The Void in Operational Due Diligence

How to approach and what to ask

Originally published in the July/August 2008 issue

Whether you are investing your own or your client’s assets, you should have full transparency into those you are entrusting. While much has been written on due diligence, there is still a void in conventional approaches due to a reluctance to ask difficult, invasive or embarrassing questions. Prior to investing, and throughout the life of an investment, investors need to take a broader, non-conventional approach to due diligence and must ask critical questions, regardless of the money manager’s reputation, status or track record. If a manager refuses answers, then investors and fiduciaries have an obligation to ask why and factor the lack of transparency into decisions on whether to invest or remain invested. While the importance of some questions may be magnified for newer funds or smaller operations, the themes are broadly applicable. Ultimately, the answers are just data points that one needs to correlate and assign a value to. Merely setting an expectation that you will take a non-conventional approach to due diligence, as suggested herein, may minimise risk.

Divide and Conquer

Investors can hone skills at identifying risk areas by becoming aware of anomalies through on-site meetings and attestation requests. Give insiders the opportunity they may be waiting for to let investors and prospects know what is going on inside a fund. Since the purpose of an on-site due diligence is to obtain information, ensure that the people being questioned will yield that result. Don’t be fooled by a well-rehearsed dog and pony show. Junior investment analysts and partners are unlikely to answer your questions truthfully if they fear it will cost their jobs. Perhaps, even more concerning is that the COO or CCO, who often works for the managing partner, may not answer as directly as you would like if other key managers are present. In an effort to mitigate these issues, separate the operations team from the investment team during due diligence meetings and conduct simultaneous interviews, making sure to spend one-on-one time with key people. Ask the same questions to different constituents and then compare notes. Address inconsistencies if you choose to invest. Those who are most candid with you may become good sources of information in the future.

Attendance and Relevant Personal Information

Active involvement by undistracted senior managers is important. Ask managing partners and other key staff how much time each spends away from the office and whether attendance is tracked. Request attendance records and probe to assess their accuracy. Absent leaders may be cause for concern, particularly in smaller funds. Ascertain whether senior people are experiencing personal situations that may impact on their ability to manage your assets, such as illness, divorce or sickness or death of a loved one. As the final judge of materiality, you need to ensure that you are advised of a relevant event in a key person’s life. Circumstances that can impact on your large placement should not be considered personal.

How are management fees spent?

You should have a detailed understanding of how the fund spends management fees, which should be used to pay operating expenses; not generate wealth for partners. The more expenses passed through to the fund, the more you should question how fees are used. Ask how much money the managing partner receives directly or indirectly from the operating budget, including salary, bonus, loans and special payments.

Additionally, if a fund’s operating footprint shrinks significantly during a period of poor performance, investors need to question how management fees are being used and whether the manager is carrying out his fiduciary responsibilities, particularly when redemptions are restricted over time.

Turnover of Insiders and Service Providers

Investors should insist that they are informed of employee turnover and then ask to speak with all former key insiders, especially operations and compliance staff. Fund managers should be requested to indemnify former employees so they are protected from retaliation. If a fund that pledges transparency to its investors refuses to cooperate, assess why and ask whether former staff members have been bound by non-disclosure agreements. You must justify reasons why you cannot speak freely with a fund’s former employees.

A fund should inform you of service provider changes. Request that managers indemnify former auditors, accountants, prime brokers, traders, and lawyers so that they may speak freely with you. Remember that providers paid for by the fund should be representing the best interests of a fund’s investors. Ask the fund manager whether any employees or service providers have ever refused to sign the auditor’s annual attestation questionnaire and, if so, why.


Ask the Managing Partner, CCO, CFO, and COO whether they have always been in compliance with fund documents, including the Partnership Agreement and the Offering Memorandum. Investors sometimes forget that the Offering Memorandum is a relevant document and that statements made therein are binding unless superseded by other legal documentation. You should consult an attorney for all legal advice, including advice on which sections of an Offering Memorandum may no longer be in force. Be specific in questions about compliance with fund documentation. For example, if a manager pledges that he will not be guided by tax implications in funds whose primary investors are non-profit entities, you should specifically ask whether any decisions or trades have ever been based on tax implications and whether any reports even exist to demonstrate the impact of trades on GP interests and tax liability. Request copies of trade logs and trade commissions to validate a manager’s stated investment discipline.

Ask the Managing Partner, CCO, and COO (independently) whether there have ever been allegations of non-compliance by any current or former employees or service providers and whether they have ever been contacted by the SEC Division of Enforcement or similar authority for any reason. While there are plenty of legitimate reasons that a firm may be contacted by a regulatory authority, investors should have this information to determine relevance to their investment decisions.

Investors should ask managing partners and portfolio managers whether they have the right to override decisions made by the CCO and then ask the CCO, CFO, and COO, as well as junior people in these functions whether this has ever occurred.

Due Diligence followed by attestation

Upon completion of a due diligence visit, and then at regular intervals, ask the fund’s Managing Partner, COO and CFO to provide a sworn attestation confirming answers. Refusal or a long cycle time to comply may warrant further consideration. Additionally, if regular fund communications such as newsletters, reports or e-mail suddenly stop, or if the content of those communications changes, question why, especially when performance is down.

Investors need to determine the materiality of answers to questions in consideration of the fund’s size, age, and current performance. Don’t wait for poor performance or blow-ups to connect data points that appear during a due diligence. Investors must remain vigilant during all market conditions. In most blow-ups, there is someone inside who knows something before the investors do. Your greatest advantage is to identify those people at the earliest opportunity and extract all relevant information from them. A non-conventional approach to due-diligence can be a competitive advantage to avoid blow-ups, maximise returns, market the organisation and protect your reputation.

Blaine Klusky is Senior Vice President and Global Operations Executive of American International Underwriters, AIG’s foreign general insurance business.