Due diligence is a reality check with an in-built veto, and
commences after the manager selection process but before the
It is not part of the manager selection process, although
it may be part of a manager elimination decision.
It is most effective prior to investment and the work is
usually heavily front-loaded, but a certain element is ongoing.
Much of due diligence is qualitative, operational, and mechanical
- it is only peripherally an investment function.
Due diligence is essentially a discipline which enables allocators
to check what they thought they knew, and realize what they
What is Due Diligence?
Do we talk about "due diligence" in our daily lives?
No. We talk about checking something, making sure, drilling
down to details
"Due diligence" is a phrase
invented by lawyers, and therein lies a clue as to its purpose.
A great deal of the point of due diligence is to be able to
demonstrate and document that you took proper care to check,
verify, and cross-reference, all the various aspects of an
investment - bluntly, to cover your back. Like detective work,
there are glamorous moments when you'll uncover surprises,
successfully avoid hidden dangers, discover lurking secrets
that a manager would rather you didn't know, and save the
world's capital markets from unspeakable systemic risk singlehandedly
just before the credits roll! But most of the time, it's a
dull process of checking, verifying, and filing all the information
Information asymmetry ("secrecy" in layman's terms)
is a part of the industry. Managers have a legitimate need
to maintain some information proprietary, and often gain no
commercial advantage from transparency when they are not seeking
new investors. However this information asymmetry also has
a negative side, allowing managers to hide what would be embarrassing.
Allocators need to understand this fine line, and, manager
by manager, understand it well.
Managers choose unregulated investment structures because
that's what investors want. Not only are most alternative
asset funds tax neutral, but they are unregulated, allowing
freedom of investment action. But as with real life, the greater
the freedom, the greater the responsibility; the degree of
control and self-discipline is decided by the manager. Many
alternative investment vehicles offer better processes, alignment
of interests, and risk management than typical regulated investment
funds, but inevitably not all do comprehensively. We need
to check what controls actually are in place, because no regulator
will do that for us.
Furthermore, human nature tends to embellish the truth. The
fisherman's catch grows longer with each retelling. By the
end of the roadshow the pitch is significantly more plausible
than in the first few days. We need to check the hard facts
behind the story.
Finally (and thankfully infrequently) there is open fraud,
where a manager has an intention to mislead investors. Deliberate
fraud is, unsurprisingly, usually well-disguised, but not
to look for the obvious clues would be negligent given most
allocators' fiduciary duties.
Bodies like AIMA www.aima.org are trying to create standards
for common levels and standards of disclosure. Institutional
investors often have a fiduciary need to have clear and comprehensive
information flows. Generally, the trend to more transparency
is established, but it's not necessarily a natural destination
for the industry.
What Are You Trying to Achieve?
We make investment decisions because we think we have understood
the proposition and the environment within which that proposition
will play out. Our process may be qualitative, quantitative,
rational, or intuitive, but unless you're conducting some
experiment involving monkeys or dart boards, then you're basing
your investment on a collection of information provided to
you or deduced by you.
Due diligence is the process of checking that information.
Most due diligence exercises start with a questionnaire that
lists the various areas of information that need to be covered.
This is a useful aide-memoire to an allocator that she has
examined all the relevant aspects of the proposed investment.
A due diligence questionnaire is usually completed directly
by the manager, unless the balance of power is in the manager's
favour (for example, if the allocators is proposing to make
an investment that is small in the context of the manager's
overall assets), in which case the allocators may assign a
researcher to go through the manager's documentation and source
A typical section of a due diligence questionnaire might
look like this1:
|Hurdle rate / High water mark:
|Any other fees:
|What costs, if any, are recharged to the fund?
|Are your fees calculated and charged in terms of equalisation structure by:
- issuing a different series of shares every time shareholders subscribe?
- the Equalisation Share method?
- the Equalisation and Depreciation Deposit method?
- the Equalisation-Adjustment method?
|Do you ever share fees with a third party?
|Have any investors been granted rebates?
Disclose any soft dollar agreement.
The manager's responses are then cross-checked against the
documentation on file, including the allocator's meeting notes.
Managers do not exist in a vacuum - they form part of their
own ecosystem, and this is helpful to allocators in evaluating
reputation, consistency, and provenance. A good due diligence
process will include verification of these external points
of contact, including, for example, sight of agreements with
service providers, and uptake of references for the individuals
in the firm. The objective is to document that verifiable
facts have been verified, and to highlight for further study
Part of the process is to establish the basis for the ongoing
relationship. The allocator should check what level of information
is given to clients, on what schedule, with what inbuilt delay,
and whether any clients receive preferential levels of information.
Furthermore the allocator needs to develop a reasonable degree
of comfort (tho' this may fit more naturally in the manager
selection process) that she has ongoing informal access to
the manager as needed.
Manager selection is not due diligence.
Good allocators will have a process to decide on managers.
It may be a highly experienced professional investor with
a deep address book, using his qualitative skill to 'smell'
a good manager; it may be a quantitative house with sophisticated
analytic tools; it may be a combination. There may be a conscious
optimization process to allocate among managers.
But this is not due diligence. Full due diligence is time-consuming
for both the manager and the allocator, and to use due diligence
as a manager selection tool would be an inefficient use of
The due diligence process comes after manager selection and
before (and then during) investment. Of course, if the due
diligence exercise throws up too many negatives, then there
may be an iterative process of vetoing one or more of the
selected managers and going back to select more, which then
go through the due diligence process again.
Some allocators will use a two-tier process where in order
to establish a foothold with a manager they will allocate
some capital on a slimmed-down due diligence process, and
then a more substantial allocation following a deeper due
diligence process. There is considerable merit to this. It
allows allocators to follow their instinct, does not waste
research resource at a point where there is less information
anyway, and when the manager is still in a development phase
and the pattern of operational risk will change rapidly in
the ensuing months, but does not risk too much capital. The
better allocators will then mandate that after a specified
period (perhaps one year), they will either scale up their
investment with a full due diligence exercise, or redeem fully.
This prevents their portfolio being cluttered with a number
of smaller holdings unsubstantiated by full process.
Due diligence is a Front-loaded Process
The bulk of the due diligence process happens before investment.
Investing in alternative assets carries significant liquidity
risks. Hedge funds typically have 15-90 day notice periods
to redeem, monthly or quarterly dealing windows, and then
5-30 day payout delays (sometimes with partial withholding
of some of the proceeds pending final accounting). So a decision
to withdraw assets is by nature a medium term strategic decision.
Let's say that a manager that you invested for their edge
in event driven strategies in public markets begins to trade
in, say, OTC instruments, and you are concerned that this
is beyond the manager's skill set. You'd like to switch to
another manager you now feel more comfortable with. The following
table shows that, if you're lucky, you may be able to adjust
your asset allocation in three months, while nine months is
a more typical turnround:
|manager puts on new trades
||manager puts on new trades
|your risk aggregation system is capable of collecting data on all assets in the portfolio daily - you discover the trades yourself
||your risk aggregation system cannot collect data on all assets, or the manager has mandated a time lag - you discover the new trades in the manager's monthly note
|your manager offers 30-day or better notice and has no queue of redemptions - you place the order
||your manager offers 45 day notice - you place the order for
||April Feb 5th
|your manager offers monthly liquidity
||your manager offers quarterly redemptions
|the manager's administrator pays in full, promptly
||the manager's administrator pays over two months
|you reinvest in a new manager
||you reinvest in a new manager
|best reallocation turnaround
||typical reallocation turnaround
Inevitably, therefore, your decision to invest must be as
sound as it possible can be, as your flexibility to shape
your allocations disappears once you make the investment.
Your due diligence process must be complete before you make
While you are invested, you stick to your due diligence process
(i) if any material facts change and (ii) as a monitoring
discipline periodically (every 6-12 months, depending on your
investment process). A material change might include the opening
of a new office, hiring new professional staff, a change of
service provider, etc, and would involve a diligence process
applied just to that event. The ongoing due diligence is a
reality check that nothing has deteriorate or changed since
the initial piece of work. Ongoing due diligence is usually
less onerous, as much static information will not have changed
(if the principal said he studied at a certain university
and you verified that first time round, it would waste everyone's
time and effort to recheck, for example).
It is good practice also to run through a due diligence checklist
on addition of new capital. Neither funds nor fund managers
remain static as they grow (or shrink!) and the strategy you
allocate incremental capital to may not have the same drivers,
constraints, and risks as the strategy you initially researched.
Operational Due Diligence
Operational due diligence focuses on the company, its administration,
the investment administration, and the service providers and
their interfaces with the manager.
In many ways this is the critical focus of the due diligence
process: while the manager and the strategy must have impressed
the allocator enough to want to make the allocation, the operational
structure is less visible, but provides the architecture within
which that investment process will flourish or wither. The
investment risk is inevitably what attracts the investor,
and is the element of overall risk that an experienced manager
is primarily being paid for, and is presumably considered
an expert in. That risk is what the investor, by the time
they conduct due diligence, is usually cogniscent of and comfortable
with. The operational risk is often less well understood,
even at a relatively late stage in the process.
While investment strategies can and do go wrong, they rarely
fail completely. When they do, of course (LTCM, Eifuku, etc)
they tend to be spectacular and hit the headlines. But more
hedge funds are killed by business and operational failures.
Most hedge funds are run by small companies or small business
units, often by the investment principals. A successful bank
trader may well have 10-15 years' experience in trading large
pools of capital, but as she starts her new hedge fund, she
has no experience of running or building a company. The organizational
risk is very high. Part of the manager selection process is
of course a judgement call as to whether that risk is insuperable
or not, but allocators must still verify and check their facts.
Have you had sight of the agreement with the IT provider?
Have you confirmation that there is sufficient working capital
in the firm? Have you interviewed the business manager/COO
as well as the investment team?
Most funds outsource some or all of their back office and
systems. The due diligence process may need to look at the
credentials of the outsourcing providers (this may not be
a major issue if the prime broker is a major investment bank,
for example, but if the administrator is a small offshore
firm you're not familiar with, then you need to check their
capabilities). Allocators should also understand and have
verified the money flows at all points, noting who has authority
to transfer what, who needs to sign off on transactions, and
who does the reconciliation (and how often, for whose eyes
etc). "Follow the money" is a key element here -
from the point at which a dollar is subscribed to the fund,
investors should be able to identify where it can flow to,
and who can direct that flow.
Even with external administration, the manager will have
an internal portfolio management system, at very least shadowing
the administrator's own system, and in many cases superceding
it operationally. Allocators need to be aware of the system,
check that it's appropriate for the strategy, and understand
how it interfaces and reinforces any external systems. Allocators
also need to understand how the portfolio is reconciled, which
is the definitive portfolio, and how its positions and prices
are arrived at. In particular, portfolios containing non-market
priced assets (OTC contracts, distressed securities, swaps,
etc) or infrequently traded or illiquid assets, will cause
the allocator to check the source of prices and their verification.
Risk management systems are integral to most hedged strategies,
whether a simple stop-loss programme, or a more complex risk
aggregation model. While it can be difficult for anyone but
the writer of the programme to understand exactly the inbuilt
algorithms in the models, allocators need to verify (i) that
the system exists (ii) what it is trying to achieve (iii)
that there is a real feedback loop so that the system's output
genuinely does form an integral part of the process.
The motivation of the individuals involved is also important,
and often critical. Allocators must understand who "owns"
the revenue flows (through equity ownership or compensation);
what the history of the partners' relationship is, and what
if any other interests they have.
The corporate strategy is as important as the investment
strategy. An essential part of the due diligence process is
to document the principals' intentions for the commercial
model. Hedge funds (and hedge fund businesses) are not linearly
scalable. They change characteristics over time and with increasing
assets. A fund of US$50m cannot behave the same way as a fund
of US$500m, and will require and be able to support a different
shape of organisation - you need to understand how it will
be different. The fund will have a capacity constraint - will
this support the aspirations of the principals or is this
an organisation that will need to diversify? Finally, this
lack of scalability is one reason to maintain an ongoing due
diligence regime. As a manager changes in size, it also changes
qualitatively, and the allocators, through regular scheduled
"reality checks" must understand how the organizational
risk is changing.
In some ways the easiest element of a due diligence process
(and often outsourced to specialist firms) is the regulatory
and personal investigation. For each principal, allocators
should check (i) the details of their resume (ii) regulatory
history in the jurisdictions where they have worked and (iii)
personal financial history including bankruptcy checks. Different
jurisdictions have different rules on what an investigator
may or may not access, but generally, at a very minimum, regulatory
and bankruptcy checks should be possible.
Allocators would not only be looking for undisclosed black
marks, but also discrepancies with principals' resumes. While
some allocators may not mind that a manager who says he received
an MBA from the London Business School in 1990, but in fact
only studied for a short executive programme, others may see
small inconsistencies as indicative of a potential pattern.
Whichever the conclusion, allocators need to have the information.
Qualitative Due Diligence
Due diligence is a qualitative exercise, for several good
First, by definition, if you can measure a parameter and
attach a number to it, it must reflect something that's happened
already. As investors we are interested in what is likely
to happen, not what has happened in the past. While there
is some evidence of risk and returns persisting over short
periods, generally, quantitative research does little to help
us understand the risk of our investment going forward.
Secondly, the majority of the parameters we want to cover
in our due diligence are qualitative, procedural, or structural
in nature. It's more likely that we have run detailed quantitative
analysis as part of the manager selection process initially,
and, subsequently, as part of our ongoing risk measurement
and management. Generally speaking, due diligence is best
documented in a paper, not on a spreadsheet.
Doing the Obvious Checks
Sometimes you just don't have time to do a full due diligence
exercise. A purist might argue that any investment conducted
without proper due diligence becomes mere speculation, but
sometimes pragmatism demands otherwise. Perhaps the manager
is closing and you are under pressure to allocate capital
rapidly. Perhaps you want to make an initial small investment
to establish a relationship with the manager, without tying
up your research team unduly.
We have done a number of these "kick the tyres"
pieces of work, and while they would be a weak legal defence
for a client if an investment were to go wrong, we believe
that they catch most of the practically important issues:
The must-do shortlist would cover:
- Risk: what could go wrong with the investment strategy
and the organisation, and where are the key weaknesses?
What are the controls or early-warning signals?
- Service providers: are they substantial and known to you?
- Term sheet and key offering document paragraphs - are
the legal, fee, compensation, and dealing schedule and procedures
- Informal personnel reference checks - are the results
of 2-3 phone calls to contacts of each of the principals
- Organisation - is there working capital, people, and IT
appropriate to the strategy and asset size managed?
- Information flows - do clients receive sufficient and
regular information, and do you have reasonable informal
access to the manager?
This last item is probably the most important. In a world
of imperfect information and huge complexity, you will never
own all the information, and what you own will be confusing
and time sensitive. What is important is that when you want
a piece of information, you can get it readily. We will not
allocate clients' capital to a manager where we do not have
reasonable access to the principals, and we see a reluctance
to divulge information to a professional allocator or investor
as a major red flag.
For a list of the typical areas of due diligence focus,
* Peter Douglas is council member for
Singapore, Alternative Investment Management Association and
member of the Advisory Board of the Chartered Alternative
Investment Analyst Association.