Manager due diligence in times of Covid-19
By Patrick Ghali (pictured), managing partner, Sussex Partners – A lively debate is currently taking place amongst allocators as to whether onsite due diligence and face-to-face meetings are still necessary given the current environment. The simple answer must be a resounding: yes, absolutely.
Due diligence, both investment and operational, has always been an integral part of a well-structured investment process. Those of us who have been around since pre-2008 can certainly attest to the fact that a lot has changed since, and the days are long gone when it was possible for managers to simply refer to their stellar track records and assume that investments would be forthcoming without any other questions being asked.
Investors have learnt that having a detailed understanding of a strategy is just the beginning and that the operational framework in which a strategy is implemented is also of great importance. The question, of course, is how to best ascertain all of this during the current period, whether process adjustments can and should be made and, critically, whether there are additional risks that necessitate closer scrutiny at present.
Now more than ever, due diligence, and importantly ongoing due diligence, must be the core of a robust institutional-quality investment process. The current crisis has significantly increased operational and business risks and so additional emphasis needs to be put on making sure due diligence processes are able to pick up on these risks as they develop and evolve.
Besides the obvious additional operational risks to look out for, it is important not to underestimate the multitude of additional risks managers may currently be facing because of the crisis. It is short-sighted to only focus on market risk and imperative to look also at areas such as valuation risk, access to financing and counterparty risk.
The current situation poses significant challenges especially when it comes to less liquid public assets or private market investments, including substantial risks of mis-marked books which could lead to significant losses for investors. Managers could be forced to realise losses because their access to financing has become curtailed, or face mark-to-market losses due to wider spreads being imposed if they are considered sub-optimal counterparties.
It is normal that due to the current restrictions on travel, approval processes are being revisited. Investors are asking whether solely relying on cold hard data may be a better approach, worried that face-to-face interactions could lead to the risk of them being sweet talked into the wrong decisions by Svengali-like, silver tongued hedge fund managers.
Our view is different. In our experience numbers can hide all kinds of sins. Simply having compelling data, blue chip service providers and a set up that “ticks every box” may be a good start but is certainly no guarantee that all is as it seems.
In many instances, the most crucial bit of information is not found in a DDQ or gleaned from a position report, but rather from a personal interaction. On paper a proposition may look very attractive but its flaws can often only be found once time has been spent onsite. An understanding of the environment in which managers operate physically, their team dynamics and interactions, and existence within an ecosystem of their peers and competitors, provide key determinants to effective due diligence evaluation and these factors are more important now than ever.
It is, for example, impossible to detect via Zoom alcohol on the breath of a trader fresh back from lunch, or to fully appreciate discrepancies between a written risk policy and the physical set up and interactions between team members taking place in real life. Often a throwaway comment, or a slight difference in how a process is being described by different team members can provide vital clues to risks that would not have been apparent on paper alone. A video call is a poor substitute for being able to spend a day or more getting to know a firm and its key risk takers on a more personal basis.
Assessing character can often be a key determining factor in coming to a final allocation decision, something not easily done in a hurry or from afar. Arrogance, one of the serious red flags for us (arrogant managers won’t admit mistakes which can lead to excessive risk taking to make up for losses or worse..), can better be gauged in person and a manager’s office set up can provide vital clues.
The same goes for management style, the reaction to a risk or compliance manager voicing an opinion (and where they physically are located within an office), and assessing the job satisfaction of key staff members which is important when evaluating a business’s sustainability. Data alone can lead to the wrong assessments and ensuring against this can only be achieved through physical meetings with managers.
The same holds true when speaking to a fund’s service providers. While standard checks are a good start and can often be done vie email and phone (e.g. asset verification, audit verification), meeting key members across a table provides additional and valuable insights. A further important check is being able to speak to a manager’s competitors and peers which is is helpful when trying to better understand the strategy resilience and a manager’s market access. This, again, is not something that usually can be achieved simply by email or telephone, but required the sort of relationship which can only be established through long term face-to-face engagement and discourse.
In the current situation, where travel is significantly restricted, the default for many investors will be to stick to either existing managers, or name recognised larger firms. This approach comes with its own issues and limitations and may well mean missing out on great opportunities. Having a global team with long established and deep industry relationships becomes an invaluable advantage in the current environment.
There is little doubt that larger investors with global resources will be at a significant advantage as they will be able to draw on local capabilities to maintain existing due diligence processes, react to emerging problems and take advantage of new opportunities. Local staff and access will be key until travel normalises. Investors unable to draw on such internal resources will either have to outsource parts of their process to trusted third parties able to effect suitable due diligence, limit their opportunity set, or become vulnerable to risks that they are not aware of.
The current crisis and the restrictions it imposes on due diligence should not be used as an excuse to let standards slip, but rather as a catalyst for increased scrutiny utilising creative means to augment process.