Operational Due Diligence (ODD) is a bespoke, continuous, and iterative process of assessing an investment manager’s operational risks across all public and private market asset classes.
More directly, ODD aims to arm investors with the information they need to answer fundamental questions, such as 1) are my assets safeguarded from fraud, 2) are my assets valued correctly, and 3) is this firm reliable?
2023 presents several unique challenges for ODD, especially in the areas of cyber security, ESG (environmental, social, and governance), rising rates, and private investment due diligence.
Cyber Security: Rising Levels of Risk
Cyber security refers to all aspects of protecting an organization, its employees, and its assets from cyber threats. Cyber attacks have become more common and sophisticated and as corporate networks grow more complex, a variety of cyber security solutions are required to mitigate cyber risk.
Since the pandemic, many investment firms have had employees working remotely, either full or part-time. Managers must think about providing the right technological resources (hardware and software) to safeguard against cyber threats. It is important that firms have regular discussions and training on how to avoid being a victim of a security breach, especially during periods when many employees are working remotely.
Outsourcing middle- and back-office functions is becoming more common among investment managers. If a manager has outsourced various functions, frequent conversations should be held with the outsourced service providers to understand the protocols they have in place to help avoid any cyber threats and data integrity.
Managers should also ensure they understand how the controls at the outsourced organization interact with their own controls. Many service providers offer a SOC 1 report in which they outline their key controls and an independent accounting firm provides an opinion on the design and operating effectiveness of those controls. Such reports include a discussion of the controls that user organizations (the manager, in this case) should have in place to rely on the service organization’s controls.
Firms can be less susceptible to a data breach if they have the correct protocols in place such as virtual private networks (VPN) and multifactor authentication, which help prevent access for anyone other than the people who should been accessing the data. Firms may also consider obtaining cyber insurance policies that can help cover any legal or other expenses related to a cyber breach, which may include coverage for ransom payments.
ESG: To ESG or Not to ESG
ESG investors aim to make investments in companies that have demonstrated their willingness to improve their performance in environmental, social, and governance matters.
While the U.S. has seen expansion of assets under management (AUM) marketed to consider ESG, the E.U. accounts for half of all global ESG investments. Greater acceptance of ESG in the E.U. is largely due to its regulatory environment, as historically, it’s been much more proactive compared to the U.S.
In a candid February 2023 interview with the Financial Times, The Vanguard Group Chief Executive Officer Tim Buckley caused a stir by plainly explaining the company’s restraint on ESG investing. “We cannot state that ESG investing is better performance-wise than broad index-based investing,” Buckley said. “Our research indicates that ESG investing does not have any advantage over broad-based investing.”
Investor appetite to fund ESG strategies, and for investment advisors to offer ESG vehicles, has been mixed. That said, investors that do decide to invest in ESG products will want to understand whether managers’ views on ESG align with theirs.
Rising Rates: Impact More Than Just Banks
Rising interest rates have prompted both challenges and opportunities for banks over the past year. While rising interest rates give banks opportunities to increase earnings by raising loan rates, they can also increase the cost of liabilities and decrease the value of investment securities held as assets. Even unrealized losses in investment portfolios can have negative effects on liquidity and present funding challenges, earnings pressures and, in some cases, capital.
Thus far, 2023 has seen four banks fail:
- Heartland Tri-State Bank – July 28, 2023
- First Republic Bank – May 1, 2023
- Signature Bank – March 12, 2023
- Silicon Valley Bank – March 10, 2023
The impact of rising interest rates spreads beyond banks. While a rise in interest rates directly causes a drop in bond prices, it can also have a negative impact on the prices of other asset classes. Central banks around the world have been raising interest rates to control soaring inflation. Central banks use this tool to monitor the currency flow and liquidity in the system. By increasing interest rates, they make borrowing more expensive, reducing liquidity and demand in the economy and ultimately calming inflation.
Impact on Equities
One of the most significantly impacted asset classes is equity. Although interest rates do not directly affect stock prices, decisions made by central banks can lead to changes in investor sentiments. Higher interest rates make borrowing more costly. This can lead to a slowdown or higher expenditures. Additionally, reduced consumer spending can lead to lower revenues for many companies.
Impact on Higher Leverage – Public and Private Debt
Firms employing higher amounts of leverage are more at risk during a rising interest rate environment. High interest rates can make it difficult to refinance, as debt is more expensive. And newly issued debt will be at higher rates, increasing interest expense.
Per S&P Global Markets: “S&P Global Ratings forecasts that costlier financing from higher rates and weaker corporate earnings will increase the 12-month trailing default rate of non-investment-grade rated companies to four percent by December, up from a historically low 1.7 percent at the end of 2022. The forecast is predicated on a mild, shallow recession later this year, though a deeper-than-feared downturn and higher interest rates could see that default rate hit six percent.”
Tightening bank lending standards can lead to private credit opportunities. Private credit can offer a complementary means of financing to traditional banks, and with more tailor-made financing options and quicker decisions from lenders.
A rising interest rate environment increases the importance of thorough ODD of private credit investments. Private credit borrows are typically small and medium-sized companies. Coverage ratios need to be analyzed to determine whether a company can cover its debt service. Borrower variable cost structures, which can be flexed as needed to preserve margins and free cash flow, need to be stress tested. Equity and levels of leverage need to be analyzed, as companies with robust equity cushions and moderate levels of leverage can expected to fare better in a rising interest rate environment.
Impact on Commercial Real Estate
High interest rate environments can have a significant impact on the commercial real estate market. Most commercial real estate investors utilize leverage to increase their returns, and an increase in borrowing costs makes that leverage more expensive for developers and investors. This in turn decreases potential returns and, therefore, demand for new projects.
Impact on Private Equity
Private equity investment firms and the businesses they manage are more reluctant to take on debt that is more expensive, which can lead to slower growth and lower returns. Higher interest rates caused by higher inflation can cut into companies’ profit margins, causing valuations to decrease and making it more difficult to exit private investments.
As exits slow down, valuations become ambiguous in uncertain times. It’s important to ensure GPs have the right valuation controls and an objective valuation process with an independent oversight process. GPs that self-administrator or work with unknown administrators should attract greater scrutiny given the elevated risk.
Private Investment Due Diligence: Remain Diligent
Per Preqin, at the end of H1 2022, global private capital managers were sitting on $3.6 trillion in ‘dry powder.’’ While GPs may feel pressured to deploy capital, it is imperative that firms continue to follow their due diligence process and adhere to their due diligence checklists.
A recent example of where private equity due diligence failed is cryptocurrency exchange FTX. FTX collapsed in early November 2022 following a report by CoinDesk highlighting potential leverage and solvency concerns involving FTX-affiliated trading firm Alameda Research. Since the collapse of FTX, many questions have been raised about the independent due diligence conducted by VC and other potential investors including:
- CFTC Commissioner Christy Goldsmith Romero questioned the lack of recordkeeping coupled with “an auditor no one’s ever heard of” as the CFTC questioned the mindset of the institutional investors
- FTX’s CEO Sam Bankman-Fried’s pitch to investors was not much of a pitch; it has been described as a “take-it-or-leave-it offer”.
- Prospective investors were told Sam Bankman-Fried planned to run FTX with little oversight. Interested investors were advised to “support him and observe.”
- No outside investors joined FTX’s board of directors, which was made up of Mr. Bankman-Fried, an FTX employee, and a lawyer
While there continue to be several challenges for ODD, it’s vital to develop best practices that help navigate and overcome these challenges. If you have any questions or would like to discuss this topic in further detail, please contact us.
If you have any questions about this information or would like to discuss your firm’s needs, please contact Kreischer Miller’s Investment Industry Group.
Authors:
Jennifer Kreischer, Director, Audit & Accounting
Patrick Cunningham, Consultant, Operational Due Diligence, Investment Industry Group
