Operational due diligence ‘Down Under’; why does it appear ‘upside down’?
By Grant Harslett , Maritime Super
Published: 18 January 2019
In response to the regulatory requirements in Australia, a representative working group of superannuation fund investors and consultants concluded that the most efficient way to improve the breadth and quality of ODD being carried out by investors was to encourage investment managers to commission an ODD report from an independent ODD firm (in the same manner as they commission external audits and controls reports) and provide that annual report to current and prospective investors (the ‘manager’ model).
This process provides the foundation for investors to make their operational risk assessment and saves substantial duplication of the ODD groundwork that is common to all investors. Both investors and investment managers benefit from this approach because it reduces the time, resources and cost spent on ODD.
In aggregate, the reduced total cost burden on the industry will ultimately improve the retirement outcomes for the members of superannuation funds. And the quality of ODD being done by investors should increase, and the operational processes of some managers may also improve.
Advantages of the ‘manager’ model
For investment managers, savings of time and resources should be experienced from reducing the quantity of investor due diligence engagement, which is often repetitive and time consuming (and would only have increased from Australian investors or their ODD providers under the old ‘investor model').
There should also be value for investment managers from the direct engagement with the ODD provider. Compared to the ‘investor model’, the manager ‘owns’ the report and can therefore engage directly with the ODD provider over their findings, and ultimately provide the manager’s responses in the report for the investors to read and review.
Using an experienced ODD provider will also provide the investment manager with regular insights into best practices across the industry. And may even lead to improvements in the manager’s operational processes.
It should provide a marketing advantage in seeking new investors; already some Australian investors see it as a necessity before considering a new manager appointment. And a manager ODD report may well lead to an investor’s due diligence being completed sooner, which means the mandate can commence sooner and so deliver fees to the manager earlier.
While the manager ‘writes the cheque’ for the ODD report, investors expect to ultimately pay their share of the report costs incurred by managers through fee scales and/or trust costs (where feasible).
A counter argument sometimes put forward to the ‘manager model’ is that the appointment by the manager, rather than the investor, reduces the independence of the provider and creates a potential conflict. But as noted above, there are precedents of manager-appointed external service providers (external audits; controls reports). And the professional reputation of the ODD providers should mitigate against a ‘soft’ report.
Finally, we note that investors can, and should, dig deeper on any aspect of the initial ODD assessment on which they might have concerns or questions, as the ultimate responsibility for the ODD risk assessment resides with the investor.
So why did the ‘manager ODD’ model appear in Australia? Firstly some background on due diligence in the Australian marketplace.
The investment due diligence process in Australia
In Australia, like most other countries, due diligence of an investment manager (or manager’s fund/product) has two broad components; investment capability and operational capability.
The initial investment capability assessment (IDD) is typically carried out by an asset consultant, or increasingly by the internal investment staff of the larger superannuation funds. The scope of the assessment depends on the particular mandate and the needs of the super fund client and hence is quite individual to each client/manager situation.
The operational risk assessment (ODD) is rarely carried out in Australia by an asset consulting firm as the required skill set is very different and, although important prior to appointment, it is also an ongoing assessment process. It is also more firm-related than mandate-related; many core operational elements relate to the investment firm and do not vary by investor. So while equally as important, the nature and timing of ODD is different to IDD.
And there is a growing view that investors shouldn’t have to undertake all of this operational risk assessment responsibility; arguably an investment manager should be able to provide independent support for their assertion that they can run their business sufficiently soundly to be able to deliver their investment proposition. Following this thesis, investors arguably should be provided with a manager-initiated report to assist the investors with their operational risk assessment.
Why the manager ODD model appeared in Australia
The ‘manager ODD’ model was driven in Australia by market forces; primarily the prudential regulator’s standards and guidance, coupled with the relatively large number of superannuation funds operating in the market.
APRA, the prudential regulator for superannuation funds, established a number of prudential standards in 2013 which all Australian superannuation funds must follow. ‘Investment Governance’, ‘Outsourcing’ and ‘Risk Management’ are three of these prudential standards which are relevant when appointing an investment manager. APRA has also issued explanatory guidance on ODD expectations in various forums; the key documents are articles in APRA’s Insights publication in 2014 and 2018.
These articles clearly set out APRA’s expectations of all superannuation funds in relation to the initial and ongoing ODD of outsourced investment arrangements.
And ‘’all superannuation funds’’ is the key here because the Australian superannuation industry, despite a significant contraction in the number of superannuation funds over recent years, still has over 100 sizable funds. And to date, not all superannuation funds had been carrying out adequate ODD.
So for all superannuation funds to reach APRA’s required level of operational risk assessment, which to be fair is nothing more than sound practice anyway, the previous delivery model simply did not scale up efficiently to handle the necessarily greater volume of ODD that needed to be carried out by investors.
Some global support
Relative to the more common overseas ODD model where the investor contracts the ODD provider, or does all the assessment work themselves, in a sense the Australian approach might appear ‘upside down’!
But Australia is not alone in seeing the merits of the manager ODD model. Two global providers have expressed their support for the model; including Laven Partners (offices in the UK and US) and Prism Alternatives (located in the US).
What is the scope of the ODD report?
The working group mentioned earlier, was established by the Australian Institute of Superannuation Trustees (AIST) which represents superannuation funds in the ‘profits-to-members’ sector (industry, public sector and corporate funds). An AIST working group of investor members, and asset consulting firms, canvassed the issues outlined above and engaged with peak investment manager bodies (FSC, AIMA) and the prudential regulator (APRA).
To implement the ‘manager model’, AIST launched a Guidance Note in 2016 which outlines the approach and sets out nine areas that should be covered in an ODD review. These areas cover all elements of an ODD review which any best practice process would cover and they are consistent with the guidelines set out by APRA.
The nine areas are: Organisation structure, Personnel, Governance and risk management, Trading processes and operational functions, Valuation processes, IT systems and security, Business continuity, Service provider oversight, Reporting.
It is critical to note what the ODD report is not! It is not an extended controls report (SOC, SSAE18, GS007). It has a much broader scope and is more forward looking than a controls report.
Most importantly the style of the ODD report is ‘advisory’ in nature and approach; it is not ‘assurance’ in the audit sense. It provides expert advice and commentary on areas of potential operational risk and on the manager’s operations relative to best practice.
Investors retain responsibility for risk assessment and decision
The independent ODD report provided by the investment manager is a foundational contribution to the risk assessment process by the investor, but the investor must make the overall assessment on the likely operational risk of using the investment manager, assessed against the investor’s risk management framework and the circumstances of the mandate.
Consequently, the investor may need/want to do more analysis and enquire on some matters before reaching their conclusion. But the aim is that investors only supplement, but not duplicate, the core ODD review work carried out, and reported on, in the independent report.
So the ‘down under’ model should enable costs savings from less duplication of ODD activities and also improve the breadth and depth of ODD assessments and the quality of operational processes.
Progress with the implementation is good. Many Australian managers are on board and the number of international managers is growing. Benefits are already being observed by both investors and investment managers.
AIST is continuing to work closely with investment manager representative bodies, FSC and AIMA, the regulator APRA, and other stakeholders, in evolving and refining the model.