“Diligence is the mother of good fortune” -Benjamin Disraeli (author and British Prime Minister)
In a recent edition of Dividend Café, David Bahnsen revisited the premise that economics is, at its core, the study of human action. It’s easily overlooked on a day-to-day basis, but the combined diligence of individuals in a society is what drives all of the economic growth and investment opportunities we experience. With this in mind, today’s quote applies not only at a personal level but also, more importantly, to our communities and society as a whole. We can all use a reminder to be grateful for the efforts of everyone else, as – without all of our collective efforts – the opportunity set for each of us would be diminished (or nonexistent).
Doing Due Diligence
In my day-to-day experience within wealth management, the word “diligence” is most often associated with the phrase “due diligence.” This notion is particularly true of the Alts world, as due diligence is “the process of evaluating the policies, procedures, and internal controls of an asset management organization (source: Alternative Investments, CAIA Level I, Third Edition…or “CAIA Level I” for short).” Due to the less liquid, less transparent nature of many alternative investments, an enhanced due diligence process is justified vs. what is needed for analyzing a publicly-traded investment fund (e.g., a typical mutual fund). Due diligence is generally divided into operational due diligence (ODD) and investment due diligence (IDD).
We’ll get deeper into ODD and IDD in the sections ahead. Before we do, it’s also worth mentioning that, for many of us (which arguably should be true of anyone in our profession, or anyone in any profession), due diligence is also descriptive of a broader obligation. As fiduciaries – as holders of the FINRA Series 65 or 66 licenses operating under an RIA (registered investment advisor) structure, or as CFP® Certificants – we should be “doing due diligence” far beyond just what goes into portfolios. The interests of our clients come first, and the duty of due diligence means constantly reviewing and improving our tools, solutions, and processes to work toward a better experience for them. In other words, due diligence is not just something we utilize from time to time, but rather something we embrace continually as a natural consequence of caring deeply about what we do and who we serve.
Due Diligence of Fund Managers
Manager due diligence covers a broad spectrum of components, as – according to CAIA Level I – the goal is primarily to mitigate “losses caused by problems with people, processes, technology, or external events.” To that end, there are seven parts to review, including structure, strategy, administrative, performance, risk, legal, and references. Most of these areas are included as part of ODD, while the performance, strategy, and a portion of the people/structure segments (e.g., the investment team, liquidity profile, and investor qualifications) fall within typical IDD, in my experience.
Because due diligence can be very labor-intensive when appropriately done, it’s often executed via a coordinated effort of multiple parties. A typical financial advisor doesn’t possess the bandwidth or the skillset to run a complete operational due diligence process. Instead, an advisor’s focus is usually centered more on the strategy itself and how it may provide value to clients. Investment analysts will frequently participate in the due diligence process with the advisor to analyze the fund, meet the investment team, and dive deeper into specific areas. However, the heavy lifting of ODD may be performed using the help of institutional due diligence providers – either on a direct basis or through Alts platforms that include ODD as part of their value proposition – depending on access points and scale of the organization. As with any skillset, larger firms may bring the due diligence process “in-house” to try and cut costs and/or increase efficiency, but that can also introduce real or perceived conflicts of interest.
On the other hand, utilizing third-party providers can add an essential element of objectivity within the due diligence process. In reality, due diligence starts with a strategy review because that is what first garners enough attention to spend additional resources necessary to pursue ODD. And if a given advisor/analyst fell in love with a strategy from the outset, and then that person was the same one performing the ODD, we’d have to at least question the integrity of the results. Thus, bringing together multiple parties to manage the overall due diligence process makes sense from both resource-allocation and objectivity perspectives.
Finding the Funds with Swag…
Practically speaking, investment due diligence (IDD) comes first in the process simply because the more involved ODD review requires significant resources. If a strategy is not compelling or valuable from an investment standpoint, then the operational quality is irrelevant. The CAIA Level I program does an excellent job of summing up the initial fund screening process in three questions:
- What is the investment objective of the fund?
- What is the investment process of the fund manager?
- What is the nature and source of any value added by the manager?
Answering those three questions will help uncover the “why” and “how” of the fund: in what assets/locations it invests, benchmarking, the team, the process, and – in aggregate – what is believed to be the competitive advantage (if any) of the strategy.
…while Avoiding the Ones that May Lag (hopefully)
Operational due diligence (ODD) is essentially everything outside of what most investors think about when considering an investment, which are the strategy and the risk/return expectations. Using Bernie Madoff as a well-known example of atrociously failed due diligence, his Ponzi scheme probably should have been uncovered through the IDD process (e.g., based on return anomalies, like having positive returns in negative markets, as early whistleblower Harry Markopolos alleged).
However, even if people could look the other way regarding the returns, the Madoff fund NEVER should have passed an ODD review. The fact that all of the investors’ cash was simply held in a bank account would be an enormous problem, but then how about Madoff fabricating trades on statements created in-house (rather than using a third-party administrator)? Hindsight is 20/20, but let’s agree there were MAJOR red flags. Conversely, when reviewing a legitimate strategy, the pitfalls aren’t always so easy to spot.
Due Diligence Requires Diligence?
As is probably becoming clear by now, due diligence involves significant resources and skillsets. For a better sense of what’s involved, below is a high-level overview broken down by the seven parts of the process. And keep in mind that each of these underlying components can have substantial additional considerations and supporting documentation (thanks, again, to CAIA Level I for me not having to reinvent the wheel here):
- Structural
- Organization – onshore/offshore, feeder structures
- People – backgrounds, education, ownership, compensation
- Registration – regulatory registration and any implications
- Outside Service Providers – Audit, legal, prime broker
- Investment Strategy
- Markets, investable securities, benchmarking, and capacity
- Competitive advantages, positioning, and idea generation
- Administrative
- Civil/criminal/regulatory actions; employee turnover
- Investor relations
- Business continuity planning, including disaster recovery
Note: these due diligence components are actually in the suggested order, in theory; i.e., going through the above three steps should determine whether a review of the fund’s performance is even warranted. The pragmatic challenge with this suggested ordering is that no one spends bandwidth on parts 1 and 3 if they haven’t already examined performance to some degree. I’m not saying it’s perfect to look at the strategy and performance before everything else, but it’s typically (in my experience) how the world of investment management works. Suppose the value proposition of the strategy makes sense. In that case, the deeper IDD and ODD analyses are employed to focus on the sustainability of results, ideally using third parties for increased objectivity.
- Performance
- Funds (many managers have more than one) and assets under management (AUM)
- Returns, drawdowns, and time horizon (being mindful of any inaccuracies or attempts to misrepresent results)
- Changes in AUM, valuation methodology (how the portfolio is priced and who performs the valuation)
- Portfolio Risk
- Compliance and risk management systems
- Measurement, monitoring, and management of risk (including Chief Risk Officer)
- Leverage (a favorite Alt Blend topic)
- Legal
- Documentation – varies from fund to fund, but private placement memorandums (PPMs), limited partnership agreements (LPAs), and subscription documents (“sub docs”) are pretty standard examples
- Investment type (e.g., LP, LLC) and minimums
- Fees, lockups, and redemption provisions
- Advisory committee (can help add objectivity)
- References
- Opinions/experiences of service providers and other investors
As it is believed that about half of hedge funds ultimately shut down because of operational issues, due diligence serves a vital role for advisors and our clients. Other reasons for failure, such as excessive risktaking, may also be uncovered through a robust due diligence process. Due diligence is not – or should not be – a simple process of just “checking the boxes.” Instead, as we touched on in Universal Financial Truth, an exemplary process combines art and science, as it can be enhanced through out-of-the-box thinking that considers additional possibilities (both positive and negative). Our general obligation of due diligence to our clients includes striving to improve our manager due-diligence processes…all of which require diligence.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
