Insights on...
OPERATIONAL DUE DILIGENCE
THE ONGOING EVOLUTION OF OPERATIONAL DUE DILIGENCE
An interview with Peter Sanchez, chief executive officer of Northern Trust Hedge Fund Services
As competition for capital grows fiercer in the hedge fund industry, every small choice a manager
makes can mean the difference between winning a mandate or losing it to another manager. One
area investors are scrutinizing more closely is a firm’s operational side.
Peter Sanchez, chief executive officer of Northern Trust Hedge Fund Services, discusses what
investors are looking for when they conduct operational due diligence on a fund. He also discusses
recent legislation and how it is putting pressure on firms to comply with a host of new regulations.
What are the biggest changes to operational due diligence in the last decade?
Are there particular areas of operations that investors care about more than others?
Operational due diligence has evolved considerably in the last 10 years. Thematically, we’ve seen
changes grouped into a few broad categories:
First, operational due diligence is a lot more formal – it’s no longer a “tick the box” item.
Hedge fund investors now bring the same intensive, hands-on approach that large institutional
investors have been employing for years with traditional managers. Ten years ago operational due
diligence for a hedge fund involved a questionnaire and perhaps a phone call. Today on-site visits
with both the manager and the administrator are quite common. Also, descriptions of controls
are no longer enough – investors want to see controls in action through demonstrations.
Second, investors focus heavily on the issues that affect them most, particularly controls
around who can move cash and the independence of valuation practices. For cash, they want to
see controls that will help prevent errors and fraudulent behavior. For example, Northern Trust
uses online tools, input/approval procedures that require two separate individuals to authorize a
wire and a third-level review by our cash team before the wire is released. Other administrators
may handle it differently, but whatever the specifics, investors want to confirm there are protections
in place against operational errors or fraudulent activity.
Valuation follows a similar theme – investors want to understand the administrator’s role in
valuation. Is the administrator sourcing prices from vendors or using models? How much of the
portfolio uses manager marks or broker quotes? What checks/controls are in place to substantiate
manager marks? All these lead to the overarching question: “How do I know my investment is
actually worth what my manager tells me it’s worth?”
Are there any recent regulatory changes that have affected the way asset management
firms must run their funds (in terms of operations and best practices)?
The litany of new regulations – FATCA, Form PF, AIFMD, EMIR and others – all place demands
on managers who are otherwise seeking to reduce costs. This inherent conflict manifests itself in
a few different ways.
First, managers are being forced to change their perspective of what are “acceptable” fund
expenses. In the beginning, managers would attempt to support regulations in-house because
they felt the pricing set by administrators was too high. Over time, they came to realize that the
level of resources required to support regulatory demands – particularly the costs of attracting and
retaining talent with the necessary expertise – actually make in-house support more expensive.
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