Compliance and Operational Due Diligence: What to do?

Operational due diligence has been at the forefront of investment decisions for hedge fund allocators including family offices, pension funds, foundations, endowments and other institutional investors for quite some time.

They want to ensure that the managers they invest in are operationally sound and the business risks are tolerable. Investors are becoming more educated and demanding, therefore requiring higher standards in the maintenance of a sound operational business. Among the top concerns revealed during ODD reviews are:

• Expenses being charged to the fund
• Lack of transparency
• Valuation concerns
• Weak compliance policies and infrastructure

While all of these rank high, the risk factor that consistently is the highest priority to investors is regulatory compliance. Looking at 2015 and beyond, regulatory compliance is expected to come under especially close scrutiny, as reporting challenges are becoming more costly and burdensome for the funds.

While a key factor when reviewing any manager, it has become increasingly apparent with regard to emerging managers that investors are not sympathetic to the unique situations and challenges of newly launched funds. They still demand the same stellar operational controls around certain procedures, such as cash movement, presence of elite service providers and segregation of duties.

As a result, these emerging managers are often more flexible in accommodating investor demands so as to attract capital. More often than not, we see emerging managers who recognize potential risks and gaps in their businesses as more attractive to investors, compared to certain established managers that may not regard such concerns as red flags.

For fund managers and firms, we suggest that you continue to place a high value on ODD by either utilizing dedicated in-house ODD teams or engaging external consultants to conduct the reviews. With recent reforms, such as AIFMD and FATCA, and the enactment of Dodd-Frank, investors, as much as regulators want to see a clean bill of health from the managers they assess. Investors cite the ever-growing regulatory oversight and increased reporting responsibilities as two areas where managers must address their key risk exposures.

These would include:

• Conducting extensive reviews of all communications with the regulators
• Strengthening the ongoing compliance program to include regular testing and internal reviews
• Developing a strong culture of compliance, where regulation is a key business priority of the firm’s senior management

Such heightened attention to compliance program review and assessment indicates that ODD risk focus is shifting and will continue to do so in the coming years.