due diligence

Operational Due Diligence on External Fund Managers – Is It That Important?

Fund managers operational quality is becoming a prominent selection factor for institutional investors. What does ODD reveal about a prospective manager?

Investors commonly expect that their capital will be subjected to loss or gain primarily due to market and investment-related factors. However, and especially with alternative investments, most fund manager failures have been linked to non-investment related factors. Operational Due Diligence is growing in importance and fund managers operational quality is becoming a prominent selection factor for institutional investors.

What does Operational Due Diligence reveal about prospective investment managers?

Even though in the past operationally focused due diligence (ODD) was considered less important compared to investment due diligence (IDD), and thus often overlooked by investors, the depth and nature of the ODD process have changed significantly since the 2008 crisis.

The scandals such as Madoff and Weavering, the volatile and uncertain markets, and increasingly complex regulatory environment underlined the importance of inspecting the operational part of manager's activities.

Awareness that malfunctions in manager's operational processes and procedures, legal structure, and organization, staffing, underlying securities, compliance policies, and procedures, or use of third-party service providers can seriously impact a fund's overall success all contribute to the growing importance of operational due diligence.

That's why it is not uncommon for operational due diligence teams to hold significant power in the manager due diligence process, even to the point that they can veto prospective investments if they fail the ODD review.

Lack of independent oversight, poor segregation of duties around cash controls, insufficient operational and technological infrastructure to support the fund’s strategy, unsatisfactory service provider engagement and unsatisfactory or ineffective remuneration policies are some of the reasons that might lead to executing veto on prospective managers.

Which areas should Operational Due Diligence cover?

Despite fundamental differences in their sizes and strategies, different investment managers are exposed to similar operational issues.

Thus, every thorough operational due diligence should review the manager’s commitment to regulations and industry best practice standards in relation to legal structures and documentation, service providers, personnel, risk management, IT and compliance.

The initial operational due diligence typically involves four main stages: documentation or “desk” review, onsite visit, service provider review and background checks.

The key areas that every operational due diligence should cover are:

  • Risks and compliance management – risk management framework, compliance arrangements, internal controls over key operational processes, personal trading policies and procedures, review policies and procedures over issues such as complaints management, internal fraud, insider dealing, conflict of interest or trading errors
  • Financial stability – cash flow information, financial statements review, financial ratio analysis against agreed benchmarks
  • IT infrastructure and security – IT infrastructure and disaster recovery, business continuity policy and practice
  • Operations and trading – operational and trading processes and procedures performance
  • People – key managers´ background checks, review of the operational staff quality and duties segregation among stuff, remunerations review
  • Service providers – oversight of key service providers, such as administrators, custodians, auditors, prime brokers, review of their capabilities and commitment

Operational due diligence questions can be a part of a due diligence questionnaire or can be created as a specific questionnaire, focusing on operational aspects.

Sample questions for Operational Due Diligence questionnaire

Questions about risks and compliance management

Does the manager have a compliance manual, how comprehensive it is and when was it last updated? Does the manager employs a dedicated and qualified Chief Compliance Officer, or relies on a third-party consultant? How do policies and procedures that address key compliance topics (e.g., personal account trading, anti-money laundering, transactions with affiliates, conflicts of interest, transactions with government officials, trade errors, cross-trading, etc.) look like? Determine regulatory registrations (both domestic and international) for the manager.

Questions examining the manager´s financial stability

What bank account is an investor’s subscription cash sent to and who controls these accounts administratively? Who can change the two sign-off control configurations (i.e., the number of sign-offs and who they can be) in the prime broker’s online payments system – does the prime broker control this, or can an employee of the manager make changes to the requirements? In the case of a payment of expenses from the master and/or feeder funds, are all expenses reviewed against payments made from the funds to further protect against fraud? Which controls exist on the movement of cash into any direct or indirect subsidiaries of the master fund, or any affiliated vehicles processing payments going to the master fund.

Questions inspecting the manager´s IT infrastructure and security

What is the disaster recovery and business continuity plan if employees cannot access the primary office or IT production environment? When the plan was last tested and what were results of tests? Who oversees the disaster recovery and business continuity planning – determine the person’s background and experience for this responsibility? How are the manager´s cyber security policies, procedures, and preparedness set – what is the level of employees´ awareness and training regarding cyber security, are third-party IT firms involved in monitoring and testing for cyber-attacks, do employees access the manager´s data and systems remotely (when they are out of office)? Does the manager have any history of attacks or data breaches?

Questions about the manager´s operations and trading procedures

Describe the process of how the front office executes a trade, how the trade flows through the middle office and back office, and how it gets to the fund’s prime brokers and administrator. Which trade affirmation/confirmation/reconciliation systems and procedures does the manager use? Which execution means (e.g., electronic vs. voice/Bloomberg messaging) does the manager use? How are the duties between the front office (trading and portfolio management), the middle office (trade processing/reconciliation) and back office (valuation/fund accounting) segregated?

Questions inspecting the manager´s staffing

Determine the size and specialization of the staff vs. firm-wide AUM, number of trading vehicles, and complexity of the strategies traded by those vehicles? Compare the staffing to previous points in time – has it increased or decreased? List the staff additions and departures over the past 24 months. Is any staff related to each other and, if so, does this poses any control weaknesses or conflicts of interest? Does the manager conduct a background check on prospective employees before hiring them? What qualifications do the staff heading the middle office (e.g., Chief Operating Officer) and back office (e.g., Chief Financial Officer) have?

Questions about service providers

Who are the managers services providers? How is the adequacy of service providers determined? Did the manager conduct background checks on service providers and what were the results?

Why is Operational Due Diligence used  more with hedge funds and private equity managers?

The term of operational due diligence has been more mentioned in reference to alternative investments, especially hedge funds, and private equity. The reason why investors put more effort into ODD for these types of managers can be explained by the fact that they are less regulated, compared to, for example, mutual funds. Both, hedge fund managers and private equity managers involve operational risks such as cash management, valuation, IT security, and the most feared – increased possibility of fraud.


Operational risks represent a real threat to the fund´s success. Investors tend to be more attentive to examining the operational side of managers. Operational due diligence as a concept gains on importance, but without thoroughly prepared and performed ODD process, the weaknesses that a manager might have can be overlooked.


If you need help digitizing your operational due diligence or your ODD questionnaire and managing the process with the help of appropriate technology tools, contact us and we will gladly answer any inquiry.

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