Navigating Operational Due Diligence in the Time of Covid-19

As hedge funds navigate the waters to position themselves for allocator investments during these unique times, they must be cognizant that allocators’ Operational Due Diligence (ODD) processes have changed and adapted to a remote working environment. The staple of the ODD process – the in person meeting – is not possible for the foreseeable future. This has forced ODD Groups to conduct diligence remotely as well as focus on new types of questions geared toward Funds’ abilities to deal with the disruptions caused by the virus and market volatility. To that end, this paper seeks to guide Funds on the areas they should expect ODD Groups to focus on during a remote diligence session in the time of Covid-19.

Is the in-person ODD meeting dead in the near future?

In speaking with a number of ODD Groups in recent weeks, it’s clear that they’ve had to amend the traditional process previously relied on to vet managers. As face-to-face meetings and in-office live reviews were an integral and necessary part of the process, the inability to conduct such live interactions with managers has caused them to adapt to the new realties and engage technologies that will allow them to effectively complete their obligations. The end investor allocation process has nevertheless carried on, albeit through virtual meetings with managers. To support those allocations and the ongoing monitoring of existing investments, ODD groups have adapted to the new “remote” paradigm and have updated their focus to include Covid-19 specific questions.

How long will the “remote” ODD last?

Most allocators have indicated that their ODD meetings will be conducted remotely for at least the next several months, but likely through the end of the year, through a combination of conference calls, Zoom meetings, remote screen sharing programs, and the use of data rooms to review documents.

Important process questions that ODD Groups normally inquire about in a live setting, usually while they look over someone’s shoulder at an office – such as walking through the life of a trade from execution through clearing – are now being done through screen sharing applications, according to several groups. ODD Groups are accessing and sharing live screens at the hedge fund remotely, as well as receiving relevant screen-shots in response to their questions. Data rooms are becoming the norm during Covid-19, as managers are typically reluctant to email documents like SEC letters and other confidential information, but do make them available via password protected data sites in lieu of access to the actual files themselves.

Remote is not a great substitute, especially for new relationships. Even with new technologies that support the new remote working paradigm, allocators and ODD Groups have said that they do not believe that Zoom, screen sharing and conference calls ultimately can, or will, take the place of looking a manager in the eyes when asking questions or being at a fund manager’s office to witness the interactions and teamwork among employees there. ODD Groups have also almost unanimously suggested that this is especially true for a first-time investment in a Fund where there has been no previous interaction. In those circumstances, an in-person ODD meeting would still be a requirement prior to making an allocation for most investors. Yet, those same groups also noted that, for an allocation to a manager they already know launching a new fund, or for the continued monitoring of existing investments, a virtual ODD process is sufficient prior to making an allocation.

ODD Focus during the time of Covid-19

When it comes to positioning a hedge fund for an ODD examination during this unsettled period, there are several new common themes ODD Groups are focused on that are based primarily on: i) the remote work environments everyone is engaged in; and ii) how the increased market volatility and potential lower liquidity of securities during the crisis has impacted hedge funds. After speaking with a variety of ODD specialists, following below are specific topics and questions related to the pandemic that have become a primary focus. Aside from the obvious focus on a Fund’s business continuity plan generally, it will be important for any hedge fund to have a strong game plan around the answers to these questions and topics going forward.

Key Man Clauses

ODD groups have become much more focused on whether Fund documents contain a “key man” clause that provides for a liquidation, orderly unwind or another specified outcome should a “key man” of the firm become incapacitated – in this case, incapacitated by Covid-19.

Securities Valuation

Since the beginning of March, there has been an increased ODD emphasis on securities valuation, as liquidity dried up significantly. While the Fed took certain steps to ease liquidity concerns for significant segments of the market, this still remains a focus. Specifically, allocators want to make sure that Funds investing in less liquid securities have a clear written valuation policy. Securities that previously had been liquid face more uncertainty going forward, especially in the credit space. Part of the ODD effort will determine if a Fund has established a valuation or pricing committee, and if so, how those committee meetings are being coordinated remotely. There were also examples of external valuation pricing providers running into issues at the beginning of the large drawdown in March and not getting prices to their hedge fund clients in a timely manner. To the extent a Fund uses an external valuation agent, one could expect a substantial number of ODD questions on this topic.

NAV and AUM Triggers

ODD groups have placed a new emphasis on certain terms in Prime Brokerage and ISDA documentation with respect to the NAV trigger language in those documents, especially where Funds are using significant leverage. Where a hedge fund manager relies on and uses leverage, increased market volatility and dramatic drops in Fund NAV have led ODD Groups to focus on these triggers and whether Funds have renegotiated them in light of increased volatility. Many ODD Groups have in fact seen Funds renegotiate NAV triggers to account for the increased volatility, with Prime Broker groups agreeing to reasonable requests.

Cash Movements

With people working from home, the cash movement process is certainly more difficult, so ODD Groups are specifically asking how funds are handling cash transfers remotely and what their current process looks like. Additionally, they would like to know in great detail how authorized fund signatories are communicating cash movements with their administration and accounting teams to ensure such communication is seamless.

Trade Errors and Breaks

ODD groups have always focused on the life of a trade at hedge funds and how a trade works its way through the system. Typically, they have done this in person, but are now doing it through screen sharing or over the phone. The trade reconciliation process has become even more important now that every employee is working from home and communication is more limited. Allocators will want to know if there have been trade breaks or errors since the pandemic, as well as whether a new process has been put in place to address communication issues with service providers for people working from home.

Allocators have also unanimously said that they want to make sure managers are in regular conversation with their Prime Brokers as well as outsourced providers if they outsource functions such as compliance, trading, CFO, operations, or back office.

Cyber Security

With most people working remotely, questions regarding the security of a Fund’s remote access systems and whether there have there been any security incidents at any of the remote locations being used by employees are now commonplace. Also, allocators want to ensure that, to the extent possible, each employee has proper cyber security measures installed on their personal devices to protect against putting any investor or firm information at risk.

Investor Redemptions and Liquidity

As a stable asset base is the lifeblood of any Fund, there is particular concern now among ODD Groups with the Fund’s current and future redemption requests from its investors. Allocators are also specifically asking about the breakeven AUM for a Fund to run the business in case of a large redemption or drawdown. Additionally, while questions focused on whether a Fund’s liquidity terms for investors match the liquidity of the underlying securities in which a fund invests have always been a key element of an ODD exam, the extreme market volatility and less than ideal liquidity in various securities has pushed this to paramount importance.

Types of Investors to which a Fund is Exposed

In speaking with numerous allocators, it has come to light that many end investors such as Endowments, Foundations, Family Offices, and Pensions have received recent capital calls from the private equity, private credit, or drawdown vehicles they are invested in. This is creating an added risk of redemptions from more liquid funds in the long only or hedge fund space to fund those capital calls. As a result, questions regarding the makeup of a Fund’s investor base by type has added importance.

Conclusion

In a world that’s so different, hedge funds must adapt and put their best foot forward with ODD Groups in order to garner an institutional allocation. Most allocators believe live ODD meetings will likely not take place through the end of the year, so having strong answers to the questions and topics discussed above will be key to passing an ODD exam and securing an allocation in the new paradigm. If there is one theme that resonated through each conversation ODD group conversation, it is the importance of continued communication and transparency with existing and new investors. The fewer surprises the better. Generally speaking, ODD Groups and allocators are understanding of the new issues arising from the virus, but want to hear of any issues directly from the manager, as opposed to from some other source.

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