Operational Due Diligence (alternative Investments)

Operational Due Diligence (alternative Investments)

The phrase Operational Due Diligence (ODD), in the context of alternative investments such as hedge funds (or private equity, infrastructure, real estate, commodities and so on), means different things to different people.

As the words themselves imply, an ODD exercise is an investigation (due diligence) into operational factors, relating to a specific alternative investment entity such as a hedge fund (or private equity fund, or infrastructure fund, etc.), which may impact future results of the target alternative investment entity.

The field of ODD has gained prominence over the past years due to the failure of hedge funds such as Amaranth Advisors and the Bayou Hedge Fund Group. Also contributing to the increase of interest in this field were the actions of alleged rogue traders such as Brian Hunter and alleged Ponzi schemers such as Arthur Nadel, Jérôme Kerviel and Bernard Madoff.

Operational risks, put simply, are the risks arising from execution of the business functions of any entity, for example an alternative investment fund, and these are distinct from its investment functions.

An ODD exercise does not include within its scope the investment functions of an alternative investment fund and therefore generally does not include the gathering, analysis and verification of information relating to the historic actual or future expected investment performance of such funds, the variance or future expected variance of the returns of such funds, or the appropriateness of the stated strategy of such funds as a (potential) constituent part of the investor’s wider portfolio, except insofar as these investment functions are or could themselves be adversely influenced by operational risks.

However, a separate “Investment Due Diligence” (IDD) exercise is often carried out by or on behalf of (potential) investors to consider investment functions. In fact, historically, it can be said that it has been more common for an IDD to be performed than for an ODD to be performed, despite strong academic arguments and empirical evidence that overall risk (i.e., investment risk and operational risk) is best capable of being understood and mitigated where both an IDD and an ODD are performed.

Read more about Operational Due Diligence (alternative Investments):  Importance, Purpose, Comparison To Operational Risk Considerations in The Context of Banks' Prudential Capital Requiremen, The Problem With Adopting A Banking-style Approach To ODD, ODD Framework Design For Fund of Hedge Funds, Operational Due Diligence On Private Equity, Recent Developments in ODD, Choosing An ODD Provider, See Also

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