Operational risks are the risks arising from execution of the business functions of any entity, for example an alternative investment fund, and these are distinct from its investment functions.
An ODD exercise does not include within its scope the investment functions of an alternative investment fund and therefore generally does not include the gathering, analysis and verification of information relating to the historic actual or future expected investment performance of such funds, the variance or future expected variance of the returns of such funds, or the appropriateness of the stated strategy of such funds as a (potential) constituent part of the investor's wider portfolio, except insofar as these investment functions are or could themselves be adversely influenced by operational risks.
However, a separate “Investment Due Diligence” (IDD) exercise is often carried out by or on behalf of (potential) investors to consider investment functions. In fact, historically, it can be said that it has been more common for an IDD to be performed than for an ODD to be performed, despite strong academic arguments and empirical evidence that overall risk (i.e., investment risk and operational risk) is best capable of being understood and mitigated where both an IDD and an ODD are performed.
Importance
The historical position is somewhat odd given the prevalence of operational risk failures in, for example, hedge fund scandals and closures over the years. As early as 2003, a study by Christopher Kundro and Stuart Feffer of Capco indicated that operational risk failings were the sole reason for 50% of all hedge fund failures (with operational risk failings being a contributing factor in other failures as well), rather than bad investment decisions alone (38%), and anecdotal evidence seems to imply that (i) the impact of operational risk is at least as pervasive in other (non-hedge fund) types of alternative investment funds, and (ii) that the impact of operational risk failings has not decreased since the Capco study.[1]
For example, a May 2009 derivative lawsuit relating to a feeder fund invested in a managed account that was exposed to Madoff's split strike conversion strategy 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.”
The clear implication of this statement is that in the absence of detailed and robust pre-investment and on-going ODD, investors simply missed the operational risks inherent in the structure.
Purpose
The purpose of an ODD exercise is to gather, analyse and (to a degree) verify information relating to operational risks to:
allow an investor in a specific alternative investment fund to form a considered view as to whether to remain invested or to divest, or
allow a potential investor in a specific alternative investment fund to form a considered view as to whether to invest or not, and
(ideally) identify conditions which the investor or potential investor may seek to negotiate to reduce the overall level of operational risk associated with a new or existing investment in such specific alternative investment fund.
A small sample of the items which may be included within the scope of an ODD is outlined below:
mark to market valuation techniques, and related processes/controls and disclosures
business continuity and disaster recovery planning
fraud risk and other irregularities
behavioral analysis of individuals (e.g. fund directors and employees/principals of the manager of the alternative investment fund) and outsourced service providers, including their incentivisation
liquidity mechanisms (“lock-ins” and “gates”)
security of assets
legal review, covering (amongst other things) design and establishment of the legal structure, advice taken by the alternative investment fund and its manager, material contracts, investment terms, indemnifications and insurances (although this may be performed as a separate legal due diligence)
review of the controls and processes employed by the fund through its main outsourced service providers (investment manager, fund administrator, transfer agent, etc.) over the management of fund assets to establish whether these are fit for purpose and being followed
review of the operating processes and record-keeping supporting tax relating to maintaining beneficial tax treatment or "keeping the fund offshore".
Comparison to operational risk considerations in the context of banks' prudential capital requirements
Much of the literature associated with ODD, particularly the academic literature, is based on an underlying definition of operational risk that was originally designed in the context of the banking industry and contained within the Basel Accords, which holds that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
The banking industry is, in most economies, subject to regulation by a national financial services supervisory body, for example the Financial Services Authority in the UK, with the regulatory regime including a requirement for banks to hold at least minimum levels of capital designed to withstand the likely incidence of various risks, including operational risks. The capital held by banks for the purpose of meeting the requirements of the relevant regulator(s) is referred to as their capital requirement or prudential capital.
The imperative of considering operational risk in the context of banks is to ascertain an amount in currency which, if maintained by the bank as capital, should (in theory at least) fully compensate for the expected impact of crystallization of the operational risks faced by the bank. When this “operational risk requirement” is added to the other elements of a bank's prudential capital requirement (relating to non-operational risks faced by the bank), the resulting total gives the bank's “total capital requirement”.
The problem with adopting a banking-style approach to ODD
Some forms of ODD fit neatly within the banking paradigm as described above, in that they look at a discrete number of operational factors, assign probabilities, co-relations between factors and estimated losses (generally based on extrapolations of historic data) and eventually come up with a single metric (analogous to the “operational risk requirement” of a bank) which is then compared to a pre-set threshold to give a simple binary answer to the invest / don’t invest or remain invested / divest question.
Despite according neatly with the theory, such forms of ODD have severe limitations; for example such forms:
• tend to incentivise “window-dressing” behaviours by the manager of the alternative investment fund (as a checklist-based approach is often employed with the majority of the questions being easily foreseeable by the manager of the alternative investment fund);
• often utilise less-experienced personnel without the experience to ask the right follow up questions or “smell a rat”;
• tend not to react (or not to react quickly enough) to new or developing risks which are industry-wide or to risks that are specific to the alternative investment fund in question or pertinent to the specific investor;
• tend to apply weightings to the risk factors addressed that are static and based on historical data, whereas in reality future likelihood of risk crystallisation and quantum of expected loss on crystallisation are dynamic variables;
• tend to apply correlation factors to separate risks that are static and based on historical data, whereas in reality correlation factors are dynamic variables; and
• tend to give binary results without identifying conditions which the investor or potential investor may seek to put in place (via negotiation with the manager of the alternative investment fund) to reduce the overall level of operational risk associated with a new or existing investment.
Increased compliance focus during operational due diligence reviews
Operational due diligence reviews performed by ODD analysts and investors have increasingly devoted significant portions of the overall reviews towards compliance related matters, which result from increased complexity and volume of global compliance regulations related to alternative investments. It has also been suggested that this trend will continue as changes in established regulations, such as Dodd-Frank, are being considered in the U.S. Investors are increasingly performing operational due diligence reviews on other types of alternative investments, including private equity funds.
Governance considerations in an operational due diligence context
Analyzing considerations related to the concept of hedge fund governance have increasingly been considered by investors during the context of operational due diligence reviews.
For hedge funds, traditional notions of governance in an ODD context have focused around the Board of Directors of offshore (i.e. - non-US) based vehicles often domiciled in places such as the Cayman Islands.
Recent developments in ODD
Madoff Effect and Operational Drag
A 2010 study shows that frauds such as Madoff have created a so-called Madoff Effect by which investors tend to tailor their operational due diligence around recent frauds while minimizing certain other operational risks.
Other recent developments:
Where a more nuanced approach to ODD is taken, the benefits accruing to the recipients of the ODD report generally include:
a team with the experience to ask the right follow up questions and “smell a rat” and the professional credibility to be able to get the right information out of interviewees, interpret this and bring to bear experience of common and best practice;
quality advice as to the relative negotiating power of the (potential) investor and the manager of the relevant alternative investment fund;
detailed recommendations regarding conditions which the investor or potential investor may wish to consider negotiating with the manager of the alternative investment fund to reduce the overall level of operational risk associated with a new or existing investment;
consideration of new and developing risks which are industry-wide, and risks that are specific to the alternative investment fund in question or pertinent to the specific investor;
Choosing an ODD provider
Investors may perform operational due diligence themselves or they may work with consultants to either outsource operational due diligence reviews entirely, or to complement their own internal efforts. The general consensus is that the forms of ODD which provide greatest benefit for investors are those characterized by:
• not relying on a checklist approach so that the investigation is bespoke for the investor's specific interests and tailored to the target alternative investment fund;
• offering multi-disciplinary solutions to legal, financial and accounting, tax, regulatory and compliance, risk management, corporate governance and internal control concerns (as opposed to skills in one particular area such as accounting);
• the involvement of a team with the breadth and depth of experience to clearly and succinctly identify “red flags” and propose practical recommendations for risk mitigation and monitoring;
• transparency of detailed findings to the end investor – note that managers of funds of alternative investment funds (e.g. fund of hedge funds managers) typically do not provide full transparency to their investors of the findings of their ODD, with investors simply becoming aware, after the fact, that an investment in an “underlying” fund has been made or that a divestment has occurred;
• succinct written responsibilities and scope, as well as clear legal liability of those performing the ODD for the quality of their work;
• individuals and organizations involved in the performance of the ODD being subject to professional requirements on ethics, independence, minimum levels of professional indemnity insurance and Continuing Professional Development of an appropriate professional body or institute, with underlying work performed as part of the ODD subject to oversight and Quality Assurance reviews by that body or institute.
• being paid for directly by the end user (i.e., the investor) rather than by the alternative investment fund or its manager (due to the conflict of interest created if the fund or its manager is the “client”) or bundled as part of a wider service (for example as is the case with a fund of funds).
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as short selling, leverage, and derivatives. Financial regulators generally restrict hedge fund marketing to institutional investors, high net worth individuals, and accredited investors.
Investcorp is a global manager of alternative investment products, for private and institutional clients. Founded in Bahrain in 1982, the firm has offices in United States, United Kingdom, Saudi Arabia, Qatar, United Arab Emirates, India, China, and Singapore. Its principal client base is in the six countries of the Gulf Cooperation Council, but it also has institutional clients in North America, Europe, and Asia.
Net asset value (NAV) is the value of an entity's assets minus the value of its liabilities, often in relation to open-end, mutual funds, hedge funds, and venture capital funds. Shares of such funds registered with the U.S. Securities and Exchange Commission are usually bought and redeemed at their net asset value. It is also a key figure with regard to hedge funds and venture capital funds when calculating the value of the underlying investments in these funds by investors. This may also be the same as the book value or the equity value of a business. Net asset value may represent the value of the total equity, or it may be divided by the number of shares outstanding held by investors, thereby representing the net asset value per share.
Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as listed aside. As for risk management more generally, financial risk management requires identifying its sources, measuring it, and the plans to address them. See Finance § Risk management for an overview.
Prime brokerage is the generic term for a bundled package of services offered by investment banks, wealth management firms, and securities dealers to hedge funds which need the ability to borrow securities and cash in order to be able to invest on a netted basis and achieve an absolute return. The prime broker provides a centralized securities clearing facility for the hedge fund so the hedge fund's collateral requirements are netted across all deals handled by the prime broker. These two features are advantageous to their clients.
A "fund of funds" (FOF) is an investment strategy of holding a portfolio of other investment funds rather than investing directly in stocks, bonds or other securities. This type of investing is often referred to as multi-manager investment. A fund of funds may be "fettered", meaning that it invests only in funds managed by the same investment company, or "unfettered", meaning that it can invest in external funds run by other managers.
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
A private equity fund is a collective investment scheme used for making investments in various equity securities according to one of the investment strategies associated with private equity. Private equity funds are typically limited partnerships with a fixed term of 10 years. At inception, institutional investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund. From the investors' point of view, funds can be traditional or asymmetric.
Fund administration is the name given to the execution of back-office activities including fund accounting, financial reporting, net asset value calculation, capital calls, distributions, investor communications and other functions carried out in support of an investment fund, which may take the form of a traditional mutual fund, a hedge fund, a private equity fund, a venture capital fund, a pension fund, a unit trust, or other pooled investment vehicle.
Alternative beta is the concept of managing volatile "alternative investments", often through the use of hedge funds. Alternative beta is often also referred to as "alternative risk premia".
An alternative investment, also known as an alternative asset or alternative investment fund (AIF), is an investment in any asset class excluding stocks, bonds, and cash. The term is a relatively loose one and includes tangible assets such as precious metals, collectibles and some financial assets such as real estate, commodities, private equity, distressed securities, hedge funds, exchange funds, carbon credits, venture capital, film production, financial derivatives, cryptocurrencies, non-fungible tokens, and Tax Receivable Agreements. Investments in real estate, forestry and shipping are also often termed "alternative" despite the ancient use of such real assets to enhance and preserve wealth. Alternative investments are to be contrasted with traditional investments.
Markov Processes International, Inc. (MPI) Is a provider of investment research, analytics and technology, used by organizations throughout the financial services industry, including: alternative research groups, hedge funds, hedge fund of funds, family offices, institutional investors, consultants, private banks, asset managers, investment advisors and private wealth professionals.
Union Bancaire Privée is a private bank and wealth management firm headquartered in Geneva. UBP is one of the largest private banks in Switzerland, and serves private and institutional clients. The bank was founded in 1969 by Edgar de Picciotto, and is one of the best-capitalized banks in Switzerland, with CHF 160.4 billion of assets under management.
The bias ratio is an indicator used in finance to analyze the returns of investment portfolios, and in performing due diligence.
Operational due diligence (ODD) is the process by which a potential purchaser reviews the operational aspects of a target company during mergers and acquisitions.
Fairfield Greenwich Group is an investment firm founded in 1983 in New York City. The firm had among the largest exposures to the Bernard Madoff fraud.
Hedge fund replication is the collective name given to a number of different methods that attempt to replicate hedge fund returns. The hedge fund industry has boomed over recent years and various studies by investment banks as well as academic papers have shown that hedge funds may be nearing an alpha generating capacity constraint. This means hedge funds can no longer produce alpha in aggregate. Replication has been claimed to remove the illiquidity, transparency and fraud risk associated with direct investment in hedge funds. With the belief that the pursuit of alpha is a zero-sum game, more investors are looking to simply add "Hedge Fund Beta" to their portfolio. These early investors have been rewarded as the replicators outperformed their direct investment cousins in 2008 due to their greater liquidity and lower use of leverage.
An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group such as reducing the risks of the investment by a significant percentage. These advantages include an ability to:
Tremont Group Holdings, Inc., a Delaware corporation headquartered in Rye, New York, is a hedge fund group with a subsidiary that advised a feeder fund to Bernard Madoff's investment advisory firm in the Madoff investment scandal. this was the second-largest feeder fund to Madoff's firm due to the group having had a long professional relationship with him as Chairman of the NASD, the precursor to FINRA, and as the largest options market maker on the NASDAQ.The firm was one of the largest hedge fund consultants and advisors globally during the seminal 1990's period and pioneered a number of ground breaking products such as the CSFB Tremont Hedge Fund Index, specialized products and venues for hedge fund investment; structured products, insurance entities, new markets and jurisdictions including the first institutional fund of hedge funds in Korea and the foundation of The Bermuda Stock exchange. Prominent board members and shareholders included; Mario Gabelli of Gabelli Asset Management, Leon Cooperman of Omega Advisors and Arthur Samberg of Pequot Capital Management. Tremont was among the first investors and/or involved in the launch or restructuring of numerous legendary funds such as; S.A.C., Quantum and AQR.
Charles J. Gradante is an American businessman in the hedge fund industry, appearing on television and before the United States Congress in that role. Sovereign Wealth Fund Institute's PensionDaily.com called Gradante "one of Wall Street's most sought after opinion leaders" for financial and economic areas. Gradante is known as one of the first hedge fund industry executives to spark a legendary debate about the risk of hedge funds growing too large rather than focusing on finding investments where they have a competitive edge; he most recently discussed the issue at a conference hosted by The Palm Beach Hedge Fund Association that was covered by Yahoo Finance and CorpGov.
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