Understanding operational risk is key to ensuring optimised performance, says Adams Street Partners

Alex Lesch, Adams Street

In the following Q&A, Alex Lesch, Partner and member of the Investment Strategy and Risk Management team at Adams Street Partners, explains the importance of operational due diligence and why ongoing collaboration with GPs helps solidify investment confidence.

PEW: Do you think investors, at large, have done enough to evolve the way they think about allocating to PE, given the huge volumes of capital flowing into this asset class?

Investors have recognised the need to evolve if they want to achieve higher returns, and private equity can certainly play a healthy role in achieving outsized returns. With many managers pursuing aggressive capital raising and fund scaling over the last few years, Adams Street has placed an emphasis on the importance of manager selection, and invests with GPs who have proven track records of investing in growth themes and trends, instead of simply chasing on-paper performance.

In challenging market environments, like we appear to be trending towards, we focus on identifying repeatable levers for value creation and growth that are not dependent upon financial engineering or leverage/debt pay down. By adhering to this strategy, we’ve been able to generate consistent returns across multiple cycles, and build attractive portfolios for our clients.

PEW: How does Adams Street think about the relationship between operational risk versus investment performance during manager selection?

Mitigating performance risk is a primary focus when investing with top tier managers. We look for managers who have deep industry experience, differentiated strategies that benefit from market dislocation and have invested across investment cycles that can deliver top quartile performance. Operational risk is one component of our overall risk analysis that we integrate into our overall assessment of a manager to ensure that investment performance is not directly impacted by operational distractions or reputational concerns. Performing operational due diligence provides us with additional data points and awareness when making an investment decision.

PEW: Does your approach to ODD differ at all, depending on the size of the manager or the type of strategy?

We take a consistent approach to analysing managers. While their structure, size and regulatory status might differentiate, our operational standard for the internal control environment, tone at the top, culture, compliance robustness and transparency are areas that we endeavour to verify are performed consistent with industry best practices.

PEW: Why do you consider it important to run ODD independently, but in parallel to, investment due diligence?

At 200+ employees with differing experience, skill and insight, it’s crucial that we share and leverage knowledge to ensure our Primary Investments team is able to make the best informed evaluations and investment decisions for manager selections. 

Independence is about ensuring that there is the ability to have differing perspectives on the attributes and acumen of a manager so as to avoid groupthink and potential blind spots.

However, better decisions are made when all parties involved have all the information to make an informed decision and are able to act upon that information as the diligence is occurring and limit any last minute surprises.

PEW: You point out that in a recent ODD process you discovered that a GP was not using dual authorisation to approve wire transfers. Is this an instant red flag?

Yes, but that isn’t automatically a deal breaker. Identifying these weaknesses is exactly why operational due diligence should be performed; to ensure that mitigating processes are established to reduce the potential for misappropriation of assets. Dual authorisation seems so obvious but there are many more subtle weaknesses in a manager’s control environment that can result in negative outcomes. Managers who are unwilling to incorporate changes that are identified by our process would be a larger red flag and would give us pause for consideration.

PEW: Could you provide another example where you’ve identified a key operational risk, and set conditions in place for the GP to address the risk accordingly?

The process of operational due diligence identifies various areas for improvement. For example, in some recent diligences we identified weaker execution of compliance policies, limited levels of insurance coverage and limited cybersecurity policies. These were items that we identified as weakness that required additional improvements to continue our investment and were areas that we followed up on post investment to ensure that they were actively being implemented.

PEW: What do you consider to be the most important aspect of collaboration with GPs, as part of your ongoing monitoring?

Collaboration with GPs is about staying up to date with the manager’s operations and how they benchmark with current industry best practices. We have a unique insight given how many managers we monitor and invest with on an annual basis; sharing what we see amongst their peers and engaging to help managers identify areas that could be buttoned up given their size and scale. Strengthening the relationship to help them better manage their organisation solidifies our confidence in our investment.

PEW: Cyber risk and ESG risk…would you say these have risen to greater prominence in ODD assessments in recent years? And if so, what have Adams Street done to evolve its ODD approach?

Cyber risk has definitely seen a rise in prominence over the last five years and the level of awareness and layered approach that managers have taken to secure their networks and data has substantially improved regardless of the asset class and size of a manager’s infrastructure.

ESG has been evolving more recently, led by an influx of non-US investors in the asset class.

Both risks have been evolving within Adams Street and while we have considered them essential in our historical processes, consistent with the industry, we are constantly seeking ways to improve upon how we diligence, monitor and consider investment to ensure both risks are top of mind.

More recently, we have integrated a research and business intelligence provider, specialising in ESG and business conduct risk, into our monitoring process. It allows us to track companies across the various ESG risk factors and translate big data into actionable analytics and metrics. Given the number of underlying portfolio companies we are invested in directly or indirectly, we are also able to independently assess and monitor concerns across our portfolio to be able to address any issues with our managers on a proactive basis.

PEW: Finally, could you briefly explain how effective you feel Adams Street’s ODD risk rating framework has proven to be?

Our ODD risk rating framework has allowed us to be more thoughtful about how we leverage our resources, engage with managers and focus on areas that have a higher risk rating.  This has allowed us to take a more focused and active approach to monitoring, post investment.

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