The Old Era of Due Diligence Is Over. Here’s What the Post-Pandemic Future Might Hold.
Covid-19 upended manager selection — and at least for some allocators, there’s no going back.
The Covid-19 pandemic impacted every area of our lives, forcing investment professionals to react to ever-changing circumstances. Much has been written about the volatile financial markets and the hectic days of trading over the past 14 months, but now we’re heading into the post-pandemic world. With people across the globe getting vaccinated against this deadly virus, we are wondering, What is the new normal for asset allocators? In particular, how will due diligence evolve? Will it return to its 2019 state — or did the pandemic permanently alter how asset managers get hired?
Like everyone else, asset allocators have spent countless hours using Zoom and other videoconferencing tools since the pandemic began. Adapting to the extra screen time proved challenging and definitely caused more than a few impediments to comprehensively completing due diligence.
“Pre-pandemic the allocator really drove the meetings,” says Shana Orczyk Sissel, CIO of registered investment adviser Spotlight Asset Group. “In a Zoom setting the manager has much more control in access and creating the image they want.”
This change in the power dynamic made many allocators feel uneasy about their due diligence efforts, and understandably so. No allocation professional wants to make a deal with incomplete information or, worse, to miss a warning sign of fraud at a fund shop. These concerns contributed to a decline in new manager relationships, with emerging fund managers especially disadvantaged as allocators nurtured existing relationships instead of cultivating new ones.
At Spotlight, for example, searches were limited to “critical needs,” Sissel says. “We focused on using managers we knew well already,” she explains. The University of Chicago’s endowment fund was likewise “more reliant on re-ups with existing managers,” according to senior portfolio manager Jeremy Heer, who identified digital events as beneficial for expanding the deal funnel.
Still, late 2019 through 2020 was an exceptionally difficult period to launch a new fund, and emerging managers will likely continue to face asset-gathering headwinds this year, as fund marketing’s move into the online realm has created new compliance concerns for everyone involved. (If you’ve ever noticed the paucity of information on a hedge fund website, you understand that they’re restrained from employing many aspects of in-depth digital marketing.)
When allocators were all but locked down, they turned to their professional networks for referrals and due diligence assistance. Everyone contacted for this story described the importance of sourcing ideas and confirming hunches during conversations with trusted contacts. (Yes, institutional investment professionals, your LinkedIn account is worth dusting off and updating.)
Michael Underhill, the CIO of Capital Innovations, drew on a particularly wide range of contacts last year. “Reaching out to the firms in our existing network — such as entrepreneurs, private equity firms, venture capital firms, co-investors, legal and accounting professionals — helped reduce the legwork for our team,” he notes.
Trusted financial professionals were able to fill in critical knowledge gaps throughout the due diligence process. At the University of Chicago, Heer relied on fellow allocators who had conducted the site visits that he was suddenly unable to perform with potential new fund managers. “We also have a consultant that we tended to ask more of during this time,” he adds.
Heer and Underhill both believe that due diligence will never return to its 2019 state. They foresee an enhanced role for technology, including videoconferencing, moving forward. “Clear, frequent, and honest communication among stakeholders is especially important during remote due diligence and will stay in place post-pandemic,” Underhill says, adding that many asset managers have upgraded their data privacy and digital security systems to satisfy remote due diligence needs.
Heer is bullish on traditional conferences, though. “You cannot get the kind of scale on introductions and opening conversations in any other format that you can with in-person events,” he says. “Video is great for some things, but talking to other LPs is an important part of any such meeting, and that’s lost in digital form.”
Sissel, on the other hand, expects due diligence to fully return to its pre-pandemic form. “I found completing due diligence incredibly difficult during the pandemic,” she says. Because she relies on observations and conversations outside of formal investment team meetings for her due diligence methodology, the Spotlight CIO doesn’t anticipate a role for videoconferencing or other alternatives to site visits. “Often you get your best insights from receptionists,” she concludes.
As Covid-19 destroyed any semblance of a traditional due diligence routine, asset allocators used a combination of technology, deep professional networks, and more than a little creativity to continue their work. Despite truly unprecedented circumstances, the allocators interviewed for this story successfully closed critical deals and maintained access to important funds.
As we (hopefully) head into a post-pandemic world, many allocators seem ready to adopt permanent changes to due diligence procedures, whereas others are anxious to return to their tried-and-true systems. Because there are no objectively correct and stringent rules for due diligence, different approaches should be both welcomed and accommodated. Flexibility in finance should become the norm as long as ethical responsibilities are met and laws are followed diligently. Everyone is due a little freedom in this new normal.
Nathan E. Yates is the owner of ForwardView Consulting and a former finance and economics professor. He holds a master’s degree in finance from Southern New Hampshire University and tweets from @NathanEYates.