What questions will investors ask in operational due diligence?

Skadden counsel Greg Norman gives his views on the areas that investors should probe during operational due diligence.

In the world of fund investments, a lot of focus can be placed on specific line items within a fund manager’s track record or projected returns calculations.

An investment in a private fund is supposed to provide beneficial risk-adjusted returns (when compared to the public markets, for example) so this focus is understandable. Nevertheless, as legal notices are at pains to remind readers, past performance is not indicative of future returns. When reviewing the risks associated with a particular fund investment, an investor should also carefully review the operations of a fund manager that keep the business running.

“Do investors receive and review the accounts of the fund manager at the outset and on an ongoing basis? Are the manager’s accounts audited, and, if so, is that work carried out by a different auditor from the fund auditor?”

Last year highlighted a number of operational failings in fund management and other financial services businesses, particularly with respect to the systems and controls procedures. For example, in one instance, a manager’s systems and controls failed to prevent the commingling of investors’ cash with that of the fund manager. In hindsight, there may have been warning signs for at least some of these failings. Investors in funds should be reviewing their own processes to try to ensure that appropriate resources are applied to “look under the bonnet” of a fund manager.

There are a number of questions that investors can consider. Do investors receive and review the accounts of the fund manager at the outset and on an ongoing basis? Are the manager’s accounts audited, and, if so, is that work carried out by a different auditor from the fund auditor? Having the same auditor is not necessarily indicative of weak controls, but an independent review provides a greater level of comfort.

Source: Skadden

Do the fund and the fund manager use third-party service providers, such as administrators or custodians? How much involvement do those service providers have in the investment process? Under the EU’s Alternative Investment Fund Manager’s Directive, EU funds must have a depositary (effectively a custodian) whose responsibilities include monitoring of cashflows. A similar obligation applies with respect to UCITS funds, but outside of the EU, the regulatory obligations applicable to funds and fund managers are generally not as specific regarding service providers. Although much of the EU regulation of private funds has come under criticism, this is one area where it may end up setting the standards that fund managers globally eventually have to meet.

What other checks and balances does the fund manager apply to its processes? Is there an independent risk management function, and, if so, is it sufficiently robust? Can the fund manager provide evidence of situations in which the risk management function has been shown to be effective? Fund managers may be instinctively reluctant to provide this type of information, but there should not be negative inferences drawn from examples of a risk management process operating properly and rigorously – quite the opposite.

As part of a legal review, investors should consider how broad the fund’s investment policy is and what disclosure obligations are imposed on the manager regarding investment activity that may be at the boundaries of such investment policy. If the fund has a representative body for the investors, what level of oversight does that body have over investment activity, particularly where there may be potential conflicts of interest? Historically, fund managers have been resistant to granting such bodies any real power, but it should be in the best interests of both managers and investors to have a dialogue about such matters.

Every fund manager is different and investors should be prepared to be flexible with their expectations. Smaller managers may not have the resources for a separate risk manager and may address risk management in a different manner. Managers running more aggressive investment strategies may need a broader investment policy to execute their strategy and produce the predicted returns.

Ultimately, a fund investor will be judged on the performance of its investments and the returns it achieves – assessed in light of its appetite for risk – whether that be for its own investors, shareholders, pension-holders or otherwise. As a result, the focus on the economic aspects of a fund investment is perfectly understandable. However, if the support structure of a fund manager is not established or operating properly, eventually the returns may be at risk.

Greg Norman is counsel with Skadden. His practice includes advising fund managers and investors on the structuring, marketing, establishment and operation of investment funds, particularly involving private equity and private equity real estate funds, as well as advising on associated regulatory issues and other in-house queries, such as commercial and employment arrangements.