Rise of the Hedge Fund Operational Due Diligence Role

Over the past four years more and more Institutional Investors have started to place a greater emphasis on a Hedge Fund’s operational/business infrastructure when deciding whether or not to invest in a certain fund. This emphasis is due largely to the belief by some investors that many Hedge Fund failures in the past could have been identified earlier if these non-investment areas of the business had been more closely monitored.  This emphasis has led to a new position and role within many Institutional Investors including hedge fund of funds, endowments, pensions and Investment Consultants; an Operational Due Diligence Analyst.

The responsibilities of the Operational Due Diligence Analyst role are constantly changing, and most likely will continue to change over the next few years until a proven process has been entrenched by numerous investors. Although many believe and understand the importance of Operational Due Diligence it is still an art in its infancy. The basic parameter is that an Operational Due Diligence Analyst role is responsible for performing the due diligence on all non-investment related areas of a hedge fund including operations, accounting, risk management, and technology.

Career Path not Clear for Operational Due Diligence Role

Presently there is not a set career path into this position, although usually the best qualified candidates come from either the operations department of a large multi-strat fund, or the Hedge Fund practice group within a Big 4 or specialized vendor. Typically these individuals were the highly ranked employees within their group and have experience working within many areas of the business.  Furthermore, they are strong communicators who can effectively relay information to their peers and managers. Some investors will build their teams with a specialist in each area, such as a tech specialist for the technology due diligence and perhaps a PhD. in financial engineering for the risk management due diligence.

These professionals are responsible for visiting potential and current investments and “kicking the tires,” just like a traditional due diligence analyst would when reviewing a potential fund or present investment.  Instead of talking to the Portfolio Manager, an Operational Due Diligence Analyst will talk with the CFO, CTO, COO, and others within the non-investment side of the business.  An Operational Due Diligence Analyst will look over the fund’s Prime brokerage contracts, the fund’s business continuity plan, disaster recovery plan, and risk management controls to name a few areas.

Due Diligence Analyst Role

Just as the Investment Due Diligence Analyst would sit across the table from the PM and ask the tough questions with nothing being off limits, an Operational Due Diligence Analyst asks tough, probing questions to these non-investment oriented professionals.  After all sides have performed their due diligence, both sides present their report and provide their recommendation on whether or not the potential fund is worthy of an investment.  I know of many cases where the fund passed the investment side of the due diligence process with flying colors but did not receive any money because the business/operational side did not provide a strong foundation for the firm and its investments. In several of these instance abstaining from making the investment saved the investors capital.

Once an investment has been made, both sides of the Due Diligence team must continue to monitor the fund and perform regular due diligence on the fund to make sure no significant changes occur which could cause the investor to withdraw their money.  This constant due diligence occurs until the investment is redeemed.

The Managing Partners of Hedge Fund’s in today’s market need to understand that Operational Due Diligence Analysts are an instrumental part of the investment process with many institutional investors. These Managing Partners need to make sure that they respect the Operational Analyst and treat them just as they would a member of an Investment Due Diligence team.  The role of the Operational Due Diligence Analyst is here to stay, as is expressed by the high number of professional investors looking to hire individuals with this specific skills set.