Every investor must carefully examine all of the risks involved in any commitment of funds. Due diligence is the process by which investors assess these risks; it is the foundation of any investment decision. There are two types of risk that investors face. First is investment risk, which contributes to investment returns. The second is operational risk, which does not. By examining the policies, procedures, and processes in place at a fund through operational due diligence, the investor can determine the likelihood that operational features will appropriately support the manager’s trading and investment activities. Investors are not paid for taking on operational risk, but it can have a significant impact on returns all the same. Increasingly, investors, particularly hedge fund investors, believe that funds must be managed by well-controlled and resourced firms to generate attractive, long-term returns.
Operational due diligence (ODD) has become increasingly important in recent years. Some of the biggest hedge fund failures in the news, Amaranth Advisors, for example, were caused by operational issues. Rogue trader Brian Hunter’s huge, leveraged bets could have been prevented by more stringent operational controls. Strict operational due diligence might also have prevented so many investors from falling victim to Bernie Madoff’s Ponzi scheme. Jason Scharfman of Cogentum Consulting, who literally wrote the book(s) on operational due diligence, suggests that operational risks are inherent contributing factors in all hedge fund failures.
Today, rogue traders and fraudsters are just two threads in the fabric of operational risk. Many investment managers are outsourcing more of their business functions. Ensuring that vendors are sound and outsourced functions are appropriately supervised has become another crucial component of operational due diligence. Particularly in this time of the pandemic, fund employees are working remotely, which introduces more potential for trouble. Cybercrime and hackers pose an obvious threat to information security even under the best of circumstances, but it becomes more difficult to keep home systems secure. And it’s not just cyber criminals that pose a threat. A mischievous toddler in the home office or a cat on the keyboard can trigger a disaster as well.
Investment managers, particularly emerging managers, need to prepare well to survive the scrutiny of operational due diligence. Some potential investors conduct the ODD themselves, while others may outsource to consulting firms that specialize in the process. Moreover, other players may take a keen interest in a fund’s operational processes as well, such as auditors and regulators. Not only will they seek to determine whether core features are in place, but they are likely to demand proof of investment in appropriate personnel, systems, and service providers.
Every successful fund, no matter what type of structure, needs a process in place to satisfy operational due diligence requirements. Many emerging firms make the mistake of creating templated documents to offer in response to due diligence questionnaires. Unfortunately, every investor is different and canned responses cannot address concerns that can differ considerably among investors. Satisfying due diligence requirements is critical for any firm that wishes to raise money, and even more so for emerging managers. Every due diligence questionnaire requires an individualized response, preferably from a professional dedicated to the due diligence process.
Certain execution processes are increasingly significant. For example, matching and reconciliation have grown enormously in importance; it’s no longer sufficient to state policy. Rather, a detailed outline of the process is frequently required.
To be successful in today’s environment, an investment manager must respond effectively to the ODD process. Investors seek funds that are managed by well-controlled and resourced firms to generate attractive, long-term returns. Luckily for managers, there are plenty of outsourced solutions designed to help them elevate the operational due diligence experience for all parties involved.
About the Author
Rebecca Baldridge, CFA, is an investment professional and financial writer with more than 20 years of experience in creating content and research for asset managers, investment banks, brokers and other financial services clients. She’s worked for some of the biggest names in the industry, including Merrill Lynch Asset Management, JP Morgan Asset Management, BNY Mellon and Franklin Templeton. Rebecca also spent 9 years as an analyst and director of equity research in Moscow, working for several Russian banks. In late 2019, she founded Quartet Communications, a boutique communications firm serving financial services clients. Her writing has been published in outlets including Pensions & Investments, MSNBC.com, Inc. magazine, and Investopedia.com. She holds a B.A. in Russian from Purdue University and an M.S. in Finance from the Krannert Graduate School of Management at Purdue.