Operational Due Diligence: What Are Investors Seeking?

By John Little and Rob Showers, BNP Paribas

Published: 27 September 2019

At the close of the first half of the year, the equities markets continue their decade-long march. With the Federal Reserve floating the notion of possible rate cuts, investors have not only remained invested, but have been willing to explore newer territories, from emerging markets to alternatives like private debt and other non-traditional strategies. While this has kept the spotlight on protections such as portfolio and reporting transparency, at the same time many clients continue to seek allocations that align with environmental, social and governance (ESG) investing best practices.

These and other themes were the focus of “Operational Due Diligence: What Are Investors Seeking?” co-hosted by BNP Paribas Securities Services and the Alternative Investment Management Association (AIMA). Held in New York on June 26, the conference included operational due diligence (ODD) professionals from Meketa Investment Group, Albourne Partners and J.P. Morgan Alternative Asset Management as panelists.

Participants shared their unique viewpoints on the challenges of navigating gatekeeper requirements, while at the same time working to keep pace with investor priorities.

ESG to the fore

Interest in ESG policies has been growing as a result of end-investor demand, proliferation of focus in the UK, and, in some cases, generational change among staff at allocators - accompanied by new CIOs interested in incorporating ESG in investment decisions. Panelists are now seeing greater ESG engagement among fund managers, and the industry has arrived at a new era where it is increasingly important to consider business practices and corporate cultures when thinking about ESG. For example, establishing protocols for dealing with workplace harassment, applying diversity and inclusion standards, family leave, and support for community outreach or volunteer work are among areas of growing importance.

When evaluating ESG, ODD professionals emphasized the need for managers to document and evidence policies in ways that are quantifiable. Regardless of size and experience, managers must be able to present evidence of monitoring compliance with their policies and have formal procedures in place in the event of a failure to comply. Culture is also highly valued in the evaluation process; the satisfaction level of employees, retention, and support for policies protecting safety and well-being are all important considerations. There is an understanding that smaller firms will not have all the data available for a robust ESG evaluation; in these cases operational due diligence is flexible and adjusts accordingly.

Evaluation is challenged by varying definitions of what ESG means to different clients – diversity for example, is not defined by the same parameters across clients. Additionally, some investors may have very specific mandates that may be confined to a geographic region, or business type (such as women- or minority-owned).  Niche requests like this can be difficult to meet.

Still, ESG remains an investor-driven, news-making phenomenon, and while it’s still early days, by consensus the movement continues to gain momentum. Not surprisingly, ODD professionals report a significant uptick in investors wanting to ensure that managers have proper policies in place. As one speaker put it: “In short, ESG is increasingly becoming a big dollars-and-cents issue for companies.”

Private markets pivot

As fund portfolios become increasingly tilted toward less-liquid alternative strategies running the gamut from private debt to real assets and more, how have operational due diligence providers responded? For one, the trend has brought issues around valuation and trading into greater relief, underscoring the need for advanced solutions and processes; firms must also ensure that funds have properly skilled people at the helm, given the level of complexity involved.

A notable challenge in private markets stems from a disconnect between the amount of lead time investment due diligence teams may believe is required for ODD and the actual time required to adequately evaluate operational risk. Participants described receiving calls from private-market managers who had abruptly decided to accelerate a fund closing and wanted the ODD team to complete their assessment on perhaps a week’s notice, posing impractical deadlines for a thorough review of firm policies, compliance controls, legal documents and so on.

Among the key operational risk concerns highlighted is a lack of independent fund administration. While private equity has generally lagged hedge funds in this area, it is by and large a “legacy issue,” remarked one speaker - one that is mainly exclusive to older firms that have self-administrated from the start. Indeed, panelists see the industry evolving; new funds launching today are more likely to have a separate administrator on board.

How much is too much?

All of these add-ons—ESG, private-market, new technologies—ultimately has led to much more work for ODD professionals. Client meetings that once lasted just a couple of hours now run at least twice as long, opined panelists. In a perfect world, one would have resources aplenty to manage the ever-growing, evolving set of ODD requirements. The reality, however, is that many firms are already running a very lean operation, and therefore must streamline even further in order to accommodate the additional workload.

To make the new responsibilities truly workable, many are increasing their reliance on risk-weighting metrics—that is, gathering as many documents and as much information as possible prior to due diligence meetings to identify which aspects of operations pose the most risk, and focusing the time spent during onsite due diligence meetings on those areas. For those who do more with less, there are also vendors that offer solutions for aggregating fund data on behalf of ODD teams, which in turn can bring even more efficiency to the table.

Barriers to entry have risen substantially over the past decade; before significant capital has been raised, startups need to ensure that adequate controls are in place. Infrastructure and resource constraints often require funds to seek outsourced services, but these also need to be monitored and controlled to minimize risk.

While there are some who insist that too much due diligence can erode alpha, when a major issue occurs, the whole industry is impacted. Accordingly, taking the extra step to make certain all requisite protections are in order - no matter how challenging or time-consuming the process may be - is not only good for investors, but for the broader industry as well.