A Weekly Operational Due Diligence White Paper
January 2, 2018
2018 OPERATIONAL DUE DILIGENCE OUTLOOK
2018 starts off strong with a continuing focus on honing the science of operational due diligence. Institutional investors and fiduciaries continue to outsource ODD or build out their ODD teams, to develop a tighter approach to completing diligence on hedge fund and private equity fund managers. Surprisingly, even as recently as 2017, it seems that a sizeable number of asset managers and allocators were conducting their ODD in-house using accounting, compliance, or investment staff, without the use of ODD specialists, but as businesses grow with the help of tax breaks and a booming stock market, these gaps will continue to close in 2018. Moreover, this specialist field of diligence has proven its merit over the years. The question remains, however, when or will the US move to a fund pay model?
FUND PAY MODEL VERSUS INVESTOR PAY MODEL – WHY HASN’T THIS HAPPENED YET?
Around the world, ODD is paid for and mandated by the institutional investor, and not the fund, like the case is for GAAP audits. Why would this be, when this creates a significant cost burden for the manager and for the investors? Why should each pension, endowment, wealth management platform, or FOF have different levels of ODD information, expertise, and take on different levels of fraud risk and operational costs? The answer seems to be three fold: a) FOFs continue to market their ODD as one of their edges, b) converting from an investor pay model to a manager pay model would theoretically put many internal ODD analysts out of work, c) and lastly the managers do not want to put all of their eggs in one basket betting their business on the operational risk assessment generated by one firm. So, today managers sometimes host hundreds of ODD meetings a year, and investors do varying levels of ODD work, resulting in tens of millions of dollars in duplicative costs. Some spending 100 hours on ODD using non experts, and some spending 30 hours a year using ODD specialists. Simply put, it is not an efficient frontier. Australia is one of the first countries to make the move and treat each investor equally by recently putting out regulatory guidelines recommending that managers/funds obtain a periodic ODD opinion from a reputable ODD firm. The process is in motion, but not yet fully up and running. When or will the rest of the world follow?
TRENDING OPERATIONAL AREAS
Current operational areas being studied by practitioners and regulators are expense allocations, HR and corporate culture, cyber security, and interaction with management and consultants as it relates to exposure to MNPI (material non public information). Specifically on expense allocations: are expenses charged to the fund actually explicitly permitted on the OM, are they accurately allocated to the proper funds (e.g. how are SMAs handled), and does the administrator review these calculations? Specifically on HR and corporate culture: how is hiring and code of ethics training handled, are background checks done annually or at all, have there been any employee HR claims? On cyber security, has there actually been a professional diagnostic performed on the firm, and what types of formal ongoing monitoring and testing is performed? For MNPI, the use of consultants and expert networks continues to be monitored, and controls around these processes are critical to a successful ODD assessment. Access to company management and long term relationships with company management also increases awareness especially with sector focused funds.