COO Connect Editorial: Interview with Jérôme de Lavenère Lussan, chief executive officer of Laven Partners
Prior to 2008, operational due diligence undertaken by sophisticated investors was viewed as intrusive and time consuming by hedge fund managers. In the post-Madoff and crisis era, hedge funds have now recognised its importance in securing investments. COO Connect Editorial speaks to Jérôme de Lavenère Lussan, chief executive officer of investment management consultancy firm Laven Partners, about the changes in the industry over the last few years.
COO: How do you distinguish between investment due diligence and operational due diligence, and what is the overlap between the two during the hedge fund manager selection process?
Lussan: Investment due diligence helps explain the market risks associated with an investment strategy while operational due diligence addresses the structural, legal and operational risks that are potentially hiding behind the day-to-day operations. Up until recently, a lot of importance had been given to investment due diligence as opposed to operational due diligence. However, both are equally important. Investment due diligence helps scrutinise the returns of a strategy, while operational due diligence focuses on risk and potential conflicts of interests that could lead to frauds or abuses. Although most investors now appreciate the importance of operational due diligence, we still find that some view it as a one-off exercise, which is plain wrong. It is important that performing investment due diligence and operational due diligence independently of one another is not as effective as combining the two. When performing operational due diligence on – for example – a US long/short equity hedge fund, it is essential to understand the return streams and the investment strategy. If by running a simple correlation analysis reveals the fund is 90% correlated to the price of gold, we would want to understand why and the application of risk management as this may be too concentrated and it could cause liquidity issues. If by digging further, we realise the fund is mostly exposed to small mining stocks, for example, then it would raise some red-flags as not being compatible with the description of the strategy and we would have to ensure risk management is proportionate to this type of strategy.
COO: What are the most important parts of operational and investment due diligence on managers?
Lussan: We believe that all parts of a due diligence exercise are just as important as each other. Due diligence is both a science and an art. The science is ensuring that the same exact steps are taken every time and that no “shortcuts” are taken. The art is to ensure that after having followed the process, no questions remain unanswered. There is nothing worse in due diligence than being “unsure” or “guessing” any of the steps required during the process. Additionally, it is essential to have a good discussion with the manager and its employees and get deep into the “real” application of the strategy, risk management and operations of a firm, and not relying on what is just written or presented to us only. This is why on-site visits are very important and must never be replaced by conference calls. Until you are in the office of the manager and can “audit” their processes, you cannot claim to have performed a detailed due diligence. Internally we call this process “trust… but verify!” We trust by reviewing the prospectus, marketing and other documents provided by the manager and listening to their explanations, but we can only verify once we have gone on-site and audited each step that was described to us.
COO: What aspects of due diligence have received the most attention in the last two years?
Lussan: In the last two years, there has been a lot more work and attention given to operational due diligence, which was not a strong part of the research process for many investors. At Laven, although we have continued to develop our processes internally, the operational due diligence work which we perform remains quite similar to pre-2008. For example, the review of valuation procedures and independence of service providers is something which we have always assessed in detail since we started in 2005. Our clients, however, have recently been more focused on the legal structure of the fund and inherent disadvantages, if any, for the client. They have also looked differently at the true independence of service providers and directors of the fund, the background checks of the managers and senior employees and have taken to reading properly the terms and conditions of the fund especially around fees and liquidity (including gates, suspensions, etc).
COO: What improvements have you seen in the operational infrastructure at funds over the last three years and what are the biggest challenges for hedge funds to confront?
Lussan: We have seen real improvements in the industry, perhaps more in the last year rather than the previous three. We have noted improvements in the independence of service providers, improvements in the way cash is handled, improvements in the internal processes of the firm (risk management, front to back office operations, compliance), but more importantly we have seen an improvement around transparency and on the time which is now allocated by managers to allow investors to properly and periodically scrutinise their operations. This is a very significant change for the future of our industry. Managers should expect that investors be given the correct amount of time to properly assess a fund and the operations of a manager before an allocation is made. However, valuation of assets is still a grey area and directors should really be far more involved with this going forward. The responsibility of directors in general is also something which we would like to see being developed further. The recognition that risk management can also create value as opposed to hinder profits is a major shift in attitude but it still has to gain momentum yet. Finally, we wish there would be an agreement for the benefit of all investors on one set of best practice standards that could then be followed by the industry.
COO: What kind of challenges do you face when performing due diligence on a hedge fund? And how do you overcome them?
Lussan: Unfortunately, operational due diligence is not a scalable process: as an analyst you have to do the job in the same way for all funds - there are no shortcuts. This amount of detailed work requires time and the only way to use time better is to have expertise in all matters from operations to legal structures and or trading systems. Everything changes all the time. Operational due diligence remains therefore a bottleneck for many investors, which is why they ask us to do this work for them. Internally we work by sub-dividing elements of the due diligence across our firm to get the most efficient and most relevant result for our clients. For example, the review of any legal documents is handled by our legal team. Similarly the review of any compliance matter is handled by our compliance consultants. Such teams of experts will then report back to our due diligence team for an in-context assessment of their review as some matters may vary depending on the type of strategies concerned. We also break down the process in a number of steps and checks which ensure that no one step is too onerous for any team member, and that many minds are at work for every review. Ultimately a project manager is always in the lead and responsible for the due diligence – however, they can work off a team of reliable experts in their fields. Even more importantly, I, the chief executive officer of the firm, must sign off every report. At Laven, we take our responsibility very seriously and that is why every report must be signed off at the top.
COO: Does the due diligence processes differ for managed accounts in comparison to hedge funds?
Lussan: Some of the real advantages of managed accounts include the liquidity and transparency on offer. Transparency, although a real plus, must be well handled. Having information is great, but it must be used effectively. By reviewing this information, most managed account providers would ensure that the same levels of risk management for example, are applied as they are to the flagship fund which the managed account is replicating. Additionally, the investor should ensure that such risk management is well enforced by the managed account platform provider. Nonetheless, we generally believe that the same process of due diligence should be applied to a managed account platform as it is to a normal fund. Although some key steps may not be applicable, the same process should be followed from start to finish so that it can be benchmarked with the rest of the due diligence analysis performed on comparable vehicles.
Jérôme de Lavenère Lussan is the founder and chief executive officer at investment management consultancy firm Laven Partners. The company, which has offices in London, Barbados, Luxembourg and Geneva, provides investment managers with guidance on fund establishment, regulation, compliance controls, risk management, operational due diligence and structuring. De Lavenère Lussan was previously a chief operating officer at a hedge fund and a financial lawyer at Jones Day.