Family office operational due diligence found wanting, warns consultant

Operational Risk
03 Jun, 2013

Family office operational due diligence is substandard despite these investors having the highest return expectations at hedge funds, a consultancy has warned.

A Deutsche Bank prime brokerage study revealed family offices had hedge fund return targets of 10.1%, yet a survey by operational due diligence specialists Corgentum highlighted almost a quarter of these outfits did not perform any operational due diligence whatsoever on their investments.  This is particularly worrying given that family offices are traditionally the biggest enthusiasts for emerging managers which tend to generate better returns albeit carry the most risks. A J.P. Morgan capital introductions group study said 34% of family offices would increase their hedge fund exposures in 2013, while 37% acknowledged they would bolster their allocations to start-ups.

“There is a risk that the lack of operational due diligence infrastructure and resources at family offices could result in investments in hedge funds, particularly newer ones, which lack the internal operational infrastructure. A start-up, even one with decent service providers, might do well and raise money, but lack the infrastructure to grow their business and operations, and this can ultimately lead to risk, or eroded returns for the family office,” commented Jason Scharfman, managing partner at New Jersey-based Corgentum.

 “Family office operational due diligence on a qualitative level has been found lacking in our opinion. Historically operational due diligence centred around trade processing, but has evolved and is now focused on information technology, business continuity planning, valuation of complex securities and regulatory compliance. We have found family offices to be lagging and behind the curve relative to other investor classes on operational due diligence. Sometimes, they will have investment personnel, or people with accountancy backgrounds doing this work, which is not enough,” he added.

The Corgentum survey added 73% of family offices indicated they did not feel confident in their own operational due diligence processes, saying they lacked training and knowledge in the area.

A staggering 79% of family offices do not document their operational due diligence procedures. This shortcoming is likely to undermine consistency in family offices’ operational due diligence processes, and handicap on-going operational due diligence. “A substantial number of family offices do not document their operational due diligence, and rely merely on meetings with hedge fund managers. If family offices do not document this work, they are at risk of missing red flags at their potential investments,” commented Scharfman.

The risk of fraud is the biggest concern among family offices, with 57% telling the Corgentum study it was their most significant operational risk. "A number of family offices were exposed to Bernard Madoff and similar frauds," he said.

Family office concerns also included regulatory risks (21%), counterparty risk (9%) and valuation issues (8%). 

Despite the Madoff hangover at many family offices, some have failed to take note. “A lot of family offices have not been exposed to fraud, or losses incurred by operational failures so it is easy for these outfits to say it is the other guys’ problem. However, some family offices do not have the internal resources to perform institutional-standard operational due diligence, and it is only when they reach around $300 million that they start to hire more dedicated staff,” said Scharfman. 

family officesCorgentumDeutsche BankJ.P. MorganBernard Madoff