Hedge funds: meet operational due diligence | Gresham

When you hear "hedge fund due diligence," visions of intense financial modelling and picking apart portfolio mathematics probably start dancing in your head. But there's an oft-overlooked aspect that carries just as much make-or-break importance in an increasingly complex fund environment: operational due diligence. 

This multi-faceted inspection of non-investment activities is quickly becoming a prerequisite for investors rather than an afterthought. Ignore it at your own risk, because even the smartest investors stand no chance if their risks are internal.

Performance Versus Operational Risk

Let's start with the big question: why should hedge fund investors care about operational risk in the first place? After all, for years the name of the game has been pure performance—did the fund managers deliver alpha or not? That's what people were paying their hefty "two and 20" fees for.

Except, we've learned the hard way that even genius-level investment acumen can get torpedoed by poor operational practices. From rogue trading disasters like Nick Leeson and Jerome Kerviel, to Ponzi scheme implosions like Madoff, to good old-fashioned misrepresentation of liquidity terms and holdings—the graveyard is full of funds that have nuclear-coded their portfolios from the inside out.

The truth is, investment skill and operational capability are two completely different muscle groups. You can have the most brilliant holders of the coveted CFA certification mapping out your security selection, while rigorously shoddy middle or back office functions are setting you up for catastrophic failures. We're talking bad practices around trade operations, cash movements, valuations, compliance—you name it.

At the end of the day, a hedge fund is just a big, complex operating business in its own right. The penalties for sloppy operations—whether it's excessive redundancies, lack of controls or general operational pandemonium—are just as harsh as having an incompetent investment team. Solid operations allow you to focus on alpha rather than mind the plumbing.

That's why today's investors are putting operational due diligence front and centre. They understand that in this era of increased complexity and intense scrutiny, having blind faith in a fund's operational risk credentials is essentially malpractice. It’s time to treat those operational capabilities with the same level of criticality as portfolio decisions.

Middle and Back Office Innovation

Operational due diligence is of the utmost importance. But what exactly does achieving operational excellence look like? 

Long gone are the days where middle and back office functions just had to keep the lights on with minimal manual processes and ancient tech stacks. With stratospheric trading volumes, complex investment vehicles and bionic regulatory regimes, innovation in operations is an existential priority.

A fully integrated tech backbone with seamless connectivity is necessary across your:

• Order management systems
• Portfolio management platforms
• Data warehouses
• Risk engines
  
  

It leads to a real effort to untangle the complex technical issues that most funds are struggling with. This modernised operational backbone allows you to run a tight ship with automation, straight-through processing, real-time reporting and data governance. 

Rather than just-in-time spreadsheet wrangling, you get industrial-strength capabilities around functions like:

• Trade lifecycle management and affirmation
• Integrated P&L and position-level transparency
• Real-time cash, liquidity, and counterparty exposure reporting
• Robust reconciliation and exception management workflows
• Dynamic investor servicing and portfolio accounting
  
  

The possibilities of middle and back office innovation are endless. And they're no longer just a nice-to-have. Having a modernised operational chassis that reduces failure points and human error is table stakes for institutional investors.

So for any fund trying to make the cut, dazzling an investor with blinding maths while brushing off the operational inspect element is a non-starter. They'll be headed for the chopping block no matter how elegant the front office looks on paper. Sustained performance demands sustained operational optimisation in tandem.

The Operational Due Diligence Review

Discussing hedge fund operational due diligence is all well and good in theory, but let's get specific on what this entails in practice. It’s a gauntlet of scrutiny and evidence-gathering that drills into the details.

Organisational Transparency

At the highest level, investors need full transparency into a fund's policies, procedures and organisational charts. This provides the operational blueprint and highlights any potential church-and-state violation between separate teams. But the real fun starts when reviewers get into the operational weeds.

Transaction Sampling and Process Validation

You’re looking at extensive sampling of transactions across all functions like trading, treasury, pricing, reconciliation and more. The mission? Validate the integrity of each process through comprehensive documentation, not just perfunctory policies. Auditors will quiz team members, analyse exception reports, reconcile records against counterparties and watch operations unfold in real-time to assess controls.

Data Governance and Reporting

The data governance piece alone is enough to fracture some funds. What protocols exist around pricing hierarchies, data flows and centralised security masters? How are positions, profit and loss and performance attribution sourced and calculated? If a number seems off, auditors need to be able to trace the lineage to the source.

Compliance, Regulatory Reporting and Surveillance

Then you have compliance, regulatory reporting and surveillance responsibilities being stress-tested to the max. Validating skills like understanding the nuances of regulations, coding programmatic monitoring scripts and demonstrating timely breach detection. One inclination of lapsed oversight is a potential deal-breaker.

Technology Diligence

Tech Diligence has its own problems, with auditors meticulously combing through a fund's application architecture for workflow automation, integration points, data flows, reconciliations and more. Not to mention pressure-testing tech resilience through cybersecurity probing, disruption scenarios and business continuity simulations.

The bottom line? Operational due diligence means removing plausible deniability around every corner of the operational construct. Your best traders lose impact if the thermal exhaust port has a bullseye painted on it. For investors, this gruelling inspection is now the entry fee.

Choosing the Right Partners

At this point, it should be abundantly clear that comprehensive operational due diligence isn't a pass or fail test you can complete with a few checklist items. It’s a complex endeavour that requires meticulous planning, specialised expertise and incredible stamina to execute properly.

For an emerging fund manager trying to garner institutional capital, attempting this process entirely in-house is essentially reckless oversight. It's like a scheduled airline trying to self-certify the airworthiness of their fleet. The conflicts of interest and competency gaps are just too glaring for investors to overlook.

From the Outside

The right approach is to bring in a highly-qualified independent third party to handle the operational due diligence lifecycle from start to finish. And make no mistake, picking the right partner for this is arguably as important as identifying the right investment talent.

You need a firm with proven pedigree and experience conducting these rigorous reviews across all asset classes and fund structures. A willingness to kick the tires without fear or favour. An multidisciplinary team combining former executives, auditors, technologists and more who can drill into every operational crevice.

Credibility and institutional knowledge are paramount. You're essentially hiring a cross-functional SWAT team to preventatively break into your own house, expose all vulnerabilities and get things fortified before the bad actors arrive. It’s not a task for dabblers or auditors willing to skim the surface.

This is also where in-house operational experts can prove worth their weight in gold. Having an internal partner that lives and breathes the middle and back office intricacies, can effectively communicate context to reviewers, and serves as a respected conduit for implementing recommendations with a sense of practicality.

Summing Up: Making the Right Decision

In the end, exemplary operational due diligence isn't easy. It requires immense effort and the right mix of collaborative partners willing to put in the work. But it's the uncompromising price of admission in an investor climate with zero appetite for operational fragility. Get it right, and your chances of capturing meaningful institutional capital soar.