Deutsche Bank study highlights growing clout of operational due diligence
The level of sophistication and influence wielded by investor operational due diligence teams has grown exponentially since the financial crisis, according to a Deutsche Bank survey of leading funds of funds and consultants, representing $411 billion in hedge fund AuM.
Operational due diligence teams exercise greater veto powers over potential investments while a growing number of operations teams – 73% at funds of funds and 80% at consultants – work independently from the investment due diligence units.
Operational due diligence has also become far more rigorous. Funds of funds, having been burnt in 2008, are increasingly having to justify their worth to underlying clients by making operational due diligence a core part of their businesses. According to the Deutsche Bank study, 66% of investors take between three and six months to complete due diligence on a manager compared with just 33% in 2003.
Investors have become more institutional since the crisis – an AIMA/KPMG global survey revealed 57% of hedge fund AuM was institutional. Much of this money is coming from pension funds, university endowments, charities and annuities whose “investment objectives place an important emphasis on risk-adjusted returns and capital protection.”
The Deutsche Bank study also revealed reasons for hedge funds failing due diligence. A lack of independent oversight – whereby funds are self-administered or self-custodied, or if an unknown audit firm is used – is a major red flag. Investors also shy away from funds with poor corporate governance oversight – an issue that has featured highly at several recent industry conferences.
Poor transparency was also cited as a reason for failing due diligence in the Deutsche Bank survey. The AIMA/KPMG survey reached a similar conclusion with 82% of investors acknowledging they had become tougher on transparency requirements. Nonetheless, hedge funds appear to have taken note with 84% stating they had bolstered investor transparency.
Investors also look unkindly on managers who fail to invest sufficient personal wealth in their funds as it means interests might not be wholly aligned. Poor segregation around cash controls, unsatisfactory operational and technological infrastructure, substandard valuation policies and insufficient checks and balances among non-investment staff were other reasons given for failing funds.
"The research highlights how important the fundamentals are to the operational due diligence process – from having the right people in place to a proven audit trail. The growing importance of operational due diligence comes at a time when investors are better educated than ever in all aspects of a fund’s business,” said Chris Farkas, head of European hedge fund consulting at Deutsche Bank.