Pamela Reid highlights the importance of employing a thorough due diligence process when choosing investments
When you shop for shoes, you generally check that they not only fit, but also that they will not immediately fall apart. Before you buy them, you effectively do your due diligence. Even though you have the potential recourse of the consumer laws if they do fall apart, this inevitably involves a fair amount of hassle. If the problem is not dealt with swiftly and to your satisfaction, you would also think twice about shopping there again. The same principles apply to investment.
Due diligence is about checking before you buy. Even where a financial loss is covered by a compensation scheme, it will not compensate for the time, hassle and worry that the investor and/or their adviser would have to go through to salvage what they can from a failed fund. Anyone who invested with Madoff would certainly have wished that they (or their advisers) had been more thorough with their due diligence.
As an adviser, when you give investors advice on the selection of investments, the liability for due diligence generally remains with you. Credibility can be severely dented if the investments prove to have major problems and the law is on the consumer’s side so you must be able to demonstrate that you have done some checking before recommending an investment.
A regulated fund comes with the presumption that client monies will be kept separate from those of the investment manager. There are controls on both the scope of the investments and the requirements for audits. In this context, ‘regulated’ means that the fund should keep within FSA rules but not that the FSA itself will audit or check the workings of the fund. Problems with regulated funds do arise. The failure of Lehman Brothers introduced the world to the issues of counter-party risk and re-hypothecation – the use of clients’ assets as collateral – and the resultant problems when the shutters came down.
How the assets are valued can also be an area of risk. You need to look particularly closely at the basis of valuation of funds holding any unquoted investments. If any assets are effectively being priced by the directors or fund manager, investors are relying on their credibility. This may be well and good for the most part, but if a rogue manager has already fled with packed bags before the right questions are raised, it is likely to be too late for the investor.
The term ‘authorised fund’ actually gives little comfort in terms of the regulation over or the security of the investments. This term refers to the range of investments that are held and who the fund can be marketed to.
When it comes to hedge funds, due diligence has become an industry in itself, as many hedge funds are outside the UK regulatory regime. Although the funds may carry an international brand name, their structure, the manager’s remuneration arrangements, their ability to borrow and the basis of valuation are all factors that need close inspection. Making a major investment without meeting the fund manager and checking who they are and what their track record is could be considered to be reckless.
A basic due diligence process would look at:
• The investment proposition
• The manager’s track record
• The audited accounts
• The background and credentials of the managers, principals and shareholders
• Whether all investors are treated equally
• The dealing and custody arrangements
• The basis of valuation
• The internal controls on the funds
• Business continuity planning.
For a substantial investment, the team of lawyers would not only expand on this list but spend expensive time obtaining the results.
Insurance companies only appoint a panel of potential investment managers for SIPP and pension fund management having carried out sufficient due diligence of the firms. These are thorough tests and should give an adviser the additional comfort that these investment managers are sound and will not compromise the safety of any investments placed with them.
While the legal due diligence checks the integrity of the fund and its managers, investment analysts look at how the returns have been made and whether this is likely to be sustainable. This second stage of due diligence checks the robustness of the strategies being used.
With the advent of the wider investment powers of UCITS III funds, this is becoming more important. Understanding and checking what a fund manager is doing, how he is investing the assets and when his approach and views change are the basics of sound analysis.
Of course, performing ongoing due diligence is equally as important as the initial research. An adviser is obliged to perform continuous monitoring of an investment and ensure it adheres to its stipulated mandate. As investment vehicles become ever more sophisticated, thorough analysis of risk controls and risk management, custody of assets and both operational and legal frameworks will become an increasing focus for advisors in their fiduciary capacity.
Pamela Reid is executive director, head of Bristol branch at Quilter
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