The Growing Need for Oversight

Would Monsieur like some due diligence on his due diligence?

Originally published in the October 2009 issue

A friend who works at a single manager fund tells me that they have been one of the lucky few to have attracted substantial investment in the last year or so, but at a cost of much more intrusive due diligence than before. Without complaint, he says that some of it is sensible, but rolls his eyes as he adds that much of it is not. The main problem is that the people coming in “don’t know what the right questions are”.

You could be forgiven for asking why they are there at all if they don’t know what they are there for. Everyone knows that in the wake of the credit crisis, the incessant blow-ups, frauds, suspensions, gates and restructurings have highlighted that due diligence is not optional. We have seen a significant increase in fear, uncertainty and doubt. Most responses to this have been a rush to redeem everything, freeze everything or check everything. A proportionate response, though, means avoiding such knee-jerk reactions.

The rush to redeem everything indiscriminately, as the European retail market did, exacerbated the problem. It is certainly not a crime to want your money back, but the reality is that hedge funds and funds of funds provide, in their way, a specialised liquidity repackaging service. What are the chances that, even in “normal” markets, banks could give all depositors their money back on demand? Already, retail investors judge their managers narrowly on whether or not they gave money back as promised.

We think there are broader issues. For example: are remaining and redeeming investors treated equally? In funds of funds, what are suspended investments actually worth? If redeeming investors get a payout at the stated NAV, are remaining investors getting short-changed if they are left with increasing amounts of unsaleable and overvalued rubbish? The very attribute that is desired by some investors may be a sign of unfair treatment, and the perfect solution – in-specie redemption – is the last thing investors want. It’s quite a paradox.

The freezing option was proposed by some consultants in Q4 of 2008. The general advice against making new allocations, irrespective of strategy or outlook, was quite damaging to the reputation of managers who had no exposure to Lehman, and had neither lost nor stolen their clients’ money. It rather over-shadowed the outperformance of hedge funds against mainstream investments.

In fairness, it does illustrate the problems that arise when influential commentators make predictions or give warnings that can turn out to be self-fulfilling, especially in times of stress. Unfortunately, it is rather difficult to measure how self-fulfilling an action or comment has been, so that debate won’t be concluded anytime soon.

“Check everything” is the new mantra. Transparency is vital. The abject and unapologetic failures of four out of the top five auditing firms, who are named in lawsuits relating to Madoff feeders, led one CEO of a rather large fund management outfit to comment that “you can’t trust auditors any more”. This has deadly implications, because previously a reasonable due diligence practitioner would have taken comfort from the presence of a major name as auditor, and taken a small auditor to be a red flag.

Today the reverse is more likely to be true. You don’t believe me? Well, the auditing profession is now too big and concentrated to be allowed to fail. If four out of the top five went the way of Arthur Andersen after Enron, there would be total chaos. The big five have almost no liability in the event of being proven wrong and an oligopolistic insurance policy on their reputation. Yet smaller auditors have more to lose from reputational risk if there is a problem. Any law suits would probably fail because auditors’ terms of reference are wrong. Unsurprisingly, there is a deafening silence from the auditors’ self-regulatory bodies. Nevertheless, the fact remains, that the validity of an audit from a brand name auditor can no longer be taken for granted.

Moreover, in the light of alleged events at Weavering Capital, even the presence of a brand name administrator is no longer quite as reassuring as it once was. It is worth saying that Weavering’s administrator did previously blow the whistle at another fund with related party transactions and nothing to cover them. Perhaps as with auditors, some teams within a firm are good, and others less so.

This is why, today, investors can’t afford to be complacent. Armies of due diligence specialists have been drafted in by boards who are rightly determined to step up governance of the investment process. This is a common theme. The demand is coming from higher up, and the executives who are more directly responsible for due diligence aren’t always sure that it is necessary. But that is the nature of governance and oversight, so it is hardly surprising. We all have to endure much greater scrutiny than before.

It is not hard to picture wealth management client meetings with the clients demanding to be assured that they do not have another Madoff in their portfolio. They may not know what due diligence is, or be able to articulate that they want more of it, but they want reassurance.

Some investors, such as ourselves, are even doing due diligence on the people who are doing due diligence, performing in parallel with the internal team. But why check everything? The old way of doing due diligence was to collect as large a file as possible, the more paper the better, ask as many questions as possible. Follow up a few, and write down the answers they give you. Job done? Er, not quite.

Managers still decline to answer some questions, and sometimes, you think they have answered a question, when in fact they haven’t, or they have answered it so narrowly that it barely relates to the original question. And managers tend to concentrate on the information they can give you, rather than the information they can’t. No prizes for guessing which is more interesting to us.

Good due diligence is about quality as well as quantity. Box-ticking is generally derided. But all three things are as necessary as each other. As I write this, a cartoon strip from Dilbert came out, always good for lampooning management nonsense. The anti-hero says: “As you know, a good process is a substitute for good employees…” There’s no harm having some sensible bare-minimum rules: some investors have a list of managers they will never invest with again, or minimum liquidity requirements. Others might avoid all managers who had any Amaranth or Madoff (but we think the issues are too complex for such simplistic rules).

That leads me into a particular area that I find fascinating. What makes a good employee? Different people have different attributes and qualities. It is generally accepted that the qualities (and motivation) needed of an investment analyst or manager and a due diligence analyst/risk analyst are quite different (see Table 1).


It may be possible to define what qualities that are necessary in a due diligence analyst, and perhaps even to define them using psychometric models, such as the Myers Briggs Type Indicator, which is based on the work of Carl Jung, and is probably the most widely used assessment tool. Such tools are not perfect, but with knowledge of the limitations, they can be very useful for predicting behaviour or balancing a team. Even if you could be sure that one type was better than another for a specific purpose, it is just as important to have a range of skills and attributes on a team.

We use what I call “conversational psychometrics” to help us judge personalities, risk-taking behaviour and team dynamics, which is really just a fancy sounding way of saying that we listen to people and use our knowledge of various psychometric frameworks to guess at what someone’s priorities are. Sometimes we ask ambiguous questions because the interpretation of the question is as interesting as the answer itself.

I think psychology is very important not just for that but for understanding yourself. If you are the sort of person who notices the one black sheep rather than the 99 white ones, then you might make a good risk manager… or a due diligence analyst. Either way, it’s a good idea to learn that most other people like to be told what they have done well, rather than have every error highlighted.

Another attribute that is important is being multi-disciplinary, so that legal, accounting, investment, quantitative and operational issues can be looked at holistically – for example, are the different documents consistent with each other? If the accountant doesn’t look at the administration agreement, the lawyer doesn’t look at the margin calculations and the investment analyst doesn’t look at the prospectus, then that is not good enough.

How do you benchmark your due diligence people? That’s not easy, but due diligence should never be left to just one person or fully outsourced. We always encourage clients to be actively involved themselves, so they know enough about the funds to know whether we know what we are talking about. But if we can surprise them with information they didn’t know, then I guess we have done a good job.

But the most critical attribute for a due diligence team is authority. This is something that is very hard to define. If due diligence executives are too – shall we say, compliant – then they may well be ignored when it really matters. So this is really a story that repeats itself in different relationships: for example, between the CEO and compliance officer, and between the chief investment officer and chief risk officer or head of due diligence. You can have a really good systematic, detailed and curious analyst, but one who is not empowered to speak his mind. Equally, I have heard of managers complaining over the heads of the due diligence people to get them to back off.

Sometimes, the threat comes from within. Internal politics and vested interests can be crippling. No one likes their ideas to be rained on by risk managers, and we have heard of horrifying interference by people who have put a portfolio together and are still in the organisation, spinning against the unfortunates who have been drafted in to sort things out. There’s actually a business rationale for this. In the case of one wealth manager I know, it has taken them almost a year to get out of one investment into which they put their clients. As the gate allowed a little to be redeemed at a time, so each contract note reminded their clients about the bad investment in the first place. It’s a painful choice to do what is best for clients at the cost of admitting a mistake.

So let’s assume you are intelligent, dedicated, risk-averse and unencumbered by political restrictions. How should you go about due diligence? And what are the right questions?

There are two lessons we can learn from Madoff. Firstly, I sometimes suspect that managers who say they are protecting the value of their intellectual property are actually hiding the fact that there is no value, as with Madoff. How to deal with such situations? In principle, I believe that investment managers with good trading ideas and methods have as much right to commercial confidentiality as any other type of business. The only difference is that clients probably have more right to know what exactly is happening with their money. When we carry out due diligence, I like to see absolutely anything I ask for on-site at that time, so there is much less opportunity for falsification. I don’t want to take copies of things that are particularly confidential; I just need to confirm to the client that they exist and if they are satisfactory. Simply put, even hedge fund managers have some rights to confidentiality. You can’t patent trading ideas, so this is a reasonable thing to want to keep quiet. However, it must be proportionate and reasonable. Otherwise it is a red flag.

Secondly, it is clear that Madoff knew how to “play” the SEC, auditors and investors. He knew what level of proof they required, and exactly what their methods and checklists had. Take auditors: he knew that once his pet auditor, David Friehling, had signed off his accounts, other auditors would mechanistically accept his word. This meant that the auditors of the feeders would not need to ask difficult questions, and would just rubber stamp the feeder accounts for a fee. Nice work if you can get it, and an excellent way to morph a dodgy audit into a copper-bottomed one.

And that is all investors needed to get past their internal processes and mitigate the red flags – a brand name auditor, along with a custodian and administrator who were doing the same tricks. With the SEC, he knew that he had to be careful not to mention documents to give them clues of what to ask for. He also knew that they generally accepted one-dimensional self-certified statements. But I guess it was a stroke of luck that the SEC’s ineffective investigations gave him a clean bill of health, and more mitigation.

And this is why a balance of systematic and what I would call “speculative” questioning is important. Don’t be afraid to ask stupid questions. In general, the manager is going to know more about his strategy than you are. That is a fact, and the object is to learn more about what they are doing. But hopefully, you will have prepared for the meetings in depth, so your questions won’t in fact be stupid. We tend to focus on one or more particular areas in detail, in addition to our systematic review. But we vary where we focus, so it is hard to predict.

Other than the questions on standardised questionnaires, some questions you should be answering for yourself, through questioning the manager include: Where are the assets really? Are there any contractual or contingent liabilities? Do they need to take any risk at all if they are comfortable just on the management fee? Conversely, what do they have to lose if things go wrong?

Do try to answer key questions like this yourself, rather than ask the manager to fill in a questionnaire. By now, it should be obvious why prepared or rehearsed answers are of limited value.


Christopher Miller graduated with a BSc (Hons) in Economics from the University of Buckingham. He gained the Securities and Investment Institute’s Diploma, and now is a Fellow of the Institute. He was previously Head of Operations, Asset Management, at The ECU Group plc, a currency manager with $1.8 billion under management.