Time to Improve the Investment Industry’s Operational Due Diligence Process

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It’s shocking when you think about it. Over ten thousand professional money managers and 75 percent of them underperform the S&P index benchmark. All those billionaire hedge fund managers and entire floors of Wall Street Skyscrapers filled with analysts and top-shelf technology providing no real added value for investors as compared to if they had just put their money into an index fund! And to pay fees for no real performance is an insult to injury! But it’s no surprise when one considers how the investment management industry does its due-diligence.

For the most part, the success or failure of an investment depends on certain measurable factors. Of course, there is stock price, Return on Investment, Return on Equity, Cash flows, etc.; however, as the level of sophistication of data analysis has increased, it appears that many of the basics of successful investing have been shoved into the background. As an experienced equities analyst, I am constantly surprised by how the basics can so easily be discarded or played down in favor of technical and fundamental analysis using sexy-techy data-based analysis that almost entirely omits the important factors of human judgment …subjective or not.

Time to Improve the Investment Industry’s Operational Due Diligence Process

Most financial analysts depend on a constant feed of data that supposedly reflect the quality and potential of a company’s stock price, which is a measure of the market consensus. However, all those data most often are far from the reality of what a “good” investment actually does: provide a desired product or service and the resultant supply-demand equilibrium. In today’s increasing competition and disruptions, just having a good product or service may not be enough for the long haul. Markets are fickle, and most data is historical and only a probable indication of the future.

Perhaps the greatest contemporary investor, the “Oracle of Omaha,” Warren Buffet, recently stated that long-term investors are better off investing in market index funds that require low, to no management fees rather than trust to stock picking and professional stock pickers. But even on a deeper level, Buffet’s well-known investment philosophy centers around the management of a company even more than its current performance. In fact, Buffet has made his billions for investors in Berkshire-Hathaway by doing deep due diligence on the company management and its ability to not only run an efficient operation but also have deep insights into its markets and the capability to be out front when markets are changing. This successful strategy of fully vetting management sometimes takes years to complete, and it starts with understanding that judging expertise requires a keen eye with a lot of operational experience.

I mean, how do young  MBAs, Financial Analysts (CFAs) judge management competence? Indeed, who does that sort of operational due diligence and what makes them able to define and measure what makes up a top-level management team?

It is not enough to just check the box on what company policies, procedures, and typical management tools abide within a company. Indeed, it is much more about how those tools are used daily that can make the difference. For example, how does some company handle exceptions, problem solve and develop its human resources? Does it focus on hiring “superstars” or is it capable of developing its own internal resources? How does it provide daily engagement and motivation? How efficiently does the management structure react to the market? To assess these more subjective issues not only takes time but also requires people who can appreciate the subtleties of difficult situations. Normally, this would require a person who has “been there and done that.” However, to find that level of experience and knowledge usually requires a person with specific experience and knowledge. This fact usually leads to qualified operational consultants with experience to sell to specific industries.

It’s unfortunate that the majority of public and private equity investors seldom use a team of operational consultants as part of the due diligence process instead of depending so much on data that can be manipulated. I suppose that crunching numbers is easier, safer and more cost-effective than using subjective assessment based on personal experience and knowledge. But is depending so much on  financial analysis the best way to select a good investment opportunity?

An argument against the concept of taking a hard look at management is that key management staff come and go. Or, there can be political factors such as a falling out between the Board of Directors and the management organization that is hard to detect in the numbers. Studies have demonstrated that successful companies and management organizations tend to develop a culture of excellence and motivation to be best-in-class. Many companies have recently established their own internal “Centers of Excellence,” but there is an inherent conflict of interest in judging oneself.

As far as performing effective due diligence for measuring management level of competence is to consider what are the top issues facing management today. According to a recent study done by Deutsche Bank Hedge Fund Consultants, the following are considered key due diligence issues that are facing investment companies:

  1. Lack of independent oversight: for self-administered funds, self-custodial funds, using unknown or small audit firms and having a board with no independent directors are all red flags which may result in a veto either on their own or when evaluated together.
  2. Poor segregation of duties around cash controls: There must be at least two signing officers, one of which should be the Chief Operating Officer (“COO”). Given recent technological developments at prime brokers and administrators, investors strongly encourage making use of either parties’ web payments systems and processes for additional layers of control.
  3. Unwillingness to provide transparency: Investors recognize and respect confidentiality around trading positions, but will factor in a fund’s strategy, disclosures made to other investors and the historical track record of a particular manager. However, they will often request sample portfolios both prior to investing and throughout the life-cycle of their investment or at the very least some sensible summaries thereof. Their analysis will vary from assessing the portfolio for style drift to detailed risk analysis.
  4. Insufficient operational and technological infrastructure to support the fund’s strategy: Different strategies have different infrastructure requirements. For example, a quantitative, computer model driven hedge fund trading high volumes requires much greater infrastructure than a fundamentally-driven low volume equity long-short manager. Other red flags include insufficient disaster recovery and business continuity planning (DR/BCP).
  5. Valuation issues: — Weak or unclear valuation policies combined with deviations of estimates to final Net Asset Values (“NAV”), restated NAV and/or qualified audits. — A change of administrators, where the new administrator does not have sufficient expertise in pricing the products in the portfolio, for example, complex hard to value positions or without a clear explanation to investors. — Chief Finance Officer (“CFO”) does not verify or sign-off pricing for illiquid instruments where values have been provided to the administrator by the portfolio manager.
  6. Insufficient checks and balances from the non-investment management staff: The Chief Investment Officer (“CIO”) need to be surrounded by a management team with the necessary seniority to ensure sufficient checks and balances.
  7. Unsatisfactory service provider engagement: Refusing to allow investor engagement with service providers is regarded as a clear red flag.
  8. Unsatisfactory or ineffective remuneration policies: Trader costs charged to the fund, rather than borne by the management company, are not acceptable to many investors. Investors also look for alignment of interests and retention of key staff, so other red flags include no or insufficient compensation deferred into the fund.
  9. Insufficient personal wealth invested in the fund: Investors have a good understanding of compensation structures at both hedge funds and banks and will develop a view of a founder’s potential liquid capital. As a result, investors will always expect a significant proportion of this liquid capital to be invested in the fund in order to align interests with their own.
  10. Lack of integrity: Personal stories, disclosures, and CVs that either omit or misrepresent findings from the background and reference checks will result in the investment being vetoed immediately.

When one examiness the above factors, it is obvious that many of the issues require the type of experience that can judge those factors. Indeed, the answers to almost all of these factors cannot be determined by objective analysis and require a certain level of real-world experience and personal insight.

In summary, a business should not be judged solely on the numbers it produces. Indeed, it is vital to look at the horse’s teeth before saddling up. Fortunately, there is a deep list of experienced operational managers turned consultants that can and should be used to add depth to the company analysis and help provide investors with a more thorough due diligence process.

Additional Reading

What Companies Should Measure

A Study of Investor Operational Due Diligence (ODD)

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