Even though in the past operational due diligence (ODD) was considered less important compared to investment due diligence (IDD) and thus often overlooked by investors, in the last decade, there has been a marked shift in attitudes on the topic.
ODD is growing in importance, and fund managers’ operational quality is becoming a prominent selection factor for institutional investors.
This brochure includes an overview of the areas inspected in ODD. It lists the main reasons why ODD teams veto managers, displaying the typical phases of the ODD, and explains how Diligend fits in to this process to significantly improve efficiency, collaboration, and traceability.
Who is subjected to ODD, and why is it done?
The depth and the nature of the ODD process has changed significantly since the 2008 crisis. Prompted by scandals such as Madoff and Weavering, volatile and uncertain markets, and an increasingly complex regulatory environment, inspecting the operational part of the manager´s activities is now more important than ever.
At first, the attention of ODD teams was focused primarily on asset classes with a higher perceived risk profile such as hedge funds and private equity. Long-only managers, on the other hand, were seen as more secure due to the heightened regulation, lesser complexity, and fewer unknowns. However, as events in the industry proved, ‘less risky doesn’t mean there is no risk” and investors have had to react and change their stance on the issue in order to mitigate future risks.
So nowadays it is widely known that many fund failures are due to non-investment related factors, i.e. malfunctions in manager’s operational processes and procedures, the use of third-party service providers, legal structure, staffing and compliance policies to name a few.
Most asset managers fit somewhere in-between the spectrum of operationally perfect and operationally unacceptable. This is where the ODD teams with their specific ratings for each fund or manager will determine if it is passing or failing.
Eight main areas reviewed by ODD teams
Despite fundamental differences in their size and strategies, different investment managers are exposed to similar operational issues. That’s why every operational due diligence check needs to review the manager’s commitment to regulations and industry best-practice standards. Especially concerning legal structures and documentation, service providers, personnel, risk management, IT, and compliance.
Operational due diligence should remain a continual process with the selected manager and reviewed on an annual basis. Monitoring is essential and done through annual surveys, review of audited annual financial statements, periodical reviews of regulatory filings and onsite visits.
- Organizational structure
Inspecting organizational structure reveals how the segregation of duties at the manager level is set, as well as if the structure can sufficiently support the investment management process. It is crucial to detect if the investment process can be performed by the team as a whole, or if it is dependent on one or two individuals, which represents a higher risk.
Personnel checks refer to inspecting the capability and appropriateness of employees based on their job roles, how many employees are involved in certain functions, and how the responsibility levels are set. Another crucial element to inspect here is the quality of employees’ remuneration policy, as well as employee equity ownership.
- Corporate governance
Inspecting corporate governance means identifying the final decision-makers in the organization and understanding what they are accountable for. It considers how much the decision making and investment process is relying on one or two individuals and whether it can be performed uninterruptedly without the presence of those individuals.
- Front to back office
Reviewing front to back office function gives an overview of how the business plan and investment strategy defined by the manager’s leading team are executed at the operational level. At this point, ODD focuses on portfolio management, order management, and investment committee performance. Back office resources, reconciliation of orders and NAV confirmations are also explored.
- Service providers
When talking about service providers, we don’t refer only to technology providers, but also to auditors, accountants, legal teams, brokerage and marketing firms. To put it simply, any third-party provider that has an active relationship with the manager. It is crucial to identify the relevance of outsourced services, reputation of the service provider, commercial and legal terms agreed between the manager and service provider, and how the co-operation is documented and managed.
- Risk, Audit & Compliance
In this area, the ODD team is focused on determining whether the manager’s business operations are aligned with contractual regulations, such as regional registration, licensing, or data compliance. The risk management framework is inspected, as is the adequateness of compliance practices to deal with capturing, monitoring and handling risks. Regarding the audit, it is crucial to determine if there is independent oversight, and if there is, the credibility of the manager’s audit firm is taken into account.
- IT, Security & Business Continuity Plan
The ODD team inspects the manager’s IT infrastructure with the aim to determine if it is appropriately structured to support the trading strategy, size, and prospective growth. Assessing efficiency of the disaster recovery plans, business continuity plans and back-up systems to demonstrate the manager’s capability to secure business operations in the case of any type of disaster.
Even though the incorporation of ESG objectives is stated in the manager’s investment policies and process descriptions, the ODD team has to make sure that the manager does indeed incorporates ESG factors into the decision making and portfolio construction.
Ten reasons why ODD teams veto asset managers
Malfunctions in the manager’s operational processes and procedures, legal structure, and organization, staffing, and compliance policies can severely impact the manager’s overall success. Therefore, operational due diligence teams hold significant power in the manager due diligence process, even to the point where ODD teams can veto prospective investments decisions if they fail the ODD team’s review.
The most common reasons leading to a “disqualification” of the asset manager during the ODD process are:
- A manager is reluctant to provide insight into certain business operations and documents
There is no doubt that some aspects of trading positions are and should stay confidential to the manager. However, an investor has a the right to request sample portfolios to assess them for red flags. Also, sample reports showcase the level of detail in information that the investor will receive from the manager through the investment cycle. If the manager is reluctant to provide insight into certain business operations or information, it is an instant warning sign.
- Integrity or key management issues
Do background and reference checks mismatch with CVs, personal stories, and disclosures? If the answer is yes, a manager veto is inevitable. Have there been more changes in the manager’s ownership structure, or senior staff departures that were not disclosed? Examples like this show the risk factor from an ODD perspective.
- Operational and IT infrastructure is not aligned with the manager’s strategy
Operational and IT infrastructure must be aligned with the manager’s specific strategy in every aspect, and especially in disaster recovery and business continuity planning. If that’s not the case, the manager will be downvoted.
- Non-investment management staff provide un-satisfactory checks and balances
If the ODD reveals that the Chief Investment Officer is surrounded by a team that doesn’t provide adequate checks and balances, the ODD team will see it as a considerable risk for the investment strategy.
- Not allowing engagement with service providers
Does the manager refuse to enable the investor to engage with its service providers? If this is the case, vetoing the manager is inevitable.
- Segregation of duties around cash control are not satisfactory
If the manager doesn’t have at least two signing officers and implemented additional layers of cash control, it will contribute to a bad ODD score.
- Significant inconsistencies in investment style
Dramatic swings in AUM, investment style drifts, or exceptional performance (either good or bad) typically represent a warning sign.
- Inadequate remuneration policies
The ODD team will mark these as red flags as they are unsatisfactory policies for retention of key staff and ineffective practice for alignment of interests.
- Valuation issues
Administrators without sufficient expertise in pricing the products in the portfolio? The CFO doesn’t verify pricing for illiquid instruments? Unclear valuation policies? deviations in NAV estimations? – All warning signs and reasons for the ODD team to veto the manager.
- Independent oversight is missing
If the fund is self-administered, uses an unknown audit firm, or doesn’t have independent directors in the board, in an ODD audit of the fund, the odds are stacked against them.
Phases of the typical ODD process and how Diligend can fit in
Check out our features list to know more how we help fund investors with their fund due diligence and monitoring processes: Investors and Consultants