Understanding an investment strategy is only part of the equation, how it is executed can be just as critical. In this Q&A, Erika Jordan, Managing Director at Channel Diligence (Australia), shares insights on operational due diligence (ODD), explaining what it is, why it matters for investors, and how robust operational practices can both mitigate risk and create tangible advantages.
Operational due diligence (ODD) is the process of evaluating the non-investment aspects of an investment manager’s operations, everything that supports the investment strategy. This includes areas like governance, compliance, risk management, technology, cybersecurity, valuation practices, and third-party relationships.
It matters because even the best investment strategy can fail if operational risks aren’t identified and mitigated. Issues like weak internal controls, poor cybersecurity, flawed valuation processes, or inadequate disaster recovery can lead to financial loss, reputational damage, or regulatory breaches. For investors and allocators, ODD provides assurance that the investment manager can safely and effectively execute their strategy, protecting capital from risks unrelated to market performance.
Inflated or overly optimistic valuations can distort an investor’s understanding of an investment’s true worth, particularly in private market funds where pricing is less liquid. These risks often stem from aggressive growth assumptions and the absence of external valuations.
Conflicts of interest is a critical risk area for investors. Conflicts can arise when investment decision-makers have competing priorities that compromise objectivity, for example, channelling capital toward affiliated businesses and structuring deals for personal gain, or undisclosed related-party transactions that benefit insiders.
Cybersecurity is a fundamental component of due diligence. Data breaches, ransomware, and weak IT controls expose investors to risks such as operational disruption and diminished trust, factors that can materially impact valuations and returns.
Limited disclosure around financial statements, compliance, and insider investments can hinder informed decision-making. This lack of transparency can lead to risks such as overcharging expenses, undisclosed related-party transactions, and misalignment with client interests, creating significant risks for investors.
I can think of many examples of operational losses, but in many of these cases the investment strategy itself wasn’t sound, such as Bernard Madoff’s Ponzi scheme or Nick Leeson’s unauthorised speculative trading at Barings Bank, which ultimately led to its collapse. However, one example where the “strategy” itself was solid is the Knight Capital incident in 2012. Knight was a major market maker with a sound, profitable trading process based on algorithmic trading.
During a software update, old code that should have been removed was accidentally reactivated, causing the trading system to send millions of erroneous orders across multiple stocks. The result was catastrophic: in just 45 minutes, Knight Capital lost $440 million, wiping out much of its equity and forcing a rescue deal. The trading strategy wasn’t flawed, the failure was purely operational, stemming from poor deployment controls, inadequate testing, and the absence of an effective kill-switch.
This case highlights why operational risk management is as critical as investment due diligence. Even the best strategy can fail if processes, technology, and controls aren’t robust.
Yes, absolutely. Strong operational discipline can create very tangible benefits for investors, often beyond risk mitigation. For example, investment managers with robust governance, clear segregation of duties, and well-documented processes tend to handle market stress or unexpected events far more effectively. This can mean smoother liquidity management, accurate valuations during volatile periods, and timely investor reporting, all of which protect investor confidence and capital.
I’ve seen cases where firms with strong information security and business continuity plans were able to maintain uninterrupted operations during cyber incidents or natural disasters, while peers struggled with delays. Similarly, investment managers who proactively disclose regulatory interactions and internal issues build trust with investors, reducing reputational risk and strengthening long-term relationships.
In short, operational excellence isn’t just defensive, it’s a competitive advantage that enhances resilience, transparency, and investor confidence.
At Channel Diligence Australia, we assess 10 core areas, including organisation, governance, personnel, investment/trading process, operational processes, valuations, compliance, information security, service provider oversight and business continuity/disaster recovery (BC/DR). In my experience, all 10 areas are equally important because a weakness in any one of them can create significant risk. For example, I’ve seen very well-known and established managers receive qualified internal control reports, sometimes the issues appear exactly where you least expect them.
ODD today requires tailored questionnaires and interviewing styles that align with the investment strategy and regulatory expectations. For example, valuation scrutiny for a private market fund with Level 3 assets should be far more rigorous than for a manager trading liquid Australian stocks. This is especially important because Australian super funds allocate a significant portion of members’ money to private markets, where complexity and opacity demand greater scrutiny.
We continuously monitor regulatory developments in Australia and globally, adapting our framework to address emerging trends and risks. This dynamic approach ensures that operational due diligence remains relevant, robust, and capable of protecting investors in an evolving investment landscape.
Start by implementing ongoing monitoring, not just point-in-time checks prior to investment. Continuous oversight of managers’ operations, governance, valuations, information security controls, insurance arrangements and compliance practices is essential.
Additionally, identify all critical fourth-party providers such as administrators, prime brokers and IT vendors. Understanding these dependencies helps assess resilience and contingency planning. These steps significantly reduce operational risk and protect portfolio integrity.
They are open to feedback, actively seeking input from ODD professionals to identify blind spots and strengthen processes. They also build a culture of compliance, ensuring that risk management is embedded in the firm’s DNA rather than treated as a checkbox exercise. Transparency is a defining characteristic, including proactive disclosure to investors about regulatory interactions and even sensitive internal matters such as harassment allegations. Many institutional investors are highly attuned to reputational risk and expect to hear about these issues directly from the investment manager, not through the media. Finally, they enforce strong governance, with clearly defined roles, segregation of duties, and robust oversight mechanisms.
These practices not only reduce operational risk but also build resilience and trust with investors, an essential foundation for long-term success.
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