Operational due diligence
Encyclopedia
The phrase Operational Due Diligence (ODD), in the context of alternative investments such as hedge funds (or private equity
, infrastructure, real estate, commodities and so on), means different things to different people.
As the words themselves imply, an ODD exercise is an investigation (due diligence
) into operational factors, relating to a specific alternative investment entity such as a hedge fund (or private equity fund
, or infrastructure fund, etc.), which may impact future results of the target alternative investment entity.
The field of ODD has gained prominence over the past years due to the failure of hedge funds such as Amaranth Advisors
and the Bayou Hedge Fund Group
. Also contributing to the increase of interest in this field were the actions of alleged rogue trader
s such as Brian Hunter
and alleged Ponzi scheme
rs such as Arthur Nadel
, Jérôme Kerviel
and Bernard Madoff
.
Operational risks, put simply, are the risks arising from execution of the business functions of any entity, for example an alternative investment fund, and these are distinct from its investment functions.
An ODD exercise does not include within its scope the investment functions of an alternative investment fund and therefore generally does not include the gathering, analysis and verification of information relating to the historic actual or future expected investment performance of such funds, the variance or future expected variance of the returns of such funds, or the appropriateness of the stated strategy of such funds as a (potential) constituent part of the investor’s wider portfolio, except insofar as these investment functions are or could themselves be adversely influenced by operational risks.
However, a separate “Investment Due Diligence” (IDD) exercise is often carried out by or on behalf of (potential) investors to consider investment functions. In fact, historically, it can be said that it has been more common for an IDD to be performed than for an ODD to be performed, despite strong academic arguments and empirical evidence that overall risk (i.e., investment risk and operational risk) is best capable of being understood and mitigated where both an IDD and an ODD are performed.
indicated that operational risk failings were the sole reason for 50% of all hedge fund failures (with operational risk failings being a contributing factor in other failures as well), rather than bad investment decisions alone (38%), and anecdotal evidence seems to imply that (i) the impact of operational risk is at least as pervasive in other (non-hedge fund) types of alternative investment funds, and (ii) that the impact of operational risk failings has not decreased since the Capco study.
A 2008 book by Jason Scharfman of Corgentum Consulting suggests that operational risks are inherent contributing factors to all hedge fund failures.
For example, a May 2009 derivative lawsuit relating to a feeder fund invested in a managed account that was exposed to Madoff’s split strike conversion strategy noted that “the Madoff story bristled with red flags that a financial professional firm performing an evaluation [ODD] and subsequent management and oversight, in good faith, could not have missed.”
The clear implication of this statement is that in the absence of detailed and robust pre-investment and on-going ODD, investors simply missed the operational risks inherent in the structure.
• allow an investor in a specific alternative investment fund to form a considered view as to whether to remain invested or to divest, or
• allow a potential investor in a specific alternative investment fund to form a considered view as to whether to invest or not, and
• (ideally) identify conditions which the investor or potential investor may seek to negotiate to reduce the overall level of operational risk associated with a new or existing investment in such specific alternative investment fund.
A small sample of the items which may be included within the scope of an ODD are outlined below:
• mark to market valuation techniques, and related processes/controls and disclosures
• business continuity and disaster recovery planning
• fraud risk and other irregularities
• behavioural analysis of individuals (e.g. fund directors and employees/principals of the manager of the alternative investment fund) and outsourced service providers, including their incentivisation
• liquidity mechanisms (“lock-ins” and “gates”)
• security of assets
• legal review, covering (amongst others things) design and establishment of the legal structure, advice taken by the alternative investment fund and its manager, material contracts, investment terms, indemnifications and insurances (although this may be performed as a separate Legal Due Diligence)
• review of the controls and processes employed by the fund through its main outsourced service providers (investment manager, fund administrator, transfer agent, etc.) over the management of fund assets to establish whether these are fit for purpose and being followed
• review of the operating processes and record-keeping supporting tax relating to maintaining beneficial tax treatment or "keeping the fund offshore".
The banking industry is, in most economies, subject to regulation by a national financial services supervisory body, for example the Financial Services Authority in the UK, with the regulatory regime including a requirement for banks to hold at least minimum levels of capital designed to withstand the likely incidence of various risks, including operational risks. The capital held by banks for the purpose of meeting the requirements of the relevant regulator(s) is referred to as their capital requirement
or prudential capital.
The imperative of considering operational risk in the context of banks is to ascertain an amount in currency which, if maintained by the bank as capital, should (in theory at least) fully compensate for the expected impact of crystallisation of the operational risks faced by the bank. When this “operational risk requirement” is added to the other elements of a bank’s prudential capital requirement (relating to non-operational risks faced by the bank), the resulting total gives the bank’s “total capital requirement”.
Despite according neatly with the theory, such forms of ODD have severe limitations; for example such forms:
• tend to incentivise “window-dressing” behaviours by the manager of the alternative investment fund (as a checklist-based approach is often employed with the majority of the questions being easily foreseeable by the manager of the alternative investment fund);
• often utilise less-experienced personnel without the experience to ask the right follow up questions or “smell a rat”;
• tend not to react (or not to react quickly enough) to new or developing risks which are industry-wide or to risks that are specific to the alternative investment fund in question or pertinent to the specific investor;
• tend to apply weightings to the risk factors addressed that are static and based on historical data, whereas in reality future likelihood of risk crystallisation and quantum of expected loss on crystallisation are dynamic variables;
• tend to apply correlation factors to separate risks that are static and based on historical data, whereas in reality correlation factors are dynamic variables; and
• tend to give binary results without identifying conditions which the investor or potential investor may seek to put in place (via negotiation with the manager of the alternative investment fund) to reduce the overall level of operational risk associated with a new or existing investment.
as well as other major hedge fund allocators, take four primary approaches towards designing their operational due diligence frameworks. These four categories are direct, shared, modular and hybrid, modular.
A 2010 study shows that frauds such as Madoff have created a so-called Madoff Effect by which investors tend to tailor their operational due diligence around recent frauds while minimizing certain other operational risks.
These other risks can include items which effect the overall efficiency and profitability of a hedge fund, a concept known as Operational Drag ® .
Other recent developments:
Where a more nuanced approach to ODD is taken, the benefits accruing to the recipients of the ODD report generally include:
• not relying on a checklist approach so that the investigation is bespoke for the investor’s specific interests and tailored to the target alternative investment fund;
• offering multi-disciplinary solutions to legal, financial and accounting, tax, regulatory and compliance, risk management, corporate governance and internal control concerns (as opposed to skills in one particular area such as accounting);
• the involvement of a team with the breadth and depth of experience to clearly and succinctly identify “red flags” and propose practical recommendations for risk mitigation and monitoring;
• transparency of detailed findings to the end investor – note that managers of funds of alternative investment funds (e.g. fund of hedge funds managers) typically do not provide full transparency to their investors of the findings of their ODD, with investors simply becoming aware, after the fact, that an investment in an “underlying” fund has been made or that a divestment has occurred;
• succinct written responsibilities and scope, as well as clear legal liability of those performing the ODD for the quality of their work;
• individuals and organizations involved in the performance of the ODD being subject to professional requirements on ethics, independence, minimum levels of professional indemnity insurance and Continuing Professional Development of an appropriate professional body or institute, with underlying work performed as part of the ODD subject to oversight and Quality Assurance reviews by that body or institute.
• being paid for directly by the end user (i.e., the investor) rather than by the alternative investment fund or its manager (due to the conflict of interest created if the fund or its manager is the “client”) or bundled as part of a wider service (for example as is the case with a fund of funds).
Private equity
Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange....
, infrastructure, real estate, commodities and so on), means different things to different people.
As the words themselves imply, an ODD exercise is an investigation (due diligence
Due diligence
"Due diligence" is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations...
) into operational factors, relating to a specific alternative investment entity such as a hedge fund (or private equity fund
Private equity fund
A private equity fund is a collective investment scheme used for making investments in various equity securities according to one of the investment strategies associated with private equity....
, or infrastructure fund, etc.), which may impact future results of the target alternative investment entity.
The field of ODD has gained prominence over the past years due to the failure of hedge funds such as Amaranth Advisors
Amaranth Advisors
Amaranth Advisors LLC was an American investment adviser managing multi-strategy hedge fund founded by Nicholas Maounis and headquartered in Greenwich, Connecticut. The firm had up to $9 billion in assets under management and collapsed in September 2006 after losing in excess of $5 billion on...
and the Bayou Hedge Fund Group
Bayou Hedge Fund Group
The Bayou Hedge Fund Group was a group of companies and hedge funds founded by Samuel Israel III in 1996. Approximately $450m was raised by the group from investors. Its investors were defrauded from the start with funds being misappropriated for personal use...
. Also contributing to the increase of interest in this field were the actions of alleged rogue trader
Rogue trader
A rogue trader is an authorised employee making unauthorised trades on behalf of their employer. It is most often applicable to financial trading, and as such is a term used to describe persons - professional traders - making unapproved financial transactions....
s such as Brian Hunter
Brian Hunter (trader)
Brian Hunter is a Canadian natural gas trader for the now closed Amaranth Advisors hedge fund. Amaranth, which had over $9 billion in assets, collapsed in 2006 after Hunter's gamble on natural gas futures market went bad.-Early life:...
and alleged Ponzi scheme
Ponzi scheme
A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from any actual profit earned by the individual or organization running the operation...
rs such as Arthur Nadel
Arthur Nadel
On April 28, 2009, Arthur Geoffrey Nadel was indicted on 15 counts including six counts of securities fraud, eight counts of wire fraud and one count of mail fraud in a federal court in Manhattan...
, Jérôme Kerviel
Jérôme Kerviel
Jérôme Kerviel is a French trader who has a pending appeal of his conviction in the January 2008 Société Générale trading loss incident for breach of trust, forgery and unauthorized use of the bank's computers, resulting in losses valued at €4.9 billion.Société Générale characterizes Kerviel...
and Bernard Madoff
Bernard Madoff
Bernard Lawrence "Bernie" Madoff is a former American businessman, stockbroker, investment advisor, and financier. He is the former non-executive chairman of the NASDAQ stock market, and the admitted operator of a Ponzi scheme that is considered to be the largest financial fraud in U.S...
.
Operational risks, put simply, are the risks arising from execution of the business functions of any entity, for example an alternative investment fund, and these are distinct from its investment functions.
An ODD exercise does not include within its scope the investment functions of an alternative investment fund and therefore generally does not include the gathering, analysis and verification of information relating to the historic actual or future expected investment performance of such funds, the variance or future expected variance of the returns of such funds, or the appropriateness of the stated strategy of such funds as a (potential) constituent part of the investor’s wider portfolio, except insofar as these investment functions are or could themselves be adversely influenced by operational risks.
However, a separate “Investment Due Diligence” (IDD) exercise is often carried out by or on behalf of (potential) investors to consider investment functions. In fact, historically, it can be said that it has been more common for an IDD to be performed than for an ODD to be performed, despite strong academic arguments and empirical evidence that overall risk (i.e., investment risk and operational risk) is best capable of being understood and mitigated where both an IDD and an ODD are performed.
Importance
The historical position is somewhat odd given the prevalence of operational risk failures in, for example, hedge fund scandals and closures over the years. As early as 2003, a study by Christopher Kundro and Stuart Feffer of CapcoCapco
Capco is a global business and technology consulting firm. It was founded in 1998 and was an early specialist in back-office and risk-management services to the financial industry.-About :...
indicated that operational risk failings were the sole reason for 50% of all hedge fund failures (with operational risk failings being a contributing factor in other failures as well), rather than bad investment decisions alone (38%), and anecdotal evidence seems to imply that (i) the impact of operational risk is at least as pervasive in other (non-hedge fund) types of alternative investment funds, and (ii) that the impact of operational risk failings has not decreased since the Capco study.
A 2008 book by Jason Scharfman of Corgentum Consulting suggests that operational risks are inherent contributing factors to all hedge fund failures.
For example, a May 2009 derivative lawsuit relating to a feeder fund invested in a managed account that was exposed to Madoff’s split strike conversion strategy noted that “the Madoff story bristled with red flags that a financial professional firm performing an evaluation [ODD] and subsequent management and oversight, in good faith, could not have missed.”
The clear implication of this statement is that in the absence of detailed and robust pre-investment and on-going ODD, investors simply missed the operational risks inherent in the structure.
Purpose
The purpose of an ODD exercise is to gather, analyse and (to a degree) verify information relating to operational risks to:• allow an investor in a specific alternative investment fund to form a considered view as to whether to remain invested or to divest, or
• allow a potential investor in a specific alternative investment fund to form a considered view as to whether to invest or not, and
• (ideally) identify conditions which the investor or potential investor may seek to negotiate to reduce the overall level of operational risk associated with a new or existing investment in such specific alternative investment fund.
A small sample of the items which may be included within the scope of an ODD are outlined below:
• mark to market valuation techniques, and related processes/controls and disclosures
• business continuity and disaster recovery planning
• fraud risk and other irregularities
• behavioural analysis of individuals (e.g. fund directors and employees/principals of the manager of the alternative investment fund) and outsourced service providers, including their incentivisation
• liquidity mechanisms (“lock-ins” and “gates”)
• security of assets
• legal review, covering (amongst others things) design and establishment of the legal structure, advice taken by the alternative investment fund and its manager, material contracts, investment terms, indemnifications and insurances (although this may be performed as a separate Legal Due Diligence)
• review of the controls and processes employed by the fund through its main outsourced service providers (investment manager, fund administrator, transfer agent, etc.) over the management of fund assets to establish whether these are fit for purpose and being followed
• review of the operating processes and record-keeping supporting tax relating to maintaining beneficial tax treatment or "keeping the fund offshore".
Comparison to operational risk considerations in the context of banks' prudential capital requirements
Much of the literature associated with ODD, particularly the academic literature, is based on an underlying definition of operational risk that was originally designed in the context of the banking industry and contained within the Basel Accords, which holds that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.The banking industry is, in most economies, subject to regulation by a national financial services supervisory body, for example the Financial Services Authority in the UK, with the regulatory regime including a requirement for banks to hold at least minimum levels of capital designed to withstand the likely incidence of various risks, including operational risks. The capital held by banks for the purpose of meeting the requirements of the relevant regulator(s) is referred to as their capital requirement
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...
or prudential capital.
The imperative of considering operational risk in the context of banks is to ascertain an amount in currency which, if maintained by the bank as capital, should (in theory at least) fully compensate for the expected impact of crystallisation of the operational risks faced by the bank. When this “operational risk requirement” is added to the other elements of a bank’s prudential capital requirement (relating to non-operational risks faced by the bank), the resulting total gives the bank’s “total capital requirement”.
The problem with adopting a banking-style approach to ODD
Some forms of ODD fit neatly within the banking paradigm as described above, in that they look at a discrete number of operational factors, assign probabilities, co-relations between factors and estimated losses (generally based on extrapolations of historic data) and eventually come up with a single metric (analogous to the “operational risk requirement” of a bank) which is then compared to a pre-set threshold to give a simple binary answer to the invest / don’t invest or remain invested / divest question.Despite according neatly with the theory, such forms of ODD have severe limitations; for example such forms:
• tend to incentivise “window-dressing” behaviours by the manager of the alternative investment fund (as a checklist-based approach is often employed with the majority of the questions being easily foreseeable by the manager of the alternative investment fund);
• often utilise less-experienced personnel without the experience to ask the right follow up questions or “smell a rat”;
• tend not to react (or not to react quickly enough) to new or developing risks which are industry-wide or to risks that are specific to the alternative investment fund in question or pertinent to the specific investor;
• tend to apply weightings to the risk factors addressed that are static and based on historical data, whereas in reality future likelihood of risk crystallisation and quantum of expected loss on crystallisation are dynamic variables;
• tend to apply correlation factors to separate risks that are static and based on historical data, whereas in reality correlation factors are dynamic variables; and
• tend to give binary results without identifying conditions which the investor or potential investor may seek to put in place (via negotiation with the manager of the alternative investment fund) to reduce the overall level of operational risk associated with a new or existing investment.
ODD Framework Design for Fund of Hedge Funds
A 2009 research paper demonstrates that fund of hedge funds,as well as other major hedge fund allocators, take four primary approaches towards designing their operational due diligence frameworks. These four categories are direct, shared, modular and hybrid, modular.
Recent developments in ODD
Madoff Effect and Operational DragA 2010 study shows that frauds such as Madoff have created a so-called Madoff Effect by which investors tend to tailor their operational due diligence around recent frauds while minimizing certain other operational risks.
These other risks can include items which effect the overall efficiency and profitability of a hedge fund, a concept known as Operational Drag ® .
Other recent developments:
Where a more nuanced approach to ODD is taken, the benefits accruing to the recipients of the ODD report generally include:
- a team with the experience to ask the right follow up questions and “smell a rat” and the professional credibility to be able to get the right information out of interviewees, interpret this and bring to bear experience of common and best practice;
- quality advice as to the relative negotiating power of the (potential) investor and the manager of the relevant alternative investment fund;
- detailed recommendations regarding conditions which the investor or potential investor may wish to consider negotiating with the manager of the alternative investment fund to reduce the overall level of operational risk associated with a new or existing investment;
- consideration of new and developing risks which are industry-wide, and risks that are specific to the alternative investment fund in question or pertinent to the specific investor;
Choosing an ODD provider
Investors may perform operational due diligence themselves or they may work with consultants to either outsource operational due diligence reviews entirely, or to compliment their own internal efforts. The general consenses is that the forms of ODD which provide greatest benefit for investors are those characterised by:• not relying on a checklist approach so that the investigation is bespoke for the investor’s specific interests and tailored to the target alternative investment fund;
• offering multi-disciplinary solutions to legal, financial and accounting, tax, regulatory and compliance, risk management, corporate governance and internal control concerns (as opposed to skills in one particular area such as accounting);
• the involvement of a team with the breadth and depth of experience to clearly and succinctly identify “red flags” and propose practical recommendations for risk mitigation and monitoring;
• transparency of detailed findings to the end investor – note that managers of funds of alternative investment funds (e.g. fund of hedge funds managers) typically do not provide full transparency to their investors of the findings of their ODD, with investors simply becoming aware, after the fact, that an investment in an “underlying” fund has been made or that a divestment has occurred;
• succinct written responsibilities and scope, as well as clear legal liability of those performing the ODD for the quality of their work;
• individuals and organizations involved in the performance of the ODD being subject to professional requirements on ethics, independence, minimum levels of professional indemnity insurance and Continuing Professional Development of an appropriate professional body or institute, with underlying work performed as part of the ODD subject to oversight and Quality Assurance reviews by that body or institute.
• being paid for directly by the end user (i.e., the investor) rather than by the alternative investment fund or its manager (due to the conflict of interest created if the fund or its manager is the “client”) or bundled as part of a wider service (for example as is the case with a fund of funds).