What's Trending - Allocator Perspectives on Investment Strategies - Q1:2018 - Pershing Prime Services - BNY Mellon

During the final stages of the manager selection process, many investors use operational due diligence to eliminate managers from a short list and select a finalist. What are today’s top operational due diligence areas of focus? What should managers be ready to address when operational due diligence professionals come knocking?

OPERATIONAL DUE DILIGENCE: AT RISK OF ELIMINATION

As the hedge fund industry has matured, operational due diligence has become an important part of the manager research process. Historically, investors used operational due diligence to identify areas of business risk, passively monitor those risks and, at certain times, use those risks as the basis for eliminating managers from a portfolio or a short list. Now, in an era where allocators themselves face scrutiny over hedge fund returns, allocators have increased their focus on all areas affecting performance, especially those caused by business management practices. As a result, operational due diligence has become an even more important part of the research process and is now used to evaluate the value proposition of a manager’s investment strategy.

INVESTOR AREAS OF FOCUS

Currently, the most sensitive areas within operational due diligence include issues impacting performance (fund expenses, valuation, and new products) and other areas of business risk (cyber and data security and alternative data sets). The views shared herein were provided by investment consultants, fund-of-funds, and funds-of-managed accounts.

Expenses: To increase returns, many investors have required management fee and performance fee reductions. As a result, managers have found ways to balance lower fee revenues with their expense levels. Many managers (as cost saving measures) have been allocating more expenses historically paid by the management company down to their fund products. These expenses include research, travel, data, systems, compliance and insurance costs.
Increased expenses being pushed out to funds have caused significant increases in fund expense ratios, which are tracked by investors.
During the manager review process, investor discussions include:
- Are these increased expenses fair?
- Do increased expense ratios and their drag on returns make the strategy attractive anymore?
Valuation: When pricing thinly-traded credits, managers often rely on bid-ask quotes from brokers. Investors shared that there were a few high-profile regulatory enforcement actions where certain managers received manipulated/favorable quotes from brokers trying to curry favor with them. This resulted in those managers mismarking their portfolios, generating misstated net asset values (NAVs) and reporting incorrect performance. As per investors, this is a big problem. They rely on fund NAVs being correct when they contribute into and withdraw out of hedge fund partnerships. Investors also rely on fund performance being correct when it’s reported.
To address investor concerns, managers have started asking their administrators to provide investors with monthly reporting on the NAV reconciliation process. These administrator-generated reports share (i) the percentage of the portfolio valued using independent sources versus those marked by the manager, (ii) the percentage of the portfolio being valued using vendor feeds, multiple broker quotes, and single broker quotes, and (iii) the actual values of positions marked using single broker quotes and provided by the manager.
During the manager review process, investor discussions include:
- Is the firm’s valuation policy appropriate for the strategy?
- How much independence is there in the process?
New Products: As managers expand their product offering to include new separately managed accounts and co-investments, many investors are concerned that the performance of their original funds may suffer because of the change in investment focus.
During the manager review process, investor discussions include:
- How much overlap is there between investment portfolios?
- Are trade allocations between the original funds and the new products fair?
Cyber and Data Security: Most managers have implemented cybersecurity and data security programs, which include device protection measures, firewall and phishing attack prevention, and employee awareness programs. Since these measures are now standard across the hedge fund industry, managers that have not taken cyber and data security seriously are considered outliers by investors.
During the manager review process, investor discussions include:
- Is the manager familiar with how many times they have been attacked?
- Can they demonstrate how they track increases/decreases in attacks?
- How do managers measure the success of prevention measures?
Alternative Data Sets: This is a newer area of focus for operational due diligence professionals. As per investors, there are two types of alternative data sets:
- Big Data: Credit card purchasing information is an example of big data. In most cases, when vendors provide this data to managers, names of the individual purchasers are not included. However, if by accident the names of individual purchasers were included, managers would be in possession of protected personal information (PPI). Managers may also be at risk when they use big data in conjunction with traditional financial data. The combined data may constitute material non-public information (MNPI).¹
  During the manager review process, investor discussions include:
  - Do managers have a process for evaluating big data sold by third-party vendors?
  - What steps do managers take to ensure that data purchased does not include (or constitute) MNPI, PPI or other like data?
- Web-Scraped Data: Some managers have developed bots that can access company websites, search for inventory, and determine estimates for company sales before the information becomes publically available. As a result, managers that web scrape may be at risk of acquiring MNPI. Additionally, there is also the risk that managers could be violating privacy law.
  During the manager review process, investor discussions include:
  - Do managers have a defined process for web scraping?
  - How do managers avoid acquiring MNPI?
  - How do managers ensure that they comply with privacy laws?

CONCLUSION

With heightened focus on hedge fund returns, allocators will continue to concentrate on business management practices of managers that impact returns and that can potentially cause operational risks. As a result, operational due diligence will continue to be used to evaluate the value propositions of investment strategies and be used as a tool to eliminate managers in a portfolio or on a short list.

¹ Lindsay Fortado, Robin Wigglesworth, and Kara Scannell, “Hedge Funds see a gold rush in data mining,” www.ft.com, (August 28, 2017)

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