Operational Due Diligence: The Forgotten Part of Due Diligence
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The evaluation and selection of investment managers is dominated by an Investment Due Diligence process focused on strategy, performance, and client objectives. Often overlooked and considerably undervalued is the Operational Due Diligence process which looks into the quality of a firm’s operations. As a necessary component of a complete due diligence process, it can be considered as the part of the process that confirms the validity of the findings resulting from investment due diligence. Comparatively, the operational process is more focused on the qualitative aspects of an investment firm and looks at areas such as people, processes, products, policy, and providers.
The overall objective of looking at the people who are employed within a firm is to verify whether their experience, qualifications and compensation are appropriate with respect to the portfolios managed, strategies employed and clients’ needs. Most investment firms can be broken down into three units: that is, a Front Office, a Middle Office and a Back Office.
All decisions with respect to portfolio strategies and fund management are within the Front Office’s mandate and as such, it is in the interests of every investor to ensure that the managers’ backgrounds are suitable for the strategies they are managing. For example, if a manager who has extensive experience in managing a long equity portfolio is suddenly at the helm of a derivatives-laden strategy marketed to current and potential clients, it is highly unlikely that that manager has a clear grasp of the intricacies of derivatives and probable that he or she will find it difficult managing their inherent risks. Moreover, how much weight can be given to the quality of management if there is no track record for that manager in that area of investment? The marketed performance itself would and should be placed into question.
Moving away from the Front Office and into the Middle Office, where Compliance, Performance and Risk Operations reside, an investor’s interest here would be to gain insight into what kind of oversight and independence exists. If a firm’s Middle Office employs unqualified personnel, the effectiveness of any oversight is significantly compromised. Take for example the situation where compliance tasks are assigned to non-compliance professionals who directly report to the Front Office. In a proper due diligence, this would raise red flags in both areas of oversight and independence. In such a case, it would be very difficult to verify whether the portfolio managers are acting in the best interests of their clients. Investors would be exposed to risk resulting from activities such as front running and style drift, which in the end can lead to significant loss of capital.
Similarly, performance reporting assigned to sales representatives and risk management personnel reporting solely to the Chief Investment Officer would significantly decrease the validity of the firm’s marketed returns and its risk management process. Clients would be left to question the independence of the oversight that these departments provide and ultimately, the safety of their investments.
The engine room of every investment firm is the Back Office; here, all the raw data is processed, accounts are reconciled, and IT is managed. Any value added analysis conducted by the Front and Middles Offices is dependent on the quality of work done on the back end. Few automated controls to capture errors that can assist the firm as a whole are a sign of a poorly managed IT department. In addition, employing accounting professionals with little understanding of investment products presents significant risks to the reconciliation and accounting of the firm’s holdings and transactions. Poor information fed to the Middle and Front Offices will result in misleading analyses that can have severe repercussions to investors’ funds.
Another area where vigilance is required by investors is to review the compensation structure of the firm’s employees and its annual turnover. A compensation structure that does not align the firm’s interest with those of its clients encourages portfolio managers to take decisions based more on their remuneration than the needs of their clients. Not limited to portfolio managers alone, performance and risk managers’ compensation structures heavily correlated to the firm’s performance would impact their independence and thus the quality of oversight.
Lastly, a firm that experiences significant turnover can be a reflection on the quality of its senior management. Responsible and experienced professionals would not remain in a poorly functioning investment firm for too long. Those remaining would best represent the qualities, or lack of qualities, of the senior management itself. Intelligent management attracts intelligence and ineptness attracts ineptitude.
Important characteristics of properly run firms are those with the necessary processes and controls in place. Firms with weak processes and controls limit their ability to prevent or quickly deal with any possible abuse within the firm, which can drag on for years and present significant risks to investors. With respect to trading, investors should be interested in what, if any, controls the firm has. Are the authorized personnel in place to perform the trades or is there an overreliance on portfolio managers to conduct all trading? As well, is the firm monitoring the trade life cycle, that is, from the time the manager decides on a trade to the actual trade itself and finally to the confirmation and settlement by the Back Office. An increase in volume of trading can have a significant impact on a firm’s ability to properly oversee trade monitoring and settlement. The impact will be felt in performance, risk and the management of the portfolios themselves. With incorrect data fed to the Middle Office, there is an opportunity for portfolio managers to take advantage of the firm’s weak controls to further their interests.
A basic aspect of any investment process and arguably the most important part of due diligence, is to verify whether a firm has the proper cash controls in place. Of the utmost importance is to ensure that client funds are being deposited into clients’ accounts and not the firm’s or the PM’s personal account. Furthermore, are there multiple signatories to oversee the cash process and prevent abuse? Cash controls need to be independent of the Front Office, where the highest incentive for abuse is present. A worst-case scenario would be if a portfolio manager managed investors’ funds for a number of years and at any time during the duration of his/her mandate, he/she was able to directly withdraw funds for his/her own personal use. This occurred in Montreal when a long-standing advisor by the name of Earl Jones had placed his clients’ money into discretionary accounts with RBC. Unfortunately, the majority of the investors’ investments were lost to fraud. In a regulatory review it was found that the bank and its brokers failed in acting as the “gatekeepers to capital markets” for their clients. However, a simple verification of Earl Jones’ firm’s cash controls would have flagged this risk and saved many of the investors’ savings.
The valuation process is another important process that every investor should look into before investing. Assigning complete responsibility of the valuation process to the Front Office alone would raise a red flag. Managers may be tempted to be aggressive in their valuation of a security or more conservative, depending on what would be favorable to the firm’s performance. A valuation process needs to be written with the proper procedural hierarchy to ensure that all investments are fairly presented. The less liquid a security, the more subjective the valuation and thus, the greater the scrutiny required. The process should also be overseen by a committee with a diversified representation that will ensure transparency and independence. Failed valuation processes were in evidence during the financial crisis as investment firms worldwide were accepting the Collateralized Mortgage Backed Securities’ valuations.
Moving from processes to the products themselves, that is the components that make up every strategy managed for and marketed to investors, investors should not take for granted the products used in employing the marketed strategy. They should look into the characteristics of those products and determine whether they are appropriate for the fund and for themselves. Are these securities liquid? That is, how easy is it to liquidate the fund at a moment’s notice or will a client be left without his/her funds at a time of need. In addition, how easy is it to price these products? Are they publicly traded securities or do they possess private equity-type pricing issues. How much does the firm depend on broker quotes to evaluate their fund? The inherent risk of each product may not reflect the advertised strategy which would increase the operational risk of the investment as well as the investment risk.
Taking a look at the products used behind the strategies will help investors gain other insights into the fund. For example, a fund with commercial real estate investments may not be appropriate for a manager with little to no experience in this area. Furthermore, the marketed performance may sound like what the doctor ordered but what kind of fees are involved and what would the investor’s true cost be? Transparency will enable every investor to make more informed decisions and looking at just some of the details can go a long way in selecting the right manager.
No firm advertises itself as one that considers ethical standards an insignificant factor and yet, we find many managers and firms taking advantage of clients. In a proper due diligence, it is important to ask and answer the question, “Does the firm have a history of a compliance culture?” This question can be answered by first taking a look at what policies the firm has in place, their history, a record of their application, and their documentation. For example, does the firm have a written error correction policy that is clearly stated, documenting its application over time and well understood by all those involved?
Compliance’s role in oversight is another key indicator in the type of compliance culture the firm has. For instance, does the compliance department independently oversee the firm employees’ personal investment accounts in order to ensure that no one person is trading any of the securities on the restricted list? Independent oversight is important in this case because a compliance department that adjusts the no-trade list to the desires of the CIO to permit the trading of securities that otherwise would not be allowed, is a department with little value to its clients. An independent compliance department is characteristic of a firm with a firm belief in the culture of compliance.
Lastly, investors should look into the firm’s regulatory history and verify whether there were any claims against the firm or any its employees. It is also important to check whether the firm has registered with the appropriate regulatory agencies. Failing to do so may leave clients with no legal recourse in case any malfeasance occurs.
Many firms outsource some or most of their operations due to their limited internal resources or for cost saving purposes. It is important to verify whether the service provides are delivering the services promised and if they are in the best interests of the clients. For example, prime brokers and executing brokers should be well known, reputable, independent and diversified. Similarly, administrators who run investment firms’ Back Office operations should be independent of the firm itself. In other words, the administration functions should not be outsourced to the CIO’s cousin. In addition, these service providers should be qualified to handle the type of work their clients are providing them. The same requirements that apply to an internally managed operations team are required for an external service provider. Finally, don’t forget to evaluate the auditors that are overseeing the investment firm.
The evaluation process of a manager or a fund can be a time consuming process with the objective of finding the best investment option for the client. Unfortunately, the investment due diligence is overly emphasized at the expense of the operational due diligence. A comprehensive due diligence includes both the investment and operational aspects of an investment firm. What the operational due diligence does is to shed light on significant risks that an investment due diligence cannot provide. It validates the quality of the fund and the management behind it. Not undertaking a proper operational due diligence will expose investors to significant risks such as misappropriation of assets and fraud. The expression, “Caveat emptor” or better known in the English language as “Let the Buyer Beware,” should be lived by and keep investors diligent in the management of their funds.
-Ioannis Segounis, Founder and Managing Director of Phocion Investments, founded the firm in 2010 with the goal of influencing the investment industry to adopt best practices. Ioannis earned a Bachelors degree in Engineering from Concordia University and an MBA from HEC Montréal. He also earned the CFA and CIPM designations from the CFA Institute.