When institutions or high net worth individuals choose investment managers, conducting due diligence is very important. Due diligence refers to the investigation and audit of investment managers before formally establishing cooperative relations. A complete due diligence checklist allows investors to fully understand the investment manager’s qualifications, investment philosophy, past performance, risk control capabilities, etc., avoid potential risks, and make rational investment choices. This article summarizes the key elements that the due diligence checklist should include from the perspectives of the investment manager’s background, investment strategy, risk management capabilities, performance track record, investor relations and legal terms, providing references for investors.
Background check of the investment management team members
The background check of the investment management team members is crucial in the due diligence process. Investors need to verify the academic qualifications, professional qualifications, past work experience and track record of the key investment professionals. This helps establish the credibility of the team and ensure they have the expertise to manage assets professionally. Specifically, credentials like CFA charterholder, certified public accountant and chartered financial analyst designate rigorous professional training and continuing education. Investors should review the biographies of each professional, looking for any exaggerations or inconsistencies. It is also important to check whether the team has a stable structure, or whether there has been frequent turnover of key investment personnel.
Evaluation of the investment manager’s investment philosophy and strategy
The investment philosophy and strategy directly determine the manager’s ability to generate stable long-term returns. Investors should conduct in-depth research on aspects like the manager’s investment style (growth, value, blend), market capitalization preference (large-cap, mid-cap, small-cap), geographic and sector focuses, portfolio concentration, active share, use of leverage, etc. In addition, understanding the manager’s competitive advantages, idea generation process, risk management principles and sell discipline gives color on how they construct portfolios. Comparing the stated philosophy and actual implemented strategy also uncovers consistency issues. If the manager frequently shifts approach or chases short-term performance, it may indicate lack of discipline.
Risk management capabilities to control downside
In addition to evaluating return potential, it is equally important for investors to assess the investment manager’s risk management capabilities. Tools like portfolio stress testing, scenario analysis, value-at-risk models and Monte Carlo simulations help gauge the portfolio’s sensitivity to different risk factors. The manager should have clear risk limits at individual security and portfolio levels. Investors should also review the application of stop-losses, position sizing, diversification and hedging techniques in limiting drawdowns when market conditions deteriorate. Transparency around previous drawdown periods demonstrates the manager’s ability to manage risk in real-world situations.
Track record of actual investment performance over full market cycles
The investment manager’s historical performance track record is ultimately the tangible result that determines hiring. Investors should gather as much actual performance data as possible, including annual returns, standard deviation, Sharpe ratios, alpha generation, up/down market capture ratios and drawdown analysis. A track record spanning different market environments – both bull and bear markets – provides the most comprehensive picture. Comparing performance to appropriate benchmarks is also necessary context. Past success achieved with a different firm or strategy does not guarantee future results, so investors should focus evaluation on present-day personnel and investment process.
Alignment of interest between investor and manager
The investment management agreement and fund legal documents codify the rights and responsibilities of the investor and manager. Investors must review fee structure, liquidity terms, incentive schemes, custody of assets and potential conflicts of interest. Management fees, performance fees, hurdle rates and high water marks should align manager compensation with investor goals. Lock-up periods, redemption notice periods and gates define the liquidity terms. The manager having “skin in the game” by investing substantial personal capital creates alignment of interest. Lastly, independent third-party service providers like auditors and fund administrators enhance governance and transparency.
A rigorous due diligence process examines all aspects of an investment manager’s operations, philosophy and track record. This helps investors select managers that best fit their objectives and risk tolerance. Conducting detailed due diligence reduces information asymmetry and allows investors to make judicious decisions.