Operational Due Diligence

Operational Due Diligence

AIST has produced an Operational Due Diligence Guidance Note to assist superannuation fund trustees meet their operantional due diligence obligations. APRA’s expectations about these obligations were most recently explained in their Insight magazine in 2018.

APRA expects funds to undertake ODD reporting in order to understand, quantify and manage operational risk inherent in appointing an external fund manager. The reporting aims to put a spotlight on the many and wide-ranging processes that need to work effectively for an investment manager to deliver to an agreed mandate. Such processes include the ability of the manager to stay in business and the culture that exists within the manager’s operations.

The AIST Operational Due Diligence Guidance Note is an initiative designed to assist superannuation funds (and investment managers) to reduce costs and raise the bar in the assessment of operational due diligence.

What is Operational Due Diligence?

Due diligence is the process of analysing the philosophy, people and processes of an investment manager to ensure it is capable of performing the functions for which it has been appointed. The ability to manage and monitor investment risk is itself impacted by the ability to manage investment operations related functions. Operational due diligence focusses on the operational capabilities of these investment operations related functions.

The goal of ODD is to understand and review the processes that need to work effectively for the investment manager to deliver to an agreed mandate. These processes may be wide ranging and vary from the ability of the manager to stay in business and withstand a serious event, to manage and direct its own service providers, to the risk control framework and culture that exists within the manager’s operations. Specific areas of focus are outlined in the Guidance Note, but should not be considered exhaustive, as a range of operational events, and their impact, may vary according to the asset class, style of investment and geographic region. An ODD review should be tailored to be fit for purpose for each situation.

The ODD process provides insight to the risk culture and approach of the investment manager. This includes the ability to identify, measure and manage ALL risks while applying its investment strategy and process.

What makes a good quality Operational Due Diligence review?

The ODD review is not a ‘tick the box’ exercise. There is expected to be a strong advisory element to an ODD report which provides insight to whether a manager is capable of fulfilling its operational obligations and that these operations are in line with industry practice. The expectation is that an ODD review also includes third party descriptions and observations of key processes and systems, and relevant evidencing and testing.

It is expected that an ODD report will opine on the ability of the fund manager’s operational processes to meet future obligations and targets outlined in an IMA or Trust documentation. Such opinion is expected to be based on an analysis of data used to verify systems and processes, desktop analysis and an onsite visitation program. To carry out the review and make these observations, it would be expected that the ODD reviewer team would include relevant experience relating to the operations of investment managers.

What is an RSE Trustee’s responsibility on ODD?

The Trustee of the RSE should have a clear process for managing the outcomes of the ODD report and be satisfied that the risks identified are consistent with, and not additional to, risk tolerances articulated in its own Risk Management Framework (RMF). In some cases additional research and assessment may be required by the Trustee to satisfy this responsibility. 

Prudential standards create a positive and enforceable obligation of the RSE Trustee to demonstrate compliance with prudential requirements and be satisfied that expected processes and risk management are in place. Therefore it is incumbent on the Trustee to demonstrate:

  • Due Diligence policies and processes;
  • Expectations with respect to the operational processes of investment managers; and
  • Evidence for all appointments, and ongoing monitoring, of the required Operational Due Diligence and how the overall assessment was made.

What is the AIST Operational Due Diligence Guidance Note?

In 2017, AIST released an ODD Guidance note that had been developed by fund representatives on our ODD Working Group.  It is a cost-effective framework to help AIST member funds meet their due diligence obligations. The Guidance Note has been adopted by many funds, ODD providers and by more than 35 fund managers. 

The AIST ODD Guidance Note can be viewed here.

The Operational Due Diligence Fact Sheet can be viewed here.

What are the advantages of the AIST Guidance Note?

  1. Using the “Investment Manager” report as a base upon which a superannuation fund does their bespoke analysis, time and resources are saved by reducing the quantity of engagement necessary and allowing focus on a specific aspect of a manager’s process that may need attention.
  2. A superfund, in many cases, has access to a manager’s ODD report prior to appointment and therefore has more information on which to base a decision. This should lead to mandates being funded more quickly - a benefit to both investor and investment manager.
  3. The practical implication of all superfunds requesting duplicative work from a very limited field of ODD providers is eliminated.

Australia is not alone in seeing the merits of the “Investment Manager” ODD model. AIST is aware of two global providers expressing support for the model. It is encouraging to receive this explicit support as global providers have been wedded to an alternative method (the investors pays model), but understand the benefits and efficiencies of the approach introduced to the Australian market.

It is also encouraging to have the support of most of our members who have resolved to follow the GN to varying degrees, depending on internal resourcing.

The list is growing, but to date there are approximately 85 investment managers in Australia (both local and global) who have committed to following the GN. In addition, we note that a couple of additional ODD providers are offering their services, a trend which is expected to continue and which can only help improve quality and increase pressure on pricing, a trend we cannot ignore. Currently AIST is in close dialogue with 5 providers.

Dialogue continues with APRA and the FSC, both supportive of the approach.

AIST continues to work diligently to improve the landscape for all members ensuring greater efficiency and cost savings across the industry. 

What template can funds use to write to investment managers regarding operational due diligence?

AIST has issued a template letter for writing to investment managers regarding operational due diligence of investments. The template letter can be viewed here.

What has been the industry feedback to the Guidance Note?

In response to industry feedback, the AIST User Group has considered a view that the AIST model cedes control of the ODD review process to the investment manager and reduces the independence of the ODD provider. This runs counter to APRA guidance.

While a worthy observation, the AIST model accepts that the responsibility of the assessment of the ODD review, with regard to their investment proposition, remains with the investor (the Superannuation Fund) whichmust be satisfied of the veracity and completeness of the report. It is anticipated that the investor can, and must, consider in depth any aspect of the assessment on which they might have concerns or questions. To this end, the GN is a complementary aid to the investor’s analysis of ODD risk.

AIST observes that there are precedents of manager-appointed external service providers (external audits, controls reports) which have the potential for similar conflicts but have gained acceptance within the industry.

In developing the GN AIST was very cognizant of the impracticalities of following the “Manager” model. Consider the time and costs involved in 60 AIST member funds all commissioning individual ODD reports on their managers. If each Fund has, say 50 managers, the number of reports required totals 3000 (this is considered a conservative estimate). Given there are approximately 5 “mainstream” providers, each would have to complete, on average, 600 reports. Even allowing for some doubling up of managers, this is a huge project that would require resources that are currently not available in the Australian market.

Where can I get more information?

Further enquiries can be directed to AIST senior policy manager David Haynes at dhaynes@aist.asn.au or on +61 3 8677 3800.