Does it really pay off to conduct due diligence, after all, it is costly and time consuming and what damages could I really avoid doing it?
The potential damages are often vastly underestimated. Our experiences show, that the consequences of issues identified can be quite dire and the damages incurred turn out to be exponentially higher than the expenses of conducting proper due diligence. Below, you may find a few selective examples of issues we have found and the corresponding damages which were incurred by the investors:
- Valuations: It is absolutely crucial to determine who provides the values for individual positions and on what basis such values are determined. It is not uncommon that values of underlying positions, particularly less liquid instruments, end up being inflated and we have incurred several situations where the corresponding write-offs were 20% or more. For a portfolio allocation of USD 20m the damage is equivalent to USD 4m.
- Signature rights: Lacking adequate safeguards against fraud and theft investment managers, and subsequently investors, risk that assets are being stolen. In such cases the resulting damages are often devastating and the corresponding hits on the NAV are often in the 50% to 100% range. For a portfolio allocation of USD 20m the damage is equivalent to USD 10-20m.
- Hypothecation: As the turmoil post the Lehman collapse has indicated, the determination whether and how assets may be re-hypothecated and to what degree they are truly segregated is absolutely crucial. Even if such assets may ultimately be recovered, the legal proceedings could render even liquid long-short strategies suddenly illiquid. A position with monthly liquidity and 30 days notice can turn into a private equity like position with a maturity of several years and high uncertainty regarding the underlying value. For a portfolio allocation of USD 20m the gap in liquidity can be up to the full amount of USD 20m.
- Subsequent damages: Any of the above described scenarios likely incur consequential damages as investors will run for the door forcing the investment manager to unwind the fund under the least favorable circumstances. This will mean that the final damages incurred will ultimately be even higher than the estimated examples above. Not to talk about the negative impact on your image and brand…
But can due diligence really detect issues?
Yes, thorough and meticulous work almost always finds inconsistencies. The question rather becomes what conclusion you draw from the findings and whether you can explicitly live with them or whether you choose to ignore them hoping there is no serious issue hidden behind your findings during the due diligence process.
But if I do find issues during my due diligence would I not be confronted with the alternate problem that I can no longer invest and have to find another opportunity first?
If the issue is indeed severe having to find a new opportunity might be the lesser of two evils. But more significantly, an important part of the due diligence process is to find means to mitigate issues detected. There are often multiple ways to address individual findings and more often than not the investment managers will be willing to work out solutions. In many cases, the changes are in the manager’s very own best interest, particularly for findings regarding the manager’s operations as the manager directly profits from more reliable and sound processes.
Well, in that regard, could I not save the costs of conducting due diligence by simply investing with the larger organizations and more trusted names relying on their financial capabilities and vast experiences to ensure that the organization, setup and processes are in line with best practices?
Certainly, you can expect that a more established organization with a larger asset and personnel base will generally be better equipped. However, size and experience are no guarantee for sound processes: Firstly, the manager might still rely on his trusted processes which served him well when he was still a smaller organization. But quite often the processes turn out to be unreliable to cope with the additional work load and complexity of larger organizations. Secondly, larger organizations are more difficult to supervise. Hence, it is not uncommon to identify lack of consistency between how processes should be operated and how they are lived by the employees responsible for them. Finally, a successful manager might simply not be as appreciative of improvement suggestions because he can afford to ignore investors’ concerns as he does not necessarily need the additional assets in his fund.
We are profoundly convinced that conducting proper due diligence, whether you conduct it yourself or have SwissAnalytics conduct it on your behalf, helps you avoid situations which can incur damages that are exponentially higher than the actual costs associated with conducting thorough due diligence.