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Horizons: Family Office & Investor Magazine

Get a Life: When FinTech Meets Operational Due Diligence

Monday, September 19, 2022

Chris is the Founder and CEO of Castle Hall, where he leads a team of almost 100 professionals conducting operational, ESG, risk and cyber due diligence on behalf of 200+ asset owners worldwide.

Chris is one of the industry’s very first operational due diligence professionals. After audit experience with both Deloitte and PwC, Chris began his due diligence career in 1997 with the Atlantic Philanthropies (a multi billion dollar foundation and early hedge fund investor). Chris then joined UBP (2001) and co- founded Amber Partners (2004).

Chris is an advocate for enhanced best practices across the asset management industry. In addition to his work at Castle Hall, Chris served for 6 years as a member of the CFA Institute Capital Markets Policy Council, acting as Chair for a maximum three-year term.

Matthias Knab: Chris Addy is the founder and CEO of Castle Hall. Castle Hall has been since 2006 a global leader in operational Due Diligence on alternative investment managers.

This year, Castle Hall has also introduced a revolutionary platform called DiligenceExchange which offers amazing benefits for both investors but also investment managers, and we’ll go into this in a moment. The platform has already been adopted by some of the world’s largest investors, but before we go there, Chris please introduce yourself and give us some background about Castle Hall.

Chris Addy: Castle Hall was founded in 2006, and over the 15+ years of our history we are very proud to have been able to work with more than 200 investors worldwide and become the largest diligence firm that is dedicated to supporting the diligence efforts of investors across the industry.

We’re very pleased to have built a global footprint; our headquarters are in Montreal, we also have coverage across Europe, the Middle East and into Australia. Our overall team has grown to be more than 90 professionals and we’re certainly looking forward to reaching the 100 professionals mark.

Originally starting just with hedge funds, we now cover all asset classes across both public and private alternatives, as well as long-only traditional stocks and bonds.

Our coverage of Due Diligence exposure to asset managers and GPs is considerably more than 2000 managers worldwide. So, we have quite a lot of experience and footprint of seeing where the industry is, seeing what is a leading practice, seeing where asset managers are lagging, and helping our clients ultimately deliver better investment outcomes through more effective Due Diligence.

Matthias Knab: How has Due Diligence changed or evolved over all those years you have been doing it, or where are we now, and what’s left to do?

Chris Addy: Diligence has changed a lot. I did my first Due Diligence review in my career, before Castle Hall, back in 1997, so I think it’s been 25 years asking asset managers questions about their operational controls and procedures.

And, of course, the key watershed moment was the global financial crisis in 2008. Before 2008, operational Due Diligence was focused on hedge funds in the aftermath of Lipper, Lancer, KL, Bayou, etc., and it was very much optional. Some investors were focused on ODD and others didn’t include that into their investment process.

We all remember that in 2008 there was a gentleman called Bernie Madoff, and as a result Due Diligence on public market hedge funds has really become a mandatory, well-established, and I think relatively mature process over the past 10 to 15 years since the GFC.

There have been some other significant changes, though. Due Diligence was traditionally a static, point-in-time process that was really based on a report. So, at the point that an investment was made, a new manager was proposed for introduction into the portfolio, we would say, “well do we have the Due Diligence on that manager when we’re underwriting that new investment?”

One of the key changes for Due Diligence is to move to a process of active ongoing monitoring. Due Diligence is, first of all, not only about completing diligence when a new manager is introduced into the portfolio, it’s about monitoring and maintaining oversight over all of the existing relationships, and then maintaining an appropriate cadence and frequency of how frequently should I be aware of things that are evolving and changing with respect to a manager’s circumstance, their fund, their operations, their business.

I always like to say the first rule of Due Diligence is: Don’t be surprised. So, it’s a really good idea to be able to keep in touch with what’s happening with an asset manager, what is changing. So I think point one is diligence has moved from static to dynamic, it’s moved from point in time to continuum.

The second major change in Due Diligence is an expansion of asset classes. So, again, traditionally, Due Diligence was about hedge funds, it was a narrow domain in the specific niche of public market alternatives.

But ultimately, for an asset owner, for a large institutional investor, a pension fund, a sovereign wealth fund, a superannuation fund, ultimately they are a fiduciary, they are delegating their asset management process when they elect to invest with a third party asset manager. And irrespective of the asset class, the asset owner needs to have an understanding and an ability to make sure that they are not being exposed to undue risk as a result of their investment with a particular asset firm, wherever they may be in the world.

So, from Due Diligence being just about hedge funds, Due Diligence is now across all asset classes, and at Castle Hall we now complete a majority of our work on private market funds, both private equity as well as real estate, infrastructure, venture capital, and private credit.

We also do an increasing amount of work with respect to long-only structures, either through public or private funds as well as through managed accounts. What a multi-asset class approach does require is flexibility, because clearly the risks of a long-only managed account held at your global custodian are potentially different than a co- investment with a large private equity firm or an allocation to a venture capital fund. Clearly, the risk of a portfolio with complex derivatives is very different from the risks of a portfolio holding farmland investments. I think there is need for a calibrated flexible approach to Due Diligence, and that’s a further move away from that traditional one- size-fits-all of “where is my report”.

And, I think, the third element that’s changed really brings together those two themes. Traditionally, Due Diligence could be done from anywhere in the world as long as you had a copy of Word and a spreadsheet and a laptop. It was a very manual, boutique process. What we need when we are completing Due Diligence on potentially hundreds of asset manager relationships across multiple asset classes is technology. So, where Castle Hall has really moved our business over a probably a decade-long initiative is to think about how we can adapt FinTech and bring in technology solutions to support every aspect of Due Diligence, from the initial allocation through to the ongoing monitoring, through to the identification of risks. We really believe that that FinTech technology is the key to a modern forward-looking Due Diligence approach. Ultimately, it’s the institutional approach to Due Diligence.

So while we may have worked as accountants – I’ve worked for many years on spreadsheets and writing Word documents – we feel that the technology solution really brings on board the power of database analytics, that’s really the forward-looking approach that investors are now requiring when they maintain their oversight over portfolios as a fiduciary.

Matthias Knab: Can you describe DiligenceExchange and the benefits the platform offers to investors and investment managers?

Chris Addy: DiligenceExchange leverages technology in two ways.

First of all with respect to the efficiency in the Due Diligence process, and then with respect to the intelligence, the insights that can come from the conduct of Due Diligence.

With respect to efficiency, at the moment there are many hundreds of investors in the world that will use their own Due Diligence questionnaire, request for proposal, request information from asset managers. And in many instances, that process is manual, it could be with spreadsheets, it could be with an online survey tool, but it involves gathering information on a very individual, bespoke and inherently duplicative basis.

What DiligenceExchange does is allow Castle Hall to gather consistent standard reference data on thousands of different fund entities and managers, GPs, as requested by our client base. And what we do is work with a consistent database, a consistent structure of data, gather data the same way, and inherently bring efficiencies and economies of scale to the data gathering and data collection process on behalf of our clients. And instead of spreadsheets and Word documents and manual follow-ups, we have a centralized research database that allows our clients to gather information consistently, on the same scope and methodology for every asset manager and general partner and fund in their portfolio, irrespective of asset class.

That’s really the purpose of bringing efficiency and leveraging a database, leveraging a standard data structure, to support the Due Diligence process.

When we come to data intelligence, Castle Hall’s benefit of course is that we work on behalf of a consortium of more than 200 clients and that gives us exposure to several thousand fund entities across the industry.

If every investor works individually, they can of course gather a picture of their own portfolio. But what Castle Hall can do is bring together a standard approach that aggregates the collective investment footprint of all of our clients and consequently gathers consistent information on a much larger data set, a much larger portfolio of information.

So, the other aspect of our technology – we first of course use database and consistent data gathering techniques to get that standard data set – but then with our technology we can then apply a set of proprietary algorithms. And what our algorithms do is identify risk factors that are in place with respect to every asset manager and every fund.

So we can say, for example, has this asset manager had a cyber security breach? Have they changed a service provider? Do they not have a dedicated chief compliance officer? Do they not have a fund administrator? Do they not have a valuation committee? Have they changed their ownership structure? In total there’s more than 200 analytical factors that can be triggered by our algorithms. For any individual manager and fund that a DiligenceExchange subscriber looks at, they are able to identify and gather insights to what is the risk profile, what are the risk characteristics of a particular manager or fund.

But because the information is gathered consistently we can then roll that up to look at a portfolio. And by using technology we can then interrogate the data, mine the data across a full portfolio to say, “Well, how many of my managers use a particular service provider, how many of my funds have an expense ratio in excess of a predetermined limit, how many of my private equity managers have broken deal fees? Is a risk triggered in a way that is expected, or is a risk triggered to say that’s something a little bit unusual, I wasn’t expecting that. Let me then compare that to other funds in the portfolio.”

With such a tech platform, we can see a risk factor and then check which other managers or funds in my portfolio have the same characteristic. But, I have to say that the real benefit of using a standardized approach and technology is to roll then everything through to industry benchmarks. If we gather data in the same way for thousands of fund entities, we can have a picture of the overall ecosystem and industry best practices across all of those different risk factor dimensions. So, our clients using DiligenceExchange, first of all can see the risks for an individual manager and fund secondly they can see how that rolls up to the risk profile of their overall portfolio, and then they can compare that to the Castle Hall’s proprietary DiligenceExchange benchmarks.

Matthias Knab: That’s fascinating. Tell us more, also how DiligenceExchange works for investment and fund managers?

Chris Addy: What a DiligenceExchange subscription provides to allocators is access to our entire research database. We certainly believe that is the largest research database that’s available in the industry. It’s significantly more than 2,500 fund entities closing in on 2,000 different manager or GP structures.

The first thing that a subscriber sees is the list of the asset managers that are under coverage. And the way that DiligenceExchange works is that each subscriber looks at a manager and sees a fund entity which is in their portfolio or of potential interest for future investment and then they raise a connection request with the asset manager in the LinkedIn style, the connection request is approved, and at that point they then have access to the DiligenceExchange report on that particular asset manager and fund.

And every DiligenceExchange report first of all is our standard reference data on the manager and fund entity. It’s not just purely a Due Diligence questionnaire where a manager just supplies data – a key part of our process is we complete a range of ‘trust but verify’ checks. Those include service provider verifications, they include verification to public domain information such as regulatory and corporate registration sources. We think it is very important when looking at data to make sure it is verified as a core anti-fraud check, so we may say we check a to b, b to c, c to d and d back to a to make sure that the representations made by the asset manager can be verified in the public domain, again, as a key protection against fraud. And with the verified reference data then our clients receive the results of our diligence algorithm, and the algorithm, as we mentioned a few minutes ago, provides first of all a list and a matrix of risks for a particular manager and fund that can then be rolled up to a portfolio level and then compared to the aggregate DiligenceExchange industry benchmark.

And it’s really there that the insights come: What are the risks for my particular manager, is that an outlier in my portfolio, and then, how does my portfolio stack up to the aggregate industry? Again, our clients are fiduciaries, so a key part of running a portfolio, an institutional pool of assets as a fiduciary investor is really to have that sense that there is a clear understanding and oversight over asset managers, we’re aware of our risks, we’re not taking unknown and unexpected risks where we have a particular concentration or exposure that clearly is an outlier an out of line of expectations and out of line with the overall risk parameters that we are prepared to accept.

An important part of DiligenceExchange, obviously we have several thousand asset managers and funds already completed based on the aggregate investment footprint of the consortium of Castle Hall clients, obviously, this is a huge industry there are tens of thousands of asset managers. Now, DiligenceExchange already includes information on about 30,000 asset managers which is based on information we’ve pulled from the Form ADV and U.S. regulatory filings, but irrespective of the asset manager and fund, if a client subscriber has an allocation to another manager that is not currently under coverage, a standard subscription allows unlimited capability to add additional managers to the portfolio to make sure that a portfolio view is complete. As an accountant, I always do like to make sure that ultimately every investment in a fund, in a portfolio, has the appropriate Due Diligence, I can tick them all, I can tie them to the balance sheet, it’s internal audit, external audit, compliance, risk... A regulator comes in, we’re not negligent, our process is compliant, we have consistent information for every manager and every fund to which we’ve deployed capital.

Matthias Knab: I understand that for the first time in the diligence domain the DiligenceExchange platform allows to aggregate data intelligence and benchmarks across the entire industry. Tell us, why is that so revolutionary?

Chris Addy: Well, from my side, I think I mentioned at the beginning of our conversation that I’ve personally been doing Due Diligence for about 25 years, and I think the holy grail is really to bring more transparency to the industry.

We work in alternatives, in an industry which is opaque, where data is difficult to gather, and I’m sure there are other Due Diligence practitioners listening to this conversation – we’ve all been told by asset managers that we are the first to ask a question. That we are the only investor that is raising a concern, all of our other investors are happy, and I don’t think there is a simple answer to a complex question but to be able to bring evidence to a diligence discussion, it moves it away from a qualitative view of experience and preference, to a tangible evidenced data point of industry behaviour.

So, let’s take something very simple as: Do I have a valuation committee? Do I have a valuation committee which is separately constituted and meets on a regular basis to look at the valuations of the portfolio? In many instances, in the private equity space for example, there isn’t a valuation committee, but there may be a portfolio investment committee, a portfolio governance committee, a management committee, so a forum typically or primarily of investment professionals who amongst their responsibilities will take account of valuation every month or every quarter as appropriate for that portfolio.

And it’s very difficult to have a conversation with an asset manager, to challenge or provide an alternate perspective that the way that works for them in the sense of how they operate their business and think about their investment process. It’s typically difficult to challenge that.

What we can do with DiligenceExchange benchmarks is to say, if we are thinking about standardized controls and procedures, what are best practices, what are the expectations of investors who are deploying their capital to a third-party asset manager, what procedures are in place? And in my mind, and the DiligenceExchange data would support this, it is best practice to have a separate valuation committee, because that allows valuations to be considered separately, as distinct from combined and rolled into an aggregate discussion about the portfolio as a whole from an investment perspective.

And importantly, it creates a risk governance and compliance forum that’s separate from the investment process, creates a degree of segregation of duties, or at least a degree of separation of intent and purpose in how the valuations are going to be reported to investors, to LPs in a in a private equity fund. And I picked that example at random, DiligenceExchange has, once more, several hundred data points where analytics are being generated. But it empowers allocator to be able to have an evidenced discussion with an asset manager, to move away from individual opinion to an objective benchmark as to industry behaviour, and identify asset managers not necessarily in case of being right or wrong, but certainly a case of being able to identify who’s leading and who’s lagging.

Matthias Knab: We’ve seen that the benchmarks and the intelligence that can be derived through the DiligenceExchange platform is truly unique. But in addition to that I think that there are also fundamental gains in terms of operational efficiencies for both investors and investment managers, right?

Chris Addy: Correct – we really do think diligence is very duplicative. Investors sending their own data, gathering questionnaires, again, excel spreadsheets or using one of the various online survey tools that allows data to be gathered, but it’s extremely time consuming.

A large manager could have a hundred investors asking for questions; it’s extremely time consuming for the asset managers / GPs of course, who need to responding and provide information. Now, we certainly firmly believe that every investor has higher value questions that may well be unique to their organization, but that’s where we’d like to help our clients spend and focus their time. In other words, spend 80% of the time on the 20% of issues and facts that matter, not spend 80% of the time getting to those 20%.

To rephrase that – when we work with a client, how can that investor use the work that our team performs to help them do their job better? And that really comes back to what’s the highest and best use of time, how can our clients move up the value chain to be able to bring higher value oversight and insight to the understanding, the diligence profile of the asset managers that they are looking at?

While in every DDQ there are meaningful questions that really are getting to the crux of risk, on the other hand, at least the first 50% of Due Diligence, it is the same for everybody. What is the asset management company called at a corporate level, what are its affiliates, where does it have its offices, what’s the biography of the chief compliance officer, who’s the auditor, who’s the administrator, who’s the valuation service provider, what’s the percentage of the assets in level three, what accounting system do they use, have they had a cyber security breach? These basic questions can be gathered in a more effective manner if they are gathered externally.

In some ways, Castle Hall is acting here as an industry utility to gather information on behalf of that consortium of 200 plus clients. And the feedback we very consistently receive is that instead of having one, two, three, four junior analysts who are really responsible for that process to reach out for questionnaires, to follow up, make sure responses are provided – it can take hundreds of hours for larger clients; that’s simply not the highest and best use of time for that internal team.

We want the internal team to start their Due Diligence process already halfway through. They’ve got the data, they can log into DiligenceExchange, see the DiligenceExchange report, the immediate risks that have been identified, the trust but verify work that has been completed, and they’re kicking off with a clear understanding of the framework, the baseline of the asset manager, and can immediately move up to say, “What are the issues that I want to dig into in more detail that are going to materially impact my investment decision? Is there a risk here which makes me uncomfortable? Are there risks that I can mitigate, or can I demonstrate that this is an entirely suitable manager that really meets our profile and is going to generate great alpha for our portfolio?”

Investors as well as investment managers can get free access to Castle Hall’s DiligenceExchange here:

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