Global family office adoption of operational hedge fund due diligence has surged in recent years after lagging behind entities such as endowments, foundations and pensions, according to a new study.
Eighty-two percent of family offices surveyed were not performing operational due diligence two years ago, but today 76 percent are doing so either on their own or through third-party consultants, according to a survey of 120 family office professionals in the U.S., Europe and Asia by Corgentum Consulting of Jersey City, N.J.
Operational due diligence is the process of analyzing operational risks, which are a fund’s non-investment-related risks. Operational risks result from an organization’s internal business and management activities and are caused by breakdowns in procedures, people and systems. These risks can include inadequate accounting controls, fraud, human error and business interruptions due to fires, floods or other disasters.
“Several years ago, this was not really on the radar of family offices,” says Corgentum Managing Partner Jason Scharfman.
The Corgentum survey found that family offices have been increasingly focused on operational due diligence in part because of the continuing stream of hedge fund failures since the Madoff scandal in 2008.
Yet even those who perform due diligence aren’t particularly assured by the process. Seventy-three percent of family offices admitted lacking confidence in their or their consultants’ ability to perform effective operational due diligence on hedge funds. Only 32 percent believe their operational due diligence processes adhere to a minimum consistent level of review, and a mere 21 percent follow a documented process.
The need for a solid examination process isn’t lost on family offices that had money with failed hedge funds, according to Scharfman. These family offices have recently been reevaluating their approach to operational due diligence because it’s a key component in minimizing fraud risk. In fact, 57 percent of those surveyed cited fraud risk as the most significant operational risk. Other perceived risks included regulatory risk, cited by 21 percent of survey respondents, and counterparty risk, cited by 9 percent.
Scharfman says family offices are also worried about operational gray areas—activities that fall between outright fraud and bad controls. One concern is the number of recent cases involving employees or ex-employees who steal data from hedge funds. “Family offices will ask us to look at information security at technical-trading-strategy hedge funds. If a fund uses a proprietary strategy and there’s a data leak, it can ultimately hurt current investors in the fund, because the competitive edge is going to be destroyed,” he says.
To reduce operational risk in hedge fund investments, Scharfman says the due diligence process should include, at minimum, interviewing fund managers, performing background investigations and site visits and verifying relationships with banks, law firms and outside accountants. It should also involve reviewing all relevant legal and financial documents, policies and procedures, certificates of insurance and uniform commercial code filings.
The full survey is available here.