Due Diligence 101: The Front Line of Alternative Investment Success


Third Wire Editorial


Due Diligence 101: The Front Line of Alternative Investment Success

LTCM, Amaranth Advisors, Madoff, Galleon—these are just a few of the due diligence horror stories older alternative investment professionals tell junior analysts at after-work cocktail hours to school them. Unfortunately for a number of investors, including some of the world’s most sophisticated institutions, these were more than just stories. The blowups were all too real, and for some firms and careers, their decision to invest in these managers was unsurvivable. The top question on many investors’ lists for years was, did you have exposure to Madoff? And if you had anything to do with Madoff or any of the feeder funds, the conversation likely stopped there.

In a world where most active fund managers fail to meet or exceed their investors’ performance expectations year after year, selecting the right managers is the single most critical factor of success, and rigorous due diligence is the front line.   

Due diligence is the investigative process that should inform every investment decision. It’s the meticulous examination of an investment opportunity to verify that it stands on solid ground—financially, operationally, and even ethically. It involves a deep dive into every aspect of a fund manager’s business and investment strategy in search of addressable problems and clear red flags. Many things beyond performance lead to a manager’s success or failure, and they all must be evaluated before investing: the management team, the operational framework, the legal structure of the fund and firm, background checks, channel checks, and even judgments of personality and the temperament of the key leaders executing the strategy and running the business—and this is not an exhaustive list btw. 

Some of our favorite anecdotes come from colleagues at a previous employer who kept meticulous files on the managers they conducted due diligence on, including the reasons they declined to invest. Proof that having an eye for failure is just as important as having an eye for success. In their trusty database, among the more memorable reasons they recorded for declining to invest in managers who eventually blew up were the cryptic Decline/Cowboy, the less cryptic Decline/Ethically Challenged, and the even less cryptic Decline/Made Off.

In practice, while a fund is an investment strategy, it is also a business being run by people. A manager might have an impressive track record, but if the management team lacks integrity or the operational systems and financial controls are weak, the investment could become compromised. For instance, a ‘Decline/Cowboy’ could signal a manager they believe takes excessive risks or has an unstructured approach to investing. ‘Decline/Ethically Challenged’ might refer to discovering a history of regulatory infractions or if you catch a whiff of something during network checks with former colleagues or via social media. And ‘Decline/Made Off’—a play on the name Madoff—is a clear red flag.

These anecdotes serve as a reminder that due diligence is not just about data analysis and ticking off all the boxes on some checklist; it’s about judgment calls and character assessments. Due diligence is the cornerstone of sound investment management, designed to systematically understand and document the process of selecting investments and improve your odds of investment success. It’s an art and a science. 

The fate of LTCM, Amaranth Advisors, Madoff, and the Galleon Group are not merely cautionary tales retold after a couple of cocktails; they are stark reminders of the pivotal role due diligence plays in the investment process. The decision of who to entrust with this critical task can make the difference between running a successful alternative investment program and becoming a warning for future generations.

Whether you choose to partner with an alternatives provider with a highly experienced in-house due diligence function—with a keen eye for detail and a robust investigative framework—or rely on the more off-the-rack approach taken by a number of the larger alternative investment platforms that outsource their due diligence process to third-party providers—is an important point to consider. Given how critical manager selection is, we know which option we’d recommend.

Contact us to learn more about Third Wire’s due diligence team, process, and capabilities. And be sure to look out for our follow-up article about third-party due diligence versus in-house, coming soon.


This article is for informational and educational purposes only. It does not take into account the specific investment objectives, financial situation, or particular needs of any reader.