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Sign of the Times: Operational Due Diligence Takes Center Stage

In light of recent market turmoil and high-profile scandals, it is vital that investors verify that their hedge fund partners' businesses and operations adhere to the highest industry standards and best practices. Now, more than ever, investors are continually exploring new and more efficient approaches to determine which funds are worthy business partners.

To assist investors with this challenging task, the field of operational due diligence has emerged and evolved rather quickly from a checklist-oriented, fact-finding exercise into a multi-faceted analysis, including both quantifiable and qualitative metrics. This field now encompasses a multi-disciplinary network of professionals possessing an impressive range of credentials and diverse methodologies. While the vast range of options may be overwhelming, investors can start making smarter decisions by thinking about where their resources are housed.

Internally Sourced Due Diligence

Initially, operational due diligence was performed internally by investment strategy analysts or chief financial officers who armed themselves with myriad checklists of varying complexity to guide them through a step-by-step investigation of a hedge fund's operations. These checklists identified red flags, warning investors to exercise caution before investing with certain hedge funds. While some organisations still follow this approach, it is often criticised as inconsistent and oversimplified.

As the industry matured, operational due diligence incorporated higher-level skills provided by auditors, lawyers, fraud investigators and operations experts. These same professionals created dedicated, internal operational due diligence teams to develop more exhaustive investigative tactics. They analysed all functions of hedge funds' businesses and operations, and became known as 'jacks of all trades' within the investment community. Often, the conclusions of the due diligence team carried significant weight, whereby investors empowered them to veto those hedge fund investments deemed unwise.

Some larger investors, demanding even greater specialisation, furcated teams into specialised groups charged with focusing on specific areas of hedge funds' businesses. For example, certified public accountants reviewed audited financials while lawyers analysed offering documentation. Some teams hired former treasury specialists to examine counterparty, financing and cash management functions.

Externally Sourced Due Diligence

As in any maturing field, there has been a proliferation of operational due diligence specialists who position themselves as outside consultants. Many of these professionals have established independent consulting firms producing operational due diligence research reports.

Many of those investors who relied solely on an internal operational due diligence function have found themselves vulnerable to high-profile fund failures and scandals that could have been avoided. As a result, many of these internally sourced diligence teams faced increased scrutiny and investors began exploring new ways to enhance and improve their due diligence procedures.

Some investors felt pressure to completely outsource the due diligence function while others looked to supplement their internal due diligence teams with an outside specialist. This is called co-sourcing.

The Benefits of Co-Sourcing

The benefits of co-sourcing can be summarised as follows:

  • Independence – Very often, the investor's internal investment strategy team rules the roost and their opinions carry more weight than those of the operational due diligence team. This may pose a conflict of interest when strategy teams are incentivised to allocate to hedge fund managers. To protect the integrity of the entire process, clear and impermeable boundaries must be drawn between investing activity and due diligence activity.
  • Compliance – All investors reporting under GAAP must comply with a new auditing standard, ASU 2009-12.  Essentially, the rule states that investors cannot blindly accept NAVs from hedge funds without independently evaluating the hedge fund manager's fair value policies and procedures. This requires additional data points that external due diligence specialists gather and report in the normal course of their investigation.  In this respect, co-sourcing with the right partner can facilitate compliance with accounting rules and reduce audit fees.
  • Perspective – Due diligence specialists have in-depth knowledge of hundreds of hedge fund managers and strategies across numerous jurisdictions. This deep industry insight may prove useful to investors and due diligence teams that are more internally focused.
  • Scale – Internal investment teams often lack the capacity to handle larger amounts of reviews during busy periods of the investment cycle. For example, if a new product is employed, the internal team may be forced to compromise the quality of their performance in order to handle the increased workload and meet a deadline. These teams may benefit from the additional bandwidth of an outside provider.
  • Efficiency – A full-time team of in-house operational due diligence analysts can be expensive. Investors working with outside due diligence experts may be able to manage with smaller internal teams, which can significantly reduce costs.

Even as economic recovery takes place, due diligence will continue to play a critical role in the process of selecting and allocating capital to hedge fund managers. In that context, operational due diligence will evolve further as an industry, and investors should think strategically about the best way to incorporate due diligence resources into their organisations. Regardless of how investors structure their due diligence resources, the goals of due diligence efforts remain unchanged: building trust in hedge fund partners and enhancing the credibility of investment decisions.

Alan Swersky is a director in the Portfolio Valuation service line for independent financial advisory and investment banking firm Duff & Phelps. He is also head of the firm's Operational Risk Due Diligence (ORDD) group and based in the New York office.

Wesley Tellie is a vice president and works closely with Alan. Duff & Phelps' ORDD practice provides investors with an independent, third-party assessment of their hedge fund managers' operating policies and procedures.

This article first appeared on on 23 September 2010.