The regulatory aspects of operational due diligence (ODD) were once seen as a secondary phase of fund manager selection, a tick-box exercise confirming that a compliance manual existed on a shelf somewhere in the firm's offices. Operational due diligence has increasingly come to be recognised as an important driver of the whole process, however. A recent survey by Deutsche Bank (Deutsche Bank Hedge Fund Consulting Group's "Second Annual Operational Due Diligence Survey", Summer 2013) found that 70 percent of ODD teams now had explicit veto authority, and that insufficient compliance policies and procedures were the second most common reason (after insufficient operational/technology infrastructure) for applying that veto.
One common misapprehension about ODD is that it arose largely as an industry response to Madoff and other scandals linked to the financial crisis of 2008. In fact, ODD was already emerging at that point as a body of conceptually sound techniques and shared understandings about best practice. The scandals of the crisis undeniably gave the development renewed impetus, however. Large investors now predominantly have dedicated ODD teams that are closely integrated with the wider investment review team. Whereas such teams were traditionally composed of accountants and operations staff, compliance and risk experts are more and more likely to be involved.
With this in mind, what are the critical areas upon which hedge fund managers should focus, and what are the red flags from an ODD perspective? This author works with a large number of firms in the alternative investment space, and these are the top six regulatory issues that clients have to get right:
1. Segregation Clear evidence of separation and independence of authority between the front and back offices is essential. Senior managers in the back office, particularly in the critical risk and compliance functions, must have the necessary experience and force of personality to push back, when appropriate, against the masters of the universe in the front office. Given that many firms are still owner-managed by traders, the chief executive officer must at least understand and be sympathetic to these objectives, and be willing to establish an appropriate compliance-friendly culture from the top.
2. Multiple roles Start-up companies, and managers in the early years of development, will rely on key personnel, typically the chief operating officer, to perform a range of critical functions, such as IT, settlements, compliance and finance. Investors do understand that small managers cannot individually resource these areas; equally, they expect to see a very special kind of person who can compartmentalise the competing demands of multiple functions, and is able to prioritise the aspects of primary importance to investors.
3. Policies and procedures Having appropriate compliance policies and procedures 3. in place, and actually implemented, is essential. These must be in a format that is understandable and useable at a practical level, by all members of staff, and must also be readily accessible. They will include critical areas such as conflicts of interest, personal account dealing rules and market abuse, including how to handle material, non-public information. Another vital component of procedures is how, and how often, they are tested. A rigorous compliance monitoring programme must therefore be in place, and be seen to be an active part of how the firm is managed.
4. Governance. This has always been a hot topic, but the focus in recent years has moved from the fund directors to the governance of the manager itself. As one investor put it at a recent roundtable discussion held by this author's firm, "my contract, and hence my due diligence, is with the manager not the fund director". In other words, an investor has to trust the manager, and believe in its integrity, and that can only come from the top. What will be examined here is the organisational structure governing the manager and, even more importantly, the substance behind the structure. Job titles and committees are all very well, but what actually happens in these meetings needs to be made clear. Discussions must be accurately minuted, and any deficiencies identified and corrected.
5. Trade errors This was the subject of a recent article which this author wrote for Compliance Complete. The important point here is to develop a rigorous principles-based approach to identifying, categorising and allocating trade errors. Increasingly, investors have tended to focus on how errors are identified, reported and investigated, so that further errors will be minimised. At the very least, they want to know that they do not pay other than in certain, very tightly defined, circumstances.
6. Treatment of expenses The question of who pays for what has again been raised in the Financial Conduct Authority (FCA)'s recent consultation paper on the use of dealing commission, and particularly payment for corporate access. Without rehearsing the arguments surrounding this particular case (and dealing commission is only one way of effectively making investors pay for expenses), it does refocus attention on some of the grey areas. The Deutsche Bank survey also found that it was now very unusual to charge employee compensation, travel costs not directly related to research, or marketing to the fund. There was, however, a mix of views on areas such as research-related travel and regulatory reporting (although clarity of disclosure is still essential).
Many of these issues have come under the regulatory spotlight in recent years; indeed, the Alternative Investment Fund Managers Directive (AIFMD) addressed nearly all these areas in different ways. In making conflicts of interest such a critical concept underpinning a significant number of areas, the architects of the AIFMD were surely right in thinking that much more can, and should, be done.
For the most part, therefore, the objectives of regulators and investors are consistent with each other. Ultimately, however, it is investors who write the cheques, and they who are more likely to have the manager's ear and to set the priorities. The commercially-driven ODD function, now with more sophisticated tools, and better resourced than ever before, may well be successful, therefore, in delivering more tangible results for investors generally.
Martin Lovick is a compliance consultant with ACA Compliance (Europe) Ltd, the compliance consultancy firm for wholesale financial services companies with a client focus of hedge fund managers, private equity managers and institutional brokers. He has worked in front line trading and asset management roles in the City for over three decades. The views expressed are his own.