Operational due diligence or “ODD” are arguably three of the most important words for any start-up manager hopeful of attracting new investors. Such is the level of expectation among institutional investors today that even if the manager only has USD20-30m in AUM and outsources the CFO function, operationally they still must look and act like a serious outfit.
As Frank Napolitani (pictured), Director, Financial Services at EisnerAmper LLP, comments: “You have to be buttoned up from a front-middle-back-office, legal, compliance and infrastructure standpoint and have answers to things; for example, on the outsourced CFO point, they might want to say, `I can’t afford a CFO currently, however I have outsourced the function to XYZ who have a great reputation and this is how they support my operation.”
For many new managers, they often find themselves wearing multiple hats. They might be the CEO, portfolio manager and CFO rolled into one. For those that can afford to hire a CFO from day one, however, the pressure is far less. In Napolitani’s view, taking on the CFO role internally is a massive learning curve and one of the main challenges for new managers.
“These are smart people and it’s important not to let ego get in the way. The smartest guys are the ones who sit back, listen and talk to a number of different service providers and consultants in the space to formulate a plan. The heads of ODD that I speak to, who oversee approximately USD100bn in hedge fund investments, say that it’s okay for a manager not to have the CFO in place, on Day One.
“However, if they say they plan to hire a CFO after they reach USD100m, the heads of ODD are going to hold them to it. They will expect to see the addition of staff and systems that demonstrate the manager is institutionalising their business,” explains Napolitani, who heads up EisnerAmper’s new launch advisory business.
Launch AUM is a big driver towards how the organisation is set up on Day One. Napolitani says that for larger launches of USD100m plus, they will generally have a CIO (founder), two to four analysts, a CFO/CCO, Head of Operations, Controller and Executive Assistant. The will generally outsource their OMS, PMS/Middle Office and General Ledger and IT (hard/soft plus cloud, telephony).
For smaller launches of under USD100m, it is acceptable to for the CIO to have up to two analysts and to outsource the CFO, as well as have a compliance consultant to help the manager operate their business with a “culture of compliance” as if they were already SEC registered. They would typically rely on the technology capabilities of their fund administrator and prime broker: EMS/OMS, real-time/T+1 reporting etc.
When outsourcing any function, however, from an ODD perspective it is vital that someone in the firm takes responsibility for the oversight and delivery of that function internally.
Since the Madoff scandal, the ODD industry has grown dramatically. Prior to this, investors would focus their attention on the fund manager’s pedigree, investment process and performance. Today, those remain key characteristics, however, the quality of the front-middle-back-office operations, in addition to legal, compliance and infrastructure, play an equally important role.
Start-ups are minded to appreciate that ODD is not just a one-time exercise with prospective investors. It is a repeatable process with investors following up on ODD with managers on a quarterly, bi-annual or annual basis. As Napolitani is keen to emphasise: “ODD is the back-end of the investment process for an allocator and it is NOT meant to `throw away good investment talent’. The research teams of allocators are looking for good talent and will have a good feel for the internal ODD process to identify gaps early in the process.
“Three key traits of high quality ODD are: Honesty, Transparency and Knowledge.”
A Deutsche Bank survey of 2012 found that 70% of ODD teams have explicit veto power in the investment decision-making process. Some of the reasons to veto an investment included the following:
• Lack of independent oversight
• Unwillingness to provide transparency
• Valuation issues
• Unsatisfactory service provider engagement
• Insufficient personal wealth invested in the fund
“The survey also highlighted that 63% of investors won’t reconsider investing in a fund previously vetoed by the ODD team. You get one shot to do this. It is therefore important that all the processes, pre- and post-trade, are in place so that the manager looks institutional from Day One,” remarks Napolitani.
To help with this, he advises managers to complete the AIMA DDQ for their fund management company. This will give new managers an insight into what they can expect and makes for a useful preparation exercise. The questions contained within AIMA’s DDQ relate not just to the fund strategy, but the business as a whole. Napolitani says that some of the more common areas that prospective investors ask about in their ODD process include:
• Straight through processing: of trades flowing from the OMS through middle office to settlement at the PB;
• Cash movements: must have two signatures and backup for cash movements (management fees, fund expenses, redemptions, etc.);
• Compliance: the dual CFO/CCO role. Most time is spent on financial functions by the CFO in smaller organisations versus compliance functions and as a result compliance suffers. Create a committee within the firm for checks and balances within those different compliance functions.
• Cybersecurity: Outsource this function to your IT service provider; it is what they specialise in. Don’t try to do it on your own. You’re built to raise capital and manage capital.
A key element of any ODD questionnaire will be determining who the fund’s service providers are. Investors need total reassurance that there is sufficient independent oversight but also that the firms carrying out this independence – for example the PB or fund administrator – have robust operational processes in place, strong balance sheets etc. This really addresses the counterparty risk issue that any ODD team will want to get a handle on.
Name brand recognition is one of several key considerations when choosing service providers, says Napolitani.
“I talk to bulge bracket, middle market and boutique firms because managers come in all different shapes and sizes and strategies. A small manager might not be suitable for a bulge bracket prime broker but more suitable for a boutique prime and vice-versa. The institutional investor community knows who these providers are,” comments Napolitani.
Technology capabilities will also need to be considered. Also, what is the knowledge and experience that the service provider can bring to the table? Everyone on the planet can support long/short equity but do they have the expertise in supporting bank debt strategies for example; can they book the trades, value the assets and provide administration, audit and tax services to such complex strategies?
“Another factor is Partner Interaction/Employee turnover. Make sure the partner you are speaking to will be covering you going forward and try to find out what the firm’s employee turnover looks like? You don’t want to have a new team supporting you for auditing and tax purposes each year, requiring you to bring them up to speed on your investment strategy, organisational structure, etc.
“I would also recommend determining what the service provider’s client base is – how many funds do they support, what types of funds (strategies) are they, and how long have those fund clients been on their books – and finally, their breadth of services,” concludes Napolitani.
