Setting Your Firm Up for Success with Investor Due Diligence

Part II

With the Superbowl right around the corner we’re continuing with our football analogy …

You’ve just received a call from an institutional investor who has seriously followed your fund for the last six months. They’ve met with you and your team on multiple occasions to review portfolio construction, understand your risk management process and review the theses of your largest holdings. Today they announce they’re ready to begin the Operational Due Diligence phase of their process.

Congratulations, you’ve made it to the play-offs! But this is no time to get complacent. There’s still real work ahead of you. This is your reality, the investment team thinks highly enough of you that they’ll invest the time and money into the Operational Due Diligence process. However, a trip to the Operational Due Diligence play-offs does not result in a defacto win, ie., an investment. I can assure you the Rams and the Bengals are still putting in the practice this week. The game’s not over yet. Not for you. Not for them.

The Operational Due Diligence Game is all about Special Teams

Don’t expect the same investment individuals you’ve gotten to know over the past six months will also perform the Operational Due Diligence on your firm and fund. It might be the case for smaller investors, but not likely for larger institutions. At the very least, a different due diligence team with alternate strengths takes the potential bias out of the choosing a manager equation.

  • Operational due diligence is typically performed by any one of the following, all of which pride themselves in identifying your operational shortcomings
    • An independent internal team at the institutional investor that specializes in firm and fund operational due diligence
    • Outside consultants who specialize in ODD
    • An OCIO with experience in the space
  • Compliance is as much a culture as it is a practice
    • It’s not a switch you can just flip on when an ODD team comes to visit
    • Compliance needs to be taken seriously from the start – if you haven’t developed and maintained a strong compliance culture, you can’t expect your team to have either
    • ODD teams are experts in asking the right questions to analyze a fund’s compliance practice and culture. If you fail on this front, you’re done, and you have no one to blame but yourself

Stick with your Playbook and Know it Cold

Your Policy & Procedures Manual, as well as your Compliance Manual, are required reading by the ODD professionals and will be used as the basis for questioning and confirming process and procedure at your firm.

It is your choice whether to share manuals outright, allow manuals to be read only onsite, or place manuals in your data room to be shared with or without an NDA.

  • Know your Offering Documents and be able to justify your terms
    • Do your Offering Documents allow for Gates? Side Pockets? If so, are the Gates at the fund level or the investor level?
    • How are expenses calculated?
    • Timing of payout? Do you allow for in-kind redemptions?
    • Are there really redemption fees?
    • Do you provide for Key-Man Insurance?

There’s no Coin Toss when it Comes to Operational Due Diligence—Leave Nothing to Chance

  • Controls must be clearly in place and easily articulated
    • How is cash managed?
    • Who is authorized to trade the portfolio? Under what circumstances?
  • What is the valuation process?
    • At market?
    • Independent marks? If so, by whom?
  • Custody – Where are assets held?
  • How do you mitigate counter-party risk?
    • Do you use multiple prime brokers? If not now, when would you consider adding additional prime brokers?
    • Repo, OTC counterparties, Swap transactions
  • Do you have the ability to cross-collateralize between funds? (We hope not since this is a big no-no in the ODD world)
  • Be able to thoroughly describe your Disaster Recovery and Business Continuity Plans
    • Investors will seriously test fund managers on this
    • Cyber-security has been pushed to the foreground of ODD
  • What are your security standards with regard to this ongoing “Work From Home” phenomena?

Good Execution and Teamwork Usually Amount to a Winning Formula

Institutional investors can’t invest in every good manager they meet. So as a manager, focus on what you can control.

  • Recruit a good compliance and operations team with solid experience
  • Then execute on your plan
  • Remember to “walk the walk” when it comes to compliance, a strong compliance culture keeps you moving down the field