Operational due diligence is the meticulous checking of non-investment factors such as terms in the prospectus, operational structure and function, fund and corporate governance and operational risk management.
Most of the investment disasters in the hedge fund world would have been picked up by good operational due diligence, and in fact many of them have been caused by lack of attention to operational issues.
Although there were many clues to Madoff’s fraud, a proper assessment would have spotted tell-tale operational red flags, such as the curiously small auditor or the anomalous lack of fees. A lot of the clues were investment more than operational, such as the lack of conformity to a split strike return pattern, and the enormous total size of his purported activities compared with the size of the market.
At Amaranth, the operational clues were to do with spotting the concentration of exposure and finding out who was actually making the trades. And any research on Brian Hunter would have revealed that he had previously incurred very large losses at his previous employer, Deutsche Bank, and was let go.
While a systematic approach to operational due diligence is important, nevertheless, it is a mistake to work off a tick-box list. Our approach is to start with a free form investigation: “What are the important issues in this specific fund?” before making sure, by the end, that everything that needs to be covered, is covered.