The financial crisis has revealed a number of prominent examples of funds suffering from operational shortcomings and a lack of internal controls and procedures. These incidental observations are supported by recent research, which has shown that more than 50% of hedge fund failures are caused by operational issues. Fund investors are therefore refocusing their attention on operational fund due diligence and are reassessing their due diligence procedures and standards. The recently published IOSCO best market practices for funds of hedge funds provide some guidance in this respect.
Heightened Operational Scrutiny
Investors’ heightened scrutiny in operational matters is not only a question of making better investment decisions. It is also necessary to protect fund investors from potential liability. Funds of hedge funds, pension funds, multi-family offices and other asset managers owe a duty of care to their investors to exercise diligence in the selection of fund investments. This includes an obligation to thoroughly review and assess the specific operational risk profile of a fund as well as the adequacy of the fund’s internal controls and procedures to deal with such risk. Furthermore, investors will have to carefully document their operational diligence efforts in order to be able to rebut any allegations that they did not comply with their obligations.
Advantages of Due Diligence Outsourcing
While a number of fund of funds and other larger investors are currently reinforcing their due diligence teams to cope with this elevated standard of care, an increasing number of fund investors are taking a different approach. They outsource operational due diligence to service providers to conduct an operational review on their behalf. There are some evident advantages to this approach:
- Expertise is a strong argument that speaks for outsourcing. While investors’ in-house due diligence teams undoubtedly have significant experience and expertise in this field, it is virtually impossible for them to be experts on the specific risks and particularities across all jurisdictions, asset classes and strategies. The operational risks inherent in more illiquid assets and exotic strategies are often significant and require an in-depth understanding of the relevant asset class and its specific execution risks. While in-house due diligence teams often have abundant expertise regarding more conventional liquid strategies, they often lack experience in this respect.
- Outsourcing due diligence provides the investor with an unbiased third-party assessment of the state of the operational affairs of a fund and the associated risks. Due diligence teams belonging to the same organisation as the investment professionals responsible for selecting and approving a fund for investment are at risk of being inappropriately influenced. A number of investors are seeking to counter this phenomenon by creating independent departments and reporting lines within the same organisation. In practice, however, these individuals work closely together and their affiliation and professional interdependence can hardly be denied.
- There is also a strong cost argument in favour of outsourcing. Maintaining and reinforcing due diligence teams is a costly exercise. Until recently, many investors have employed more junior employees for operational due diligence who sometimes lack the necessary expertise and experience. Hiring more experienced senior staff will be expensive. Obviously, this argument is even stronger for the medium to smaller-sized investors who cannot afford to maintain significant due diligence teams.
Shift in Fiduciary Duty
While there are number of good reasons for fund investors to outsource operational due diligence, it is important to note some of the legal and practical consequences and particularities of such practice:
- Outsourcing due diligence will shift the investor’s duty of care away from the actual due diligence process to the selection and monitoring of the due diligence service provider. The investor needs to exercise due care in the selection of the service provider in order to be satisfied that the service provider has the ability, including the technical and human capacity, to undertake the provision of the service effectively and to a high standard. The investor will not be held responsible and therefore will not be liable for an error or omission by the service provider unless it can be shown that the investor acted negligently in the selection of the service provider or failed to adequately monitor the service provider’s performance. The investor will therefore have to establish appropriate internal processes and procedures for selecting and approving service providers as well as monitoring their performance. Furthermore, the investor should properly document compliance with such processes and procedures.
- It will be important to clearly set out and define the level and focus of the third-party due diligence, the desired work product, as well as the responsibilities of the service provider and the investor in a written service agreement. The service provider’s work will have to be tailored to complement and interface with the financial, strategic and performance due diligence which will continue to be carried out by the investor. While any overlap of the service provider’s and the investor’s own due diligence should be minimised, significant risk-bearing matters and areas cannot be left uncovered as a result of insufficient coordination between the principal and the service provider.
- A fund investor using a third-party service provider to conduct due diligence will have to make sure that any potential conflicts of interests that may arise between the service provider and the fund investor or the service provider and the fund, whose operations are to be reviewed, are excluded or adequately addressed. Any potential conflicts of interest must be properly disclosed and assessed whether they may impact the independence and objectiveness of the audit to be carried out by the service provider.
Recent operational fund failures have painfully reminded investors of the fiduciary duty they owe to their investors in operational matters. It is therefore only logical for investors to intensify their due diligence efforts in this area. The heightened scrutiny in operational fund matters is leading an increasing number of investors to outsource operational due diligence to third-party service providers. Outsourcing is a cost-efficient way of adding critical expertise to obtain an unbiased and objective assessment of the specific operational risks inherent in a fund. Outsourcing also allows investors to focus on their core business: reviewing and assessing fund strategies and diversifying risk through allocation. For the very same reasons, outsourcing of (financial, legal, tax, commercial and other) due diligence to independent third-party specialists is considered market standard and best practice on the asset investment level, ie in investments in private equity, real estate and other complex illiquid assets. It can therefore be assumed that the current trend among investors to increasingly outsource the review of the operational risks, procedures and controls of investment fund will continue and lead to the development of a new best practice standard for the industry.
Dr Markus Federle and Frederic Berthier are co-founders and managing directors of THE FAIRSKY GROUP, an international group of companies specialised in fund due diligence for investors. Before founding the company, they were partners in a $400 million alternative asset manager.
This article first appeared in The Hedge Fund Journal (November – December 2009 issue).