Operational due diligence: a powerful tool for hedge fund investment

By Sarfraz Thind

Operational due diligence on hedge funds has been in the spotlight since the Madoff and Rajaratnam affairs blew open the doors to hedge fund fraud. These days most investors will have an operational due diligence division and no question is considered too stupid to ask.

“We have absolute veto. A recent case saw fund which would only let us approach the directors through the lawyers in writing so we immediately vetoed the investment.”

Chris Goodeve-Ballard

Since the Madoff scandal, operational due diligence (ODD) has become one of the single most important aspects in hedge fund analysis. A survey by Deutsche Bank’s hedge fund consulting group last month found that almost three quarters of investors ranked a fund’s compliance and regulatory framework as the top priority for 2013. And nearly 70% of ODD teams now have explicit veto authority in the investment decision making process, which was exercised in almost 10% of manager reviews. The survey, which polled global investors with a total hedge fund allocation in excess of $724bn, also found that 63% of investors won’t reconsider investing in a fund previously vetoed by the ODD team.

Prior to Madoff, investors evaluating a hedge fund would have firstly looked at the performance. This has changed now.

“We live and work in an increasingly regulated environment so ODD is a key area of risk mitigation – it has teeth, consequences and impact,” says Toby Hogbin, head of marketing and product development at Martin Currie.

“Post-financial crisis having clarity and understanding of product structures, operational governance and robust oversight is a matter of proof rather than a matter of trust. Now investors are looking for a more granular understanding not just of the investment process but of product structure.”

Road to recovery

Hedge fund investment has recovered spectacularly since the worst of the financial crisis. Total hedge fund capital increased by a net total of $40bn in the second quarter of the year to a record $2.41trn, according to Hedge Fund Research. With these vast figures in mind the emphasis on operational control is hardly surprising. And nothing is off limits.

“Before if you asked certain questions of a hedge fund you might be said to be stupid,” says Mike Paciullo, global head of operational due diligence at IAM. “For example, if a hedge fund said its prime brokerage was Lehman Brothers no one would question the viability of this. Post-Lehman, everything is on the table. No question is now too stupid to ask.”

According to Deutsche Bank, almost 80% of investors have a dedicated ODD team and will conduct an average of 50 manager reviews a year. Nearly half of all managers with more than $500m in assets-under-management have responded to the greater demands of due diligence with increased staff while 99% of funds have added employees devoted to regulatory compliance, according to a joint KPMG/Alternative Investment Management Association ( Aima) survey issued last year.

The emphasis on operational risk management has been driven by regulatory initiatives over the past few years, most notably the EC (Markets in Financial Instruments) Directive (MiFID) of 2004, the Capital Requirements Directive (CRD III) of 2010 and the work of various international agencies such as the European Banking Authority. There has been a move towards a far more prescriptive approach to risk management generally, with regulators now demanding specific process-driven enterprise risk management systems.

New directive

Most recently it is the Alternative Investment Fund Managers Directive (AIFMD) which is acting as the push for hedge funds to ensure they have robust operational structures and procedures.

“AIFMD has carried on from where MiFID left off, applying much of the operational risk management requirements that MiFID introduced, heightening the degree of prescription and the level of responsibility and introducing new specific requirements” says Donnacha O’Connor, partner at law firm Dillon Eustace. “It has introduced new requirements in the areas of valuation, liquidity management, investment management due diligence and transparency. For example, it requires specific due diligence to be carried out by the manager when making investments and choosing prime brokers and counterparties. It has been the single greatest push for raising operational risk management standards in the EU hedge fund sector.”

Some of the above have always been carried out by investors in various forms. Others are new.

Cash management – or the controls of money moving in and out of the fund via depositaries and custodians – is a key new role for depositaries under the AIFMD and the level of legal liability and prescribed requirements for asset safe-keeping have also been significantly heightened. The custodial risk assessments and operational requirements of depositaries are expected to become important factors in the selection of markets in which managers will trade, as well as the choice of prime brokers by the manager. The AIFMD introduces a quasi-strict liability standard for depositaries in the case of the loss of certain financial instruments held in custody including where those assets are held in custody by prime brokers. The depositary will only be able to transfer this responsibility to the prime broker where it has an objective reason for doing so, the manager agrees and the arrangement is clearly disclosed to investors. In future prime brokers with operating models or business characteristics that do not meet the requirements of depositaries might not be entrusted with custody of fund assets by depositaries.

No ‘one size fits all’ approach

The general level of complexity of hedge fund strategies and breadth of assets traded mean that valuation is another area being pushed by the regulators. Hedge funds willnow have to ensure timely reporting and accuracy of valuations which in many cases would require independent, third-party valuation sources. The rules are generally designed to bring transparency and better risk control to the industry.

But, says Penny Aitken, partner and head of research at fund of hedge funds FQS, regulatory work, though well intentioned, cannot hope to encompass the entire hedge fund world through a single, generic set of rules. Hedge funds span different geographical locations, strategies, underlying assets and reflect different operational standards, which means there is no one-size-fits-all pattern.

“AIFMD and the other rules are trying to move things towards standardisation,” says Aitken. “Regulators are trying to understand transaction flows and see that all is monitored. But at bottom this is still a very heterogeneous market and can be a minefield in some ways. You still have the underlying documents that vary so much. You are dealing with different strategies where things like leverage can be important in some and not others and this is all reflected in the documentation.”