Views on Operational Due Diligence

Kinetic Partners bulletin

Originally published in the September 2013 issue

According to Deutsche Bank’s recent Operational Due Diligence Survey, new and changing regulatory requirements will influence operational due diligence (ODD) reviews and 74% of ODD teams surveyed ranked a fund’s compliance and regulatory framework as a top focus area for 2013. So, it is important to understand what investors need to be asking managers and indeed, to understand what the operational risks are of AIFMD and other regulations. Investors should understand what advice the manager has taken on marketing to EEA investors and the associated risks. Investors too will need to appreciate the different marketing, depositary and transparency requirements applying to each fund and fund manager location combination (subject to each EEA state’s interpretation of the AIFMD Article 61.1 transitional).

Investors’ operational risk appetite (i.e., how much operational risk they are prepared to tolerate), will be influenced by what type of investor they are, where they are located, their experience of allocating to alternatives, their experience of frauds, blow-ups and allocating around the 2008 period as examples. Appetite too will be influenced by allocation size. Must-haves for investors will centre around custody and safeguarding of assets, knowledge of the service providers, segregation of duties, robust asset transfers and no crimes or fines. With these criteria in mind, investors can allocate their finite time and resources to focus on the areas where they have least tolerance for operational risk.

While all investors have concerns specific to the fund managers to whom they have allocated, the risk factor that keeps investors up at night, more than any other, is the accuracy of the NAV being reported to them. Investors need to know that the capital account statement they receive from their administrator represents the true NAV of their investment. They need to know that when they submit a redemption notice that they will receive the full amount of the proceeds listed on the statement (subject to moves in the market).

It is critical to perform due diligence not only on the manager but on the administrator as well. Valuation policies must be reviewed and tested both on initial due diligence as well as at regular intervals on an ongoing basis. Administrators need to be not only experienced and reputable, but must also be tasked with a full and proper scope of work in order to mitigate this risk.

Fraud, regulatory action, counterparty risk and valuation continue to be the operational risks of most concern to investors.

Opinion of a head of operational due diligence, European fund of funds
Both Dodd-Frank and AIFMD place additional reporting requirements on managers. The most onerous reporting will be to the regulators but there will be some additional investor reporting requirements as well.

Following the global financial crisis, there has been growing recognition that, given the increasing size of the shadow banking industry, enhanced regulatory reporting would become a requirement. Indeed, there was agreement amongst many that such reporting would answer some of the criticisms of the industry.

The scale of this reporting was a disappointment to many. Managers are having to adjust systems and data sets in order to create some of the classifications of data requested. There is considerable senior management time and a financial cost associated with simply getting the data formatting right. Some put the overlap between reporting requirements for Form PF and AIFMD at 50-60%. This is helpful, but due to the lack of joined up thinking between regulators, an unnecessary burden is being placed on managers. Many managers are now regulated in several jurisdictions, meaning they are caught by multiple reporting formats and sometimes conflicting requirements.

Some managers are looking to outsource the creation of the various reports to the extent that it is possible. Fund administrators (and others) are working on systems on their side to pool information from managers with their data sets as administrators in order to cover the data requirements of Form PF/AIFMD. The technology lags the regulators’ requirements at present. Whether the fund should pay all or part of the cost for creating the forms is a leading question and no doubt over time a standard will develop.

What is in no doubt is that this is a real cost to managers. Whether this is worth it in terms of increased confidence in the industry and answering industry critics will likely be a matter of discussion for some time to come.

View from Asia
Although the hedge fund market in Asia continues to grow (the Hong Kong fund management business grew 39% in 2012 to HK$12.6 trillion, with overseas investors accounting for about HK$8 trillion of AUM), the scale of hedge funds in Asia is relatively small compared to the markets in the USA and Europe. Being an immature market for hedge funds, the problems facing some managers in the region include the lack of qualified and experienced operational personnel from a hedge fund background and, due to the size of AUM, some managers in Asia operate with limited resources, both in terms of staff and operating systems. These concerns can potentially lead to deficiencies in internal systems and controls.

Regulators in Asia understand the importance of ensuring that hedge funds are able to operate in a stable regulatory environment, but at the same time acknowledging the importance of having sufficient rules and regulations in place to protect investor interests. In 2012, the Monetary Authority of Singapore (MAS)implemented a new enhanced regulatory regime for fund management companies, and some of the key requirements are to put in place an independent and dedicated compliance function, implement a risk management framework and have internal audit arrangements to be commensurate with the scale, nature and complexity of operations.

In China, amendments to the Securities Investment Funds Law became effective from 1 June 2013 and enable hedge funds to raise funds legitimately in mainland China for the first time. The new law means managers will be required to register with the newly established self-regulatory organisation – the Asset Management Association of China. This requirement will hopefully create a regulated and transparent hedge fund market in China, which will in turn attract large institutional investors.

Kinetic Partners is a global professional services firm focused exclusively on the financial services industry. Kinetic Partners provide a full range of consulting and regulatory compliance, due diligence, tax, forensic, audit and assurance services. Launched in 2005, they have over 170 staff in eight locations.