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AlphaWeek Q&A: Mark Flanagan, Risk, Special Projects and Operational Due Diligence, Aon Hewitt

AlphaWeek’s Greg Winterton spoke with Mark Flanagan, a Principal in AON Hewitt’s Global Investments Practice in London, about 2 roundtables he runs - a new Chief Operating Officer (COO) roundtable, which held its inaugural meeting on November 2nd at AON’s office in London, and his already established ODD roundtable, which is into its third quarter of existence.

GW: Mark: to start us off, on Thursday November 2nd, you held your inaugural COO event; tell us more about that and how it came into being.

MF: I wanted to create a forum where it was safe for COOs to ask questions, and for seasoned ODD professionals to assist, by giving an insight to what institutional investors are looking for, not only generally, but also from a topical standpoint. The COO roundtable is unique in that the agenda was set, and will continue to be going forward, by the COOs themselves. Most industry conferences are high level and usually there are one or 2 ODD professionals speaking and there is no time for Q&A; my roundtable is 100% Q&A with senior ODD professionals from nine different firms. There are no manager presentations, no selling, nothing like that. For me, that type of interaction is a first in the market.

At the event itself, we had 70+ COOs in attendance; they were given the opportunity to send in a list of topics for discussion ahead of time and we ended up with an agenda of 40 questions which we broke into various categories including a rapid-fire round, technical, service providers (including administrators, independent directors, IT and cyber security and finally a round specific to start-up / emerging managers. All category had a Q&A session at the end.

The issue of investor feedback to the COOs was also a hot topic. Some ODD/ investors don’t give feedback which I feel is a mistake, partially if a manager is open to addressing any concerns that the investor may have; similarly, some COOs don’t bounce ideas off investors, which can also be a mistake. There is almost this imaginary line between investment managers/COOs and investors and their ODD teams: I think we should all be on the same page and free to discuss items in an open manner. Quite often, investment managers don’t want to ask a question of their investors for a perceived weakness, and be either humiliated or looked down on; so, the idea of the COO roundtable is to keep everything out in the open and transparent. Risk - or rather preventing risk - is my day job. The safer I can make the industry for all investors, the safer it will be for my investors. I want to try to enhance overall market standards so that they become not only best practice but standard practice across the industry. After all, we are all in the business of making money and keeping risk low, from both sides.

Mark Flanagan
Aon Hewitt's Mark Flanagan

GW: Regarding the make-up of the ODD roundtable, who is represented, and where are they from? Will you be focusing on specific asset classes?

MF: We’re open to any asset class – hedge, private markets, long only – that’s the idea. If you’re doing due diligence, you’re welcome to join. The constituents are primarily in London, because that’s where I’m based, but we have participants from the US and EU as well. I have requests from COOs, ODDs and other folks to host something in the US, and, whilst I have no immediate plans to host a physical roundtable in, say, New York, the US ODD folks are on the mailing list, they do get a copy of the agenda and meeting notes and often contact me for a one on one conversation to bounce ideas off.

GW: What have been the main results of these meetings so far?

MF: The ODD roundtable consists of ODD professionals from firms like Mercer, Willis Towers Watson, AXA, Santander, Aberdeen - it’s people from various financial institutions who would be investors or allocators, but we also have representation from AIMA and the CFA. We have around 100 people globally on the distribution list, and 40+ of these have attended one or both previous meetings in London. We have another meeting coming up on November 30th. It’s an eclectic group – we at AON advise on over $5trn of assets, but we’re also working with family offices that advise on less than $1bn. Some work with hedge funds only, some private markets only, some long only.

I was conscious that many roundtables just talk shop, and I wanted to produce something useful, so we had a sub-group of the ODD roundtable put together a directors DDQ, an administrator/firm level DDQ and a fund-specific DDQ because the idea was to create something that we can all use as investors. The original DDQs were written by those who answered the questions, so that was an obvious conflict of interest; furthermore, DDQs were not asking the questions investors wanted to ask. They were often too open, resulting in generic, marketing style answers. It was a good document to get an overview of the manager, administrator or director, but it didn’t help to understand risk.

I felt the documents needed to be revised to ask more specific questions. Consequently, the questions on the new DDQ are more binary and risk based. I’d like to note that a DDQ is to highlight certain areas; it is not meant to cover everything. If the DDQ highlights a risk, it’s something we will discuss in detail. Managers will always get a chance to address any of these concerns.

GW: Investment managers will want to know what the main things are which ODD teams like yours want to know about their firm/fund. Can you give some guidance here please?

MF: There are a raft of things an investment manager should be prepared to speak to. We want to know about the control or ownership structure of the firm - who has what influence, and what is the culture? We want to know about the infrastructure of the fund; what is the adoption of technology? What are the segregation of duties and competence of the staff? How do they assess, respond to and tackle risk? What service providers are being used, what for, and what is their quality and independence? What about the safekeeping of assets and the ability to liquidate them?

GW: Are you seeing any trends from a geographical perspective – i.e. are UK/European investors looking for anything specific vs. US investors, for example, that managers need to be aware of when pitching investors?

MF: I can speak more to trends of the managers more than investors, but I have observed that the gap in independent governance between the US and Europe – where the US previously lagged - has closed in the last few years, particularly in hedge funds.

There is still a large gap between private markets firms (Private Equity, Real Estate, Infrastructure) and liquid asset classes with respect to independent oversight. In PE, there is less take up of LPACs (Limited Partner Advisory Committees) due to litigation risk, which actually leaves a hole in governance. We’re also seeing more synthetic boards where the GP is an LP, but it’s not something that investors are comfortable with because it hasn’t been proven.  We are pushing to have administrators be appointed to, or if they have been, to have more responsibility over the custody of the assets (cash and portfolio) of the fund and the SPV, i.e. being a signatory on the bank account, and also be responsible for and to be part of the sale or disposal of any asset. Most ODD teams would agree that this is the biggest risk to this asset class and we are looking to have these controls implemented.

ODD teams are now looking at counterparty risk in greater deatil, whereas years ago this may have been more the remit of the research teams.

GW: What advice can you give to, say, a younger fund that is getting ready to start pitching institutional investors for the first time? Are there common mistakes that you see these firms making when they are going through the ODD process?

MF: For every manager looking for an investor, there is an investor looking for good returns. Larger managers are – operationally speaking - a safer bet, but younger managers, with a good track record should not be afraid to approach a large investor.

When you do, the number one thing to consider is ‘transparency, transparency, transparency’ – warts and all. Assuming the returns are consistent, the investor must feel confident that you are looking after them first and yourself second. This will ensure a long term and solid relationship. To that end, your COO is the most important appointment, as it’s likely out of the area of expertise of the person launching the manager, i.e. the portfolio manager. Whilst you need someone with the technical skill set, you also need someone with gravitas that you can put in front of investors.

Many investment managers outsource a lot of the back-office and support functions, which is not a problem, but you need a COO that can manage and challenge those relationships. You can outsource these functions, but you can’t outsource the responsibility for it to work.

Finally, on this note, remember that the cost to an investor of performing due diligence on a small / emerging manager will be more detailed, onerous and costly than a larger one; the costs could run to anything from $100-200k and more if it's chargeable time. If an investor is restricted to say 10-20% of a fund or AUM of the manager, that could mean a small ticket (for the investor) and thus not worth the effort.

GW: And what about the larger, more established funds? Are you seeing different themes emerging that these firms need to consider?

MF: Not really. Larger managers are being more transparent than, say, five years ago, but themes are less about size and more about asset classes or jurisdiction / regulation. Larger managers tend to have a more conservative investor base compared to smaller managers, so the difference in themes is that you would have the larger managers leading the theme to set best practice and others following.

GW: Regarding a fund’s service providers, what information are ODD teams at the end investor looking for here?

MF: This has changed quite a bit over the years. On the administrator side, they have become more transparent, but they have also taken on a larger role, including some regulatory reporting. We now have DDQs for the administrators and, more recently, the directors. Directors are also being challenged like never before; for example, we want to know what the work that they’re doing is, and we want to be able to evidence this and importantly, we need to ensure that they are capable and prepared to challenge the manager and the eservice providers of the fund. There is less of a shroud of mystery now about directors than there was a few years ago.

We’ve long conducted onsite visits with administration firms, but we now have them with directors, IT service providers, compliance consultants and valuation agents. On the IT service provider side for example, we are looking at their capacity, scope, service offerings and market position

In the hedge fund space, post-Madoff, the investment manager due diligence process is quite evolved, and is a mature industry now.  Basically - the reviews these days are more holistic and detailed than ever before.

GW: Still on service providers, but focusing more on technology now. Funds likely want to be able to use technology to expedite the ODD process, but do end investors have a similar appetite for using these tools? Does some of this technology detract from the human process involved in manager selection?  

MF:  Tech doesn’t detract from the process, it assists, but if you rely on tech alone, you are always at more risk of missing something subtle. For example, tech allows the manager to prepare their responses in advance, however the creates situations where they are under no pressure to respond immediately. In a face to face meeting, you can see someone’s body language, but it also allows the ODD professional to stray into other areas, as well as keeping the conversation flowing. This is why I’m not a fan of video conferencing – you need a more relaxed setting to get to the bottom of things. Furthermore, certainly for the smaller manager, if you are not prepared to sit down in front of a manager and discuss your investment face to face, you are taking too much risk.

GW: What are your clients asking you about MiFIDII and therefore what impact do you expect it to have on the ODD process?

MF: Clients want to know how prepared managers are for MiFID II. It is part of the ODD process, though it’s difficult to access pre-implementation, as there is nothing to test and managers are still in the implementation phase. Naturally we would be concerned if the managers had not completed their gap analysis and thought about external assistance. Research fees is the big topic on investors mind but less of an issue with respect to ODD. I would expect a lot more OOD work to start post Jan 3rd 2018 where ODD teams are better able to benchmark managers implementation efforts.

GW: The other big thing is cyber security. Data breaches are happening more frequently now, and the UK FCA is investigating the recent Equifax breach, for example, so it’s very much on the radar of the regulators. What are investors looking for from managers with regards to their cyber security processes?

MF: Cyber is a hot topic and has been for a few years. We are expecting firms to have annual penetration and vulnerability tests and to have these testers / consulting firms rotated annually too, and we expect the testers to be internally and externally tested. Importantly, we expect managers to react immediately to any critical or high-risk areas noted on the report.

GW: Before we sign off, let’s quickly go back to the COO Roundtable you hosted in London recently. What’s been the initial feedback on that?

MF: I received a surprising amount of positive emails the day after the meeting. In particular, a comment from a COO which really stood out and is exactly what I was trying to achieve: “Massive thank you for organising last night and to you and the panel for all your insights. It was the first time I felt that ODD is not a “them and us” event but a “shared we” event. Understanding the process from your side the quantum of the “buy in” you make was a real eye opener, and makes me appreciate more your role in all of this.”

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