Report Shines Light on Funds of Funds' Operational Due Diligence

Nov 16 2010 | 6:42am ET

Operational due diligence at funds of funds is under the microscope in the latest white paper from Infovest21.

The hedge fund information services company interviewed operational due diligence specialists, consultants, attorneys, certification specialists, prime brokers and recruiters to find out what investors should be considering when assessing a fund of funds’ operational due diligence team.

According to Daniel Celeghin at Casey Quirk, the key is keeping operational due diligence separate from investment due diligence. “End-investors should look closely at the operational due diligence team at a fund of funds. How does it relate to the investment due diligence team? Is there overlap? Are they independent?” Celeghin believes operational due diligence at a fund of funds should be a dedicated role. “It isn’t an added responsibility for an investment team member, the risk manager or the chief operating officer.”

Julia Herr, a hedge fund lawyer who headed the operational due diligence team at a large US-based fund of funds, told Infovest21 that the skills required to undertake effective operational due diligence are such that “It can be challenging if not impossible for a single person to pull it all together. Some may have strength in one area and general knowledge in another. An effective operational due diligence group must have all the bases covered.”

But she also noted the value of such groups:

“Some funds of funds’ operational due diligence teams that were proactive and negotiated better terms in side letters, likely enjoyed better performance and liquidity in the fall of 2008/early2009. And those who were organized and savvy enough to challenge some of the fund restructurings that occurred during that same time period also probably earned their fees. An ounce of prevention really was worth a pound of cure,” says Herr.

Veto power is another issue—Celeghin says some investors look for an operational due diligence veto. “The operational due diligence head is a dedicate role where absolute veto power exists. If the founder of the firm pounds his fist on the table, what the operational due diligence individual says at the end of the day is the ultimate decision. It is not so much the decision to hire but the decision not to hire. A manager may check all the boxes from the investment perspective but the operational due diligence head can veto.”

Herr says that investors should recognize that many firms define “veto” differently. What’s more important for investors to understand is what veto really is, who has it and what the firm’s incentive and reporting structures are.

The white paper also touches on the question of outsourcing operational due diligence, which Herr says some firms do as an “insurance policy,” i.e. someone to fire if things go wrong. Outsourcing can also be a popular choice where it can be charged to the fund, says the white paper, if done in-house, it may be more difficult to allocate those costs.

According to a Corgentum study of approximately 275 funds of funds, 27% had dedicated operational due diligence (i.e. at least one employee’s full time responsibility was dedicated to operational risks), 21% used the shared approach (i.e. operational due diligence was conducted by the investment due diligence team), 28% had a hybrid structure (some combination of the various approaches) and 14% were modular (i.e. the operational due diligence process is categorized into functional components and parsed out among different specialists e.g accounting, lawyer etc).

Corgentum found that 46% of the funds of funds with assets under $1 billion used a hybrid approach while 29% used a shared approach while dedicated frameworks accounted for 14%. For funds of funds over $1 billion in assets, 32% had a dedicated framework while 30% had a shared framework.
 


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