What Are the Top Operational Risks for the Investment Management Industry?

Blog post Team CENTRL 2022-03-28

Investors understand that even seemingly slight operational oversights or blunders can have far-reaching consequences for their investments.

That is why they conduct lengthy reviews and on-site due diligence for any potential investment in an effort to limit operational risk.

There is a lot on the line, including immediate financial losses and legal liabilities, and investors are not compensated for taking on unnecessary operational risk. Many factors can contribute to operational risk while developing an investment strategy.

What is operational risk, exactly, and what are the most common examples in the investment management industry? These are the questions we’ll answer today.

What is Operational Risk?

The Basel Committee on Banking Supervision (BIS) defines operational risk as “failure coming from insufficient or failing internal processes, people, and systems or external circumstances.”

Potential triggers could be based on malicious intent, such as fraud. But it could also be human error, lack of oversight, information system failure, even natural disasters.

The scope is so wide, that without proper risk assessment followed by appropriate due diligence procedures, it is easy to overlook a potentially destructive risk.

What is Operational Due Diligence?

Operational Due Diligence (ODD) is a process initiated by investors to analyze investment managers’ operational infrastructure to uncover and minimize any operational risks connected with the investment.

With operational due diligence, investors can discover any “red flags,” insufficient internal processes or controls, or possibly fraudulent activity, before signing on the dotted line.

They can also uncover and manage any operational risks connected with a potential investment that may not be deal-breakers, but still must be appropriately mitigated.

As part of a comprehensive Enterprise Risk Management (ERM) or Operational Risk Management (ORM) program, operational due diligence is forward-looking and focuses on proactive measures.

It examines the operations behind the investment manager and decides if they will be sustainable in the future.

What are the Top Operational Risks for the Investment Management Industry?

Although a robust ORM program is a rational, proactive, and preventative tool, it is not without its challenges, like the fact that potential operational risks vary from investment to investment.

However, we examine the most common operational risk categories to be considered during the due diligence process below.

Supply Chain Risks

Supply chain screening and management are becoming increasingly important as more businesses outsource and employ third and fourth-party suppliers for critical operations and services.

Therefore, it is essential to ensure that investors consider any potentially hazardous risks presented by vendors working with the investment managers organization.

Environmental, Social, Governance (ESG) Risk

ESG, and specifically, the environmental impact of a company’s use of natural resources and the climate risk of its activities is also a vital element to keep in mind when examining operational risks.

These issues might include carbon footprint, toxic chemical use, waste management, role in water contamination, and influence on deforestation.

To combat these risks, many investors are now seeking investments that rely on alternative sources of energy, green transport systems, and implement other environmentally friendly initiatives.

Cyber Risk

Information security is a growing business concern. Internal and foreign threats are growing and appear random in their onslaught. As a result, a solid cybersecurity plan and implementation have become an essential component for investment managers to possess.

Corporate compliance and risk management teams must monitor such information appropriately, methodically, and efficiently to prevent vulnerabilities from damaging a potential investment.

Additionally, bad actors can also initiate supply chain attacks, compromising their servers and assets potentially undetected. Which highlights the importance of managing the aforementioned supply chain risks.

Geopolitical Risk

The repercussions of international tensions and international market events are more vividly felt in the increasingly integrated global investing landscape.

Therefore, ORM programs should be flexible enough to adapt to changes in procedures or practices through multiple jurisdictions.

For example, as the Russia-Ukraine conflict rages on, the United States, the United Kingdom, the European Union, and several other nations have imposed sanctions on particular Russian corporate groups, people, and the Russian state.

This will most certainly have an impact on investment managers and their associated operational risks.

Business Continuity Risk

Natural disasters, like hurricanes, can also expose flaws in a businesses’ emergency planning.

Because this operational risk can seem rare and far off, many asset management firms may not prioritize management of it until it’s too late.

Therefore, the evaluation of backup procedures and business continuity plans of investment managers should be a key component of due diligence around operational risks.

Compliance Risk

Finally, investment managers continue to face operational risks related to regulatory and compliance obligations.

Ensuring that investment managers have the right skills employed to respond to new regulatory requirements is critical to company survival. As an investor, a compliance violation can be devastating.

Thus, investors need to be sure to continuously monitor compliance risks associated with their investments.

How CENTRL’s DD360 Can Help You Manage Operational Risk

DD360 is a cross-operational due diligence platform that investors, fund managers, and consultants can use to produce greater transparency and accountability in their due diligence process workflows.

DD360 has a straightforward user interface with powerful automation and analytics. It gives managers simple, straightforward, and quick access to data they can use to improve due diligence strategies.

DD360 can also boost productivity considerably as it provides a single source of truth to manage operational risks associated with investments.

Schedule a demo to learn more about how DD360 can help you enhance your due diligence processes and better manage operational risk.

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