Trust, but verify due diligence on long-only equity strategies, consultants say

Operational due diligence for long-only equity strategies can fall short when compared with efforts to look under the hoods of private equity or hedge fund operators, industry insiders say.

And that’s a mistake, they add.

“I think in the U.S., some (asset owners) have this perception that there’s less risk, which is not true,” said Gregg Sommer, Chicago-based principal and head of Mercer Sentinel Group’s investment manager operational risk assessment team for the Americas.

Mr. Sommer added: “The concept that a long-only or mutual funds don’t have many of the same risks is a false perception.”

Long-only is perceived as a more straightforward, less complex structure with fewer moving parts, he said. And asset owners tend to assume risk associated with a long-only equity strategy is low because it often is offered by large, well-established organizations.

Operational due diligence is generally recognized as everything from scrutinizing the manager’s personnel, processes and procedures behind operations, examining its compliance policies and procedures and confirming its cybersecurity and disaster recovery systems. Efforts to scrub these back-office operations gained traction around 2010, fueled by big headlines over the collapse of Ponzi schemers that included Bernard Madoff.

Though there haven’t been major implosions specifically related to long-only strategies, events like the Madoff scandal and when the U.S. Securities and Exchange Commission charged F-Squared Investments Inc. with defrauding investors with false performance advertising – an event that ultimately led to the firm’s bankruptcy in 2015 – are reminders of the importance of conducting thorough operational due diligence and that asset owners need to be vigilant.

John B. Kemp, managing director for operations and risk at the $48.5 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, agreed that the operational due diligence done on long-only equity strategies by consultants in general “receives less emphasis” than that of hedge funds, “but that doesn’t mean there aren’t risks we need to be cognizant of.”

James H. Grossman Jr., PennPSERS’ chief investment officer, added: “If you look at the operational due diligence along a continuum, the hedge fund consultants provide the most in-depth operational due diligence you’ll see. It gets progressively less in-depth as you move towards traditional asset classes.”

Mr. Grossman said this is often because of the complexity of the strategies. “Hedge funds are using more exotic strategies, they use leverage and they bring in different types of risk.”

Michael J. Benson, senior investment professional in PennPSERS’ risk group, added, too, that he and his team have seen “an expansion of focus” on operational due diligence for long-only equity shops.

However, although most long-only mutual fund and separate account structures can seem sturdier and less risky than alternative investments, risk can still exist.

“With complexity comes risk, with size comes complexity. And those things have to be monitored,” Mr. Sommer said.

Thusith Mahanama, co-founder and CEO of the Boston-based client reporting services provider Assette LLC, agreed that long-only strategies have fewer unknowns than those of alternatives. But just because the industry practices for long-only structures are well-established, firms conducting the due diligence should still verify that individual firms are indeed following such practices.

“Relative to (other) alternative investments, a lot goes into private equity. One reason is the infrastructure and operational structures for equities are more plain vanilla than the ones for alternatives,” said Mr. Mahanama.

Ultimately, asset owners are more comfortable with long-only equity because it’s connected to public markets and established processes, Mr. Mahanama said. However, he noted that it’s important to go beyond just the track record when examining a long-only strategy. The operational due diligence process needs to ensure there are people, processes, infrastructure, technology and compliance to support the investments.

“From time to time we hear the best investment strategies go off track because of operational issues,” he said. “Just because it’s an established strategy doesn’t mean individual firms are following processes.”

He added that although most firms do follow a standard process, those conducting the diligence need to “trust, but verify.”

If operational due diligence is not thorough, Mr. Mahanama warned that investors can face problems ranging from vulnerability to a cyberattack (if the long-only shop doesn’t have proper cybersecurity) to losing data (if no proper backup or disaster recovery controls are in place) to compliance and regulatory issues.

Rian Akey, a partner and global head of operational due diligence at Aon Hewitt Investment Consulting Inc., told P&I although he doesn’t believe operational due diligence in long-only equity strategies are lacking, it can be inconsistent from consultant to consultant and “a relatively nascent discipline.” He added that discipline is important to protect the investor from various forms of risk, and it’s a discipline investors are beginning to take more seriously.

“By and large (operational due diligence) gained most of its toehold post-Madoff,” Mr. Akey said, referring to Bernard Madoff scandal. “Now, with people thinking more critically on what risk operational due diligence can identify, it’s becoming more expansive. But on the whole, the discipline is about 10 years old, maybe less than that.”

Mr. Akey also noted the process for long-only “is evolving.”

“We’re seeing more clients interested in this. Some groups are already all in and making it an underwriting standard in their process. Others are starting to tiptoe into it a little more,” he said.

One money manager that P&I spoke with said he was “surprised” to hear that consultants are finding the operational due diligence being done on long-only shops is inconsistent, since that’s not been his experience.

“We definitely get some pretty thorough due diligence questions from our clients,” said John Haller, chief technology officer and head of operations for Legg Mason (LM) Inc. (LM) affiliate ClearBridge Investments LLC.

Mr. Haller noted, however, that it is possible that asset owners perhaps do not need to do that much to figure out if a long-only equity manager has a strong and secure platform.

“No one has unlimited time to explore something in the depth they’d like. It may not take a long time for (an investor) to get a sense of the maturity of a firm with a long history and robust processes in place,” Mr. Haller added.

Michael Rosen, a principal and chief investment officer of Santa Monica, Calif.-based consultant Angeles Investment Advisors LLC, said he sees no problem within the industry but understands why there’s typically more effort in evaluating the operational efforts of hedge funds than long-only.

“Up until recently, hedge funds weren’t required to be SEC-registered. So historically, (the industry) got into the habit of doing extra due diligence on the operational side of hedge funds simply because there was no regulatory oversight of their process.”

But now that hedge funds generally are registered with the SEC, they’re still given extensive due diligence, typically because they’re more complicated than long-only shops. “Long-only shops have always been SEC-registered, so there’s been some regulatory oversight for some time. So that gives us some comfort. So the due diligence review is simpler,” Mr. Rosen said.

“I don’t think there’s any issue. I’m very comfortable with our operational due diligence. It’s extremely thorough. We’ve not had any problems.”