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Operational due diligence important to mitigating risk

21st May 2018

By: Anine Kilian

Contributing Editor Online

     

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Investing in operational risk management is key to mitigating corporate fraud, poor governance and simple errors which result in losses for companies and consequently investors, Mercer Sentinel Africa Middle East, India and Turkey head Nigel Morriss said on Monday.

Addressing media at a briefing in Johannesburg, he noted that the role of good governance, including the accountability of the board, its true independence and the appropriateness of its composition, could not be overstated.

“No organisation is too big to fail and investment institutions operate with concerning risk levels,” he said. 

He highlighted that, recently, several instances of lax due diligence in the operational space had resulted in sizeable losses for companies and their investors.

Recent headline-grabbing examples include the case of the Madoff Ponzi scheme in 2008, which resulted in $50-billion of losses; Axa Rosenberg in 2010, with $217-million of losses owing to an information technology coding error; and MF Global in 2011, with $2-billion of losses stemming from an alleged failure to protect segregated client accounts.

He further added that the Steinhoff case, for example, highlighted the importance of a proper corporate governance structure.

Reports emerged in 2017 suggesting that the South African international retail holding company was involved in alleged massive accounting fraud, including the overstatement of the company’s financial position.

“Bond yields blew out to more than 14% the week the scandal broke and Moody's Investors Service slashed the company's credit ratings to junk . . . and then slashed them again three weeks later,” he said.

Morriss, meanwhile, highlighted that the historical lack of attention to operational due diligence was changing, particularly in the face of new and evolving regulations that mandated a thorough assessment of operational processes and controls.

“When overseeing an institutional investment programme, the predominant focus is invariably on investment returns and risk management. Asset owners are inundated with information and resources to help manage their investment portfolios,” he noted.

In contrast, he pointed out that operational risks and costs associated with investment implementation, and the use of third-party service providers, had typically received limited attention in the past.

However, he said some investors recognised the increasing complexity of operational processes, regulations and compliance and the costs and risks associated with the same.

“A comprehensive risk assessment should include a thorough overview 
of the front, middle and back office functions — that is, investment due diligence focusing on alpha generation and operational due diligence focusing on the risks and costs of execution that could result in alpha erosion,” he said.

He added that, in the face of a rapidly changing investment and regulatory environment, institutions were being held equally accountable for managing both investment and non-investment risks.

Prudent institutions can no longer afford to be complacent about non-investment-related risks and the potential consequences of ignoring the same, Morriss said.

“Good governance dictates that operational due diligence assessments receive greater focus as institutions seek to meet their fiduciary commitment to their investors. Despite the relative lack of expert resources in this space, institutions are required to be aware of these risks and to actively manage them,” he said.

The previously prevalent approach of a superficial “check the box” exercise will no longer meet regulatory scrutiny and institutions’ fiduciary burden to investors. Organisations will now be required to conduct a comprehensive operational due diligence exercise.

Morriss noted that this exercise should include an assessment of global standards and best practices such as governance, controls and processes, investment operations and execution risks, and service providers.

“Operational due diligence should not be viewed as a static exercise; rather, it is a constantly evolving framework of key elements that are critical to the assessment of 
an organisation’s middle and back office operations and functions,” he said.

Edited by Chanel de Bruyn
Creamer Media Senior Deputy Editor Online

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