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Operational Due Diligence – Part 3 of a 3-Part Series

Operational Due Diligence  –  Part 3 of a 3-Part Series

About our Contributors
ICS Group is a regulatory compliance consulting firm specializing in providing compliance support to the financial services and insurance industries. We help our clients comply with regulatory requirements and industry standards. Our clients include: registered investment advisers, private equity funds, hedge funds, mutual funds, broker-dealers, insurance companies and state pension plans. Our team of highly experienced compliance professionals know from first-hand experience what regulators are looking for, the industry standards that apply, and how to develop and implement cost-effective business-oriented solutions.


Operational Due Diligence (“ODD”) has grown in importance significantly for institutional investors looking to invest in funds. Prior to 2008, ODD played an insignificant role compared to investment due diligence (“IDD”) when it came to investors making their final investment decisions.

Because of the 2008 financial crisis and the string of investment scandals and bankruptcies (e.g. Bernie Madoff and Lehman Brothers) that followed as well as the onerous 2010 Dodd-Frank Act, investors now rely heavily on ODD as well as IDD when making final investment decisions. A 2014 Deutsche Bank study of 70 institutional investors around the globe revealed that:

  • 65% of their ODD teams have explicit veto authority in the investment decision-making process, which was exercised in almost 7% of manager reviews.
  • 63% of investors won’t reconsider investing in a fund previously vetoed by the ODD team.

Emerging managers make up the majority of the 7% of managers being vetoed, likely because emerging managers tend to not have sufficient resources to manage the operational aspects of the firm. Since it is unlikely that investors will reconsider investing in a fund that was previously vetoed by the ODD team, it is extremely important for emerging managers to be prepared for the ODD process.

WHAT TO EXPECT

ODD is a comprehensive review of everything about your business other than how investment decisions are generated and executed. Institutional investors realize that there are operational risks in addition to investment risks that could potentially impact their investment. The purpose of the ODD is to make sure the firm is operationally well-managed. The major components of the process include:

  1. Comprehensive document request and/or due diligence questionnaire (“DDQ”)
    1. Review of fund documentation to ensure adherence to governing documents.
    2. Review of the business – its history, AUM, personnel, etc.
    3. Ensure there are policies and procedures in place to manage the firm’s operations.
    4. Ensure the Compliance Program is operationalized and effective to manage the firm’s risks
    5. Role of third-party vendors.
  2. Background checks on key persons
    1. Ensure managers’ backgrounds are suitable for the strategies they are managing.
    2. Is prior work history and experience accurate?
    3. Is there any aspect of the key person’s background that was not disclosed?
  3. On-site visit
    1. Interview of key persons to ask follow-up questions relating to the document review and DDQ.
    2. Review of Server Rooms, especially if the firm does high frequency trading.
    3. Review of Wire Transfer Authorizations
    4. Observe live trading, OMS System.

AVOID DEAL KILLERS AND RED FLAGS

If a manager does one of the following during the ODD process, it is likely to kill the deal:

In addition to deal killers, there are red flags that ODD practitioners look for during the ODD process:

  1. Finding material information that was not disclosed to investors. – Do not hide material information that needs to be disclosed. Sometimes during background checks of key persons, ODD practitioners find material information that should have been disclosed to investors. You want to disclose any information that may be material before it is found in a background investigation because it will help to build a relationship of trust with investors.
  2. Lack of Transparency around Side Letter Agreements – Without disclosing a particular investor’s name, managers should be willing to disclose to investors what terms other investors have in the fund to establish trust.
  3. Lack of Clarity around internal process of operations and the role of a Third-Party Service Provider – Managers should have a clear understanding of what an outside vendor does for them as well as a clear understanding of operations. For example, if your organization only has 10 people or less and you are asked, “Tell me the turnover within your organization”, you should know the names of the people that left and when they left.
  4. Inability to articulate the compliance policies and procedures – ODD teams have realized how important compliance is to a firm’s sustainability. Managers should have a firm understanding of their compliance program and should be able to articulate an accurate response to any question raised.

HOW TO PREPARE
In addition to avoiding deal killers and red flags, here are some ways you can be proactive to ensure a positive ODD result for your firm:

  1. Complete a popular DDQ (e.g. AIMA DDQ) or create a proprietary one so that you are prepared to answer questions during the ODD process.
  2. Hire an independent consultant to do a Mock ODD exam.
  3. As a complement to a DDQ, managers should create an ODD slide deck that includes:
    1. Life of a Trade
    2. Internal Committee
    3. Compliance Policies and Procedures
    4. Business Continuity Plan
    5. aluation Process
    6. List of Service Providers

For more information on how to prepare for the ODD process or for a mock ODD exam, reach out to ICSGroup today. As always, we are here to help.

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