Mitigating Risk

With a single stack

By Robert Teel on May 14, 2014 in Technology

The fear of having a prospective investor pull their capital pledge from your fund raising effort is enough to make any fund manager lose sleep.  Losing a $100 million commitment means you can kiss $2 million in annual management fees goodbye. If your firm is particularly unlucky, other investors will follow suit.  Now imagine that you lost that investor because they were unhappy with…your financial reporting.

Reporting systems don’t usually command much attention from managers at real estate investment firms when they think about asset and portfolio risk management. More likely, they devote a tremendous amount of time and intelligence to structuring a portfolio with assets that fit the right risk profile as set by the fund’s objective.  The creative sides of their brains crowd with questions: Does this property have an upside that can be exploited?  Are the tenants locked in?  Will this submarket rebound next year?

But there’s another type of risk that’s not so sexy, and many fund managers often consider it a lesser priority: operational risk.   This category of risk encompasses the technical aspects of back office operations along with legislation and rules interpretations.  Operational risk management extends to the investor pool, as fiduciary obligations are part and parcel of accepting an investment commitment.  Potential trouble looms for a firm that does a commendable job of creating, protecting and nurturing investor relationships but ignores the risks inherent in their accounting and financial reporting operations.

Operational risk is heavily tied to a firm’s business systems, and the two sure-fire ways to reduce risk in this particular area are to get off of Excel and QuickBooks and on to a mature accounting system, and to consolidate disparate systems into a single application and database. “But I’ve got a great accounting staff—they’re working extremely hard and I get all my reports within 45 days of month-end.” The staff may be the greatest ever, but they can’t perform to their full capability if they use multiple systems and have to enter data multiple times to track, manage and reconcile information. Multiple systems also slow down the accounting close and reporting process.   As for Excel and QuickBooks, the controls in those systems are just not robust enough to warrant investor confidence that operational risks are in check.

Addressing operational risk just isn’t as much fun as touring a potential purchase in downtown Manhattan to analyse asset risk…followed by a steak and martini dinner with the broker.  But over the past several years the penalties for mismanaging operational risk have in some cases taken priority over portfolio risk management, especially when a regulator or investor strategic investor is involved in the discussion.

Ten years ago, firms could convince consultants that they were easily managing the accounting and reporting with the right combination of (1) management oversight; (2) spreadsheets; (3) a general ledger system (even QuickBooks); (4) the sheer volume of staff; and (5) the promise that they were implementing a technology solution.  But those days are over.

Today, before receiving a commitment from an investor, a firm will be subject to some level of due diligence.  Institutional investors will often send a third-party consultant to conduct this due diligence and evaluate the firm for investment-worthiness. Risk presents in several categories, ranging from human errors such as failing to perform adequate background checks on prospective employees and simple keystroke errors to the portfolio risk that arises from the decisions and actions involved in real estate investment.  The consultants might also help manage the investments for their institutional clients, which means they receive your monthly reporting. As a result, due diligence comprises a very rigorous evaluation of your back office function—both staff and technology.  The best case scenario occurs when firms have a vertically integrated system with a great staff, allowing the consultant to “check the box” next to Back Office on their due diligence checklist.

However, even the best investment management companies can run into problems when the organization’s front office (investor reporting) and back office (asset management) operations aren’t in sync because they operate on separate technology platforms.  This lack of cohesiveness with multiple systems often results in technology hindering, rather than advancing, the management of investment portfolios.  The more reliant investment companies become on multiple systems to automate investment accounting, consolidations, investor reporting and ancillary functions such as customer relationship management and budgeting and forecasting, the greater the risk if the systems don’t work well together.

A major drawback to using separate, disjointed technology platforms at the asset and portfolio levels is the heavy use of interfaces (including some home-grown interfaces) that cobble them together. This separation rarely allows for smooth, automated business processes and frequently results in loss of data, inaccuracies, and difficult management of compliance and auditing. This can produce a higher risk rating for internal operations.

Realizing this, many investment companies are discovering that they can sharply mitigate all types of risk by discarding separate, manually maintained, interface-dependent front office and back office systems in favor of an automated “single stack” technology solution that combines investment accounting, consolidations, performance reporting and investor reporting with asset-level operations.  As EY noted in a survey on risk management for asset management in 2012, “While risk managers have previously invested in personnel and processes, the future points to improved technology as the key to enabling more effective risk management of nearly all types of risk.”  By eliminating interfaces, manual data entry, and faulty decision-making from erroneous or incomplete information, managers can mitigate all categories of risk while equipping their organizations to successfully navigate Sarbanes-Oxley requirements and other compliance regulations.

Lowering risk matters because mature potential investors being solicited for funding often care as deeply about operational risk as about the risk of the underlying investments.  Beyond the investor level, the stakes in risk mitigation extend to the regulatory sphere.  For example, the U.S. Securities and Exchange Commission is empowered to subject registered investment managers to Presence Exams, which encompass compliance policies and procedures in a variety of areas including marketing statements, portfolio management, safety of client assets and valuation processes.  Successfully weathering a Presence Exam—and other regulatory requirements—requires more than preparation: It requires the right systems to minimize risk for companies and their clients by tracking user audit logs and other documents for changes to vendors, bank accounts and journals.

With risk mitigation on the mind of both investors and regulators, how can investment firms categorize operational risk within their information technology systems?    Where can a single-stack approach to technology help reduce operational and portfolio risks?  Some areas include:

• Capital call requests and distributions.  Typically, the amount of capital requested by an investment firm is determined by the front office, while allocating that capital call to investors is left to the back office—a potential disconnect.  Investor allocation spreadsheets that are completed manually could potentially include incorrect calculations that carry over and call for investors to contribute more than they should.  An integrated front office with a single point of entry for capital calls prevents this possibility.  Similarly, distributions can be mishandled in the absence of integrated front office and back office systems.  When the front office makes the decision to distribute funds, incorrect distribution formulas can calculate the wrong amounts or send them to the wrong people.
• Asset data loading.  If investment management and property management data are kept on separate platforms, faulty interfaces between the two operations can give rise to inaccurate accounting information, with misinformation eventually passing on to investors.  Combining investor actions and property operations into one system truly unifies investment managers and property managers as a single, fully connected organization.
• Investor reporting.  Reporting is guided by the back office but done from the front office.  Errors resulting from spreadsheet formulas and exports from the accounting system to the calculation engine can result in reporting incorrect information that investors place on their own balance sheet.  This exchange involves interfaces and potential risk of delivering incorrect or watered-down information.
• Disaster recovery and monitoring.  A unified platform also provides access to software-as-a-service systems that include offsite hosting services that protect client data in the event of natural or man-made disasters.  A single-stack system eliminates the risk to data that an investment company assumes by self-hosting and reduces IT infrastructure expenses
• Drilldown.  A single stack technology system lets investment managers effortlessly go from investor capital balances through funds and all the way to property valuation and financial reporting, and even to risk factors at the tenant level, such as a tenant’s financial health and investment strategy and asset mix, expiring leases and forecasted revenues.  This type of drilldown and analysis is only available if the underlying asset operations database is the same database used for investor reporting, portfolio reporting and investment accounting.
• Investor relations.  A single system supports customer relationship management by providing the latest information, from the capital balance to the email address, for any investor.  In addition, accurate results can be published quickly to an investor portal.

Technology can create or mitigate risk.  Many investment management companies are finding that compliance and internal controls are much easier to manage with only one system of record, with a single point of entry for operational areas ranging from reporting and investment accounting to asset management.

Robert Teel serves as senior vice president, commercial and investment management, Yardi®