Operational Due Diligence (“ODD”) is a dynamic and ongoing process to identify red flags that can result in outsized monetary losses and potential fraud revelations.  

Designed to mitigate operational risks and costs pertaining to investment operations, ODD supports the investment team in the evaluation of the risk profiles of the investment manager and the investments. Through this process, we can also assess the alignment of interest between the investment managers and investors.

At Hawksburn, we execute ODD using a bottom-up approach where we have over 40 years of practitioner experience and empirical data that covers real-world operational issues. A bottom-up approach also facilitates the optimal allocation of resources as it directs attention to practical operational issues.  

Several high-profile fund failures such as the Madoff fraud scandal in 2008 (estimated loss of US$65 billion), the Envy Global nickel investment case in 2021 estimated loss of S$1 billion), and the Abraaj Group’s fraud in 2022 (estimated loss of US$136 million) establish the need for thorough ODD.  

How to Approach Operational Due Diligence

Our ODD process covers a broad spectrum of categories including, but not limited to, the following key topics:

  • Review of legal documents
  • Fund cost and fees
  • Fund liquidity
  • Conflicts of interest
  • Audited financial statements

Review of legal documents

As part of the initial ODD procedure, legal documents consisting of, but not limited to, constitutional documents and the offering documents are reviewed.  

  • Incorporation – Funds that are incorporated in well-regulated and tax-efficient jurisdictions are generally preferred.  
  • Registration of Manager – It is important to check if the investment managers are registered with a regulatory body as this provides assurance that they are transparent and have good internal controls and processes in place.  
  • Fund terms – One key point to note is whether the fund is a newly established fund vehicle or converted from an existing entity. Should it be the latter, it is necessary to be mindful of the potential claims, legal, and regulatory proceedings. For funds that are re-domiciled from another jurisdiction, further investigation on whether they are liable for historic claims is required.  

Fund cost and fees

Total Expense Ratio (“TER”) TER is a measure of the total operating costs associated with running the fund, including management fees but excluding performance fees. TER impacts the investment returns – the lower the TER, the higher your returns will be.  

  • Expenses profile: We assess the nature of fund expenses and whether they are standard or non-standard costs. Taking fund setup costs as an example, are the amounts unusually large? What is the amortisation period for these costs?    
  • Trend analysis: We compare the fees across multiple periods to spot unusual increases or decreases which necessitate investigation.

Performance fees – High-Water Mark (“HWM”) is set to protect investors from overpayment of performance fees. A red flag should be imposed on a fund that implements a resettable HWM. Investors should also be aware of the frequency of performance fee crystallisation (annual or quarterly).

Fund liquidity

The liquidity of funds is associated with fund redemption terms, lockups and gates. It is important to ensure that the liquidity profiles of the investments align with the liquidity of our fund vehicle to avoid cash flow problems.  

Conflicts of interest

  • Service providers – All service providers should be independent and reputable third parties. The absence of an independent third-party service provider should be regarded as a red flag because it can impair objectivity, resulting in conflicts of interest.  
  • Side letters – We endeavor to verify if the investment manager has entered into any side letter arrangements which may give rise to concessional fees, terms and conditions. For example, the investment manager may have allowed an investor to redeem its investments at a shorter notice relative to other investors. Such an arrangement may lead to conflicts of interest between investors.  

Audited financial statements

Given that the financial statements are independently audited in accordance with International Standards on Auditing or Generally Accepted Auditing Standards, they form part of the core ongoing ODD documents. Various aspects of the audited financial statements such as the auditor’s opinion, expenses and disclosures are examined.  

  • Auditor’s opinion – An unqualified opinion is the most ideal because it implies that the financial statements are free from material misstatements and faithfully represent the financial performance and position of the fund. Further investigation needs to be done should there be a qualified opinion as this suggests that the auditor is not comfortable issuing a clean audit report.
  • Contingent liabilities – Defined as liabilities that may or may not occur subject to the outcome of an uncertain future event, potentially leading to negative future profitability and cash flow. Contingent liabilities with a high probability of becoming actual liabilities are likely to impair the valuation of the fund. Common contingent liabilities include claims and litigations.  

To summarise, we firmly believe in the importance of ODD in evaluating the risk profiles of the investment managers and to assess their level of interest alignment with the investors. A rigorous ODD process can mitigate non-investment risk and costs thereby safeguarding against massive financial losses and unmasking potential frauds.

If you are interested in finding out more about gaining exposure to any investment themes explored in this article, please email us at info@hawksburn.com 

Written by Kai Ting Teo, Investment Analyst, July 2022