On the Record: How do you do operational due diligence?
On-site visits becoming more important
The importance of operational due diligence (ODD) has increased vastly. We carry out ODD checks on up to 20 managers a year. Our investment team commissions the business assurance team to start the ODD process on a new manager. I don’t have the right to veto a decision by the investment team but I have a reporting line to the CEO and trustee. I have not yet had to use this.
The approach to ODD depends on the asset class. If it is something esoteric or the manager is US-based we might outsource.
If we are doing ODD in-house we start with a questionnaire, which deals with topics such as governance, compliance, and controls and oversights in the investment process. While the managers are completing this, we do some desktop checks, using LexisNexis, which collects any publicly available information on the company, and regulatory checks. We might also analyse managers’ accounts.
On-site visits are becoming important, as more managers tend not to share information electronically. We ask for dedicated time to read documentation on-site, without the manager’s representation there.
We do come across issues that raise concerns from an ODD perspective quite regularly, although outright rejections are few. Part of our work involves communicating about the areas where we would like to see improvements. Where possible our legal team would integrate these into negotiations, so we can achieve comfort that way. We see a variety of managers’ reactions to ODD and we now rate them on this.
I am also a member of an ODD forum for institutional investors, where pension funds share experiences and thoughts on how to develop an industry standard, for example on questionnaires. A collective approach would raise the bar.
Rejecting managers on ODD grounds
Elo has always done ODD for all its external mandates across all asset classes and it is fully integrated into our investment process. We do ODD when investing in a new manager and while following existing portfolio managers.
Elo does not have a dedicated ODD team. Portfolio managers do the ODD themselves and also conduct ODD with the help of our consultants and our lawyer, who specialise in investments.
All investments can be split into two categories of risk: investment and operational. Operational risk is usually not reflected in the price of a security but can have a significant effect on investment returns.
At Elo, the ODD process includes analysing fund valuation policies, trade operations, infrastructure and business continuity, as well as regulatory and media checks. We visit offices before investing, using our consultants’ resources for on-site due diligence.
On multiple occasions, we have decided not to use an investment manager because of things uncovered doing operational due diligence. This has happened when screening for new managers and during the ODD process for existing managers.
On one occasion, we discovered new material information about a manager’s investment policy and processes. This was followed up with a thorough investigation, which concluded a violation of best practices had taken place. Elo decided to redeem its investment.
Risk management proof wanted
We don’t have specialists with a sole responsibility within operational due diligence. This topic is included in the request for proposal process, which includes a questionnaire that asks about operations, trading and execution, risk management, systems and technology, along with other areas.
We upgraded this ODD questionnaire a couple of years ago. This decision was inspired by regulators as well as requests from our clients.
Usually when we perform on-site visits, we have some of the answers to the questions proved. So, for example, we will ask for live demonstrations of risk management systems. If necessary, we will also make use of special expertise within the risk management department or from outside.
A big advantage of our liquid asset classes is that the majority of our mandates reside with our in-house custodian, which gives us comfort due to the ring-fencing of the assets.
Generally, we find we are comfortable with the managers we assess from an operational point of view. In one case, we felt the risk management system employed by an asset manager was not strong enough. Eventually, we decided to go with a different manager.
Interviews by Susanna Rust