Operational due diligence (alternative investments): A Comprehensive Guide

Operational due diligence is a crucial step in the alternative investment process, ensuring that a potential investment is viable and will generate returns.

It involves a thorough examination of a company's operations, including its management, infrastructure, and processes. This review helps investors identify potential risks and opportunities.

A well-conducted operational due diligence can save investors from costly mistakes and provide a clear understanding of the investment's potential.

Operational due diligence is crucial in alternative investments, as it can make or break an investment. A study by Christopher Kundro and Stuart Feffer of Capco in 2003 found that operational risk failings were the sole reason for 50% of all hedge fund failures.

Operational risk is a pervasive issue that affects not just hedge funds, but also other types of alternative investment funds. Anecdotal evidence suggests that the impact of operational risk has not decreased since the Capco study.

The Madoff scandal is a prime example of operational risk failings. A lawsuit in 2009 noted that "the Madoff story bristled with red flags that a financial professional firm performing an evaluation [ODD] and subsequent management and oversight, in good faith, could not have missed."

Operational due diligence is a complex process that involves multiple steps, including developing questionnaires, reviewing documents, and conducting lengthy interviews. The process can be cumbersome for both investors and managers.

Here are some key steps in the operational due diligence process:

These questionnaires can be in multiple formats and often have customized questions, making the process even more complicated.

The purpose of an operational due diligence (ODD) exercise is to gather, analyze, and verify information about operational risks in alternative investment funds. This helps investors make informed decisions about whether to invest or divest.

An ODD exercise allows an investor to form a considered view about the operational risks associated with a specific alternative investment fund. This can help them decide whether to remain invested or to divest.

A small sample of the items that may be included within the scope of an ODD is outlined below:

These items can help investors identify conditions they may want to negotiate to reduce operational risk. By understanding these operational risks, investors can make more informed decisions about their investments.

A good diligence process starts with a review of manager documents and policies to gain an understanding of operations, valuation policy, lifecycle of a trade, IT infrastructure, and compliance.

The ODD team should conduct meetings with key personnel, including the CFO, CCO, COO, and head of trading, to determine the institutional quality of operations and ensure implementation of written policies, adequate internal controls, and proper segregation of duties.

The ODD team should study changes in assets under management, capital commitments, ownership structure, key hires and departures, compensation structures, strategic plans, and other material issues.

To conduct an ODD review, you'll need to gather a lot of information about the operational infrastructure of the investment manager and fund.

This information should help you answer key questions, such as whether the fund's terms meet your investment objectives, whether the investment manager has the appropriate staff in place, and whether the operational infrastructure is suitable for the investment strategy.

Conducting an ODD review can take anywhere from 2 to 3 months, depending on the cooperation of the investment manager and the complexity of the investment.

However, with the help of ODD software, such as DD360, the timeline can be significantly reduced, and the process can be streamlined and automated.

Here are some key steps to conducting an ODD review:

Some key benefits of using DD360 include:

Governance considerations are a crucial aspect of operational due diligence reviews, particularly for hedge funds. Analyzing these considerations has become increasingly important for investors.

In an operational due diligence context, governance has traditionally focused around the Board of Directors of offshore-based vehicles, often domiciled in places like the Cayman Islands. This focus is a key consideration for investors.

The conflict of interest created when the fund or its manager is paid directly by the investor rather than the fund or its manager is a significant issue. This is a common practice, but it can lead to problems.

Investors are increasingly performing operational due diligence reviews on alternative investments, including private equity funds. As a result, governance considerations are becoming more complex.

Investors may perform operational due diligence themselves or work with consultants, but the best approach is to find a provider that offers bespoke investigations tailored to their specific interests.

A good ODD provider should offer multi-disciplinary solutions to address various concerns, including legal, financial, accounting, tax, regulatory, and compliance issues.

Their team should have a breadth and depth of experience to clearly identify "red flags" and propose practical recommendations for risk mitigation and monitoring.

Transparency is key, with the provider sharing detailed findings with the end investor, although some managers of funds of alternative investment funds may not provide full transparency.

A clear and succinct written responsibility and scope, along with clear legal liability, are essential for the provider's work.

Individuals and organizations involved in the ODD should be subject to professional requirements on ethics, independence, and Continuing Professional Development, with their work subject to oversight and Quality Assurance reviews.

Liquid alternatives can provide a different way to diversify a portfolio, as seen in the challenging UK investment environment over the last two years.

From dizzying politics to eye-watering levels of inflation, the last two years have proven challenging for UK investors.

These challenges have highlighted the importance of diversification, which can be achieved through alternative investments.

Investing in liquid alternatives can be a smart move, especially in uncertain times like the last two years. The UK has seen its fair share of challenges, from politics to inflation, making diversification a priority.

Liquid alternatives offer a way to spread risk and potentially boost returns. They're often less correlated with traditional markets, providing a unique opportunity for investors.

Investors may find liquid alternatives appealing due to their relatively low minimum investment requirements. This makes them more accessible to a wider range of people.

The last two years have shown that even the most stable investments can be affected by external factors. Investing in liquid alternatives can provide a degree of protection against these risks.

By incorporating liquid alternatives into a portfolio, investors can potentially reduce their overall risk and increase their chances of long-term success.

Venture Capital is a type of alternative investment that allows individuals and institutions to invest in startups and early-stage companies with high growth potential.

A large UK insurance company's internal investment team was looking to make an allocation to a venture capital fund, highlighting the growing interest in this type of investment.

Venture capital firms typically invest in companies that are not yet profitable, but have a strong potential for growth and returns.

The internal investment team of a large UK insurance company was looking to make an allocation to a venture capital fund to diversify their portfolio and potentially generate higher returns.

Venture capital investments are often made in exchange for equity, giving the investor a stake in the company's future success or failure.

Multi-Asset Credit is a type of investment that involves lending money to corporations or governments through a diversified portfolio of assets, such as bonds, loans, and other credit instruments.

A reinsurer was looking to increase its allocation to multi-asset credit, which suggests that this type of investment can be a strategic move for institutional investors like pension schemes.

A large UK corporate pension scheme appointed bfinance to conduct a deep dive ODD assessment of a reinsurer's multi-asset credit investments, indicating that thorough due diligence is crucial when investing in this space.

Investing in multi-asset credit can provide a steady income stream and diversification benefits, making it an attractive option for investors seeking to balance risk and return in their portfolios.

Operational due diligence is tailored to each client's unique needs and strategy type. This means that the breadth and depth of the ODD process will vary depending on the client's specific requirements.

The team at bfinance works closely with clients to create bespoke DD questionnaires that reflect their individual needs. These questionnaires are designed to gather the most relevant information for decision-making.

Direct engagement with asset managers is key to an effective ODD process. bfinance proactively works with managers to resolve areas of weakness and shares emerging industry best practices with them.

Conducting Operational Due Diligence in real estate investments can be a complex process. A prominent public sector pension fund once sought support in conducting a thorough ODD assessment of a real estate investment opportunity.

This process involves a thorough review of the investment's operational capabilities, including its management team, financial health, and compliance with regulations. A thorough ODD assessment helps investors make informed decisions.

A thorough ODD assessment helps investors make informed decisions.

In-depth assessments are key to operational due diligence.

bfinance ORS delivers a tailored assessment of managers' policies, procedures, and resources related to key control functions. The breadth and depth of ODD is tailored to reflect the strategy type, asset manager, and choice of vehicle.

Client needs are reflected in bespoke DD questionnaires that highlight the information most pertinent to decision-making.

Direct engagement with managers is crucial in resolving areas of weakness.