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Do operational due diligence service providers need industry standards?

By Richard Szwagrzak, CFA, CFO/COO

Trafalgar Capital Management (UK) LLP

Q4 2013

 

Hedge fund investors have demanded ever more complex scrutiny of potential investments in recent years and increasingly rely on operational due diligence (ODD) service providers to do the work on their behalf. But how should investors assure themselves of the quality of advice they receive from independent ODD specialists? If the reputation of the principals of investment managers is no longer sufficient justification for investment, how can the reputation of the principals of ODD service providers be sufficient justification for reliance on their advice? Prudent investors should adopt a structured approach to their assessment of ODD service providers consistent with the ODD framework demanded by their investment mandate.

 

The regulators agree. Back in 2005, the International Organisation of Securities Commissions (IOSCO) issued its principles on outsourcing. The first of IOSCO’s principles gets straight to the point: an outsourcing firm should conduct suitable due diligence processes in selecting an appropriate third party service provider and in monitoring its ongoing performance. In implementing this principle, the Financial Conduct Authority’s rule SYSC 8.1.8 expands on the matter: the service provider must have the ability, capacity, and any authorisation required by law to perform the outsourced functions, services or activities reliably and professionally; the service provider must carry out the outsourced services effectively, and to this end the firm must establish methods for assessing the standard of performance of the service provider; the service provider must properly supervise the carrying out of the outsourced functions, and adequately manage the risks associated with the outsourcing;  appropriate action must be taken if it appears that the service provider may not be carrying out the functions effectively and in compliance with applicable laws and regulatory requirements;  the firm must retain the necessary expertise to supervise the outsourced functions effectively and to manage the risks associated with the outsourcing and must supervise those functions and manage those risks.

 

So investors should structure and document processes and procedures that provide the means to assess the quality of candidate ODD service providers. As ODD forms part of the investment process, the same approach should be taken as that for assessing the suitability of investment managers. Background checks should be made on the ODD service provider's principals. The ownership structure should be reviewed as should the organisational structure. Are there any conflicts of interest? Do they themselves rely on key service providers? What are their internal compliance procedures and are they subject to regulatory scrutiny? Finally how robust is their ODD methodology and what assurance is there of the consistency of its application? What is the realised track record of recommendations made?

 

Assessing the robustness and consistency of application of a service provider’s particular ODD process is tricky. What makes one better than another’s and how should the efficacy of ODD be measured? To attempt to answer these questions an investor needs not only a framework for making the assessment of an ODD process but also evidence of its consistent operation. Access to the ODD service provider’s records may be difficult to obtain. Moreover, the investor must have its own resources available to review them.

 

Having appointed an ODD service provider, investors must monitor the service provider’s performance and have a contractual means of modifying unsatisfactory behaviour or of terminating the service if necessary. Such a contract might also include provisions on confidentiality, a clear service level agreement including provisions on how service levels will be monitored and an obligation on the ODD service provider to provide information on its service, when requested, to the investor and to its regulators.

 

Hedge funds and their managers require that any confidential information shared with a potential investor and its ODD service provider is protected from inadvertent or intentional unauthorised disclosure. The contract should prohibit the disclosure of a hedge fund’s proprietary information except as necessary to provide the ODD service. Subcontracting by the ODD service provider should be strictly controlled, particularly with regard to confidentiality. Investors should assure themselves that the ODD service provider has appropriate information technology security procedures established to protect confidential information from industrial espionage and maintain the trust of potential investee hedge funds and their managers.

 

Even as the ODD service provider ensures confidentiality, its records must be available for inspection by the investor and its regulators to allow for appropriate oversight of the outsourced service. Just as investors demand transparency from hedge funds and their managers, so should they require disclosure of processes and results from their ODD service providers.

 

Concentration risks should be considered by investors in the case where one service provider provides ODD services to multiple investors. Investors should seek out information on the ODD service provider’s clients and possible conflicts of interests arising from other business activities pursued by the service provider.

 

The FCA recently published its Thematic Review on Outsourcing in the Asset Management Industry, which concluded that managers need to do more to manage the risks associated with outsourcing. The report observes a wide variation in the effective oversight of outsourced processes by asset managers. Effective oversight requires expertise as well as appropriate management information systems, service level agreements and operational risk management. An outsourced service cannot be a substitute for internal expertise. While the report does not cover ODD specifically, prudent investors should be guided by its broad conclusion that common practice is not always best practice.

 

Standards of best practice should be established for the assurance of investors and to encourage the constructive engagement of hedge fund managers in the design of ODD methods. The development of these standards should be led by investors to address the issues raised by IOSCO’s outsourcing principles. The standards should propose methods for assessing the efficacy of ODD processes particularly for smaller investors with more limited resources. The standards should be used as a tool to help educate potential hedge fund investors. It is in the interest of investors, hedge funds and their managers to collaborate on these standards to achieve the better outcomes for investors and a more efficient allocation of resources for hedge fund managers.

 

richard.szwagrzak@trafalgarcapital.com

www.trafalgarcapital.com

 

 

 

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