Asset Owners Put Managers on the Operational Hotseat

How do you run your business?

If it sounds like an open-ended question for pension plans, endowments and other institutional investors to ask fund managers, it is intended to be. Institutional asset owners hope it will elicit a lengthy discussion over the policies, procedures and technology the fund manager uses to make money before they decide it is safe to allocate their assets.

A growing number of asset owners are relying a combination of external due diligence consultants and dedicated internal experts to perform an in-depth evaluation. Ideally, the experts will have worked in investment management operations and be familiar with the ins and outs of the entire trade lifecycle and what can go wrong. They must also be prepared to ask tough questions and not take a vague response for an answer. The analysis has become so rigorous and complicated that a new organization, the Investment Management Due Diligence Association (IMDDA) has just been established to set industry standards and certification for due diligence professionals.

A fund manager can no longer simply say that it hires brand name service providers or is licensing brand name applications. Asset owners typically review several dozen asset managers before making a decision on where they will allocate their assets. Now they are asking asset managers to prove that their operations stand out above the crowd to make the cut.  Asset managers are willing to go through the extra painstaking work to win the ultimate prize — millions of dollars in funding.

Asset owners weren’t always so meticulous when investigating their fund manager’s “plumbing.” Historically, they cared only about how investment results were generated and the due diligence questionnaires they distributed relied on a check-the-box approach to answering basic questions about whether they performed a task in-house or outsourced it. Although the financial crisis may have prompted asset owners to delve into market and credit risk more thoroughly, it was the Madoff scandal of 2009 that brought the need for rigorous operational due diligence center stage. Even if investors were blinded by Bernard Madoff’s consistent performance during a down market, they should have questioned the fact that his wealth management firm cleared trades on its own, yet had no account at US market infrastructure, Depository Trust & Clearing Corp. (DTCC). That meant that the trades were never executed in the first place.

It doesn’t take a Ponzi scheme for an asset owner to lose its shirt. A trade which is incorrectly booked and allocated, not settled on time, or ties up the wrong collateral could put a dent in a fund manager’s hard-won profits. So can missing a voluntary corporate action — such as a tender offer or exchange offer — or picking the wrong payment option. “Asset owners should care about operational due diligence because it is an opportunity to assess how capable fund managers are at handling operations and taking care of operational issues when they arise,” says Heloisa Chaney, partner and chief operating officer at 400 Capital Management LLC, a New York-based hedge fund management firm.

What was once a handful of questions and a perfunctory conversation has now turned into a time-consuming process for asset owners and managers who rely on a C-level executives to make the final call. The ubiquitous questionnaire is just one of the tools used. The asset manager’s answers will generally prompt additional questions and in-person visits between C-level executives on both sides with the internal and external subject matter experts to help drill down on specific areas of concern.

“We start off with the fund manager’s organizational chart which identifies the rules and responsibilities of the team to understand who is in charge of what processes, and which applications as well as which third-party service providers are used to perform specific functions” explains Anne Dyer, manager of business due diligence and compliance for the investment department of the Howard Hughes Medical Institute in Chevy Chase, MD. She is also a member of the advisory board of the new IMDDA.

What to Ask

The savviest asset owners will ask the most questions and expect the most detailed answers about the procedures to ensure trades details are accurately captured, that they are accurately recorded, that collateral is accurately calculated and transferred; that corporate actions are accurately processed and that trades are accurately cleared and settled. The word accurately means that nothing short of a 100 percent success rate is acceptable and if that can’t happen, it had better be close enough. The asset owner should ask for a trial run of each of the operational functions using a fictitious trade as well as verification that operations staffers have been sufficiently trained in using applications. Also important is knowing that the technology has been thoroughly tested, say fund operations managers.

Asking about the escalation process in case something goes wrong is advisable, say institutional investors. “What if” questions test the ability of the fund manager to respond quickly to mistakes. The most common front-office error, fund operations managers tell FinOps Report, is an incorrect trade allocation — a percentage of the block trade might have been booked to the wrong investment fund or violated trading policy. The most common back-office error is a failed settlement because either cash or securities were not delivered on time.

Such a “what if” scenario also needs to be applied to the fund manager’s business continuity plans. Asset owners must be ensured that the fund manager is prepared to handle a natural disaster or man-made one, such as a computer glitch which could otherwise stop trading in its tracks or lose critical data. With the SEC now requiring that registered investment advisers have a business continuity program (BCP) in place, it is only fitting that asset owners ask fund managers how they plan to fulfill the US Securities and Exchange Commission’s mandate for the following four elements: maintenance of critical operations and the protection, backup and recovery of data; prearranged alternative physical locations for employees to work; communications with clients, employees, service providers and regulators; and the identification of third party services critical to the fund manager’s operations. At a minimum asset owners should ask if the fund manager has a documented BCP, has provided staff with the necessary training on what to do, and has ever conducted an audit of its program.

When it comes to asking about third-party service providers, asset owners will want to know why they were selected and the exact terms of the service level agreements. Using an external agent doesn’t absolve the fund manager of ensuring that the fund administrator, prime broker or other service provider is doing its job correctly. “Asset owners need to understand the decision-making process, the reasons alternative service providers were not selected, and how the fund manager and service provider will effectively interact,” explains Marshall Terry, managing director of Rotation Capital Management, a New York-based hedge fund management firm. “Outsourcing isn’t the right term. It is co-sourcing. The service provider’s team should be an extension of the hedge fund manager’s own staff rather than a completely separate entity, which establishes accountability and ownership on the part of the provider, and an open dialogue and collaboration between the provider and the hedge fund manager.”

Asset owners need to be particularly careful when asking about the reasons an asset manager didn’t select a well-known provider for its middle and back-office operations. Most do so for no other reason than to attract institutional funding, but new regulatory capital requirements are forcing banks to be more selective about which asset managers they will accept. Therefore, fledgling asset managers might have to fess up that they had no choice but to settle with a smaller service provider. At that point the questions should be targeted at whether the service provider can deliver what the asset manager and its investors require.

“Technology is the great equalizer and there are plenty of firms which have state-of-the art applications,” says Terry, who is also a member of the IMDDA’s advisory board. Regardless of who is chosen, the asset owner needs to know that the fund manager has established a testing process to prove the provider is doing its job correctly and will correct any breaks. “It isn’t a one-time deal,” says Terry. “A regular review process needs to be in place.”

Although reviewing post-trade operations will likely take up most of the questionnaire on operational due diligence, asset owners shouldn’t forget to ask about the asset manager’s data management procedures. That includes the process used to procure data, eliminate any discrepancies, and distribute the data across the organization, says Terry. Without clearcut policies outlining who does what, when and how, the asset owner cannot be reassured that the data used is accurate and timely. Mistakes in reference, counterparty and pricing data can easily lead to incorrect calculations of valuation, investment and counterparty risk, not to mention regulatory reports. Any of those could prompt a regulatory audit and investigation.

Depending on the fund’s investment strategy, a discussion on valuation policies should also be included in the list of questions. Fund managers are responsible for coming up with the fair value of non-exchange traded securities and if they don’t follow a correct process they could easily end up mispricing a single asset or even an asset class. Depending on how heavily the fund manager is invested in that asset, investors could be misinformed about the fund’s performance and discover the glitch too late — when they try to redeem their stakes. One fund management operations director who spoke with FinOps suggests that at a minimum asset owners should ask to see the valuation matrix to analyze the methodology and inputs used to price each asset class and verify that the firm followed those policies by doing a test run of matching up the prices the asset owner comes up with to those the fund manager comes up with. Asset owners should even ask to see the minutes of board meetings which could provide valuable insight into how valuation glitches were resolved.

Last but not least, “Asset owners need to make sure that there are rigorous procedures to ensure the fund manager doesn’t get hacked and if there is a breach what it will do,” says Dyer. In other words, they should find out how the asset manager protects against a cybersecurity breach which could leak its trading strategies and list of institutional investors. Asset managers often store their data in an external location where they may not have control over security measures. Because of the SEC’s more rigorous oversight, fund managers must now ensure that their external and internal network connections can withstand a breach. Among the critical questions an asset owner should ask is what are the proactive detection and response capabilities of the asset manager and how it measures the success of its program.

Future-Proofing

Although most of the asset owner’s investigation into the fund manager will likely focus on the present, the future shouldn’t be ignored. Once the asset owner finishes all of its questions on the fund manager’s current operations and technology, it should ask the asset manager how it plans to handle the eventual growth in assets under management. The asset owner should ask about whether the asset manager will add staff, more service providers, and how it will scale its applications. Investors need to know how the potential increase in operating costs will affect them.

Even if a fund manager’s responses to all of the asset owner’s questions don’t raise a red flag, that doesn’t mean the asset owner should breathe a sign of relief. The most common warning sign is the one most often overlooked, say fund management operations managers: discrepancies between what the fund manager tells the potential investor and what it tells the SEC and other regulatory agencies through Forms PF and ADV.

Asset owners need to match up the numbers on the value of assets under management, performance results, investment strategy and risk metrics, says Dyer. Differences indicate that the fund manager has either intentionally misled investors or has weak controls to catch wrong information before it was released. If the fund manager can’t keep its story straight on the basics, how can the asset owner trust what it says about the rest of its operations.

Although asset owners might ask fund managers different operational questions depending on their past experiences and focus, their goal is the same. They want to be the reassured that the fund manager has the operational framework to deliver its investment results. Trust but verify should be the first motto. The second: if you sense something is wrong, it likely is.