Infovest21 White Paper:Assessing the operational due diligence function at funds of funds

“Some funds of funds’ operational due diligence teams that were proactive and negotiated better terms in side letters, likely enjoyed better performance and liquidity in the fall of 2008/early2009. And those who were organized and savvy enough to challenge some of the fund restructurings that occurred during that same time period also probably earned their fees. An ounce of prevention really was worth a pound of cure,” says Julia Herr, a hedge fund lawyer who headed the operational due diligence team at a large US-based fund of funds.

Over the past several years, many funds of funds have been reassessing how to conduct operational due diligence. Different variations exist.

Infovest21 interviewed a number of experts in the area including operational due diligence specialists, consultants, attorneys, certification specialists, prime brokers and recruiters to determine, among other things, what qualities an investor should look for in assessing a fund of funds’ operational due diligence team. The findings, which are detailed in its just-released white paper, include:

• Dedicated and independent
Operational due diligence has be separate and independent from investment due diligence, says Daniel Celeghin at Casey Quirk. “End-investors should look closely at the operational due diligence team at a fund of funds. How does it relate to the investment due diligence team? Is there overlap? Are they independent?” Celeghin emphasizes that operational due diligence at a fund of funds should be a dedicated role. “It isn’t an added responsibility for an investment team member, the risk manager or the chief operating officer.”

• Qualified talent
Operational due diligence professionals require a combination of skills as they encompass a variety of areas including hedge fund operations, accounting, legal review of the offering documents and governance structures and incentives. “It can be challenging if not impossible for a single person to pull it all together. Some may have strength in one area and general knowledge in another. An effective operational due diligence group must have all the bases covered,” says Herr.

• Veto power
Some investors look for an operational due diligence veto. Celeghin says, “The operational due diligence head is a dedicate role where absolute veto power exists. If the founder of the firm pounds his fist on the table, what the operational due diligence individual says at the end of the day is the ultimate decision. It is not so much the decision to hire but the decision not to hire. A manager may check all the boxes from the investment perspective but the operational due diligence head can veto.”

Herr says that investors should recognize that many firms define “veto” differently. What’s more important for investors to understand is what veto really is, who has it and what the firm’s incentive and reporting structures are.

• To outsource or not to outsource?
Herr points out that many firms may outsource because it provides an insurance policy – someone to fire in the event of a disaster. Outsourcing can also be a popular choice where it can be charged to the fund. If done in-house, it may be more difficult to allocate those costs.

She says that outsourcing can also serve a complementary role i.e. supporting one’s team or providing a second opinion.

Another large institutional fund of funds says it doesn’t outsource operational due diligence because the process is highly integrated to the investment process. “We use quantitative/qualitative research, portfolio, risk, operational due diligence and legal. They all collectively play a role. As long as you have the right controls in place, you won’t want any of those functions to be a “lap dog” to the hiring process. You want to exercise judgment if you can roll that into an approach. You get a balance of integrity, independence versus insight."

Reality: Only 27% have dedicated operational due diligence
Based on Corgentum’s study of approximately 275 funds of funds, 27% had dedicated operational due diligence (i.e. at least one employee’s full time responsibility was dedicated to operational risks), 21% used the shared approach (i.e. operational due diligence was conducted by the investment due diligence team), 28% had a hybrid structure (some combination of the various approaches) and 14% were modular (i.e. the operational due diligence process is categorized into functional components and parsed out among different specialists e.g accounting, lawyer etc).

Corgentum found that 46% of the funds of funds with assets under $1 billion used a hybrid approach while 29% used a shared approach while dedicated frameworks accounted for 14%. For funds of funds over $1 billion in assets, 32% had a dedicated framework while 30% had a shared framework and 23% used a hybrid approach and 234% took a modular approach.

As investors demand more operational due diligence reviews, funds of funds will likely dedicate more resources to operational due diligence in an effort to differentiate themselves among their peers.



Excerpts from just-released Infovest21 White Paper