cases also demonstrations of key
software used to manage the funds operations.

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, 19 , along with a Rating Report
describing the rationale for the rating.

Ongoing Monitoring
OQ ratings are monitored on an ongoing basis.




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.
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Moodys Related Research

Special Reports

Moodys Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds, October 2006

Assigning Unsecured Credit Ratings to Hedge Funds, April 2007 (102552)

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, 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. funds/..alternative investments


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Report Number: 116772


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June 2009 Rating Methodology Moodys Global Managed Investments Operational Quality Methodology for Hedge Funds