Many are familiar with the industry buzz phrase, Operational Due Diligence, although many industry experts prefer the phrase “business risk due diligence” – in either case the review is the act of digging deep to discover the inherent risks of doing business with a third party investment manager.
It begs the question: in today’s highly regulated world post FoFA, how well do you really know your fund manager? Do you fully understand risk as it pertains to doing business with any particular funds management outfit? Should you even care?
Alex Wise from specialist fund manager Select Asset Management continues his second of a four part CPD mini-series with an insider’s account to better understand what goes on to determine the key (non-investment) risks in funds management. (Click here to read the first article in this CPD series).
Business Risk Due Diligence is an important part of any allocation decision. The main drivers are always likely to be forward looking views of strategy and manager performance, however since a number of high profile investor frauds such as Trio in Australia and the Bernie Madoff affair in the United States, greater scrutiny has been placed on operational and business due diligence globally. It should be made clear that whilst thorough Business Risk Due Diligence should assist in uncovering concerns and inconsistencies, it is not a fool proof method of uncovering any highly sophisticated fraud. However, several ‘red flags’ – common to the Trio case and the Madoff fraud should have put investors on notice.
A thorough Business Risk Due Diligence review will consider the risk of a catastrophic event or, in crude terms a “blow up”. Effective due diligence provides a much broader insight into the overall quality of each manager’s business, including the firm’s culture and operational philosophy. Indeed, “business risk” due diligence is probably a more helpful description than a more limited “operational” due diligence framework.
It is important to consider both Business Risk Due Diligence and investment research, when making an investment. Whilst it is important to differentiate between these disciplines there are clearly multiple points of overlap that exist.
The Manager
Many investors believe that larger managers rank lower on the operational risk scale and are thus relative ‘safe havens’. Whilst it widely believed that smaller boutique managers tend to be exposed to greater operational risk it is also true that larger managers often have complicated business models and may exhibit significant operational risks. Larger investors may have “deep pockets” and resources but many investors believe the outperformance or ‘alpha’ is higher in smaller, more nimble managers. Operational processes do vary within the asset management industry and investors need to do their homework on a particular manager and fund before investing.
Investors should consider whether there has been appropriate investment in people, systems and other infrastructure. After analysis, investors have a good indicator of whether the manager is investing in infrastructure for the long haul or treating the management vehicle as a “cash cow”.
Business Risk Due Diligence should include a review of the manager’s personnel. The manager’s team of people is important not only in implementing investment strategy but also in supporting that implementation through operations. Some fundamental questions that should be asked include:
- are the managers significantly experienced to run the strategy?
- are business support staff appropriately qualified in accounting or law? (A good test is to review the qualifications of the key staff and where possible take references. I have seen some underwhelming qualified people acting as “Chief Compliance Officers” and even an electrician sitting on an offshore fund board!
Segregation of duties is important and high level Business Risk Due Diligence should uncover the roles of the portfolio manager and the COO or back office manager.
Technology is increasingly available and affordable, and as such any review should include some review of the manager’s technology platform. In my experience technology and business continuity plans of fund managers in Australia often exhibit weaknesses for example in appropriate server security or untested business continuity plans.
We have noted far deeper adaptation of cloud based technologies in overseas fund managers and expect this trend to continue into Australia. Users of the cloud should have significant redundancy in internet connectivity in place with multiple ultra-fast internet connections.
The back office functions are clearly important in any fund manager but often overlooked or treated as mundane. Trade reconciliation, settlement monitoring and valuation are hugely important areas. Failed trades represent a risk not only to the manager but also to the fund and its investors. Furthermore valuation errors can have a significant impact on net asset values or “NAV”s.
In respect of compliance, investors are looking for a compliance culture. This doesn’t mean a business has to be bogged down in red tape: in fact an easily applicable set of rules is more appropriate for a smaller manager than a 200 page document that nobody reads. In terms of personnel a seasoned compliance officer and an experienced, independent compliance committee provide a solid base from which a compliance culture can grow.
The Fund
Most investments are carried out through fund structures. In Australia these are unit trusts and elsewhere these are typically companies or partnerships. No matter what the structure funds are legal entities and governed by a set of constitutional rules and offering documents. Whilst these documents contain powers, discretions and authorities they are low on practical content. A Product Disclosure Statement for example contains limited practical information other than perhaps the fees (unless they are hidden through swaps) or timeframes for redemptions and subscriptions.
A PDS does not typically include some important information, for example who calculates the fund’s unit price or the identity of the custodian and auditor.. These are material issues and investors should ask questions to ensure sufficiently qualified and rated counterparties are involved. I have seen examples where affiliates of the manager are used in various roles without adequate disclosure. Additionally we would prefer accounting firms with dedicated financial services practises to be carrying out the audit. There are still many managers who prefer to hire lesser known auditors effectively “doing things on the cheap”.
Practical investment terms of redemption and subscription should be carefully reviewed. It is also important to match the redemption terms of the fund with the liquidity of the underlying investments. For example, if a fund holding illiquid credit or property offers daily liquidity investors should consider what will happen if unitholders stampede for the door in significant numbers? Investors should understand the ‘gating’ powers. During the GFC investors were left holding illiquid investments for significant periods of time – often with managers and “responsible” entities charging substantial fees during those periods.
The fund structure offers significant opportunity for managers to align their interest with investors. Investors should want to know the answer to one simple question “how much money does the portfolio manager have invested in the fund?” Few diners eat at a restaurant where the chef refuses to eat his own cooking. In our experience this is a question that largely goes unasked and unanswered by many investors and researchers. We have also seen many examples (particularly in Australia) of high earning portfolio managers with insignificant amounts invested in the fund. Investors can make up their own mind as to whether they think the manager has sufficient alignment with investors.
Another area for alignment is performance fees. In essence if the manager performs he gets paid. However it is not quite as simple as that and investors should look at high watermarks, benchmarks and equalisation. Some performance fees allow a manager to collect performance fees even where the fund’s performance is down for the year, investors can make their own judgements on whether that is fair. Equalisation is uncommon in Australia but it effectively means an investor pays an individual performance fee from the time they invest. Due to the fact that few fund administrators in Australia have purchased systems that allow equalisation; investors can lose out in paying performance fees when the fund performance is below the level at which they invested.
To recap
Many investors and advisers are constrained by their resources but governed by a best interest duty. Investing with a poorly organised manager with inequitable fund terms, liquidity mismatch and a weak auditor are unlikely to be in the client’s best interest. Investors should also have some method of concentrating resources only on the highest risk managers.
Business Risk Due Diligence should capture the operational and wider business risks; in particular what can go wrong. Experienced investors weigh the risks of what can go wrong against the ability of the manager to make money. Only in doing this can investors truly satisfy the best interest test.
Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes.
