The need for operational due diligence

Aberdeen Asset Management’s head of operations – alternatives Neil Dolby explains to Pensions Age why the spotlight has brightened on operational due diligence

What is Aberdeen’s process for conducting operational due diligence (ODD)?
When looking at hedge funds, what we are seeking to do is to look at the fund itself and its service providers. Our investment due diligence team covers the investment process, so what we are looking at is the operational process – for example, the trade lifecycle, how valuation and reconciliation works and corporate governance. So, as well as visiting the CFO of the underlying manager, we view it as absolutely critical to look at the administrator, whether they are fully understanding and reconciling the assets and what their processes are around that and valuation, as well as looking at other counterparties such as the auditor and legal advisers. We like to drill down to get the detail of what is actually happening. We may not get a tick in every box but if we are satisfied with the overall controls then we are comfortable to approve the fund. This may be different to some of the newer players, some of whom are slightly more ‘tick box’ in their approach.

At the investment committee our right of veto is used very rarely and a decline tends to be a joint decision between the investment and operational teams. We are not approaching this exercise from the point of view of seeking to fail somebody. If there are weaknesses from an operational point of view, our style is to try and feed that back to the target manager and to work closely with them so that in six months’ time we could invest. That has happened on a number of occasions. However there have been occasions when those improvements have not been made so we have been unable to invest.

So it’s not a one-off process, it’s something that you continue to monitor?
For an investment that is passed, ODD is an ongoing process. We have regular reviews. We will see the manager and the administrator annually to check the independence of those processes. We also receive the annual financial statements and will go through those in detail, and we want to receive the statements independently, so not from the fund manager but from the auditor or administrator.

What are the biggest issues you encounter when conducting operational due diligence?

Traditionally, the things we were focusing on before the market crisis of 2008 were whether the assets existed, correct valuation, governance and litigation. Where things have moved now is that those areas remain absolutely critical but the additional pressure is regulation across differing regimes. Funds were effectively unregulated and some managers were too. Post the market crisis that has completely changed; we have AIFMD and a number of other regulations around the world. So we also establish what the manager is doing to ensure regulatory compliance, which is a difficult issue, as regulation is not always clear nor consistent across the world.

Has there been more focus on operational due diligence by pension funds?
When we started this off many years ago, a lot of investors saw it as a beneficial add-on but not of absolute importance. But in the past five years investors recognise that you need to have a process around operational due diligence and that process needs to be independent from the investment team. Skill sets for an operational due diligence analyst are different – you want a large, well rounded team with the right mix of experience, people who have been undertaking ODD for a number of years, people with accountancy experience, external ODD experience etc. This is exactly what we have.

So how important is operational due diligence, what difference can it make?
Very important. What we are seeking to do at the end of the ODD process is to get comfort around the downside risks. We are seeking to reduce fraud and mis-valuation risks and checking processes around asset existence - basically identifying if we need to leave a fund other than for investment reasons. We have never found ODD to be a confrontational process. Hand-in-hand with the investment team, we are seeking to achieve the same thing – seeking to ensure an investment is sound, to protect and enhance returns for our investors.

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