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Home > Blogs > All About Alpha > The Rise and Rise of Operational Due Diligence

The Rise and Rise of Operational Due Diligence

The Rise and Rise of Operational Due Diligence All About Alpha

“Sunlight is the best disinfectant”
US Supreme Court Justice Louis Brandeis

The Madoff scandal exposed the Alternative Investment Industry to widespread allegations of substantial neglect, in terms of its Due Diligence processes. Understandably since then, Operational Due Diligence (ODD) has moved from a neglected, peripheral activity to center stage within the industry.

The main aim of Hedge Fund Operational Due Diligence is to ensure that the fund is being managed in accordance with best practice operationally and that all aspects of its operation are above board.

This article will consider what a Hedge Fund Investor or Fund of Hedge Fund Manager needs to do, who they should visit and what they should ask?

At Global Perspectives our Senior Staff have experience running the global ODD programmes for some of Europe’s largest Fund of Hedge Fund Managers. We have asked the hard questions and seen it all before.

A substantial part of successful Hedge Fund ODD is a judgement call. You know the facts, but how do you really make yourself comfortable that your investment will be managed properly?

Our view is that you cannot accurately determine this with a phone call. To gain comfort with the people who will be directly and indirectly managing your investment, you must go on-site.

For an investor to evaluate whether to proceed with an investment, they need to meet with all of the parties associated with the fund (outlined below). It is not enough to meet with the Investment Manager.

Ignore consultants or hedge funds that try and tell you a phone call is good enough. It is not.

As any experienced ODD practitioner will tell you – you need to see the whites of people’s eyes.

Investment Manager


The investment manager will likely send you their standard AIMA questionnaire in advance of your meeting. While this is a useful starting point it is imperative to see beyond this.

You are interested in understanding the detailed operational processes of the fund manager – from initial subscription to the fund, right through to the portfolio’s investments and the process of eventual redemption.

In asking your questions (and seeing beyond that questionnaire), it is important to follow the flow of cash into the fund and understand operationally what will happen as the money is invested, valued and finally returned to you as an investor.

One area to pay particular attention to is the Fund Manager’s protocol surrounding the movements of cash from the fund. Although this sounds obvious, it is scandalous the level of standards that existed in parts of the industry before the global financial crisis, regarding how and when money could be moved from a Fund.

In one memorable instance the Founder & Manager of a $4 billion dollar hedge fund we spoke to was allowed to move up to $5 million dollars of the Fund’s money to any account worldwide – with just his signature (“but sure he would only be stealing from himself” was their outrageous excuse).

In this case the Hedge Fund Manager had difficulties understanding why we would not approve an investment until this policy was changed – but changed it was. Thankfully this level of amateurism is in the past and will disappear completely as the industry matures and becomes dominated by large Institutional Investors.

Another area to focus on is around access. Will the Fund Manager give you free, independent and unrestricted access to the Fund’s Service Providers?

If not, then this is a major problem.

We have had successful, well-known Hedge Fund Managers try and stop us speaking to their administrators (“you would only be distracting them from their work on the Fund”). This is not good enough and should be a red flag to any savvy investor.

Thankfully this sort of active prevention is becoming rarer and rarer, as Hedge Fund Managers chase allocations and Investors stand their ground.

Lastly, remember when you plan your visit to the Investment Manager it should be built around the following core tenet

“Don’t tell me, show me

Everything the Fund Manager (and Administrator) tells you must be backed up with clear, verifiable evidence. You need to see their systems, see their processes and see their controls.

If all of this sounds cumbersome, that’s because it is. It could also save you from being a victim of the next Madoff.

Administrators


As the role of the Administrator increases in importance in our industry, a large part of ODD is now focused on the administrator’s processes and how they manage (which is after all), the Fund’s official books and records.

Now that the US self-administered fund model has (thankfully) gone the way of the dodo, institutional investors want to see a robust, efficient and responsible third party administrator in place for every potential Hedge Fund to review.

Some Administrators boast about their internal propriety systems, others promote their “best of breed” industry software. What is important to each investor is different and this will largely dependent on your individual risk appetite.

Most Administrators in the Hedge Fund industry report being inundated with ODD requests in the last few years. Many of the larger shops have set up specialist internal teams to facilitate these visits and co-ordinate the responses.

This is great, but it’s important to look beyond the standard responses and actually see how their controls work and their processes take place (just like at the Investment Managers).

One trend we have noted recently is the attraction of Administrators with large parent banks. Investors want to know there are very deep pockets behind their Administrator (ironically as more and more administrators seek to limit their liability in their administration agreements).

Given the demands from Institutional Investors identified, above it is unsurprising that a wave of consolidation has enveloped the Administration industry. Large Administrators are buying smaller outfits and many independent shops are quietly up for sale.

One final point to remember is around asset segregation. The endless, legal black hole which confronted many Hedge Funds after Lehman’s collapsed could have been prevented if assets had of been properly segregated. It is vital you ensure that there is no co-mingling of assets at your administrator. You must see clear evidence that your assets will be segregated in an account in the name of the Fund.

Auditors


Even today many Investors complete their ODD process by speaking to the Fund Manager and the Administrator only. That is not enough.

Hedge Funds (particularly in the US) are often audited by small (and very well regarded) specialist audit firms, which are well outside the Big 4 in terms of scale and coverage.

The driver here is of course the Madoff debacle and his infamous unknown 3 person audit firm in Florida (complete with an 88 year old lady and only one practising accountant).

As a potential investor you need to be comfortable that your auditor can perform their function in accordance with industry best practise. They are your main layer of protection as to the correct operational execution of the fund.

Auditors are peer reviewed every couple of years. You should be able to see the results of this process and make yourself familiar with the findings. Ignore attempts at obfuscation and insist to see the report (or at least the Executive Summary). This will not make you any friends, but now that all the large Audit firms are Limited Liability Companies, it is up to you to ensure you are happy that have your investment is protected. Your financial comeback in court is limited.

The Auditor should be able to flag any past issues that have arisen with the Investment Manager (or generally within the industry). You should feel comfortable that the fund’s audit firm fully understands all aspects of the industry and the assets and instruments being traded.

Just like at the Administrator, the important question here is -

“Who is watching the watcher?"

The short answer is – you are.

Software Vendors


The asset management industry is becoming more and more dependent on its software. Our suggestion is that you speak to the vendors of the main software used to value and price your potential hedge fund. Essentially this will be the administrators software.

If it is proprietary then you will want to know how it is supported. This includes meeting the individual’s responsible for keeping it running smoothly and secure.

If it is an off the shelf system then you need to familiarize yourself with this company and its background as well as ensuring it is well managed and solvent.

For both types of software you will want assurances that the vendor has a clear development plan to update their software so it encompasses all forthcoming regulatory requirements. These should be met quickly and efficiently and incorporated into the software well in advance of legislative requirements becoming law.

Understand the vendor’s testing processes and its speed to market. There is so much regulatory change taking place across the industry this is crucial (e.g. FATCA, AIFMD, Dodd Frank etc).

Finally, all investment managers and administrators will have a Business Continuity Plan in place (if not then you shouldn’t be considering an investment). Nowadays many of these disaster recovery programs are outsourced to third parties at specific off-site locations.

This article was written by Shane Brett, Managing Director of Global Perspectives, and originally published on AllAboutAlpha under the title: The Rise and Rise of Operational Due Diligence

Tags: Administrator , Auditor , Best Practice , due diligence , hedge fund , hedge fund industry , hedge fund managers , Hedge Fund Research , hedge fund strategies , hedge funds , Investment Manager
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