Due Diligence

Originally published in the May 2011 issue

The rule for investment (and for life) used to be, “Look before you leap”. But only a few years ago, the word ‘look’ in this context implied a reassuring glance more than an in depth observation. And the glance was almost always at the numbers.

During the 1990s and the early years of the new millennium investors were almost exclusively focused on performance and the likelihood of a good series of numbers continuing. Quantitative measures were the order of the day and among the regularly voiced concerns were the possibility of style drift (an unheralded change in investment direction), about capacity and, from time to time about gearing or leverage.

Of course different financial environments give rise to different rules and ways of doing things. Indeed, it may always be the case that an increase in regulatory supervision will always follow rather than anticipate financial problems or crises. Thus the current banking crisis has prompted a raft of potential new rules, indeed laws – and not only for banks but for the alternative investment community as well.

Many of these rules and the new, much broader due diligence obligations this article describes, are about process rather than about strategy/performance issues, but it is fair to mention that the majority of the hedge fund collapses of the 1990s were performance- rather than process-led. LTCM famously collapsed because of over-leverage in a Russian fixed-income market resolutely going in the wrong direction. Four years earlier Michael Steinhardt, along with George Soros and Julian Robertson, was caught flat-footed by an unexpected change in the Fed’s interest rate level (and direction) and his investors barely survived the experience. But, to repeat, these and other debacles were strategy-led, arising perhaps from excessive gearing or excessive arrogance, and there was no suggestion of middle or back-office failures or, worse, planned criminality.

Forensic analysis
However, Bernie Madoff was also operating in the 1990s and for investors today the thought of being too polite to ask about the quality of the behind-the-scenes operation is risible. The combination of recent cases of fraud and the current climate of low or negative market returns has awoken investors of all types to conduct more detailed and intensive reviews of the firms they choose to entrust with their assets. So the notion of ‘look’ has been replaced by an almost forensic level of research and analysis extending far beyond the close confines of the fund and its manager.

Today, investors also take a hard look at a fund’s internal operations and infrastructure as well as the service providers these firms interact with. This new, broader analysis opens up a fund’s entire operational landscape so investors can review items such as reconciliation practices, exposure monitoring, technology practices and disaster recovery, valuation procedures and counterparty reconciliations.

Service providers get scrutiny
The service providers the manager works with, the prime brokers, accountants, lawyers, custodians, administrators and occasionally others such as cash managers (remember Sentinel?) are now seen as a key point in the due diligence process. For example, investor due diligence may now involve a complete review of a fund’s auditor, fund administrator and the trading counterparties they are using. The issues that arose out of the Lehman bankruptcy certainly emphasized the importance of counterparty management and the necessity to limit exposure of the funds.

From a fund manager’s perspective, this expansion of the investor’s due diligence boundaries, necessarily leads to a change of emphasis internally. As stated, managers used to be exclusively concerned with performance believing that if the numbers were strong everything else would look after itself and some of them would have taken a dim view of enquiries about the quality or efficiency of their back-office systems and administrative support. Today, compliance and overall risk management require equally as much due diligence attention as the front office investment strategies. And the manager who wants to attract significant investment must assure the investor that: first, there is a compliance control network in place that actively monitors fund activity (as opposed to simply reviewing data after the fact); and second, that the firm has appropriate risk measurement practices in place.

From a compliance perspective, today’s investors require written compliance procedures and details on whether compliance testing is automated or manual. The scope of compliance has now also been expanded beyond simple prospectus compliance to include things such as anti-money laundering as well as the explanation of performance calculations and the way in which performance is reported. Furthermore, the compliance function itself is likely to be greatly expanded if, as widely anticipated, the European Union’s proposed Alternative Investment Fund Managers Directive comes into force next year.

Risk measurement
As the markets contracted over the past year, it is clear several firms believed they had the appropriate risk measurement processes in place, yet the risk appetite/propensity of the firm was proved to be considerably more thanwhat had been estimated, thus leading to difficulties and, in some familiar cases, severe problems. Among others, managers investing in OTC or derivative instruments were prone to such issues. For example, it is possible to believe a CDS position is insuring a direct investment in a high yield security, yet if the CDS counterparty selling the ‘insurance’ is not solid, the stability of the insurance is itself under threat and must itself be reviewed by the risk measurement/management process.

Segregation of duties is also key. Investors increasingly need to ensure the manager is using reliable service providers and that there is an appropriate segregation of duties. It is equally important the fund administrator is conducting full independent processing and valuations of the portfolios. This is the case because the integrity of valuations of hard to value assets can be compromised if the administrator is simply taking prices provided by the fund manager for those positions. Overall, appropriate valuation procedures and controls are also of utmost importance, especially in today’s environment where valuations can be easily questioned. That said, a market-wide directive of FAS 157 in the United States is now providing a standard framework for classifying the harder to value assets and reporting effectively on the pricing used for those assets.

Investor servicing has long been ignored, but now this is one of the most important criteria in deciding to support a manager and to invest in a particular product. The impression is that investors are saying to managers that with performance now significantly lower than the high double-digit percentage years of the 1990s and the early years of the new millennium, an acceptable balance is to treat investors with much greater courtesy and efficiency and to have systems in place that respond to this new climate. For example, the processing of subscriptions and redemptions and handling of all customer cash is now a key component of a due diligence review. Furthermore, as fraud is a key topic of interest and concern, investors will want to ensure that the cash invested in a fund is handled properly and there are controls in place to prevent any theft or fraudulent activity.

In the last two or three years, due diligence has evolved from a (somewhat superficial) process undertaken prior to investment to an ongoing function confirming and reconfirming a wide range of aspects of a manager’s and fund’s operations. No longer a one-off box ticking exercise, a systematic, IT supported approach is now required so that investors can assure themselves, as far as possible in the current financial climate, that their money is safe. At the same time, managers must dedicate significantly more time and additional resources to establishing this assurance.