Most people think that due diligence is just about operational due diligence, because it is not always obvious what can go wrong on the investment side, and operational specialists are usually not equipped to tackle more esoteric investment questions.
We actually find it hard to separate investment and operational due diligence, because the investment manager himself is often the single biggest source of operational risk.
Investment due diligence seeks to verify that the manager’s track record is valid. It scrutinises the investment team to make sure that the investment philosophy and strategy disclosures in the DDQ are reflective of real practice, and that nothing significant has been left out. Above all, we want to be sure that the manager’s risk and return profile matches what the client is looking for.
We do this in several ways. First, we analyse the track record, and the underlying investments with quantitative analytics, looking for corroboration of the manager’s stated investment behaviour, or anomalies that could point to something else going on. Then we interview the investment staff to better understand how they interact together. We are always looking to cross reference and verify as much as possible. If there are risk limits in the prospectus, do the people managing the fund know what they are? Have they ever been breached? What happens if they are?
Was the DDQ written by a marketing guy, hoping that whatever was promised to investors would eventually become policy? Do the exhaustive risk reports actually get used by the manager, or are they just for show?
There are few hard and fast rules for investment due diligence, and a deep understanding of each strategy is required to know the right questions to ask. But for example, with Madoff’s returns, a good question would have been: “What should the returns of a split strike options strategy look like?”
For Amaranth, investment due diligence questions would have been: “Are you dominating the natural gas market, and what would happen if you tried to liquidate your positions at short notice?” In fact you could have asked the same type of question to LTCM.
An investment due diligence specialist would have the knowledge to assess the risks derived from derivatives, fund leverage and the market, whereas an operational due diligence specialist probably would not.