Operational Due Diligence (alternative Investments) - The Problem With Adopting A Banking-style Approach To ODD

The Problem With Adopting A Banking-style Approach To ODD

Some forms of ODD fit neatly within the banking paradigm as described above, in that they look at a discrete number of operational factors, assign probabilities, co-relations between factors and estimated losses (generally based on extrapolations of historic data) and eventually come up with a single metric (analogous to the “operational risk requirement” of a bank) which is then compared to a pre-set threshold to give a simple binary answer to the invest / don’t invest or remain invested / divest question.

Despite according neatly with the theory, such forms of ODD have severe limitations; for example such forms:

• tend to incentivise “window-dressing” behaviours by the manager of the alternative investment fund (as a checklist-based approach is often employed with the majority of the questions being easily foreseeable by the manager of the alternative investment fund);

• often utilise less-experienced personnel without the experience to ask the right follow up questions or “smell a rat”;

• tend not to react (or not to react quickly enough) to new or developing risks which are industry-wide or to risks that are specific to the alternative investment fund in question or pertinent to the specific investor;

• tend to apply weightings to the risk factors addressed that are static and based on historical data, whereas in reality future likelihood of risk crystallisation and quantum of expected loss on crystallisation are dynamic variables;

• tend to apply correlation factors to separate risks that are static and based on historical data, whereas in reality correlation factors are dynamic variables; and

• tend to give binary results without identifying conditions which the investor or potential investor may seek to put in place (via negotiation with the manager of the alternative investment fund) to reduce the overall level of operational risk associated with a new or existing investment.