There have been a number of concerning news stories about the investment management industry in the last few weeks that brought back to me all of the concerns that went around the hedge fund industry during the Madoff crisis. And the 2008 financial meltdown. And the 2010 insider trading scandal. And the Petters Ponzi scheme.
In no particular order:
- We learned last week that the crypto currency exchange QuadrigaCX, which melted down when Gerald Cotton, the exchange’s co-founder suddenly died in January, may now be an even bigger mess as the funds may have been stolen by Cotton before his sensational, mysterious death in India.
- We learned that the SEC fined KPMG $50 million for illicit use of PCAOB data, cheating on training exams, and altering their past audit work to ‘reduce the likelihood of deficiencies being found during [PCAOB] inspections.”
- We learned that the LF Woodford Equity Income Fund nearly collapsed as the manager gated the daily liquidity fund and suspended redemptions. Apparently, a meaningful amount of illiquid investments were well hidden in the fund’s “trash ratio” which were suddenly exposed when large withdrawals and poor performance caused the fund’s overall liquidity to plummet.
- Natixis’s H2O Asset Management is in crisis mode as the manager revealed that six of their funds had invested in private, unrated bonds (actually loans) which were not permitted in the fund’s investment mandates. Morningstar has questioned the “liquidity and appropriateness” of some of the fund’s holdings and the firm’s AUM is down over 3 billion euros in the last 3 days.
While these scandals are all recent, they brought back many of the same questions and concerns that were voiced after every other scandal ‘How did no one notice these problems before’, ‘How in the world did institutional investors miss the warning signs’, and ‘Didn’t someone do institutional ODD reviews before they invested?’.
I have met with so many endowments and foundations that are doing ODD as a check-the-box exercises or are doing none at all. I have talked with many public and private pensions that don’t have time to read through the audited financial statements and the ADV Part 2 Brochures. I have worked with sovereign wealth funds and family offices that didn’t run background checks on investment managers before investing. It seems that so many institutional investors are relying on someone else to do the heavy lifting when it comes to ODD – assuming that if the manager was an operational mess than surely someone somewhere would have noticed and said something. It seems we never learn from past mistakes.
To be clear, undertaking a full and complete institutional operational due diligence review is a cornerstone process for alternative asset investment. If your organization cannot be sure if the fund’s assets exist, you shouldn’t invest. If your organization cannot describe in full detail exactly how all of the fund’s assets are being valued, you shouldn’t invest. If you don’t know who all of the fund’s service providers and counter-parties are and exactly what services they are providing to the manager, you shouldn’t invest. If you cannot afford to run background checks on a fund manager’s key, C-level staff members, you shouldn’t invest. If the manager is not using best practices for funds control, compliance, systems, cybersecurity, expense allocation, fund governance, asset custody, and conflicts of interest resolution, you shouldn’t invest.
Asset allocators need to take full fiduciary responsibility for the assets they manage and employ an institutional, skeptical, critical, investment and operational due diligence program. It is no longer acceptable to assume someone else must have done an ODD review of the manager, or that your consultant must have done an institutional review of the managers they promote. Too many allocators are chasing performance and ignoring proper due diligence protocols and I think we know how this will end because we’ve seen it happen again and again.
John Ward is an instructor for the IMDDA and Managing Director in the Alternative Asset Advisory Group at Duff & Phelps where he runs the firm’s global due diligence practice. Contact him at firstname.lastname@example.org
John will be teaching the upcoming class - Operational Due Diligence - Hedge Funds, 40 act, UCITS and Insurance-linked Funds on July 23rd and 24th.