Post the 2008 financial crisis, regulatory requirements regarding operational efficiency have become more stringent, resulting in an increased focus from firms on their operational due diligence.
Operational due diligence is the process by which investors evaluate how an investment firm is managed, and whether the firm’s personnel can be trusted to manage the firm for the benefit of its investors, not just its managers.
Implementing an effective operational due diligence procedure, however, requires careful consideration of various operational and non-operational factors simultaneously. We take a look at what these various factors are that fund managers and allocators need to bear in mind when taking ownership of their operational due diligence tasks.
Why is operational due diligence important?
Operational due diligence enables increased oversight on investment and non-investment related factors like compliance, trading, valuation, operations, management and technology. Operational efficiency that is robust and meets regulatory requirements is critical for optimal business performance and ensuring your firm and your counterparties are following best practices. A holistic assessment of a firm’s operations thus ensures that various risks such as operational lapses, regulatory failings and reputational concerns are adequately considered and evaluated
Additionally, optimal operations are critical for raising capital, as full transparency is necessary for building trusting relationships between fund managers and fund allocators. As such, proactively addressing risks through an effective operational due diligence process should be a high priority for both fund managers checking operations, and fund allocators evaluating managers.
What to consider when assessing your operational due diligence processes
Your firm’s operational due diligence process should provide transparency into key policies and processes, and have sufficient resources and infrastructure available to perform oversight and monitoring functions effectively. Additionally, organization-wide documentation consistency needs to be demonstrated and adequate processes need to be in place to prevent any potential harm to the firm.
Key areas your operational due diligence process should cover include:
- Risk and compliance management and how issues such as complaints, insider trading, conflicts of interest and trading errors are handled
- The financial stability of the firm as per information such as cash flow, financial statements and remuneration reviews
- IT infrastructure robustness and security, and what disaster recovery and business continuity procedures are in place
- Operations and trading processes and the performance of these procedures
- Key managers and their track records, operational staff quality, and how duties are segmented among staff
- Oversight of key service providers, as well as their capabilities and commitment, like administrators, custodians and auditors
Let’s explore the specifics of three key operational due diligence considerations below.
Optimal policies
A core enhancement to operational due diligence processes is the drafting and implementing of optimal policies. Policies pertaining to account dealings as well as internal conduct need to be implemented and preferably formalized into a compliance manual, which is regularly reviewed and updated as needed in line with regulatory and internal changes. Additionally, a formal valuation policy that explains your valuation process and pricing sources is important for pricing transparency, which is necessary for allocators and regulators alike.
While creating and maintaining policies can be a resource-intensive exercise, it’s not an area to be overlooked, as saving on costs in this particularly important compliance practice is a mistake that can cost your firm even more in the long run.
Effective cybersecurity
Cybersecurity complacency, especially for smaller firms that assume they aren’t big enough to justify procedures like penetration and phishing testing, is a big risk to operational efficiency. It’s important that fund managers have effective information security policies in place that outline what response and escalation processes need to be followed in the event of a cyber-attack, as well as what disaster recovery mechanisms are in place for IT to ensure business continuity.
However, the key to cybersecurity resilience is education and staff training, which managers should make mandatory to staff on at least an annual basis, and can even be done in conjunction with phishing and penetration testing.
Digitally-enhanced oversight
Using Excel alone is no longer a sufficient means of managing orders and portfolios, especially because of the risks associated with siloed data and manually tracked business processes. For more efficient operations, adopting fully integrated digital solutions that automate operations, improves service provider and transaction oversight, and streamline functions like portfolio construction, is encouraged.
Operational oversight is limited with Excel spreadsheets, but the most sophisticated management system solutions offer Excel integration, allowing managers to streamline the move to a dedicated oversight system without too much change, ultimately saving time and reducing operational and compliance risks.
An additional benefit of a solution like this is that it enables seamless communication and data sharing between fund managers and fund allocators, while giving allocators the ability to use a single tool to integrate both manager data collection and due diligence documentation. And usually cloud-based, these solutions offer optimal data security. To find out more about how AlternativeSoft can provide digital operational due diligence solutions, click here.
What about outsourced compliance?
Some fund managers opt to outsource their compliance function and rely on compliance consultants to ensure an appropriate compliance infrastructure is implemented. Although this is commonplace in many firms and jurisdictions, an effective compliance culture requires effective internal monitoring of compliance in tandem with the ongoing reviews provided by third-party compliance consultants.
It’s worth noting, however, that from a regulatory perspective, meeting compliance requirements still rests with the firm and as such, firms need to account for the external compliance support they receive. Although outsourcing compliance support can be a more efficient way to ensure compliance, conducting proper oversight of outsourced compliance functions is critical to an effective operational due diligence process, and to meeting regulatory requirements.
Summary
Effective operational due diligence is a responsibility that can no longer be ignored. Fund managers and allocators need to take ownership of their operational due diligence to ensure that their operational performance doesn’t pose any risks that may otherwise go unnoticed if, for example, only investment due diligence processes are prioritized.
By taking stock of the key considerations outlined above, firms can start identifying and addressing problems, and even start improving operational efficiency for the long term. In addition to this, adopting effective digital investment management software, like AlternativeSoft’s solutions, can support managers and allocators in their journey to optimizing operations and performing optimal due diligence tasks.
