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Industry Voices

Commentary: What should due diligence do?

When institutional investors decide to carry out their fiduciary obligations by investing assets with an investment manager, how do they know what they are getting?

Or, to put it another way: What should due diligence do?

Ten years after the global financial crisis, what have we learned about due diligence? Before the financial crisis, institutional investors frequently relied directly on a manager's self-generated documentation and reporting for information regarding assets under management, net asset value, customer statements, investors' capital accounts and, of course, fund performance.

Bernie Madoff and the collapse of Lehman Brothers made it clear that even large investment managers needed to rely on third-party administrators to provide this information to investors.

Today, no institutional asset owner would rely on the investment manager's assertions for this information. Why? Because the investor, for example, a pension plan, is a fiduciary, and when it makes an investment decision it does so as a fiduciary. After seeing the repercussions of the financial crisis, no fiduciary today would fulfill its fiduciary duty without third-party verification of this kind of information, such as net asset value and customer statements.

Surprisingly, a decade out from the crisis, many institutions still will unquestioningly accept other kinds of information, such as portfolio construction, from managers without performing "due diligence" on the information. The classic institutional investor's question — "How do I know what I own?" — can only be addressed through better use of data science and technology and by third-party verification.

Typically, when investment managers seek to increase assets under management, they have a process that increases in intensity and detail, from an initial email and follow-up telephone call to securing a non-disclosure agreement and then providing detailed performance data.

Often an investor will want to measure the manager's performance against certain benchmarks or see how that manager's portfolio would diversify and enhance the allocator's portfolio. If, after all this work is done, and the manager's story and references hold up, then the due diligence process begins.

But what does due diligence really do?

Of course, a site visit by the potential investor is necessary to make sure that the people and office actually exist. An examination includes a study of risk, trading practices, cybersecurity, even proper locks on the doors. But how does due diligence deliver a real understanding of the facts and data behind the manager's story? A manager can explain trading practices and risk management practices and position level thresholds, but that is not enough.

Any manager seeking to raise institutional capital should have a due diligence questionnaire already filled out. Most investors' questions are similar, so the manager should be able to anticipate them. It is likely the allocator will have some unique questions or a questionnaire of its own, but the ability to deliver clear due diligence information is crucial.

And the ability to deliver third-party data is increasingly important. It is interesting that investors often seek audited financials, or an audited track record. They do so because they seek third-party verification of the numbers in the manager's story. Yet they will still accept a manager's statement regarding the portfolio's risk to a move in the price of oil, or exposure to interest rate risk.

Increasingly, we expect to see investors raise their level of scrutiny in due diligence. This will include requirements for position-level data verified by a third party. Who vouches for the data that indicates how much a manager loads to the momentum factor, or how much of the manager's success is due to position sizing? Who stands behind the "batting" and "slugging" average figures and the "beta to the S&P"?

Institutional investors must ask these questions. As fiduciaries, they must receive answers to these questions. And managers who seek allocations from these institutions must be able to provide reliable, verifiable answers to these important questions.

In today's world, an investment manager may retain his or her discretion, but will increasingly need to defend that discretion with data.

Charles E.F. Millard is managing director of the Kiski Group Inc. and served as director of the Pension Benefit Guaranty Corp. from 2007 to 2009. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.