Operational Due Diligence as a source of alpha

In an Opalesque TV interview last week, Stephen Brown, Professor of Finance at the New York University (NYU) Leonard N. Stern School of Business (and an ex advisor to the AT&T Pension Fund), presented his findings on research surrounding the topic of how operational due diligence as a source of alpha creation should feature as a form of risk mitigation in selecting hedge fund investments as part of a portfolio.

Professor Brown’s research clearly presents the case of operational risk being a more predictive measure of failure than other risk measures, and concluded the following:

  1. Conflicts of interest are highly correlated with operational risks. For example, a manager that conducts its own brokerage dealing for the fund it manages is more likely to have operational risks than one that does not.
  2. By gathering and simply analysing all Form ADVs that were filed with the Securities and Exchange Commission in the US since 2006, the results show that 2% of all managers had spent time in prison.
  3. By assessing 444 background check reports from private investigators, 9% of all managers assessed lied about whether they had faced any prior legal or regulatory proceedings. By speaking to external sources, private investigators determined that although these managers had said that they had no prior issues, the opposite was true. In fact, one manager who claimed to have no prior lawsuits had a total of 22 historical lawsuits.

Brown also adds that investors’ attention has been on what should be the optimal amount of hedge funds in a portfolio, and whether diversification helps to lower operational risk. In his closing remarks, he focuses on the fact that diversification only helps when due diligence can be afforded and conducted appropriately, with the cost of operational due diligence to be calculated at a minimum of $15,000 per report through the hire of an outside consultant, who benefits from economies of scale across a client base.

Internal due diligences, performed at the same level as the ones done by professionals, are estimated by Professor Brown to be closer to a marginal cost of $50,000 per report, making it very expensive for most institutional investors.

Laven Partners, is a leading specialist of outsourced operational due diligence, consulting for a broad base of professional investors with a focus on alternative funds and fund of funds.

Our professional due diligence product, the Independent Process of Operational Due Diligence (IPODD) is one of a kind in the industry and is priced at exactly $15,000 per report.

For more information about our operational due diligence services, please visit our website.

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