November has presented many opportunities for reflection what with the European Directive for Alternative Investment Managers, the insider trading actions by regulators in the US and UK, the reported inflows into hedge funds, the drama around the departure of key personnel on the fortunes of investment managers and much more. I think there is more to be played out on all of these so I thought I would address something different – an area which is the subject of much received wisdom in our industry.
I read an interesting report recently on developments in operational due diligence and one of the areas it covered was the power of veto. I have always been fascinated by how investors approach this issue at due diligence meetings because the existence of or even lack of a power of veto is not enough of a safety or warning mechanism on its own even though investors seem to set great store by it.
The exercise of a power of veto by an operational due diligence team is seen as a positive by most investors – an indication of independence of function – and indeed that is exactly how it should be – at least theoretically.
But that focus on its own would be insufficient. The reason for this is quite simple – if those doing operational due diligence need to exercise a power of veto then it is generally an indication of two things, both of which can have extremely serious consequences: The first is a misalignment in the interests and motivations of the investment and risk teams and the second a polarisation in positions that indicates that there could be no meeting of minds. The occurrence of either is corrosive in a team.
In my case, the lack of veto powers lead to my having to resign from an otherwise extremely interesting job and having veto powers (and exercising them) caused my being fired from another! There was clearly a misalignment in our approaches but mercifully history proved my position in both to be right. How should investors have reacted in each instance? The circumstances of each departure would have given a clear indication of the concerns that they ought to have had. It is the misalignments resulting in the departures that should have been the subject of examination in determining whether the case for investment remained.
The most successful outcomes in due diligence processes are iterative interactions between investment and due diligence teams. This requires the tabling of issues, a discussion on the range of outcomes and a meeting of minds on the best approach to be adopted. In such an ideal world there would be no need to exercise a power of veto as there would be agreement on the moment to walk away and where there was no clear agreement the concerns of the due diligence team would be respected rather than a veto having to be tabled. After all an exercise of a power of veto would be a statement that the investment team needed saving from themselves – that should not be viewed as a positive – why would investors really want to place money with such an investment team?
It is worth noting that in the long run investment teams wield far more influence as they are regarded as the rain makers – due diligence teams are simply the brakes – and brakes can be and are replaced.
It is therefore the processes around the decision making process that are of much greater importance than the presence or absence of veto powers.
But that does not mean that I do not advocate the power of veto for a due diligence team – simply that its exercise should be viewed as a warning sign rather than an indicator of a healthy investment approach and an absence of exercise should result in much greater scrutiny of the investment decision making process.
©Jaitly LLP