Managing operational risk in fund investments has been a topic of discussion for a number of years. In 2003, a Capco whitepaper entitled “Understanding and Mitigating Operational Risk in Hedge Fund Investments” concluded that over 50% of hedge fund failures were due to operational risk. The paper also concluded that this risk could be mitigated through the concept of “Operational Due Diligence” (ODD). In addition to its application in alternatives, ODD is now a critical function for multi-manager, multi-asset class pension funds, endowments, foundations and other asset allocators around the world. In fact, ODD teams at asset allocators can play a critical role in determining whether a fund manager should receive a commitment, subscription or redemption.
With the development of more effective due diligence capabilities, asset allocators have been able to play a key role in reducing the “external” operational risk within the fund management organizations. The irony is that many of these same allocators have done a poor job in managing the “internal” operational risk within their own operations. As a result, internal operational risk within many asset allocators still needs to be better understood, developed and managed.
Operational risks vary in both degree and nature. Certain types—incomplete or untimely holdings’ valuations, exposures, performance and risk information—can directly impact returns. In addition, issues related to “operational leakage,” such as errors, omissions or poor cash forecasting, can result in financial losses (e.g., unfunded liabilities/missed capital calls). Still others can cause lost credibility from such mishaps as incorrect financial statements, misstated board reporting or missed regulatory filings. More serious infractions, like fraud, can create reputational risk that can impact the organization’s main source of funds.
The sheer volume of documents asset allocators receive from funds can be overwhelming. Estimates and valuations, transaction-related notifications, financial statements and tax statements are just a few examples. A portfolio of 150 funds can generate an average of 4,000 documents a year that an investor must ensure are received, captured, stored, and analyzed. Operational risks are further exacerbated as asset allocators grow in size and structural complexity while expanding into more diverse asset classes such as private equity, real assets, real estate, direct investments, derivative overlays and other alternatives.
On the positive side, there are many regulatory bodies, boards and trustees that not only understand operational risk, but also ensure their respective organizations have made the requisite investments into their internal operations, accounting and operational due diligence teams. These organizations are often supported by sophisticated internal operational teams and third parties, such as auditors and consultants. Some allocators are also requiring insight into fund investments as part of their oversight responsibilities. For example, there has been a recent increase in the number of state pension funds that now have a statutory obligation to publish aggregated performance and management fees related to the funds (or separately managed accounts) in which they invest. Some allocators have taken this requirement one step further, requiring that the fees they pay to third-party managers and service providers are validated.
Unfortunately, many asset allocator organizations are not giving their investment operations and accounting teams the funding and/or oversight they need. As a result, they lack the staff and technology necessary to both optimize returns on their investments while avoiding operational risks that could result in significant financial and reputational losses. These challenges can be addressed using internal resources or by outsourcing best practices to an expert service provider such as SS&C. Either way, ensuring that operational risk is managed and mitigated is always a good strategy.
Written by Chris Kundro