Due Diligence: Making a List; Checking it Twice.

I was interested to read an article by Alan Andreini about the increasing burden of investors’ due diligence of external managers and, specifically, hedge funds. Here’s a blurb:

“Ten years ago, a hedge fund’s stellar track record would overshadow investors’ worries about the fund’s everyday operations. Operational due diligence was a check the box function that took a few hours at most...Today, all hedge fund managers who seek the large and stable institutional allocations must understand what it takes to assemble and operate an infrastructure that will pass examination under today’s new operational due diligence microscope. The game has changed.”

It’s encouraging to hear that investors are taking their due diligence efforts more seriously. No doubt the game has changed over the past few years (thanks to Bernie Madoff, Allen Stanford, etc.). Apparently, the three-day boondoggles to New York and London may be a thing of the past.

Anyway, what’s really interesting about Andreini’s article are his research findings on the operational due diligence items that are most pressing for institutional investors today. Here’s what he found the investors were focused on:

The quality and character of a hedge fund’s financing arrangements—in other words, funds are looking at a hedge fund’s counterparty risk exposure;
The quality of a fund’s surveillance procedures (to identify potential insider trading);
The scope of a fund’s legal documents (with a view to giving more rights to investors);
The independence and competency of the Board;
The ability of a hedge fund manager to deal with the new and looming costs of regulation; and
The ability to cover every-day expenses with working capital.

I think that’s a pretty good list of high-level topics. Nonetheless, I thought I’d ask a close friend of mine who (literally) did 50+ due diligence audits of external managers for a major sovereign fund post crisis. (He has a lot of frequent flyer miles). Here’s what he told me were the key factors that determined whether funds made the cut:

“Andreini’s comments are high level and fundamental. But I’d add the following issues as being crucial in our thought process: We look quite hard at the management framework and ownership structure to ensure there is alignment of interests (and no criminals); We want to ensure the funds follow local practices and regulations — that they have their licenses and so forth in place; We evaluate the investment / front-office arrangements to ensure the fund has an investment committee and a formal decision-making process; We then look for sound operational procedures (for which we have some pretty detailed definitions); We look for sufficient compliance and control arrangements to prevent mandate breaches; We look for standardized and appropriate risk management and valuation procedures; We ensure the fund has unbiased and independent reconciliation and reporting (via a Custodian); and, in sum, We verify that the presented strategy and operations match up with the on-the-ground reality.”

Due Diligence: Making a List; Checking it Twice.

Institutional investors are taking their due diligence efforts more seriously. No doubt the game has changed over the past few years (thanks to Bernie Madoff, Allen Stanford, etc.). The three-day boondoggles to New York and London may be a thing of the past...