Keys to Operational Due Diligence

One of the issues that is top of mind for managers is fundraising, and with that comes navigating the operational due diligence process. Time and time again, we are asked ‘what are some of the “pitfalls” or “red flags” during the operational due diligence process?’  As an emerging manager, resources may be limited – whether that be operational capital, AUM, or headcount. So, what are some things that a manager should be aware of and what are some keys to passing operational due diligence?

Typically, unless there is a major issue or red flag (i.e., lack of transparency, lack of honesty, material ongoing litigation, SEC exam findings that have not been addressed, etc.) operational due diligence professionals will work in a consultative way with a manager in order to improve on the items that raise concern.

More often than not, it is the aggregate of several “yellow flags” that will cause the manager to be vetoed. In 3 words, the best way to summarize passing an operational due diligence inquiry is process and plan. Be sure to speak to what processes/tools the fund has in place and utilizes, what the thought process was when implementing these processes/tools and why it is appropriate for your fund.

As it relates to the following items, a fund manager must be able to explain why a decision was made to insource or outsource a function, how a specific vendor fits into the strategy, and what the plan is to revise/adjust an approach and build/improve on the infrastructure as the fund grows.

• Outsourcing: Outsourcing key functions is a creative and effective way to build an infrastructure at the early stages. It can be helpful as it relates to segregation of duties. But, it is important to be able to explain why certain vendors were engaged: Do they specialize in your strategy? Does their client service approach complement your needs? Are they imperative to your growth plan from inception through $1B, $5B, $10B; or is there a plan in place to insource at a certain AUM level?  “Cost savings” is not a sufficient response. “Everyone uses them” is not a sufficient response. “They have a good reputation” is not a sufficient response. 
• Service providers: Similar to the questions regarding the thought process of choosing vendors for outsourced functions, your approach for selection of key service providers (administrator, fund accountants, prime brokers, and attorneys) should be the same. Do your selected vendors have experience working with similar strategies? Do they provide the required service level to respond to your questions and concerns in a timely manner? Be sure to explain to the investor what your thought process was while selecting the vendor. Again: “Cost-savings” is not a sufficient response. “Everyone uses them” is not a sufficient response.  “They have a good reputation” is not a sufficient response. 
• Cybersecurity: Be sure to identify who internally is accountable for certain responsibilities and why. If a function has been outsourced, who is responsible for managing the outsourced vendor? Why have you outsourced to the selected vendor and how does that vendor complement the fund’s strategy? 
• Compliance: Do not think that because you are an unregistered manager, you are flying under the radar and compliance does not matter.  It is important to have an institutional mindset and approach from Day 1. Do not wait until you are a registered advisor to have a “culture of compliance” – this approach A) causes a C-suite change on Day 1 of registration and B) changes your overall process on Day 1 of registration. It’s also important to note that compliance is a function that investors prefer to see a designated internal contact for, but can be supported externally. 
• Other Due Diligence Items: The AIMA DDQ is always a good place to start, but the nuts and bolts of operational due diligence are learned during an on-site visit. It is helpful when a fund manager is proactive in the process; provide Appendices to your DDQ which include AUM, performance data, organizational charts, trading flow charts, etc. Provide deliverables ahead of the on-site visit. Some items to note are:
  • Form ADV (if relevant)
  • Offering documents
  • Limited partner agreement
  • Valuation policies
  • Business continuity plan 
  • Counterparty documents and agreements
  • Code of ethics
  • Security policy
  • Compliance manual