What is Operational Due Diligence?

If you plan to invest in a hedge fund manager, acquire a target company, invest in private equity, or pursue other alternative investments, then you’ll need to execute operational due diligence (ODD).

ODD is an investor-initiated process for assessing the operational infrastructure of investment managers and funds to both detect and mitigate potential operational risks associated with your investment.

With rising risks and increasing regulatory pressure, the value and necessity of performing this initial assessment and ongoing monitoring once invested will only continue to grow.

In this guide, we’ll share the objectives and best practices for ODD processes, and provide answers to frequently asked questions around ODD.

What Are the Objectives of Operational Due Diligence?

Operational due diligence is a complicated, multi-step process which spans the workflows of both investors and managers.

For investors, the due diligence process consists of multiple steps to the assessment, including:

• Developing questionnaires,
• Review of a multitude of documents,
• Lengthy interviews with investment managers, and
• Management of issues and risks.

For managers, the process is equally as cumbersome. Managers must answer hundreds of questionnaires that are a critical component to the due diligence process as well as participate in lengthy due diligence meetings with both prospective and existing investors.

Further complicating matters is the fact that these questionnaires come in multiple, disparate formats and often with customized questions.

Key Steps for Implementing Operational Due Diligence

While the processes of ODD practitioners may vary depending on a variety of factors, the end goal regardless of process is to eliminate or mitigate as much operational risk to your investment as possible.

In order for that to occur, there are a number of steps ODD professionals can take to facilitate that effort.

The following step-by-step summary will help to outline best practices for conducting operational due diligence reviews.

Step 1: Reviewing Documentation

Today, the vast majority of investment managers have invested time and resources in developing detailed documentation that outlines key information about both the investment manager and their funds.

This documentation can be a valuable tool for performing an initial assessment of whether or not the fund is a viable investment and meets an investors’ criteria of investment. It can also provide an early look into the operational infrastructure that the investment manager has in place to identify any initial red flags.

Some of the key documentation that is reviewed at this stage includes the following:

• Due diligence questionnaire (DDQ)
• Fund offering memorandum
• Fund audited financial statements
• Regulatory filings such as the SEC’s ADV
• Operational policy and procedure documents
• Marketing Presentations

Step 2: Conducting an On-Site Visit

Conducting an onsite due diligence meeting with key members of the investment managers’ team is a critical component to the due diligence process.

Clearly, this process has been materially impacted over the past two years as a result of the global pandemic. But despite this challenge, there are various aspects of the ODD process that are assessed during this onsite visit which include but are not limited to the following:

• What is the company culture?
• What systems does the investment manager have in place to facilitate its operations?
• Are staff members qualified to be performing in their roles?
• How do the team members interact with each other and is there the appropriate segregation of duties in place?
• Do the operational procedures that are outlined in their documentation mirror what they are doing in practice?
• Is there a culture of compliance in place?
• Does the office provide an appropriate level of IT security?

Step 3: Conducting a Background Check

An often overlooked but critical part of the ODD process in conducting a background check on the firm, its key principals and stakeholders. The background check allows you to verify and understand the following:

• Educational and professional background of key personnel
• Regulatory and legal matters of the firm, key personnel, fund
• Potential affiliations that may present conflicts of interest
• Negative media related to the firm, key personnel, fund

Conducting background checks involves time, resources and qualifications that most investors don’t have in house and, therefore, it tends to be eliminated from the ODD process; however, the background check provides key insight that cannot be obtained directly from the investment managers.

Therefore, investors should consider relying on a third-party firm that specializes in conducting these types of checks to supplement their internal processes so as not to overlook an important element to the ODD process.

Step 4: Assessing Key Third Party Service Providers

Funds are typically reliant on a number of key service providers to maintain their operations. At a minimum this includes a third-party fund administrator but often also includes an auditor, prime brokers, custodians, board of directors, etc.

Today, it is also not uncommon for investment managers to outsource a number of their operational processes both to either supplement their internal resources or in lieu of bringing these resources in house at all.

This can include outsourced compliance, CFO/COO, IT/cyber security providers, etc. Therefore, a thorough ODD process also includes assessing key service providers to ensure that they are qualified and carrying out the appropriate functions for the investment manager and/or funds.

Step 5: Analysis

As you’ve likely gathered by now, going through an ODD process involves obtaining a lot of information about the operational infrastructure of the investment manager and fund. But what should you do with it all?

The crux of conducting an ODD review is taking all of the information that you’ve gathered throughout the process and analyzing the implications that it may have for your investment.

Being armed with this wealth of information should at a minimum enable you to answer the following questions:

• Do the fund’s terms meet my investment objectives?
• Do I feel that the investment manager has the appropriate, qualified staff in place to carry out the fund’s objectives?
• Is the operational infrastructure that the investment manager has in place appropriate for the investment strategy?
• Has the investment manager taken the appropriate steps to sufficiently mitigate any unnecessary operational risk?

ODD Frequently Asked Questions

Now that we’ve outlined the typical steps associated with conducting operational due diligence, we’ll now answer some of the most frequently asked questions by our clients.

How long does it take to conduct Operational Due Diligence?

There are a variety of factors that could impact that timeline for conducting an operational due diligence review of an investment manager but largely it is driven by the cooperation of the investment manager and the complexity of the investment.

The timeline also depends on the various other stakeholders involved in the process such as key service providers and the time associated with running a background check.But, on average, we estimate the process to take between 2 and 3 months for a new investment.

Conducting Operational Due Diligence with DD360

With ODD software however, that timeline can be significantly reduced as it allows for a more automated and streamlined approach to gathering the vast amounts of data that are required to carry out the process.

Undoubtedly, conducting an Operational Due Diligence review requires comprehensive knowledge gathering and time investment. This is where DD360 can help.

DD360 is a multi-party operational due diligence platform used by both managers and investors to streamline the entire operational due diligence process.

The platform provides an intuitive user experience coupled with deep automation and analytics to help simplify much of the process.

DD360, with the help of its automated collaboration, workflows, and report generation, can help you increase the efficiency when it comes to conducting operational due diligence by up to 50%.

It also improves the effectiveness and quality of your processes with the help of its comprehensive analytics functionality.

Some of the other features of DD360 include:

• Easy extraction of answers from DDQs for easy use for analytics
• Automated RFI and DDQ workflows
• Automatic generation of reports
• Single repository for storing all your documents
• Single retrieval point for all your data
• Easy management of issues
• Effortless tracking of report usage by clients
• Managing central repository of all reports and control distribution to clients
• Collaborating with clients within the platform
• Publishing reports to investors with the required permissions
• And more

If you wish to streamline your operational due diligence process, we encourage you to learn more about DD360, or schedule a demo today.