Operational Due Diligence (ODD)

Those managers that take Operational Due Diligence seriously set themselves in good stead to win the trust of capital allocators and grow their business; those who don’t are in for a tough ride. Here are some pointers as to the kind of questions that emerging managers should be prepared to answer when they approach allocators.

You’re an emerging fund manager ready to launch your new fund and you’re stoked that you got that far. Like any self-respecting portfolio manager, you know your way around your pitch-deck like the back of your hand.

Risk management? No problem.

“We operate a layered hedging strategy to manage our FX risk and impose limits on portfolio concentration…”

But then you realise the capital allocator isn’t talking about the risks faced by the fund; he’s talking about the risk of your meeting a premature death, and what are the precise contingency plans in place were that to happen.

“Urm…”

What Is Operational Due Diligence?

Operational Due Diligence, or ODD, is a type of due diligence preparation that most emerging managers treat as an afterthought. ODD is the questioning that your fund management firm will have to pass before a serious investor places money with you. Ignoring the ever-tougher requirements that ODD pose is a mistake that could cost you dearly. It could cost you lost clients and income, or even your entire firm.

As an emerging manager, this subject is all the more relevant for you. A survey from the CAIA, a professional body dedicated to creating greater alignment, knowledge and transparency for investors, indicated that nearly 90% of investors believe that emerging managers require a more intense due diligence process than their more established peers.

This is no surprise given the regularity of investment firm failures, not to mention outright frauds, that have taken place in recent years.

Those managers that take ODD seriously and have done the groundwork set themselves in good stead to win the trust of capital allocators and grow their business; those who don’t are in for a tough ride and a few expensive lessons.

Here are some pointers as to the kind of questions that emerging managers should be prepared to answer when they approach allocators. Don’t forget to add them to your operational due diligence checklist! (What, you don’t have one yet?)

Financial Stability

Given that most emerging managers are effectively start-up companies, allocators will want to ensure that you aren’t going to disappear overnight. They may want to know:

• The current level of cash in the fund management company.

• The current cash burn.

• The composition of the shareholder register.

• The level of assets under management (AuM) needed to reach breakeven.

• The composition (and concentration) of the client base.

Many jurisdictions have in place a minimum liquidity requirement that the management company must meet or exceed at all times, so it’s also worth taking this into account when talking about your liquidity position.

Outside of showing you are solvent, you will also have to demonstrate that your firm can afford to put in place and operate the necessary structures and processes.

Regulation & Compliance

Is compliance taken care of internally or via an outsourced third party?

These days, many emerging fund managers rely on their compliance consultants to maintain the necessary compliance infrastructure for their firm.

However, if this applies to you, then make sure that this doesn’t simply amount to a box-ticking exercise and your firm actually follows through on recommendations and implements its own internal procedures to achieve this.

If you do use third-party consultants for meeting your compliance needs, then consider putting in place a plan for internalising the compliance function when your company reaches a certain level of maturity. If not, then be prepared to explain why outsourcing the compliance function is the optimal approach. It is fine to have it outsourced, but you need to be able to answer some very detailed questions about this matter. Are you prepared? In between your passion for picking investments and managing a portfolio, do you allocate enough of your time to tend to these matters?

Like it or not, compliance is simply a fact of life for fund managers and is only set to become more prominent and wide-ranging in future. Make sure you have a plan to stay ahead of the curve when it comes to this important aspect of ODD, and allocators will reward you for it.

Outsourcing

It’s not just compliance that emerging managers tend to outsource. Oftentimes, the manager will outsource the entire back- and middle-office functions, which enables them to focus their attention on managing money.

In a more extreme scenario, a manager might use a regulatory hosting platform, whereby they “piggy-back” on another firm’s management license. If this is you, then be prepared to talk about the due diligence you did on the host firm before meeting allocators. Also, it is worth noting that some allocators may discourage such an arrangement and favour full oversight of risk management from day one.

Whatever your arrangements, make sure you know how to justify them in the context of your own situation. Although service providers can indeed free up time and resources for managers, they nevertheless require careful and continual monitoring.

Skin In The Game

Put simply, if you as the fund manager have little or no equity in your fund and/or management firm (otherwise known as “skin in the game”), then you are unlikely to inspire much faith among allocators. Also, how significant is this investment vis-à-vis your own personal net worth?

It is important that all key staff are properly incentivised in order for their interests to be properly aligned with investors. However, be prepared to talk specifically about the structure of bonus payments:

• Are bonuses deferred?

• Is there a threshold above which the deferral activates?

• Are such deferrals reinvested into the manager’s own funds?

If questions like these come up in meetings with allocators, would you be able to quickly pull out all the necessary documents and show that you have the processes in place and the details on your mind? If not, then you will be in for a hard landing. This is now the reality of the fund management industry.

Obviously, some staff may require greater liquidity in their financial arrangements, but it is important that you understand how each staff member’s remuneration works and fits into the wider picture – and can justify this to capital allocators.

Fundraising

What are your arrangements for raising capital? How will you get to critical mass? Do you have an independent fundraising team? Perhaps you outsource this to an independent fund marketing firm?

Way too many emerging managers place too much emphasis on their track record – “the track record speaks for itself”, is often the remark. Yet raising capital, especially for a new fund, is THE MOST DIFFICULT thing you’ll probably do in your lifetime – excluding perhaps getting married, buying a house, or raising a child.

Ask yourself this: Can you really afford to spend day upon day meeting investors, most of whom will never invest in your fund? Do you have the time to attend all those roadshows, appear on all those podcasts and do all that networking?

Delegating this task to someone else – whether that be an internal staff member or a third party – could just be the best decision you ever make. Allocators will also take note, as it means your time and energy won’t be sapped away by this incredibly consuming endeavour and you’ll be able to focus on what you do best – managing money!

If you are planning to hire a third-party fund marketing firm, did you include a suitable retainer in your budget? Can your emerging manager reach profitability even if you split fees with someone else? Again, these are questions that any emerging manager will have to answer when meeting serious allocators.

Counterparty Risk

The most obvious relationship when we’re talking about counterparty risk is the one between the fund and the prime broker. Many funds will launch with a single prime broker, which exposes them to considerable operational risk, although there are often financial incentives to channelling business through one broker.

Best practices for managing counterparty risk include:

• Ensuring robust internal procedures relating to portfolio and risk assessment.

• Formalising outsourcing procedures and the use of portfolio management systems.

• Separating banking services from the brokerage relationship.

• Using a recognised and regulated third party which is independent from the financial counterparty for the fund’s administration.

At the very least, new funds should make sure they choose a well-respected and visible prime broker and custodian which will help establish confidence among allocators. Plans to diversify counterparties in future as AuM grows could also be viewed favourably.

Cyber Security

The threat of cyber-attack is now a fact of life for all businesses, not just the financial sector. However, the financial sector’s particular characteristics make it a major target.

Don’t be the firm that makes cyber-security an after-thought, as this is becoming an ever-greater area of concern for capital allocators, who will want to ensure that all the right protections and procedures are in place – and are being followed!

But it doesn’t end there. Showing that you’ve also vetted any counterparties regarding their own cyber-security precautions will also reflect well on you. E.g., what have your service providers done to ensure they are secure against cyber-fraud?

In Conclusion

Setting up a fund management firm comes with very high barriers to entry. We wanted to publish this article as a useful guideline for anyone who is looking for information about this subject, but also as a (brutal) reality check about the requirements of fund management businesses in the 2020s.

Whatever stage you’re at with getting to grips with all this, remember to be transparent and honest with your answers and explain to capital allocators how you intend to address any challenges you might have. This will go a long way towards addressing any concerns an allocator might have about you and help to build the trust that is the life-blood of doing business.

Realistically, no emerging manager is going to be in a position where it has zero ODD issues that might be a cause for concern for allocators. Above all, remember that everything is a learning process, and the important thing is to convey a sense of direction and awareness. Allocators will be understanding that emerging managers will have areas where they still need to improve – and the important thing is that you accept as much and show a clear pathway towards reaching the next level of operational excellence and resilience.

Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.