How Advanced Operational Due Diligence Helps GPs Stand Out to LPs

Updated on: February 8, 2024

Not so long ago, GPs rarely shared due diligence proactively. Now, LPs expect it.

Being an expert dealmaker isn’t enough. The elite GPs of today realize that understanding the nuances of fund administration and putting adequate risk management procedures in place is on par with having an optimal fund composition.

In essence, operational due diligence (ODD) is an evaluation as to whether a prospective manager is prepared to deliver strong or expected returns, securely as assessed by criteria such as historical track record, collective investment team experience, anticipated fund strategy, and incident response plan.

ODD serves as a litmus test of what LPs can expect from GPs down the road and shows whether a manager is transparent in the eyes of investors.

Prioritizing the Operational Due Diligence Timeline

As part of due diligence questionnaires (DDQs), response time and preparedness are top indicators of how well a GP can meet LP expectations. Proactively meeting industry standards, such as those outlined by ILPA, could help attract investors.

“What I think helped propel that trend of transitioning to outsourcing is that there was so much operational due diligence being done in the hedge funds space, and LP’s were so used to having a third party fund administrator or prime broker. I believe it will continue to trend in that direction, which is great news for Gen II.” - Kristine O’Connor, Managing Director and Chief Financial Officer, Franklin Park

GPs should both highlight their successful history of executing good due diligence and show how they have plans in place to mitigate future risks. Understanding future ODD triggers, such as key man clause activation or failure to meet ESG targets, is essential for managers looking to effectively manage their relationships with key LPs.

The lifecycle of ODD does not cease once the check is signed, and remaining prepared for future diligence is something that fund managers must stay vigilant about post-close.

Demonstrating an understanding of compliance also plays a key role in properly executing ODD, especially as regulation continues to evolve. ODD that shows how a GP can adapt based on real-time changes instills confidence in LPs. Managers who can’t speak to how they plan to address industry changes raise a red flag in the eyes of a prospective LP.

Third Parties As ODD Assurance

With such high expectations and myriad layers of ODD, delegating to a trusted partner is a sound strategy. A fund administrator is well-versed and well-practiced in compliance, reporting, and transparency to deliver peace of mind and can differentiate GPs. A reputable partner provides an extra layer of insurance, which is especially important if a GP’s internal capabilities aren’t substantially built out.

Even more, third-party valuations are often considered the gold standard. GPs can seamlessly upkeep a reporting cadence without concern of inherent bias. Third-party providers can place financial statements and cash flow tracking documents directly into the hands of LPs quickly, while also ensuring GPs are aware of any discrepancies that might make the difference for getting a fund allocation.

Accuracy is just one part of their overall approach to mitigating risks, as LPs are increasingly looking for GPs who embrace technological innovation and data-driven strategies. Strong digital capabilities are now a hallmark of a trustworthy GP.

“From a cybersecurity perspective, if you do have an internal team who's looking after your IT infrastructure, it's a good idea to have a third party come in and kick the tires because they're independent. They can do an internal-external penetration test and double check the controls and security you have around the system.” — Elizabeth Ferry, Director, Operational Due Diligence at StepStone

Cybersecurity, for one, is a top focus for investors. Just like views have changed on how a GP selects a bank, a manager’s cybersecurity capabilities are paramount. In terms of remediation, managers prepared for ODD can provide their LPs with clear plans, including details about treasury management reporting in the event of a crisis.

Tech Stack Tipping Point

Elite GPs are noted for their tech stacks. The technology enhances the speed, accuracy, and depth of their due diligence processes. This extra edge is even more important as private market investments dwindle, making them stand out and enabling them to exceed LP expectations.

GPs looking for new LPs to allocate or existing LPs to reallocate must create a modernized tech stack to maximize operational due diligence practices that can evolve alongside a changing industry. An enhanced tech offering can help provide insights into complex risks mitigated by operational due diligence, from cybersecurity to ESG reporting.

“They [LPs] are looking to understand the steps that you're taking in your ODD process and, as the GP, what you're telling your investors about your ability to protect data, the security you put around it, and technology that you're utilizing in that regard.” — Jeff Gendel, Principal at Gen II Fund Services

In such a competitive market, prioritizing ODD enables GPs to stay ahead of investor requests, deploy trusted tech, mitigate risks effectively, and ultimately produce returns in an uncertain environment. Not only will ODD continue to remain a key part of the LP-GP dynamic, but GPs who leverage LP feedback and findings during this phase will find they can improve their internal processes, even after handshakes have been made.

Published on: February 8, 2024

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