Policing a Fund’s Due Diligence Environment

Originally published in the May 2011 issue

All managers have a launch date in mind. When the fund starts trading and begins to make huge returns, everyone wants to get on the money train. Managers do not want anything to hold up this process. This is not a reference to the “regulatory hijack” that some parties have to deal with in relation to the form filling, box ticking and waiting lines for hedge fund registration. Instead, it is the delay taken up by the performance of due diligence tasks.

Notwithstanding the view that a due diligence exercise may not add value to a fund’s bottom line, it can be argued that adequate performance of due diligence ensures a smooth ride. In addition, it helps to keep investors’ money safe; a detailed analysis is completed on what the fund invests in, who it accepts as an investor and who is hired as a service provider, including a fund administrator or a director. A thorough exercise will identify competent operators and will act as a check and balance that nothing is being put into the fund that will taint everything else, which may lead to the fund’s demise. As stakeholders begin to appreciate this practice, there may be a gradual departure from an emphasis on the speed of the fund launch or in making a quick return. This change will demand satisfactory due diligence at the inception of the fund as well as throughout its life. It also means looking at different areas of risk.

Stakeholder practices
One observation is that investors who perform due diligence on potential investment funds usually place more emphasis on the area of investment risk. This leads investors to focus on investment strategy, fund performance, fee structure and how the investment fund values its assets. While investment risk carries a lot of weight when selecting an investment fund, operational risk should not be ignored and must be factored into the decision making process. Focusing solely on investment risk is similar to a prospective investor being captivated by the beauty of the fund’s track record, celebrity status of the manager and the persuasiveness of the words in the manager’s presentation and the offering document. Operational risk can be likened to the sobriety of the conductors on the money train, what procedures they have in place and whether these are consistently followed in terms of proper trade execution and management, fund administration, and business continuity planning. In addition, having inadequate internal controls or processes or weak conductors driving these operational components can have very high financial impacts if an investment fund were to experience a key event.

Outsourcing fund administration and reducing operational risk
Outsourced fund administration has now become a best practice among investment funds as it provides a level of transparency for investors and reduces the risk of fraud by the fund manager.

However, inherent operational risk is still present for both the fund manager and investors by outsourcing this operational function. If fund administrators do not have adequate internal controls over operations or sufficient business continuity planning in place, this presents a high level of risk. This risk may affect the fund manager’s operations as well as the investor’s access to record keeping and reporting (or even a loss of capital gains depending on the severity of a key impact, if realised). Lack of proper business continuity plans is a great example of how risk can be significantly increased if a fund administrator experiences a disaster such as an earthquake and or a tsunami. The obvious question that investors should ask here is how the fund will be affected if all current records are destroyed.

In the absence of documentation, it would be taxing for stakeholders to reconstruct transactions from memory, attempt to demonstrate the completeness of procedures or confirm the existence of investments. It is therefore important for a fund to select a fund administrator or other service provider that has good systems in place and that is ready to provide a paper trail. One rapidly growing and efficient fund administration outfit which frequently tests its disaster recovery plan and updates its business continuity plan is Apex Fund Services. Apex has 21 offices globally and provides fund administration to a fund of any size. It competently performs due diligence on new managers and investors into any fund administered by the group and has completed SAS 70 audits. For this reason, Apex has gained traction with investors and is poised to be one of the world’s top five administrators in a short timeframe.

It is the type of fund administrator that investors should be thinking about when they need answers to effectively assess material risks associated with an investment fund.

Notwithstanding this important role played by administrators like Apex, stakeholders must also look at the responsibility of other service providers.

Another key element for the success of a fund is its board of directors. The board is the watchdog for investors and is responsible for the overall supervision and monitoring of all of the fund’s service providers. Board members should be aware of the processes and systems used by the administrator and investment manager and should check periodically (even on a random basis) that such processes and systems are working well to achieve the due diligence objectives of the fund.

For this reason, it is important for stakeholders to analyse the proposed composition of a fund’s board. In making a selection, here are some of the things that can be reviewed from a due diligence perspective:

• Background and experience of directors – have they worked in a capacity as an investment manager, analyst, administrator, lawyer or accountant? This will increase their level of familiarity with the issues that may arise and there will be more comfort in terms of competence to develop or enhance existing internal controls and resolve critical matters;

• Conflicts of interest – are they disclosed?

• Are there any records of regulatory breaches by any fund on whose board a proposed director sits and can any actions be attributed to a breakdown in internal controls?

• Can a prospective board member demonstrate an understanding of systems and procedures used by the administrator?

• What is the oversight and review methodology of the proposed director? Will he be “hands-off” and sign documents when requested or will he conduct periodic meetings with the manager and administrator in order to ensure that a reporting function exists between the fund and service providers?

Depending on the jurisdiction of the fund, various due diligence documentation may also be required. Stakeholders should familiarize themselves with such requirements.

The evaluation of the risk of an investment fund must include operational due diligence in the general process. This will assist in effectively assessing the overall risk of investing in a fund. Attention must also be paid to the key persons performing these functions. For example, a stakeholder cannot depend solely on a fund manager’s operational due diligence of its third party service providers. This is because a fund manager could easily select a provider based on cost savings to the fund alone rather than risk aversion. This may increase the total investment risk for the investor or the fund as a whole.

At the end of the day, a good functioning board must be involved. It will oversee service providers and work to achieve a reduction in operational risk. Failing this, investors will need an independent party to police the due diligence structure to ensure that the fund has a sound foundation on which to grow.