Understanding the Core Components of Operational Due Diligence

Satisfying investor expectations through operational due diligence is a key factor in any fund’s success, whether the investment manager is an established hedge fund or an emerging manager. Following major instances of fraud, as well as fund blowups precipitated by operational deficiencies, today’s investors expect access to all operational information. Managers that can respond fully and efficiently in the due diligence process are significantly more likely to see cash committed.

Operational due diligence is conducted across the full complement of non-investment activities. Firms must anticipate providing information on managers and employees, including their backgrounds, experience, qualifications, incentives, and potential conflicts of interest. The role of management, corporate governance, and oversight will be of particularly keen interest, as will IT infrastructure, trade processing, custody, compliance, regulatory oversight, and more. Some core components of particular interest follow:

Governance: While scrutiny of the professionals responsible for the actual business of investing is imperative, equally critical is responding to questions about the fund’s governance. Potential investors will examine the role of the fund’s external directors, seeking to discover how directors are chosen and compensated, their qualifications, the frequency of board meetings, and how directors exercise oversight and control.

Valuation : A manager’s valuation policies are of considerable concern to investors. Valuation methodologies are typically outlined in a fund’s offering documents, and potential investors will seek verification that valuation is carried out as stated. Also, due diligence will seek to confirm the frequency and objectivity of pricing, and that the sources of price information are reliable. Investors will want to ensure that the final price used is accurate and consistent with pricing methodology and that a written policy exists for resolving price discrepancies. Valuation policy should be transparent, well-articulated, reviewed by a third-party such as an administrator, and reconciled daily.

Asset Security: Be prepared to offer comprehensive information on custodians, prime brokers, and derivative counterparties. Non-custodial assets, such as private equity holdings, will be subject to additional scrutiny.

Accounting and Trade Capture: The due diligence process will demand extensive detail regarding execution, confirmation, settlement, and reconciliation, typically including a “life-of-a-trade” process. Post-trade processing software that offers matching and execution-scoring capabilities, as well as analytical features, can shed considerable light on the robustness of internal systems.

Cash Control: Investors will demand stringent controls on the movement of client funds. Particularly critical is that one employee alone is not able to disburse or transfer funds on his or her signature alone. There must be dual signatories and a three-step prepare, approve, and release mechanism in place for transfers to be affected.

Fraud: The importance of fraud detection measures cannot be overestimated, and due diligence will require a detailed description of internal monitoring controls, particularly controls implemented continuously.

Supervision of Outsourced Functions: Funds employ many third parties in the course of business, including external fund administrators, valuation agents, IT providers, compliance consultants, and others. Due diligence will seek to determine how third parties are managed and supervised, as well as seek information on legal and contractual liability and resolution of disputes.

Business Continuity: This is a critical concern, particularly as the business disruptions imposed by the COVID-19 pandemic reminded us all of the impact black swan events can have. Funds should be able to offer evidence that backup systems have been successfully tested to demonstrate the accessibility of all critical applications such as email, accounting, and trade processing software. Digital files should be transferred daily to secure offsite storage and backed up, and a detailed contingency plan should exist to anticipate a range of disasters.

Asset managers may find it challenging to achieve top decile performance over time, but it is fair to say that those managers with a robust infrastructure and better controls, procedures, processes, and oversight are more likely to generate sustained outperformance. The way managers respond to the ODD process is certainly essential in raising assets, but the process of preparing to respond to ODD can help funds identify and rectify shortcomings that could be detrimental to their future success.


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.

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