July 14, 2017
If an operational due diligence (ODD) executive exercised their veto during the pre-crisis golden era of hedge funds, they would typically be shown the exit. The mid-2000s is littered with examples of out of work ODD professionals sacked for simply doing their job and refusing to sign off on an investment they thought was either risky or fraudulent.
The most immediate lesson following the crisis at institutional investors, which lost money through hedge fund misadventure or plain theft, was that they should have listened to their ODD colleagues. The next few years were something of a homecoming for ODD professionals, many of whom were given greater authority within their organizations to veto investments where they had doubts or reservations.
A Deutsche Bank study conducted in 2013 found 70% of ODD teams had veto powers over hedge fund investments. Reasons for blackballing hedge funds include poor segregation of duties around cash controls, limited oversight, insufficient transparency, weak operations and technology infrastructure, poor service provider choice, a lack of net worth in fund, or misaligned remuneration.
Despite all of the talk about veto powers post-crisis, there are concerns that a minority of institutions continue to ignore recommendations made by ODD teams and are ploughing through with investments into managers that may not meet reputable operational standards. This is occasionally attributable to the limited universe of profitable hedge funds, prompting some investors to give managers the benefit of the doubt about an operational shortfall, provided they deliver returns.
However, there are softer approaches adopted by institutions if they disagree with the ODD team’s verdict. If an institution identifies a promising hedge fund, and the ODD team takes issue at the manager, then a compromise can usually be found. This may result in the institution going through with the investment, but making the on-going allocation conditional on the manager rectifying and remedying all of the concerns the ODD team flagged.
Neither scenario is ideal. Disregarding ODD feedback sends a terrible signal as it would suggest an organisation is fragmented and imbued with internal cultural differences and skewed approaches to risk management. If an ODD team raises a complaint, then there is usually good reason. Investing in a hedge fund which offers exciting returns but is equipped with poor operational controls is unacceptable, and it is a breach of fiduciary responsibility.
As such, investors should not allocate to a manager with lousy operations, but work with them to make improvements to their infrastructure. Many institutions will provide feedback to hedge funds that have failed ODD, and often promise to consider them again for investment provided enhancements are made. This is the best approach to take when considering a manager with a “good story” but poor operations.
ODD is now more credible than what it once was. Perhaps the big risk for ODD is that of complacency. One hedge fund COO said that prolonged periods without a serious operational blow up at a hedge fund occasionally led to investors losing their ODD focus. While some investors do not take ODD as seriously as they should, the majority are robust in their approach.