Dawn M. Levant, Manager, Audit & Accounting
It was the best of times; it was the worst of times. This well-known phrase keeps coming to mind as we evaluate how to move forward when it feels as though the whole world has collectively stopped moving. While approximately 300 million people, just in the United States, have been asked to stay at home, the world has not stopped moving. The markets are open, and during these turbulent times effective due diligence is more important than ever.
Yet, can there be “effective due diligence” during a pandemic?
As COVID-19 continues to develop and present new challenges, so too must operational due diligence professionals adapt and develop new policies and procedures to ensure non-investment risks are addressed. Due diligence should never be a “check the box” exercise, and while today that has never been more evident, gathering consistent, easily-applied data can help an investor identify higher-risk managers.
Gather Basic Information from your Investment Managers
It may seem obvious, but the idea is to formulate a quick snapshot to help an investor understand its risks, determine its liquidity, and assess transparency issues. Some areas in which to gather this information include:
- Manager location – As new virus hotspots emerge, do you know which of your managers could be affected?
- Manager size– Smaller managers will be at greater operational risk due to a smaller headcount and lack of segregation of duties. Should a key employee get sick, are there sufficient resources and back-up functions to keep the investment process moving?
- Service providers – Which service providers are used for your funds? Has the manager reached out to the service provider to determine whether there will be servicing problems?
- Counterparty exposure – Ask each investment manager to provide prime broker and counterparty exposure.
- Front office – Ask each investment manager to provide a summary of the impact to the front office, including any effect to the execution of the investment strategy or the deal timelines.
- Back office – Ask each investment manager to provide a summary of the impact to the back office, including any changes in controls and procedures due to employees working from home.
Beyond the Basics – Adapting to the Challenges
- Documentation Review. Part of what makes due diligence using only remote procedures a less than ideal model is the reluctance of investment managers to release sensitive documentation. With travel restrictions in place for the foreseeable future, investment managers, investors, and due diligence professionals will have to be creative in addressing access to sensitive documentation. This applies to not only the due diligence professional, but also the investment management staff – how is the investment manager obtaining relevant documentation during its investment due diligence?
- Virtual “Trust but verify” is still a fundamental component of operational due diligence. An onsite visit provides the opportunity to observe employees, processes, and systems in action. With most, if not all, of an investment manager’s staff working from home and on-site visits suspended, due diligence professionals can obtain a significant amount of information through questionnaires, social media, a review of Form ADV, and even the investment manager’s website. Virtual visits include “a walkthrough of systems” through screen shares and video conferencing.
- Interviews. Although in-person interviews are a great way to glean information from a manager, video conferencing is a viable alternative. Interviews are important not just for what is said, but due diligence professionals will pay close attention to non-verbal communication as well as corroborations between front, middle, and back office personnel. As stay at home restrictions continue, due diligence professionals and investment management personnel are becoming comfortable with conducting interviews remotely. Video conferences can still allow the interviewer to read body language, walk through the life of the investment, and assess whether the story “fits.”
- Business Continuity and Disaster Recovery. Most investment managers have business continuity and disaster recovery plans in place. Typical plans address isolated events such as a power outage or an inaccessible office building. Most do not address a pandemic with widespread quarantines, travel restrictions, and most, if not all, employees working from home. Annual BC/DR testing is more often than not executed when the office is not at 100 percent capacity (e.g., a long weekend or a week in summer when a higher than normal percentage of employees are on vacation). COVID-19 has tested these plans and highlighted weaknesses. Due diligence professionals should ask about any problems, and more importantly, any changes that have been made in response to COVID-19.
- Regulatory Concerns. Investment managers and due diligence professionals should be aware of any regulatory changes due to COVID-19. The SEC and OCIE have both released statements in response to COVID-19. OCIE has indicated it may discuss with registrants the implementation and effectiveness of business continuity plans. The SEC has stated that the June 30, 2020 deadline for complying with Reg BI will not be changed in light of COVID-19. Investment managers should ensure any changes in policies and procedures are carefully documented and consistent with legal requirements. Well-designed compliance programs that are not properly documented or implemented will often lead to regulatory enforcement actions.
As COVID-19 continues to evolve and market participants continue to adapt, due diligence professionals will need to evolve and adapt as well. Due diligence professionals are adapting to virtual environments, watching for regulatory guidance, and developing an understanding of policy and procedural changes.
As we move past the pandemic, due diligence professionals and investors should ask for copies of policies and procedures as well as disaster recovery and business continuity plans. Any documentation that has not been revised or updated as a result of COVID-19 should be a red flag.
While we are in what can only be described as “the worst of times,” we can still develop best practices that will carry forward with us as we look forward to the “best of times.”
Dawn M. Levant can be reached at firstname.lastname@example.org or 215.441.4600.
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