When investors approach a hedge fund to begin the operational due diligence process, they will have likely done some degree of investment due diligence already. During the investment due diligence process, investors are often accustomed to the idea of framing their due diligence approach in a context that is appropriate for the particular hedge fund strategy under review. So for example, as an investor you would likely have a different set of considerations and benchmarks you employ when evaluating a long-short manager versus a distressed manager. In the minds of most investors, the two strategies are different enough that they merit different types of investment reviews. Logically, this makes sense. Investors want to apply a degree of analysis that is customized to the peculiarities of each strategy.
Of course however, in addition to strategy specific concerns there are certain elements of the investment due diligence process that are more general in nature and can be universalized across all strategies under review. For example, all hedge fund’s employ some sort of research process. The specifics of these different research processes differ of course across various hedge fund strategies, and then to even put a finer point on it across managers in the same strategy. The point is that in general when performing investment due diligence, regardless of the strategy under review, there is a general consensus that the research process should be analyzed across all strategy types.
When it comes to operational due diligence however, investors tend to over focus on the general and strategy agnostic operational risk categories but seem to falter when it comes to customizing the process for a particular strategy. Examples of the common general categories reviewed could include things such as understanding a fund’s post-trade settlement and reconciliation procedures. Similar to our investment due diligence general category example of all hedge funds having a research process, all hedge fund’s regardless of their strategy necessarily at some point execute trades. Understanding this process, would therefore be a general component of investors operational due diligence procedures. Other common examples of these general categories could include the areas of compliance, valuation procedures and business continuity. These general operational elements are all in place in some shape or form across all hedge funds.
As noted above, however it is more of a difficult stretch for some investors to consider how to frame operational due diligence in a strategy specific context. Consider the example of the valuation procedures employed by a hedge fund. In a long-short equity hedge fund that trades only liquid securities, the valuation process from an operational perspective is very straightforward since all assets are typically easily priced from third-party vendor feeds such as Bloomberg or Reuters. Contrast this with a distressed hedge fund that may hold level two and level three assets. From an operational risk assessment perspective, an investor might logically want to kick the tires harder with regards to this manager’s valuation procedures. There are several reasons for this. Firstly, the manager may have more discretion in the process, particularly for items which are manager marked, and therefore, there is a greater risk of manipulation posed to investors. Additionally, there may be less independent oversight of these procedures by groups such as fund administrators and auditors. As such, an investor that applies a more general approach to valuation analysis may leave some key areas un-researched and expose themselves to operational risks they might not have fully diagnosed.
Corgentum Consulting, an operational due diligence and background investigation consulting firm, works with hedge fund investors to customize operational due diligence reviews for different hedge fund strategy types. Without such customization investors run the risk of becoming trapped by a checklist due diligence approach. Instead, by customizing the operational due diligence process to cover strategy specific operational due diligence reviews investors can better tailor the operational due diligence process to each strategy and produce a more comprehensive and often useful operational due diligence review.