Due diligence lessons from the Goldman Sachs resignation letter

Muppets
Goldman Sachs managing directors allgegedly refer to their own clients as “muppets.”

There has been much attention paid to the recent resignation letter from former Goldman Sachs Executive Director Greg Smith in which he highlights his criticism of the culture at the financial giant. Mr. Smith's letter also outlines his criticism of how certain employees at the firm might view their clients. In one part of the letter, he even references that he has observed managing directors refer to their own clients as “muppets.”

Mr. Smith’s letter got us thinking about how evaluating a fund manager's corporate culture is part of the due-diligence process that often times gets overlooked. When evaluating a fund manager, be it a hedge fund, private equity fund or traditional manager, many investors not only review the fund's historical performance or the specifics of a particular investment strategy, but also try to determine what is in the manager's investment DNA. What does the manager possess that gives them that extra investment edge?

The same can be said of a fund manager’s operational infrastructure. Mr. Smith's letter in particular focuses on his criticism of the way Goldman views and interacts with its clients. This is a key part of what investors should attempt to diagnose during the operational due-diligence process. Operational due diligence, which focuses on evaluating primarily a fund manager's business or purely non-investment-related risks, affords investors with an opportunity to move beyond performance numbers and diagnose the overall functions and attitudes of an organization. Evaluating such hard to pin down topics as organizational culture and attitudes toward clients are a type of operational risk known as meta risk, and one that a detailed operational due-diligence process can make inroads in evaluating. When investors have the discipline to ask the appropriate questions during due diligence, they can quickly get a good read on the type of organizational culture at play.

Mr. Smith’s letter also highlights the importance of monitoring conflicts of interest. Mr. Smith’s criticism of Goldman suggests that the firm might put its interest ahead of those of its clients. What he is outlining is the issue of conflicts of interest. Investors performing due diligence on fund managers can evaluate, and hopefully avoid, managers that possess such conflicts by analyzing a number of traditionally operational risk factors including legal structuring, trade authority and compliance controls.

Similarly, during the due-diligence process investors can take measures to evaluate a fund manager’s attitude toward managing client money. As the recent AIJ scandal in Japan outlines, some fund managers seem insulted at the mere idea of investors performing due diligence on them at all. Others might make the due-diligence process difficult or not be very forthcoming at all. If a fund manager ridicules an investor for performing due diligence or isn't responsive to due-diligence requests, investors should seriously consider if they want to enter into any sort of business relationship with a fund. Such problems during due diligence might be red-flag indicators of future problems.

While Goldman has attempted to portray Mr. Smith as a potentially disgruntled employee, his letter highlights some good points about items investors might want to consider during the pre-investment due-diligence process. Focusing on diagnosing a fund manager’s culture during the due-diligence process can often lead investors to avoid working with organizations that might not appreciate their business, or even worse, might be unresponsive to investors should problems arise.

Jason A. Scharfman is managing partner of Corgentum Consulting LLC, a Jersey City, N.J.-based operational risk consultant to the alternative investment industry.