Operational Due Diligence: Considerations for Investors

With a choppy fundraising climate and uncertainty about broader global macro trends, as well as in some cases heightened capital constraints, many LPs are keenly focused on ways to improve their investment processes. On this episode of Ropes & Gray’s Alternative Asset Insights podcast series, partners Isabel Dische, Vince Ip and Sean Seelinger focus on some best practices for operational due diligence (ODD) to assess potential risks stemming from a sponsor’s operations.

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Transcript:

Speaker: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. Joining me today are my colleagues, Isabel Dische, Vince Ip and Sean Seelinger, based in New York, Hong Kong and London.

With a choppy fundraising climate and uncertainty about broader global macro trends, as well as in some cases heightened capital constraints, many LPs are keenly focused on ways to improve their investment processes. We regularly field questions from investors hoping to benchmark their own investment processes with those of their peers, ensuring that they are applying appropriate discipline as they deploy capital. In today’s discussion, we’ll focus on some best practices for operational due diligence (ODD) to assess potential risks stemming from a sponsor’s operations.

Vince Ip: Very briefly, one can think of operational due diligence as an assessment of whether a manager is set up to manage the fund’s investment strategy successfully and for the duration of the fund’s term. This is far from a new concept, but operational due diligence has been receiving heightened attention from many of our investor clients in recent years in part because of some fairly dramatic issues that have arisen at high-profile managers in recent years.

As a general matter, the starting due diligence questionnaire (DDQ) checklist for most of our investor clients often is based off of the sample questionnaires from one or more of the Alternative Investment Management Association (AIMA), the British Private Equity & Venture Capital Association (BVCA) and Invest Europe checklists, although many investors supplement with questions from the Institutional Limited Partners Association (ILPA), the Principles for Responsible Investment (PRI) and other industry groups, as well as internally developed questions based on the investor’s own risk appetite.

At the core, these questions are intended to probe the viability and robustness of the fund’s investment and operating processes. For example, what is the firm’s governance and organizational structure? Who are the decisionmakers? How are those key decisionmakers compensated? How is carry allocated? Related, how are staff across the organization incentivized? To whom do non-investment functionalities report and how are those functionalities organized (such as legal, finance, compliance, operations and IT)?

Isabel Dische: Many of our clients also try to understand not only the caliber of both the internal teams and external service providers, but also to understand potential liabilities and reputational issues. How is the team monitoring for such liabilities? How robust is the firm’s compliance culture? What resources are available to address issues that may arise? How has the firm handled any such issues in the past? What potential resources may be needed in the future (both in terms of current and future capital needs, management attention and additional human capital resources)?

All of these questions look not only internally but also to the various external service providers that may be involved in managing the fund. In particular, investors may want to ask what operational controls are in place to monitor and supervise the firm’s service providers.

Sean Seelinger: Another key area for consideration is diligence of a manager’s processes to assess and mitigate the risk of value diminishing compliance, ESG and other reputational issues in underlying investments. Key questions are whether a manager has specific compliance and ESG diligence processes? How robust are they? Who is responsible for them?  Do they apply to all investments or just certain types? Over the past several years, the number of managers with robust, dedicated diligence workstreams for compliance and ESG issues has significantly increased, particularly for managers taking large equity positions. However, there is still large variance in market practices.

Beyond the initial investment diligence process, it is also important to understand how a manager mitigates these risks post-closing. Is there a process in place to track the implementation of diligence recommendations post-closing? Does the manager have minimum baseline standards for portfolio company compliance programs to adhere to? Is there a structured process for monitoring compliance and other reputational risks throughout the investment lifecycle? There is no one-size-fits-all or perfect answer to these questions, but they are important questions to ask as the scope of regulatory, compliance and ESG risks expands.

Speaker: Another key line of questioning is around the overall viability of the firm. Bluntly, does the manager have sufficient capital to fund its operations? How will the manager be financing its own capital commitment obligations? Answers may vary based for newer managers than for more established ones. For example, a younger manager may simply not have as much cash at hand. It’s also worth asking for visibility on who on the team will be putting in capital. For example, what alignment does the LP have with those team members it views as key to successful execution on the fund’s strategy?

In recent years, there’s also been a trend toward financing GP commitments, and LPs will want to ask about the GP’s plans in this regard (and then potentially negotiate some guardrails around such financings).

Isabel Dische: All of these operational due diligence questions need to not only feed into the investor’s initial investment decision, but based on what it learns through the ODD process, an investor may choose to negotiate the terms of its investment differently. For example, we’ve seen investors negotiate for enhanced liquidity rights that might be triggered by developments in an underlying event. Or an investor may negotiate for a contractual undertaking around the allocation of carry across the investment team as a way to ensure that the decisionmakers it views as key are properly compensated. Even more common would be for an investor to enhance its reporting requests based on items identified during the ODD process.

Vince Ip: Yes. And we’ll see investors press for a manager to bolster its back-office infrastructure based on the ODD process. For example, if there are concerns that those functions haven’t kept up with growth in the manager’s funds, or that the manager’s technology platform and/or information security controls could be enhanced, an investor might ask for undertakings to address those issues.

Ultimately, whether and how the ODD process feeds into the negotiations or simply informs an investor’s investment decision depends on the investor’s leverage in the negotiations. An investor negotiating a bulkhead commitment to a new manager will have more leverage than one making a smaller commitment or one making an investment in a well-established platform.

Speaker: Clearly, we’d all agree that a robust ODD process is a key element in a fund investor’s investment process. But it is equally key for the investor to periodically reevaluate and tailor that process to reflect the circumstances of the particular investment.

Thank you, Isabel, Vince and Sean, for joining me today for this discussion. And thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. Of course, if we can help you navigate any of the topics we discussed:—please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple and Spotify. Thanks again for listening.