This is how it should be done.

With alternative investments, manager selection is crucial to success, and due diligence is the cornerstone of this process. As we’ve discussed in previous articles, far from being a simple checklist or rubber-stamp formality, due diligence is an in-depth exploration of a manager’s operations, strategy, risk management, performance history, and organizational framework, delving into both qualitative and quantitative aspects of both the potential investment and backgrounds of key personnel. At least, that’s what it should be. 

…far from being a simple checklist or rubber-stamp formality, due diligence is an in-depth exploration of a manager’s operations, strategy, risk management, performance history, and organizational framework, delving into both qualitative and quantitative aspects…

Consider these two real-world scenarios.

Scenario 1: When compromise is not a virtue.

An analyst at a third-party due diligence provider reviews a new fund from a large, well-established fund manager—Manager X. It’s the same evaluation process they complete hundreds of times each year, pretty standard, with no major red flags. The analyst gives the new fund a ‘B’ grade—not terrible, a fair score given that it’s a new, relatively unproven strategy for Manager X.

The next day, the analyst is visited at his desk by his boss. It turns out that a ‘B+’ is the minimum grade required for funds to be accepted for listing on alternative investment Platform Z, an important source of AUM for many funds these days. Apparently, phone calls were made, conversations were had, and they wondered if the analyst wouldn’t ‘revisit’ the analysis and grade.

The implication was, for someone higher up the food chain, it is important that this new fund from Manager X is able to be approved on Platform Z along with their other funds. And the junior analyst—with a wife, two kids, and a mortgage—is not willing to die on this sword. Plus, he figures it’s a name-brand manager, so the odds of something going horribly wrong should be slim, right? He shrugs his shoulders, quietly submits to pressure, and revises the new fund’s grade to ‘B+’ without much fuss.

And the junior analyst—with a wife, two kids, and a mortgage—is not willing to die on this sword. Plus, he figures it’s a name-brand manager, so the odds of something going horribly wrong should be slim, right? He shrugs his shoulders, quietly submits to pressure, and revises the new fund’s grade to ‘B+’ without much fuss.

Scenario 2: Annoying sticklers, but we love them for it.

A due diligence analyst at an RIA is evaluating a new fund being launched by two seasoned and well-respected portfolio managers. The new fund will operate as a combination of the strategies these two managers have run successfully — albeit separately — for 8 and 10 years, respectively. 

However, to qualify for investment, the RIA requires funds to have a track record of at least three years, and unfortunately, the new fund technically doesn’t have a track record. 

After a few conversations with the portfolio managers, the due diligence analyst determines that it will be acceptable to use their combined historical track records to represent the track record of the new fund because they are running the same strategies—with proper disclosure, of course. 

The following week, as the due diligence analyst is finalizing the investment memo to submit to the RIA’s Investment Committee for approval, he reads in the PPM that the new fund has actually included the ability for the fund managers to hold up to 10% of their positions overnight—not a feature of either individual strategy in the past.

The analyst explains to the two managers that, while seemingly small, this is actually a material deviation from how their two strategies were historically run, and as a result, he is unable to accept the combined track records as representative of the new fund’s performance. Meaning the new fund doesn’t have a long enough track record for the RIA to invest.

The analyst explains to the two managers that, while seemingly small, this is actually a material deviation from how their two strategies were historically run, and as a result, he is unable to accept the combined track records as representative of the new fund’s performance. Meaning the new fund doesn’t have a long enough track record for the RIA to invest.

There were a few more conversations, including one with the RIA’s full Investment Committee. Ultimately, they took their usual conservative approach and decided the new fund could not be approved at this time—despite the fact that the two managers were highly seasoned and well-respected, and odds were, their fund would likely perform as well as the managers expected. The RIA would continue monitoring the new fund and revisit its investment decision in three years.

Which type of Due Diligence would you prefer?

The stark contrast between these two real-world scenarios underscores a key difference between firms relying on third-party providers or those conducting due diligence in-house. In the first scenario, the pressure exerted on the junior analyst to adjust a fund manager’s grade to meet business objectives illustrates a potential conflict of interest and a compromised due diligence function. This scenario raises concerns about the quality and reliability of due diligence when business factors can so easily sway the outcome, even if most people would consider the difference between a ‘B’ and ‘B+’ grade to be minor.

The stark contrast between these two real-world scenarios underscores a key difference between firms relying on third-party providers or those conducting due diligence in-house.

In the second scenario, the due diligence analyst and RIA’s approach demonstrates a commitment to maintaining rigorous standards and a process that is not influenced by relationships or outside business objectives. The decision by the analyst and RIA’s Investment Committee to not approve the new fund, despite the solid historical track records and reputations of the managers involved, highlights the prioritization of thorough, principled analysis over convenience or established reputations. This instance showcases the importance of preserving the integrity of the investment selection process, even when it means making tough decisions.

Contact us to learn more about our due diligence process and how we can help you navigate the alternative investment industry successfully.

Disclaimer:

This article is for informational and educational purposes only and should not be construed as providing tax or legal advice. It does not take into account the specific investment objectives, financial situation, or particular needs of any reader. Readers should consult with their own tax, legal, and financial advisors to determine the appropriateness of any investment strategy or approach mentioned herein.