By Todd Sloan
Over the last few years, our clients across the investment management community have seen a heightened focus on operational due diligence driven by a surge of institutional money into hedge funds. In addition, several fraud cases have caused significant losses for even the savviest investors. Regulators are also shining a bright light on hedge funds as they have gained popularity across both retail investors and pension plans. Having the right technology and third-party relationships in place is more important than ever before.
Performance Versus Operational Risk
Hedge funds are acutely aware of the reasons why investors perform a thorough operational due diligence process when evaluating where they park investment dollars. Operational risk is more relevant than ever because investors cannot assume that a hedge fund manager has a functional operational infrastructure to protect investor assets.
Yet, fund performance often blinds the investor to the actual operational deficiencies found during the operational due diligence process. Also, investment managers are driven primarily by performance fees, where gains often come from trading esoteric asset classes. These asset classes can have broader valuation ranges than equities and greater settlement hurdles, and are far more challenging to research when problems arise. Added complexity, coupled with greater transaction volume, is a recipe for disaster.
Middle and Back Office Innovation
The good news is there have been significant improvements to middle- and back-office technology and a substantial increase in the number and range of services being offered by financial technology providers. For many hedge fund managers who have outgrown their initial technology and staffing footprint, there are several options which can promote a process-driven operating model that was once limited to larger investment managers due to cost. These include solutions for reconciliation, data aggregation and fee billing; managed services offering flexible “right-sourcing” models combining operations expertise and technology; or fully outsourced services for operations.
The Operational Due Diligence Review
Institutional investors are now taking a closer look at the operational controls and processes hedge funds use to protect their assets. The operational due diligence review covers much more than a firm’s organizational chart, fund structure, back-office procedures, valuation methodology, and performance. It also scrutinizes the third-party relationships in place with fund administrators, custodians, brokers, and vendors. With that in mind, there are two critical points hedge funds must consider when choosing the right vendor relationship, with service quality and the reputation of the third-party vendor being front and center.
First, hedge funds must forge partnerships with proven service providers who have undergone independent audits performed by reputable firms with a solid understanding of the investment management space. Second, hedge funds should consider the experience of third-party vendors and the types of clients they serve today. As a hedge fund, it doesn't make sense to partner with a vendor where the vast majority of its client base resides on the sell-side or in a completely different sector.
Choosing the Right Partners
Operational risk is here to stay, which is why investment managers must remain diligent in scrutinizing every aspect of a hedge fund's business with particular emphasis placed on the middle and back offices. Investors need to increase their focus on operational controls and third-party relationships, rather than wait for regulators to uncover an issue, or worse, for investors to experience a significant loss of capital attributed to the hedge fund’s inefficient processes or partnerships with incompetent vendors.
In general, investors who take a close look at a hedge fund’s operational risks will make more informed investment decisions. Hedge funds must choose the right partners to demonstrate the integrity of their operations to investors. A robust operational due diligence process benefits both investors and hedge funds as all parties involved will have the confidence that adequate attention has been given to performance, operational risks and controls.
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Todd Sloan is a results-driven executive who has spent more than 20 years helping the investment management community connect with automation in the areas of reconciliation and exception management workflow. He drives Electra’s buy-side industry engagement and solution strategies.