The landscape of the financial markets is full of constantly evolving regulation, complex financial instruments, customized investment structures, and increased scrutiny from investors. Now may be the time to evaluate your operational due diligence program.
What is Due Diligence?
Generally, due diligence refers to the care a reasonable person would take before entering into a transaction with another person. Operational due diligence is the review of an investment manager’s operations, with a focus on operational risks.
Investment Risk vs. Operational Risk
Investment risk is defined as the probability of occurrence of losses relative to the expected return on any particular investment. Operational risk is defined as the risk of loss resulting from inadequate or failed processes, people and systems.
Although investment risk is a key driver of investment returns, operational risk is just as important, particularly since it is uncompensated. Historically, investors spent a great deal of time and money analyzing the strategic risks involved with different investment approaches. This was despite the old adage that “past investment results are no guarantee of future results.”
Common operational risks can be found in the following areas:
- Trading processes
- Valuation policies
- Fund accounting
- Regulatory compliance
- Cash management
- Fund service providers
- Business continuity planning
- Counterparty risk management
Operational due diligence allows for a deeper understanding of an investment manager’s policies and procedures and whether they are designed to minimize these types of uncompensated risks. The goal of any operational due diligence program is to understand the overall risk culture of the investment manager and hopefully avoid any investment that is at risk due to poor operations. While it is impossible to eliminate all risks involved with any investment, a strong due diligence program can help mitigate and better understand the weaknesses and operational risks.
The Often Neglected Risks
A strong due diligence program will look beyond the “typical” operational areas noted above. Often this may require delving into proprietary information, but walking through systems and controls while testing for specific transactions is usually the only way to uncover often neglected risks. It may also require time and resources not available to the investor. While these risks are often neglected, they should be included in any due diligence process. These risks can include:
- Appropriate Controls – Are transfer instructions from accounts administered by an independent administrator? If self-administered, are dual signatures and call back procedures required? Are the duties of authorization, execution, and recordkeeping adequately segregated?
- Appropriate Staffing – Is the investment manager adequately staffed with appropriately trained employees?
- Background Checks – Investors may opt to conduct background checks on key employees if the investment manager does not perform regular checks on its employees.
- Compliance – Is there a dedicated compliance officer? Is the compliance program regularly reviewed? Are employees offered regular training?
- Dependence on Key Employees – Would the loss of this individual impact the assets under management, the investment strategy, or the ability to generate revenue?
- Due Diligence – Is the investment in private equity? Is the investment in a fund of funds? What is the due diligence process at the investment manager before making an investment? Is there a systematic and adequate selection process? Is there an investment committee?
- Financial Stability – Review of the investment manager’s financial statements should provide clarity. Some investment managers consider these statements confidential. If financial statements are not provided it is important to determine if assets are greater than liabilities and the firm is expected to be cash flow positive.
- Management and Performance Fees – Are fees adequate or does the firm rely on performance fees to cover expenses? Is there an unusually complex structure in place? Are the terms of the fee structure understood by both parties? Hurdle rates and waterfall calculations complicate the calculation of performance fees.
- Related Parties – There should be independence with regards to service providers. Related brokerage and custody relationships are potential warning signs.
A Partnership – Why Work with a Due Diligence Consultant?
Due diligence cannot take a “cookie-cutter” approach. For many, due diligence is still a “tick the box” approach. Common due diligence practices largely focus on the investment side, yet investment due diligence without operational due diligence is just not sufficient.
Operational due diligence reviews will vary depending on the type of fund/investment manager that is subject to review; yet each review should include, at a minimum, onsite interviews with various key employees and a walk through of both the front and back office. Listening to investment manager personnel describe their systems and controls is no longer adequate. Investors should be asking for demonstrations of the systems so they can see the controls in action. The process should include analyzing documents and walking through trades and the due diligence performed by the manager so that the investor can determine if the manager has described the process the way they think an investor wants it to be or how it actually is.
A strong combination of investment and operational due diligence allows an investor to have the most complete picture of an investment manager and its operations. Due diligence professionals understand seemingly simple details can slip through the cracks and a potentially large risk will go unnoticed. Investors should ask the following of their due diligence team:
- Are you up-to-date with current regulatory compliance requirements and industry best practices?
- Do you evaluate the entire operations of the Investment Manager?
- Are you customizing testing with your investment guidelines?
- Do you provide a well-documented report in which risks are identified and explained?
- Do you provide on-going monitoring?
Due diligence is a critical component of the investment process. A great benefit of conducting due diligence is providing advice on how the operations of the investment manager can be improved. An independent due diligence consultant has the advantage of observing hundreds of processes in place at various managers and can utilize this knowledge as feedback to a prospective investment manager. A strong due diligence program will not only lower risks but will provide investors with long term partnerships in their choice of an investment manager.
For more information about this content, contact kmiller@kmco.com or 215.441.4600.
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