Mark Seaman is senior managing director of co-sourcing services at Gravitas, which provides cloud-based and co-sourced software and services to the alternative investment community.
Asset management firms must prepare for the hundreds of questions found in a typical due diligence questionnaire, but until recently, questions that probe outsourced operations providers were not as widespread as one would expect. That seemed to be an oversight given the potential risks of outsourcing operations.
Considering the issues facing asset managers in today’s challenging environment, as well as their need to use vendors to address operational hurdles, the situation raises questions about potential reliability gaps. And there is no sign that this trend of greater scrutiny of operations is diminishing. After all, savvy institutions and consultants are investing more time and effort in operational due diligence, and it is an area to which asset managers give short shrift at their peril.
Close to 60% of asset managers in North America said the cost of running their business has increased as they struggle to meet regulatory and risk-management demands, according to a 2012 Ernst & Young global hedge fund and investor survey. Those managers that reduced costs cited increased outsourcing and technology efficiencies, among other reasons. It is no surprise, therefore, that we are seeing a greater focus on due diligence oversight of key vendors as part of the standard due diligence questionnaire.
Meanwhile, last year’s Hurricane Sandy thrust New York asset managers’ disaster preparedness, recovery and business-continuity capabilities into the foreground overnight. The disaster made a visible and strong technology vendor relationship a critical point of differentiation in due diligence. Even before Sandy, managers were faced with unprecedented demands from regulators and investors for consistency and accessibility to data spanning risk, compliance, marketing and reporting. Those demands have only increased in frequency and intensity.
While the landscape has changed, the good news is addressing the four discrete stages of an operational due diligence exercise need not be an onerous undertaking for managers. Below are operational tasks that will help managers stay out of trouble.
Pre-Due Diligence Operation
The ability to create a tangible, organized and accessible picture of an asset manager’s controls and how the firm operates will greatly expedite the operational due diligence review. This starts with the formation of a due diligence team with strengths in various aspects of the process.
Key items during this preliminary stage of the process include:
• Operational controls around the firm’s daily positions and cash-management procedures
• Counterparty exposure and oversight
• Integration of the investment thesis and risk-management controls
• Interconnection between the firm’s investment activities and operational controls
That last point includes how executives across various departments validate them.
In addition, managers should assess the degree of visibility and consistency of portfolio information across the firm, as well as the firm’s privacy controls, compliance processes and regulatory oversight.
Pre-visit Preparation and Site Visit
For investors and consultants, the importance of maximizing the on-site due diligence meetings with asset managers cannot be overstated. The more managers can learn about institutions’ and consultants’ expectations in advance, the greater the dividends.
Asset managers should ask investors and consultants to provide as many insights as possible – beyond the core due diligence questionnaire request – into particular areas of interest, including what they need to know about the role of service providers in the asset manager’s operations.
The appropriate executives should review all due diligence materials prior to the visit. During a site visit, institutional investors and consultants will expect managers to introduce the people behind the front lines. They will be looking to expose material issues, inspect the integrity of the physical office and uncover potential business continuity risks.
Service Provider Validation
Service providers are increasingly the backbone of sound operations for an asset manager. Investors and consultants seek alignment between the asset manager and its key service providers, especially where oversight and business continuity are concerned. Managers must therefore work with their vendor partners to ensure that the service providers’ practices and standards measure up to their own, as they are extensions of the asset management firm.
Key vendor review points include business continuity and disaster recovery plans; data integrity and security; and integration of oversight controls and management with the manager’s process. Other important vendor review issues include the degree of transparency and consistency of information, as well as the levels of automation, control and duplication in the firm’s work stream.
Ongoing Monitoring and Support
Due diligence for asset manager selection has rapidly evolved from a one-time exercise into an ongoing practice. Tight correlation of global markets and an ever-changing regulatory environment, among other factors, have made it imperative for investors and consultants to review managers and service providers continually.
The most common operational pitfalls prolonging the due diligence process are incomplete data requests and poor meeting preparation, which necessitate multiple follow-up requests for data from both the manager and vendors.
Under a best practice approach to operational due diligence, managers should actively engage service providers from the start to secure an efficient, productive experience for all stakeholders. Asset managers must realize that investors and consultants regard their firm and its key service providers as an extended but tightly integrated ecosystem, collectively integral to successful operations.