Yes. A rigorous operational due diligence (ODD) review is a core piece of the investment manager underwriting process that allows limited partners (LPs) to make informed investment decisions. Recent banking sector events, including yesterday’s collapse of First Republic Bank, highlight the need for a constantly evolving ODD framework capable of identifying and addressing both ongoing and new risks that managers may encounter. More specifically, this episode reiterated the importance of evaluating non-investment personnel qualifications, the manager’s counterparty risk management controls including cash and treasury management functions, and the general partner’s (GP’s) role in overseeing and influencing certain underlying portfolio company practices.
Strong managers not only have investment skill, but also operational skill. The purpose of ODD is to evaluate this operational skill by identifying business and operational risks specific to each manager and determining how (and if) those risks are mitigated. Business and operational risks include financial loss occurring from inadequate internal policies, system and controls failures, human error, fraud, or management failure. External events, such as cybersecurity breaches, natural disasters, and other business disruptions, contribute to business risks. During their review, ODD professionals should ensure that the business is appropriately structured and resourced with qualified people, robust technology, and service providers. In addition, the ODD review should include an assessment of the manager’s operations platform to confirm that it is appropriately aligned with the complexity of the investment strategy and that there are strong procedures, controls, and separations in place.
Assessing the capabilities of managers’ non-investment leadership teams is a key element of a comprehensive ODD review. The recent events highlight the importance of scrutinizing managers’ non-investment talent and closely underwriting key C-suite (COO, CFO, CCO, etc.) members to ensure they’re aware and capable of executing their responsibilities at the fund and management company level, while also serving as a resource for portfolio companies. Many of the managers most impacted by the banking stress were small boutique shops, often with lean or fully outsourced finance and accounting functions. Despite these limitations, the expectations for the manager’s ability to oversee and manage key back-office functions, including cash and treasury management activities, have only increased.
As part of the evolving counterparty risk management assessment, an ODD review should ensure managers are maintaining, at a minimum, a second banking relationship. One relationship should be with a systemically important bank. Except for some of the largest funds, which often maintain a credit facility and can negotiate favorable terms with multiple banks, many private equity and venture capital managers typically maintain one banking relationship to support business needs at both the management company and fund level. In addition to maintaining diversified banking relationships to ensure timely access to capital, managers should regularly test these bank accounts to confirm operability, including access to capital, in the event of a future crisis. A focus on the credit and liquidity risks surrounding cash positions should also be part of the ODD assessment. This includes evaluating the GP’s approach at the management company and fund levels to managing credit risk of uninsured deposits and the steps they have taken to maximize principal protection, such as the use of US government-only money market funds, direct Treasury bills, or cash sweep programs.
Historically, the ODD scope has been focused on the management company and fund levels, but it has gradually expanded to specific portfolio company practices. For instance, several years ago, portfolio company employee conduct and cybersecurity practices came into scope. An assessment of the GP’s role and oversight of portfolio company cash and treasury management practices should also be conducted. Although the GP’s ability to effect change can vary depending on the nature of their investment, their role in overseeing and communicating best practices to portfolio companies better prepares them to support portfolio companies in challenging times.
The latest events in the banking sector have reinforced the importance of maintaining a robust ODD framework. Evaluating all elements of an investment manager’s non-investment function is essential in enabling LPs to make prudent and timely investment decisions. Investors should thoughtfully engage with GPs to ensure proper oversight and risk management controls are in place to mitigate relevant risks.
Mike Coppens
Head of Business Risk Management