An investment can fail because the strategy did not work. That is a risk investors accept knowingly; it is what they are being paid to bear.
An investment can also fail because the manager could not calculate a NAV correctly, because nobody independent ever confirmed the assets existed, or because one person could move money without a second signature. Those are not risks investors are being paid to bear. They are risks that were available to be found beforehand.
Operational due diligence exists to find them.
The division of labour
Investment due diligence (IDD) examines the thing the manager sells: strategy, market opportunity, sourcing advantage, underwriting process, portfolio construction, risk management, track record, attribution, and terms.
Operational due diligence (ODD) examines the business behind it: legal structure, service providers, valuation governance, cash movement controls, compliance program, technology and data, personnel and key-person exposure, business continuity, insurance, and the financial condition of the management company itself.
IDD asks whether the manager can make money. ODD asks whether the manager can run a business and whether the money will still be there.
Why they are staffed separately
The separation looks bureaucratic and is not. It exists because of a consistent behavioural pattern.
Investment questions are more engaging. A team examining a compelling strategy with strong returns and an articulate manager will naturally direct its attention and its remaining time toward the thesis. Operational questions — who countersigns wire instructions, when was the last SOC 1, how is the interim-month valuation methodology documented — are tedious and easy to defer.
Institutional allocators responded by staffing ODD as a separate function with an independent reporting line and, commonly, an independent veto: the strategy cannot proceed over unresolved operational objections, regardless of how attractive it looks.
Whether that veto is genuine or advisory is one of the more revealing things about an allocator own process. A veto that has never been exercised is either evidence of excellent manager selection or evidence that it is not really a veto.
What ODD actually examines
Service providers, independently verified. The administrator, auditor, custodian, and prime broker — confirmed by contacting them directly. This is elementary and it is skipped often enough that it remains one of the highest-value checks available. Historic frauds have involved fabricated or misrepresented service provider relationships that a single phone call would have exposed.
Valuation governance. In illiquid strategies this is the centre of the review. Who determines marks. What independent input exists — an independent valuation advisor, third-party pricing, appraisals. How the methodology is documented, whether it has been applied consistently, and how a disagreement between the manager and the administrator or auditor is escalated and recorded.
The specific concern is straightforward: where the investment team controls valuation without independent constraint, the party whose compensation depends on performance is determining performance.
Cash controls. Who can initiate a transfer, who authorises it, whether dual authorisation is enforced by the system rather than by policy, and how changes to standing payment instructions are verified — ideally by callback to a previously known contact.
Segregation of duties. Whether the people valuing assets are organisationally separate from those trading them, and whether either can move cash.
Administration model. Third-party, shadowed, or self-administered, and if self-administered, what compensating controls exist. See fund administration vs. self-administration.
Audit. The auditor identity and experience in the strategy, the opinion history, whether there have been restatements, and any going concern matters. See private fund audits.
Compliance. The compliance program, the chief compliance officer independence and seniority, examination history, and any regulatory matters.
The management company itself. Its revenue, whether it is profitable at current assets, its runway, and its ownership. A management company under financial stress is an operational risk regardless of how the fund performs.
Documents versus reality. Reading the marketing materials, the DDQ responses, the partnership agreement, and the audited financials side by side, looking for places where they describe different arrangements. This is unglamorous and it produces a disproportionate share of serious findings.
The findings that stop a deal
Practitioners tend to converge on a similar list of red flags:
- Service providers that cannot be independently confirmed, or that are unaware of the relationship as described
- Valuation controlled entirely by the investment team with no independent input in an illiquid strategy
- One person able to move cash unilaterally
- Undisclosed related-party transactions surfacing in the financial statements
- Auditor changes without a clear explanation, or an auditor with no practice in the strategy
- Material inconsistencies between marketing claims, legal documents, and audited results
- Evasiveness or delay on straightforward operational questions
That last one deserves its own note. A manager that responds to routine operational questions with irritation or delay has provided information. Managers with sound operations generally answer these questions easily, because they have already answered them for someone else.
The asymmetry
Among practitioners it is widely held that operational failures destroy capital more completely than investment failures do — and the reasoning is structural rather than statistical.
A strategy that underperforms loses some of the capital. A manager that misstated its NAV for years, or whose principal was moving money, can lose all of it, and the loss arrives with no warning from the performance reporting because the reporting was the problem.
Investment risk is also compensated. An investor accepting strategy risk is being paid for it in expected return. Nobody is paid for accepting the risk that the administrator does not exist.
This asymmetry is the entire argument for the function. It also explains why ODD has become steadily more prominent since the frauds of the late 2000s, which were operational failures that no amount of investment analysis would have caught.
For smaller allocators
Full institutional ODD is expensive and out of reach for many advisors and individual investors. The realistic version is to do the highest-value checks rather than none:
- Confirm the administrator and auditor independently. A phone call.
- Read the audited financial statements, including the notes and any related-party disclosure.
- Ask who determines valuations and what independent input exists. Listen to how readily the question is answered.
- Ask about cash controls and dual authorisation.
- Read the partnership agreement provisions that matter in stress — gates, suspensions, side pockets, amendment powers.
- Compare the marketing against the legal documents.
- Consider a third-party report where the commitment justifies it.
Six of those seven cost time rather than money, and together they catch a meaningful proportion of what full ODD is designed to find.
This guide is educational and general; it is not legal, compliance, or investment advice.
Frequently Asked Questions
What is operational due diligence?
The examination of a manager business infrastructure rather than its investment strategy: legal structure, service providers, valuation process, cash controls, compliance, technology, personnel, and the financial condition of the management company. Its question is whether the operation is sound and the assets are protected.
Why separate operational from investment due diligence?
Because they require different expertise and because, combined, the investment questions crowd out the operational ones. Investment analysis is more interesting and more central to the allocation thesis. Institutional allocators commonly staff operational due diligence separately, with an independent reporting line and the ability to veto.
Can operational due diligence veto an investment?
In many institutional programs yes. A common structure gives the operational team an independent veto, so that an attractive strategy cannot proceed over unresolved operational concerns. Whether the veto is real or advisory says a good deal about how seriously a firm takes the function.
What operational findings are most serious?
Inability to independently confirm service providers, valuation controlled by the investment team without independent input, absence of segregation between those who value assets and those who move cash, undisclosed related-party transactions, and inconsistencies between marketing materials, legal documents, and audited financials.
Does using a well-known administrator mean operational diligence is satisfied?
No. An administrator presence is a positive signal and not a conclusion. Engagement letters define and limit what an administrator independently verifies, and it works from records and instructions the structure provides. The useful question is what the administrator actually verifies versus what it accepts on trust.
Sources
- SEC Rule 206(4)-2 under the Investment Advisers Act of 1940 (custody rule)
- AICPA SOC 1 (SSAE 18) reporting framework for service organization controls
- ASC 820, Fair Value Measurement
- Institutional Limited Partners Association (ILPA) due diligence guidance
