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Outline what a due diligence questionnaire can contain.

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

The idea

A due diligence questionnaire is a standardized list of questions sent to the manager, and industry bodies publish templates. It normally covers the firm and its ownership, personnel and key-person arrangements, assets under management and investor base, the investment strategy and process, performance and attribution, risk management, operations and valuation, service providers with contact details, fees and liquidity terms, legal, regulatory and litigation history, compliance, insurance, and business continuity. Its value lies in forcing consistent, written, dated answers that can be compared with the offering documents, audited statements and what the manager says in meetings. Its weakness is that it is self-reported and may not fit the specific strategy. The exam point is that the questionnaire is a starting point whose answers must be verified independently.

A practice question

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

Which topic belongs in the operations section of a due diligence questionnaire?

  1. The manager's forecast of next year's returnsWhy not: A forecast is not an operations matter and is unreliable as evidence.
  2. The valuation policy and the identity of the service providers - correct
  3. The biographies of the portfolio managersWhy not: Biographies belong to the firm and people section.
  4. The offering's performance fee rateWhy not: Fee terms belong in the terms section.

Operations questions concern valuation, service providers, trade processing, cash controls, compliance, technology and continuity.

A harder one

Which mapping of questionnaire items to sections is most appropriate?

  1. Gates to terms, stress tests to risk management, reconciliation to operations - correct
  2. Gate provisions to risk management, stress test results to terms, reconciliation frequency to operationsWhy not: Misplaces gates and stress tests: gates are liquidity terms, stress tests are risk measures.
  3. Gate provisions to terms, stress test results to operations, reconciliation frequency to risk managementWhy not: Puts stress testing under operations and reconciliations under risk.
  4. Gate provisions to operations, stress test results to risk management, reconciliation frequency to termsWhy not: Treats gates as an operational process and reconciliations as a contractual term.

Gates govern redemptions so belong in terms. Stress tests are risk measures. Reconciliation is a back-office control, so it belongs in operations.

The hardest tier

An allocator plans to use a standard equity long/short questionnaire for a fund that trades distressed credit. Which adjustment is most important?

  1. Add questions on stock borrow availability, short-selling costs and the cost of locating hard-to-borrow sharesWhy not: These are equity long/short topics, not the main issues in distressed credit.
  2. Add questions on intraday trading speed and execution algorithmsWhy not: Distressed credit is not driven by execution speed.
  3. Add questions on valuation of illiquid credit, side pockets and workout expertise - correct
  4. Remove the operations section because credit funds have fewer controlsWhy not: Illiquid credit increases valuation risk, so the operations section matters more.

A DDQ should be tailored to the strategy. For distressed credit, valuation of illiquid positions, redemption terms and the manager's workout skills are central.

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