Institutional investors and pension funds are increasingly investing with fund managers who specialize in alternative investments. While investments in infrastructure real estate, private equity and hedge funds can enhance returns and diversify risks, this creates greater complexity and opacity for fund governance and operational due diligence.
Pension fund trustees are investing in these more opaque arrangements in order to achieve superior returns and reduce investment risk through diversification. There is also a growing trend towards fiduciary investment management, where fund trustees delegate selection and monitoring of fund managers to a fiduciary investment manager, which creates an additional layer of potential opacity. For these reasons, fund governance and operational due diligence responsibilities are becoming much more demanding and investors are acutely concerned with effective oversight of collective investments.
Some larger pension funds have responded to the challenge by adopting a more thorough and professional approach themselves; and by incorporating investment experts into their fund governance structures. But many smaller funds rely on external investment experts, consultancies and other advisory bodies and a number of larger firms have evolved integrated administration offerings, providing complete outsourced solutions.
While this enables the funds to draw on greater market knowledge and operational professionalism, it is clear– and regulators have emphasized – that reliance on third-party administrators does not absolve trustees from ultimate legal responsibility. There is increasing pressure to demonstrate that the approach to operational due diligence is sufficiently robust to manage the increased risks.
The primary fund due diligence challenge for pension fund trustees is to ensure that they understand the assets in which their funds are invested and the risks attached to them. Operational due diligence needs to be placed at the heart of strategy implementation from the beginning. Whereas previously the appointment of third party managers depended on an assessment of their market knowledge, investment capability and track record, due diligence now needs to extend to cover a wide range of operational and management considerations.
In addition, continual performance monitoring and review is critical to ensure that risks are managed and that the trustees’ fiduciary responsibilities are discharged effectively. It is now essential that formal operational due diligence reviews be undertaken regularly, not only on the appointment of new managers but on any major change in investment strategy and periodically to ensure continued compliance.
A primary objective is to assess and understand conflicts of interest within the manager as well as how effectively their own processes monitor and avoid existing and emerging conflicts of interest. The manager’s oversight and monitoring of key service providers – administrators, custodians, prime brokers, auditors and other service providers – is crucial, as is its financial stability as evidenced by an analysis of audited financial statements, cash flow information and key financial ratios. Assessment of personnel capability requires evaluation of directors and key employees, including background checks and reviews of remuneration conditions. The risk and compliance assessment must also involve review of trading and operational processes and procedures.
Since the financial crisis, pension investors have increasingly come to recognize the need for effective operational due diligence processes alongside the evaluation of investment performance by managers. Meeting these challenges requires access to different sets of expertise from those traditionally shared by pension trustees, including the ability to critically evaluate management systems, processes and compliance.
Since inadequate operational management and processes can leave pension funds open to the risk of underperformance and regulatory sanction, these are issues that trustees can no longer ignore.
Operational due diligence (ODD) enables effective operational management for investment managers.