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Explain what goes into the due diligence procedure that investors follow in appraising a manager.

FRM® Part II · Risk Management and Investment Management · Performing Due Diligence on Specific Managers and Funds · FRM2.IM.12.b

The idea

Due diligence on a manager is a structured, repeated process rather than a single meeting. A typical sequence has seven stages. It starts with a quantitative and qualitative screen, then review of the offering documents and a questionnaire, then meetings with the principals and an on-site visit. Next come independent verification, analysis of track record, risk and operations, and an investment committee decision with negotiation of terms. Ongoing monitoring follows after the investment. Independent verification means background checks on principals, off-list references and direct contact with the auditor, administrator and prime broker using details the investor sourced itself. Information supplied only by the manager cannot be trusted by default. Investment and operational due diligence are often done by separate teams. The exam point is that a refusal to allow verification is a reason to stop, and diligence does not end at the investment date.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which step in manager due diligence best illustrates independent verification?

  1. Reading the offering memorandum prepared by the manager's lawyersWhy not: The offering memorandum is manager-supplied information, not independent confirmation.
  2. Calling the fund's auditor and administrator using contact details the investor found independently - correct
  3. Accepting the reference list the manager providesWhy not: Manager-selected references are likely to be favourable; independent off-list references are needed.
  4. Reviewing the audited statements without contacting the auditorWhy not: Documents alone cannot show who prepared them or whether they are genuine.

Verification means obtaining information from third parties through channels not controlled by the manager. Documents supplied by the manager are inputs to be checked, not checks.

A harder one

An allocator designs a diligence process for a new manager. Which sequence is most logical?

  1. Investment committee, screening, on-site visit, background checks, questionnaire, monitoringWhy not: Places the approval decision before the evidence has been gathered.
  2. Screening, on-site visit, investment committee, questionnaire and document review, independent verification, monitoringWhy not: Puts approval before document review and verification.
  3. Questionnaire, investment committee, screening, independent verification, on-site visit, monitoringWhy not: Sends the questionnaire and obtains approval before any screening or verification.
  4. Screening, questionnaire and document review, meetings and on-site visit, independent verification, investment committee, ongoing monitoring - correct

The funnel narrows by evidence: screen, document review, meet and visit, verify independently, decide, and then monitor. Approval comes after the evidence, not before.

The hardest tier

An investor is satisfied with a manager's track record and strategy. The manager refuses to let the investor contact the auditor and administrator, citing client confidentiality, but offers audited statements and a signed letter from the administrator. What is the best course of action?

  1. Invest because audited statements and the administrator letter provide enough assuranceWhy not: Relies on documents delivered by the manager, which are the items that need independent confirmation.
  2. Treat the refusal as a red flag and wait for independent verification - correct
  3. Invest a reduced amount and monitor the fund closelyWhy not: A smaller allocation limits the loss but does not resolve the integrity concern the refusal raises.
  4. Ask the manager to arrange a call that the manager attends and hostsWhy not: A call hosted and attended by the manager is not independent verification.

Inability to verify through independent contact is itself a warning of possible fraud or weak controls. The standard response is to hold the allocation until verification can be done.

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