Back to Basics: The Value of Operational Due Diligence

Due diligence has evolved significantly in recent years, transitioning from a specialist “consulting” discipline, focused only on hedge funds, towards an institutional, fintech enabled risk management tool.

As the scope of due diligence has expanded, it is perhaps helpful to revisit the basic question – why complete ODD in the first place?

Castle Hall has identified four factors which demonstrate the value of an effective, systematic due diligence process. ODD adds value both when onboarding new asset managers, and when monitoring operational risks across the current, invested portfolio.

AVOIDANCE OF LOSS DUE TO OPERATIONAL FAILURE                                   

The nightmare scenario for any investor is to allocate to a manager which is subject to fraud: there will always be investment managers who steal cash from their funds, manipulate valuations or cheat around compliance controls.

Even in the absence of direct dishonesty, any asset manager can make an honest mistake. Effective controls and procedures, commensurate with the size and complexity of a manager’s firm and strategy, reduce the risk of errors such as fat finger trading, reconciliation mistakes, or problems with trade allocations between funds.

Has the asset owner completed sufficient diligence to veto a proposed allocation to a manager with an elevated risk of operational failure?

REDUCE ORGANIZATIONAL RISK THROUGH DOCUMENTED AND EVIDENCED DILIGENCE

Over time, virtually all investors will face a situation in which an external manager relationship fails, liquidity is restricted, and there is potential for loss of some or all of an investor’s assets. At that time, the investing organization will come under intense scrutiny from internal and external constituencies (regulators, government bodies, external auditors, the board, internal risk management, internal audit etc.). Negative publicity can also lead to unwelcome reputational risks for the investor, especially when investor organizations are high profile and politically sensitive.

Effective initial and ongoing diligence, when documented and approved, enables investors to stand behind their work, demonstrating that decisions were only taken after appropriate due diligence.

Has the asset owner (a fiduciary) completed sufficient diligence to demonstrate a robust process, consistently applied, when subject to scrutiny around any external manager relationship?

“OPERATIONAL ALPHA”

“Operational Alpha” means that a manager with a better business infrastructure will produce better outcomes, which means better performance.

“Past performance is no guarantee of future returns”, with few managers able to maintain top decile or quartile performance over meaningfully lengthy periods of time. All things being equal, an asset manager with better controls, procedures, management and resources is more likely to produce sustained outperformance. Factors such as better systems, better and more timely data, better IT security and better alignment of interests demonstrate a well organized fund management business that is likely to stand the test of time.

Has the asset owner completed sufficient diligence to direct capital towards asset managers with superior businesses in terms of resources, systems and management?

ADVERSE DEVELOPMENTS

Effective operational diligence monitoring helps investors validate that their initial rationale for allocating to a manager remains in place. In particular, ongoing ODD can rapidly identify adverse developments, enabling the investor to promptly withdraw from a manager which has staff turnover, regulatory actions, legal claims or which grows too quickly.

Has the asset owner completed sufficient diligence to monitor asset managers and identify firms which have begun to deviate from their business plan and / or industry best practices?

Straightforward concepts - but sustained and significant value from ODD for the investor community.