Foundation — Why investors must do their own due diligence, and what they examine

12.1 Fund Due Diligence

As fund selection is one of the key drivers to favourable outcomes in AIF investing strategy, fund due diligence is a requirement for prudent investors as well as the basis for better investment decisions.

The general definition first: due diligence is "the process of investigation and evaluation, performed by investors, into the details of a potential investment, such as an examination of operations and management and the verification of material facts".

Then the twist that matters here:

In the context of AIFs, the phrase 'due diligence' has to be interpreted slightly differently. AIF investment products are marketed privately and are, therefore, essentially meant for informed investors. Such investors are expected to conduct their own due diligence before investing to safeguard their investments.

This is the crucial distinction from Chapter 11. There, the manager did due diligence on an investee company — Investor Due Diligence or DDR. Here, the investor does due diligence on the fund and the manager. Two different exercises, both called due diligence, and the exam tests whether you can tell them apart.

The investors need to ensure that the proposed investment in the Fund meet their investment objective and is in alignment with their risk appetite. Prospective investors have to make an assessment of the investment manager's potential and track record on which a lot depends for the desired investment outcome besides the specifics of the AIF scheme(s) itself.

From a service perspective, it is necessary for a manager to ensure that investors are provided with sufficient information about the prospective AIF to make an informed decision after the completion of their due diligence. Distributor has to play a significant role in enabling this process by providing necessary assistance to investors to procure the required information from the fund documents and through direct solicitation from the fund offices.

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12.1.1 What makes AIF due diligence unique

As information on AIFs is not publicly available, the main source of information is the PPM circulated by the fund for a proposed scheme. In addition to the PPM, it is necessary to collect additional information from the respective fund house or office of the investment manager. The management of this activity is seen as the main source of competitive advantage for a potential investor.

Read that last sentence again. Gathering information others cannot gather IS the competitive advantage in private markets — because everyone can read the same listed-company annual report, but only some investors can get real answers out of a fund office.

The subjectivity problem

Due diligence is generally based on cross-referencing and cross-checking, but often the lack of suitable comparable and information makes the analysis highly subjective. The high reliance on qualitative aspects and judgment can obscure potentially good AIF opportunities. For example, in many cases, newer AIFs are avoided, not necessarily because the fundamentals are not right but simply because not all points of the due diligence can be supported by tangible evidence.

The workbook's own illustration is worth holding on to:

Let us consider a sector specific AIF that focuses on infrastructure sector. The fund manager may have specific expertise in identifying several emerging opportunities in the sector due to prior expertise. But investors may overlook the fund due to prevailing sectoral issues or general discomfort with long gestation and high risk factors. In such cases, the manager may not be able to provide enough prior evidence of transactions since some policy changes may have opened new doors very recently.

A genuinely good manager can fail due diligence simply because the opportunity is new and there is no track record of a thing that has only just become possible.

The free-riding warning

In some cases, once a reputable institutional investor has provided capital commitment, other investors tend to place credibility and believe that it has carried out a proper due diligence. However, it is necessary to appreciate that every investor may have specific required outcomes from a due diligence process. Investors should not take comfort from the fact that a large institution has provided capital commitment to an AIF and therefore it is investment-worthy.

A large institution's presence is not a substitute for your own due diligence. Its objectives, tax position, horizon and risk appetite are not yours.

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The four-step approach to fund selection

Considering the unique elements of fund due diligence, the following broad approach is useful for fund selection:

1. Quantitative Selection — It would be necessary to develop a template of quantitative investment criteria for fund selection based on specific investor requirements that would narrow down the fund selection process. Fund management teams that meet the objective criteria such as investment horizon, hurdle rate, past performance record, capital commitment, drawdown phase etc. can be short-listed for each investor.

2. Investment Management Team and Infrastructure — Alternative investments are based critically on the skills and attributes of the manager. Furthermore, the management team needs to be supported by sufficient analytical resources (macro, equity, credit) to effectively implement their investment process. Through necessary interviews and background checks, it is necessary to assess the quality of the team... The organisational structure of the management company also needs to be reviewed to ensure there are adequate processes in place to institutionalise the management function. A review of the adequacy of staffing and compensation structures of the management team is also an important part of the due diligence.

Note the word institutionalise — an investor is checking whether the fund is a firm or merely a person.

3. Investment Process Review — The entire management function that ranges from identification of investee companies till exits are made, decision-making process, checks and balances in decision-making, quality of research and methodologies and risk management practices are important in this segment of due diligence.

4. Past Performance Review — Suitable inputs can also be obtained by a review of the past performance of the fund / manager with a peer comparison and benchmarking to listed markets to explore alpha generation potential. Assessment needs to be made as to how a manager has driven performance and how that reflects in the track record, whether it is consistent with the fund philosophy and investment regulations.

Quantitative Selection → Team and Infrastructure → Investment Process → Past Performance. Four steps in that order.

Where distribution ends and due diligence begins

To sum up, while scheme/product assessment and customised marketing by distributors to investors is required at the first level, it has to be followed by fund due diligence to be conducted by investors at the next stage before firming up capital commitments.

AIFs seek capital commitments from sophisticated investors and institutional investors. These investors may be High Networth Individuals or Institutions such as Endowments, Foundations, Pension Funds, Sovereign Wealth Funds, Banks, Financial Institutions, Insurance Companies and other corporate entities. Corporate Institutions have a pre-defined methodology for screening a potential investment. Such institutions seek for 'Red Flags' or any internal and external factors that may materially impact the stated risk-return objective of the investment.

Red flags = internal and external factors that may materially impact the stated risk-return objective.

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12.2 The sixteen areas of Investment Due Diligence

Investment Due Diligence is done to analyse the financial performance and factors influencing the financial performance of an AIF, in order to verify the expected return and risk factors stated by the fund in its PPM.

And the timing rule, stated twice in the chapter:

Investment Due Diligence is performed by Institutional Investors, after screening potential funds, based on pre-determined risk-returns objectives, and short-listing the target AIF for a potential investment. Due Diligence process should be ideally completed BEFORE signing legal documents and investment agreements, which binds the institutional investor to commit capital to the fund. Timely completion of due diligence can allow the investor to negotiate the terms and conditions for subscription to the fund, based on the due diligence reports and analysis.

Complete it before signing — because the report is your negotiating leverage. Once you have signed, you have nothing to trade with.

1. Investment Strategy

The stated investment strategy is analysed to check for the investment methodology and risk factors involved while investing in targeted securities, such as excessive limits on short positions, excessive derivative-trading, concentration limits and factors of illiquidity. In case of a Category III AIF, leverage is also a crucial factor for investors, which may increase the potential risk of the Fund portfolio, as seen in the classic case of Long Term Capital Management Fund, in USA.

The LTCM case — the workbook's own cautionary tale

Long Term Capital Management (LTCM) was set-up by John Meriwether from Salomon Brothers. The Fund had a very long track record of highly profitable relative-value strategies. It used to perform convergence trades in the European, Japanese and USA Sovereign Bond Markets, by purchasing relatively under-valued bonds and selling relatively over-valued bonds.

For the fund to make significant profit, it needed to make many highly-leveraged positions. This was because the difference between the converging trades was miniscule. By 1998, the fund had equity of USD 5 billion and had borrowed over USD 125 billion, operating at a leverage ratio of 30:1.

The Russian sovereign debt had defaulted in the summer of 1998, which drove a rapid flight to quality in treasuries, and the source of their relative value profits turned into a significant loss position. These losses were compounded by the high leverage taken by the fund.

LTCM was forced to liquidate all holdings and close. There was fear that the downfall of LTCM could have spiralling effects in the global financial markets, causing catastrophic losses throughout the financial system. Goldman Sachs, AIG and Berkshire Hathaway on September 23, 1998 offered to buy out the funds partners for USD 250 million and decided to inject USD 3.75 billion and to operate LTCM within Goldman's own trading division. The final bailout was USD 3.65 billion.

The downside trigger on account of the Russian default caused the demise of LTCM due to the leverage deployed and the sheer size of their positions relative to the broader market.

The numbers are examinable: John Meriwether, from Salomon Brothers. Equity USD 5 billion, borrowings over USD 125 billion, leverage 30:1. Trigger: the Russian sovereign default of summer 1998. Buyout offer USD 250 million on 23 September 1998 by Goldman Sachs, AIG and Berkshire Hathaway; injection USD 3.75 billion; final bailout USD 3.65 billion.

And the lesson: the strategy was sound and the track record long. What killed it was leverage plus position size relative to the market.

2. Investment Management Team

The Investment Manager should have relevant exposure and experience in the same asset class of securities, in which the fund is making targeted investments as the investment strategy. The minutes of the Investment Committee meetings should also be reviewed, to check the investment management and approval process adopted by the Fund.

Investment Due Diligence should also include reviewing the past investment experience of the team inter-alia involved in equity research, trade execution, order management, sales, compliance and fund administration.

3. Fee Structure of the Fund

A higher fee-structure, if adopted, by the Investment manager should be justified by the past performance, industry exposure and reputation of the investment manager, in the domestic capital market. If the past performance is not significantly high, a higher fee structure would be undesirable and would be a potential risk factor for the investors.

Institutional Investors would also review the fee structure applicable for all class of units to be issued by the AIF. Investment Managers offering a fee structure with lower Management Fees and higher Incentive Fees may be preferred by some institutional investors, based on their risk appetite. Other risk-averse investors may prefer the standard rates for Management Fees and a lower Incentive Fee, to avoid taking excess risk.

There is no single "right" fee shape. Low management fee plus high incentive fee suits an investor happy for the manager to be paid on outcomes. Standard management fee plus low incentive fee suits a risk-averse investor who does not want the manager tempted into risk.

4. Hurdle Rate / Target Returns

Hurdle rate in the context of AIF investments is the rate of return from the fund that a fund manager has to achieve before being entitled to any additional return or incentive. Therefore, the hurdle rate if achieved by the fund fully accrues to the investors.

Then the passage the exam loves, because it is counter-intuitive at both ends:

If hurdle rate is fixed too low in comparison to the general market returns (say 8 to 10%), it would mean that the fund manager's task becomes easier and they may get a higher share of additional return or incentive. On the contrary, if the hurdle rate looks too ambitious (say 25%), it is possible that the fund manager may be tempted to try too hard and take undue risks in trying to achieve it so as to be entitled to their incentive. Therefore, hurdle rate should be fixed reasonably and in context (say 15% in the Indian context).

A hurdle that is too LOW overpays the manager. A hurdle that is too HIGH tempts him into undue risk. About 15 per cent is the workbook's Indian benchmark.

In addition, the fund manager may mention a target return that they intend to achieve from a prospective scheme or fund. This would provide enough guidance to investors as to the level of risk taking being proposed by the manager.

5. Risk Factors and Leverage

Risk Factors mentioned in the PPM should be carefully analysed for any unnecessary risks and warranties claimed by the Fund. The investors should have the knowledge of permissible concentration limits, limits on short positions and limits on leverage taken by the Fund. A Fund may choose to have self-imposed restrictions on sectoral limits, type of securities to invest in and targeted market segments, among others, as per the PPM. SEBI has prescribed maximum leverage limits for a Category III AIF, in relation to its Net Asset Value.

6. Risk Management Controls and Policies

Risk Management policies of the fund outline the procedures to be adopted by the AIF, in case of any breach in prudential norms prescribed by SEBI and the team members responsible to do so. The internal controls on pay-in and pay-out of cash and securities should be carefully analysed, to ensure that adequate safety measures and authentication policies are adopted by the fund, when executing trades.

7. Government Reforms and Taxation

Government Reforms in India have encouraged the growth of AIFs. Investors should analyse the impact of current and expected government policies and taxation structures, on the net return of the fund and the distributions made to the investors. Compliance with taxation policies and timely payment of indirect taxes and direct taxes, if applicable, is an indicator of strong operational policies within the fund.

Note the reasoning: tax compliance is treated as a proxy for operational discipline, not merely a tax matter.

8. Macro-economic Factors

Economic cycles, global risk factors and political risks are crucial, for the investment strategy of the AIF to be implemented successfully. Investors should analyse the possibility of negative returns and worst-case scenarios, such as war, pandemic, and domestic geo-political risk factors impacting potential returns.

9. Regulatory Compliance and Legal Proceedings

Investors should verify timely compliance of domestic regulatory norms, by the potential AIF, in terms of Registration with the domestic regulator, compliance with prudential and reporting norms and timely payment of applicable taxes. Any legal proceedings against the fund may also result in contingent liabilities for the fund, thereby impacting the net distribution of funds to investors.

10. Business Operations and Internal Controls

Effective operational controls and internal controls are a pre-condition in today's financial markets, for managing investors' money. An AIF should document all the internal policies and processes for every department within the fund. The investors must ensure that the fund has all basic controls, such as maker-checker control and access controls when handling confidential data relating to the clients.

Maker-checker control and access controls — two named minimums.

11. Engagements with Third-party Service Providers

All AIFs appoint external service providers such as a fund administrator, custodian, registrar and transfer agent, auditor, legal advisor, fund distributors, etc. Investors should verify the potential conflicts of interests with all service providers, in form of related party transactions, understand the important terms of contract and verify that the interests of the service providers are aligned with the interests of the investors in the AIF.

12. Business Continuity and Disaster Recovery Plans

Business continuity can be impacted, due to material Key-Person events or natural disasters. The investors should ensure that AIFs have adequate business continuity plans and policies, which outline the future course of action on account of unpredictable events. Disaster Recovery Plans are also crucial for an AIF with the increased use of technology for the purpose of executing trades and maintaining client's data.

13. ESG Policies

Institutional investors should analyse the ESG policies adopted by the fund. If a potential AIF manager has a reputation of being unprofessional at workplace, not providing adequate workplace safety to employee, then investors would prefer to not invest in the fund. Similarly, if an AIF is unable to fulfil all the Corporate Governance requirements, such as following transparency norms for timely disclosures of information to investors, holding Investment Committee meetings on a timely basis or appointing independent directors on the Board, the investors would prefer not to invest in the fund with inadequate governance policies.

Under the SEBI Stewardship Code all AIFs in collaboration with other institutional investors, are required to monitor and engage with the investee companies on ESG factors and monitor the inherent ESG risks at the investee company level.

Notice that ESG here is not only about the portfolio — it is about the manager's own workplace conduct and governance.

14. Potential Conflicts of Interest

The potential conflict of interests is identified by the Investment manager and disclosed in the PPM, before the investors commit capital. The conflicts may be internal conflicts with the fund sponsor, investment manager, affiliates and trustees, or external conflicts, with custodians and third-party service providers. Investors should carefully analyse every potential conflict and its impact on the estimated returns of the fund. Most AIFs have a conflict resolution policy outlined in the PPM.

Internal conflicts: sponsor, manager, affiliates, trustees. External conflicts: custodians and third-party service providers.

15. Transparency and Investor Reporting

Institutional Investors always prefer timely disclosure of detailed information relating to the investments made by the fund. The AIFs should provide timely disclosures to the investors, on a monthly, quarterly or yearly basis, in the formats prescribed by SEBI. An AIF may choose to report more frequently than the prescribed limits of quarterly reporting or monthly reporting, to give comfort to investors.

16. Other Factors

The investors conduct a thorough review of such other factors as necessary and conduct on-site visits, whenever possible, to physically verify the existence of staff members, policies and procedures claimed by the AIF. Such process may be done internally, by appointing a dedicated team of due diligence professionals, having industry experience in legal and financial domain. Alternatively, some small-size and mid-size institutional investors may choose to appoint third-party due diligence experts, with qualified and dedicated staff in areas, inter-alia including investment management, finance, legal and regulatory compliance.

On-site visits to physically verify the existence of staff members, policies and procedures. That phrase is there for a reason — a PPM can describe a compliance department that does not exist.