Why Investors Are The New Regulators Of Alts

By Bob Goldbaum, SVP Product & Market Strategy, Backstop Solutions Group

You thought the U.S. Securities & Exchange Commission (SEC) was tough on the private investment industry? Wait until you meet the new regulators. You know them already. You do business with them every day. The new regulators are the investors – your Limited Partners (LPs) - you seek as clients.

In recent years, the SEC has been more closely scrutinizing the private investment industry. Whether or not they will continue to do so is up for debate. But it is a moot point, because the SEC’s laser gaze has had an unintended (but not unexpected) consequence: along with operational failures and fraudsters, it has motivated institutional investors to demand for themselves a new degree of transparency from the managers they invest with.

We’re not talking about portfolio transparency. As an alternative investment firm, you probably frequently debate the right to keep your intellectual property – your positions and trades – confidential.  Investors are focusing on and demanding operational transparency. Put simply, they want to know that that you are running a tight ship before they invest their capital. This makes investors the ultimate regulators, because if they don’t like what they see, they won’t invest. The net result for managers is to comply or risk eventual shutdown due to a lack of investment capital.

Many institutional investors  have dedicated Operational Due Diligence (ODD) teams to evaluate the organizational quality of alternative investment firms. These ODD teams may be composed of internal experts or external consultants (outsourcing is a very common practice for LPs). The Due Diligence Questionnaire (DDQ) is usually the first level of inquiry used by ODD teams, followed by more detailed probes into a manager’s operations and third party vendors.

ODD teams are now more rigorously scrutinizing matters such as:

  • The nature of and adherence to operational policies and procedures
  • Compliance procedures and mock audit results
  • Oversight of and accountability for all aspects of daily operations, regardless of whether tasks are performed in-house or through a vendor
  • End-to-end cash management practices
  • Fee and expense allocation guidelines
  • Regulatory compliance within any country where funds are sold
  • Employment, compensation, and incentive practices
  • Cyber security

It’s critical to remember that Investment Due Diligence (IDD) teams might vet a strategy, see that it is generating an attractive alpha, and want to invest – but they usually can be vetoed by the ODD team. The ODD team is looking for red flags on the operational side of the business. A red – or even a yellow – flag can be enough for the ODD team to nix the potential investment as too risky for the investor.

Should the fact that investors are taking on the role of the new regulators cause concern for you? Not if your operations are of institutional quality. There’s really no reason not to disclose as much as possible about your operations to potential or current investors. The real question is, how well equipped are you to answer these new institutional demands and requirements of their ODD teams?

You may think  that you have the best overall investor services operations in the world and use the top service providers, but if you don’t have centralized client and account information in industry-specific systems that also help with compliance efforts, an ODD team might recommend against investing with you.

It’s time to move beyond the spreadsheets and generic software that cause unwanted complexity and confusion to a data repository and reporting system specifically built for the private investment space. A system that can help you capture operational data quickly and provide the organizational transparency that accredited investors and their authorized, interested parties want. If you have anything less, your next investor-driven ODD effort might not generate the results you are looking for, harming your chances of raising and retaining capital.

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