"An Operational Due Diligence review is best constructed in layers, rather than as a checklist driven pass/fail exercise." Scott Nussbaum, Cross Capital
[The Institute for Innovation Development recently talked with Scott Nussbaum, Director of Operations at Cross Shore Capital Management, which manages both a larger, more established hedge fund manager portfolio and the Cross Shore Discovery Fund, which allocates to newer or under the radar hedge fund managers. We asked Scott, from their unique vantage point as an investment research firm and institutional investor focused on long/short equity hedge funds, how he performs operational due diligence on the evolving hedge fund industry.]
Hortz: Can you share with us your philosophy on performing operational due diligence on hedge fund managers?
Nussbaum: For us operational due diligence is not a pass/fail exercise, where the allocator seeks to satisfy an extensive checklist ensuring that the hedge fund manager adheres to “best practice” in every area of its business. This may seem counterintuitive, because after all, who would want to invest with a manager who doesn’t employ best practices throughout their business?
But in reality, the difficulty with the check-the-box approach to operational due diligence is that once you go down the road paved with “best practices”, this effort can end up taking on a life of its own, becoming un-tethered from the true objective of an due diligence review - taking a good hard look at the full operational and technological capabilities and safe guards of the firm. Especially when investing in emerging managers - defined as managers who are under $1B in AUM – taking a “best practices” centric approach to operational due diligence sets up nearly every manager to fail as they could not possibly match the operational infrastructure, staffing levels, business processes, and resources of the industry’s largest managers who, from a practical perspective, set the bar for “best practices.”
Hortz: So what then are the goals for an operational due diligence review, especially for emerging managers?
Nussbaum: Operational due diligence, at its core, is about satisfying two key points about a Manager:
- Our assets are sufficiently safe from non-investment related risk
- We will receive important information about our investment that is both accurate and timely
These two seemingly simple sounding goals belie an in-depth research effort involving a range of underlying considerations. And the due diligence review must be tailored to the hedge fund manager under consideration, taking into account the manager’s strategy, size, age, operating environment, personnel, ambitions, and infrastructure. This we term more of a “principles” based approach to due diligence.
Hortz: Can you explain why you call it a “principles” based methodology? What is the mindset or procedural difference?
Nussbaum: Since we’ve concluded that we can’t, and shouldn’t, use the same checklist to evaluate the operational infrastructure of a $20B vs $200M manager, we need something else instead. Cross Shore has an operational due diligence template designed to pursue a thorough review of each area of a manager’s operational infrastructure --- valuation, performance reporting, ethics, cybersecurity, compliance, etc – with the goal of understanding and establishing comfort with the manager’s practices, highlighting key risks, and identifying mitigating factors in place.
We wouldn’t insist on seeing the same level of IT infrastructure, real-time analytics, redundancies and operational staffing at a Fund that holds 15-25 plain vanilla long/short equity positions and averages 0.4x turnover as we would expect to see at a Fund that holds 100+ long/short equity positions and a range of related derivatives that averages 8x turnover in the portfolio. In both funds, we would insist on the manager maintaining a sophisticated approach to their operations; but the needs and risk factors in each fund necessitate an adaptive, principles based approach to evaluating each rather than the application of an absolute, one-size-fits-all “best practices” approach.
Hortz: Please share with us how you go about this deeper due diligence process.
Nussbaum: An operational due diligence review is best constructed in layers. An initial, cursory review of any manager can identify whether or not there are any “red flags” in a handful of areas that are critical to asset safety: Does the manager work with credible, independent service providers throughout all key areas of its business --- counsel, audit, administrator, custodian/banking relationships, technology vendors? Does the manager employ a quality third party fund administrator who independently values the portfolio and communicates directly with investors? Does the Manager have highly qualified, dedicated operations professionals overseeing the non-investment side of the business? Satisfying a simple, but non-negotiable initial checklist that addresses a handful of items such as these quickly screens out managers who would likely not survive a full-blown operational due diligence review.
After this initial screening process, we shift towards a principles-based approach that provides a framework to evaluate not just emerging managers, but any manager, without succumbing to a pass/fail approach. It is at this point that an operational due diligence research process truly gets underway. This next layer is to learn about the manager rather than jumping into an evaluation of the manager. The due diligence reviewer needs the ability to read and understand not just the manager’s legal documents, but the manager’s business documents --- marketing materials, investor letters, investor reports, the DDQ, etc.
Only after we have a solid understanding of the manager and have established where the areas of highest risk lay does the operational due diligence review program begin to take shape, and being tailored to that manager: What differences would we expect to see in the compliance program of a manager who actively turns over the portfolio taking cues from technical factors and market action versus a manager who actively seeks an informational advantage through fundamental, company specific research to trade around earnings calls? What differences in disaster recovery/business continuity plan testing would we expect, or want, to see in a manager who holds 100+ positions across long and short equities & derivatives with an average holding period measured in days versus a manager who runs a concentrated portfolio with an average holding period measured in quarters? What valuation policies & procedures would we expect to be in place for a manager who trades entirely in exchange traded securities vs a manager that invests in non-exchange traded securities? For a manager advising both separately managed accounts alongside private funds, what would we expect to see with respect to trade and expense allocation policies and procedures?
Hortz: What do you see as to how innovation and technology is shaping the hedge fund industry?
Nussbaum: Innovation and technology, as it relates to operational due diligence, is most evident in the systems that managers are able to employ. Service providers and vendors are leveraging technology to scale their offerings, tools and resources that were once available only for larger managers, to make them available to any manager, of any size. Fund administrators are leveraging the cloud to provide powerful tools and control to even the smallest hedge funds. Software companies who previously could only be engaged by the largest funds to design proprietary trading analytics are able to offer subscription based services to any manager. Cybersecurity defenses applied against a sophisticated cloud-based, shared IT infrastructure are much more powerful than what a small manager operating its own servers could reasonably be expected to implement on a cost effective basis. It has become increasingly more accessible for smaller managers to implement and maintain sophisticated operational systems that historically were only feasible for large managers.
We also see this increased focus on innovation and the application of new technologies leading to a new age of competition in the hedge funds industry. Interestingly, besides deploying new technology in their back offices to drive efficiency, improve controls, enhance data management, strengthen cybersecurity, and increase compliance responsiveness, we are starting to see more investment and experimentation in the front office where alpha is generated.
Hortz: Based on your experience, what is your best advice to financial advisors in performing due diligence on both large and emerging hedge fund managers?
Nussbaum: Be cautious that operational due diligence is easiest when taking a methodical, checklist based approach to ensuring best practices, but do not solely rely on this methodology. Remember that investing is about accepting & managing risk, not avoiding risk. Operational due diligence should be no different.
We feel the keys to an effective operational due diligence review program are as follows:
- Understand where “best practices” matter vs where “principles” matter and implement an effective initial review process and operational due diligence plan accordingly.
- Rely on credible operational due diligence review personnel who have the ability to truly learn and understand the nuances of a manager’s strategy and business, and are capable of transforming that insight into an effective operational due diligence program.
- Customize and tailor the due diligence review to each manager, taking into account the manager’s strategy, AUM, staff, lifecycle, ambitions & aspirations.
- Prepare, prepare, prepare for an onsite meeting in order to identify the key questions and concerns worthy of in-person discussion. The worst thing you can do is waste your face-to-face time with a manager going over a checklist.
- Seek to identify the key operational risks and explore what processes, including technologies, the manager has in place to mitigate those risks; do not expect the absence of risks.
This article was previously posted on Financial Advisor Online.
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