Analysis of the fittest: A new era of operational due diligence

While no one could have predicted a breakdown of traditional communication channels between investors and managers, the leap to online vetting like most things nowadays is a trend that has accelerated due to the pandemic. Vin Molino, head of risk and operational risk management solutions at Northern Trust, said the due diligence process is evolving and adapting day by day, but the expectations of investors for quality analysis remains the same. Northern Trust recently put out an article on the shift in operational due diligence practices. Officials highlight that the COVID-19 global pandemic is changing how business leaders across industries carry out their usual operations. It is estimated that in the U.S., 66% of employees worked from home during the pandemic with investment managers and operational due diligence (ODD) teams being impacted similarly. “I don’t think anyone has agreed on what is happening,” he added in that there have been a number of industry-wide webinars on operational due diligence and general conversations about virtual due diligence and best practices. Indeed, Albourne Partners recently gave a recent presentation to pension fund trustees on how they have shifted their due diligence work at a public pension fund meeting (via video link). The consulting firm revealed that as onsite due diligence is being replaced by video calls, the actual numbers of reference calls has increased. It all has added up to more manager interactions with consultants and investors despite the loss of in-person contact and body language insights from on-site meetings. At Northern Trust, Molino works in the Front Office Solutions team and brings with him experience of working at consulting firms and funds of hedge funds over the years, including Mercer and Permal. His group at Northern Trust expanded into risk management services when Molino joined in July 2019. The aim of the new unit is to allow asset owners to review and assess the operational strengths and risks of investment managers, including those managing alternative strategies such as hedge funds, private equity funds, real assets and direct investments. The Front Office Solutions team is led by Melanie Pickett. Pickett joined Northern Trust in 2017 from her role of chief operating officer of Emory Investment Management, which is one of the largest endowment investment programs in the U.S. “Complex asset owners have focused their efforts around operational risk management in the decade since the global financial crisis,” she said in the announcement of the formation of Molino’s unit last summer. The aim was to go beyond traditional asset servicing offerings in serving sovereign wealth funds, institutional investors and family offices. While the move to remote onsite visits was not something the team was planning for last year, Molino said that the preparation for ‘meeting’ with a manager is much the same as it always has been. A conversation is set up with the manager and documentation is collected. “We say of course that we can’t see trading systems and the operations on-site. So at that point you need to become creative and need to meet halfway,” Molino said. Sensitivity around some of the documentation could be a stumbling block, but at Northern Trust the team has been suggesting, and with managers approval, the signing of a non-disclosure agreement. A particular document can then be scanned via a video call and Molino’s team will simply have to trust that the document is real, but then again that would be similar if they had met a manager in person, he added. They also look for evidence of trading systems. If Molino were to be on an onsite visit, typically some time would be spent overseeing the trading department. A trader would put in a dummy trade or show a trade that had already been processed that is evidenced from looking over the head trader’s shoulder. Now that process is just done over a web call too. Another operational due diligence checklist item is infrastructure and physical evidence of it -- such as data rooms and technology tools. Even prior to the pandemic much of the data and technology is in the cloud or housed offsite at a data warehouse, added Molino. So, unless a visit was paid to a data warehouse, that key infrastructure proof was challenging to prove. Still that is not to say that the virtual process is less effective in weeding out potential manager problems. In fact, Molino views the process being an improvement to pre-pandemic times. “Typically, onsite would last hours over a one-day meeting,” said Molino. “There would be pressure to keep things moving and a challenge of coordinating with many people’s schedules. Then there was the time of getting on a plane and meeting them. Sometimes you would have to skip things.” He added that his team can now spend more time on each topic as it relates to the manager vetting process rather than keeping it to a set schedule in order to accommodate multiple-managers or staffers often competing schedules. Now he says that they are provided much more comprehensive view of risk on behalf of Northern Trust’s clients with off-site due diligence. There too have been a new series of questions rising out of the current WFH environment, including business continuity plans, technology in place to allow trading from home and more importantly compliance oversight of traders with concerns such as insider trading becoming more worrisome. All told, in Molino’s estimation the process of manager due diligence has been sped up too as managers are more able to schedule remote calls and all are becoming comfortable with the new way of assessing risk albeit while maintaining social distancing.

Analysis of the fittest: A new era of operational due diligence

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