The most obvious consequence of an investor failing to perform robust operational Due Diligence (“ODD”) is direct financial loss, but there are other situations that could prove equally problematic.
ODD, in-house or using a third party, helps to avoid potential operational errors or fraud by focusing on the operational controls of an Investment Manager (“IM”) and the investment entity (the “Fund”).
ODD allows you to invest with operational conviction and stay invested. It identifies and assesses the IM and Fund specific non-investment (operational) risks including people, organisation and governance, operational process, regulation, compliance, IT/cyber and service provider dependencies.
Here are five areas that could cause potential loss without appropriate ODD:
1. Environmental, Social and Governance (ESG)
Being associated, as an investor, shareholder or an employee, with an organisation that has a poor or declining ESG score can damage your reputation.
Today in the investment management sector, as across most of financial services, the moral considerations of ESG are important. Typically, perfORM Due Diligence Services (“perfORM”) will review ESG issues at the IM level. These include checking an organisation’s transition to carbon neutrality, confirming appropriate remuneration, diversity and whistleblowing policies, as well as examining issues such as employee related litigation and staff turnover.
2. Operational Efficiency
Systems failures, such as outages or website crashes, may not lead to an immediate decline in an organisation’s profitability, but they are likely to damage a reputation, particularly if repeated. To defend against these issues, ODD reviews confirm the durability and security of an IM’s systems and ensure that the operational model is robust, with sufficient processes and procedures in place. Checks should also be performed on providers of outsourced services.
In late March, a hacker stole roughly $600m in digital currencies by exploiting a weakness in the ‘digital bridge’ built to help users and companies transfer assets from one blockchain to another.
It has subsequently been revealed that across the asset class “more than $1 billion in crypto currency has been stolen by exploiting flaws in such bridges in little over a year.” This incident demonstrates that there is no digital infrastructure, even blockchain, whose security should be accepted at face value without regular checks and tests.
4. Crypto Currencies
As well as being a popular target for cyber-attacks, the new world of crypto currency investment and trading requires regular ODD reviews if investors want to have confidence around the safety of investments.
One important issue is the custodianship and security of digital assets, particularly given the continuing debate questioning whether crypto currencies are assets or currencies, which alters their legal status. The requirement for ODD examination here is underlined by the fact that unlike their colleagues running hedge funds, for example, many crypto IMs have an array of custody options to choose from, including self-custody, a decision which requires case-by-case examination.
5. Reputation and Liability
Go into any supermarket and you will immediately be confronted by a range of products, edible or otherwise, which promote themselves as be vegan, sugar-free, better for the environment, and so on. Impressive claims but are they true? Has anyone checked?
Promoters of investments often make equivalently impressive claims, and regular ODD reviews can provide re-assurance that these claims are true.
Again, this is not necessarily about money but about reputation and sometimes legal liability. Those entrusted with the care and disposition of other people’s assets, be they consultants to family offices or pension fund managers, do not want to be found to have committed capital without due care and attention.
For example, investing in “greenwashed” rather than green funds, or to management groups where the glass-ceiling is preventing the advancement of female employees is still firmly in place. There is personal career risk here, and furthermore risk of possible legal action for failures in governance should a selected portfolio be found, for example, to contained sanctioned assets.
Enabling fact-based decisions
ODD is not the alchemist’s stone for the investment industry, but it does play a key role in underpinning responsible decision-making. As Sherlock Holmes once commented, “It is a capital mistake to theorise before one has data.”
perfORM Due Diligence Services Limited (perfORM) is an award-winning provider of ODD services for a diverse base of UK and international Allocators, Investment Managers and Service Providers.
Launched in 2019 as the only London-based and technology-led ODD service of its kind, perfORM is a growing team of six highly experienced ODD consultants with a laser-like focus on client service which ensures high levels of client satisfaction, trust and partnership. perfORM joined the JTC Group in October 2021.
Co-Head – Quentin Thom
Co-Head – James Newman