Book 5. Risk and Investment Management

FRM Part 2

IM 10. Performing Due Diligence on Specific Managers and Funds

Presented by: Sudhanshu

Module 1. Past Fund Failures, Due Diligence and Evaluation

Module 2. Operational Due Diligence

Module 1. Past Fund Failures, Due Diligence and Evaluation

Topic 1. Past Fund Failures

Topic 2. Due Diligence Elements

Topic 3. Manager Evaluation

Topic 4. Manager's Due Diligence

Topic 5. Risk Management Evaluation

Topic 1. Past Fund Failures

• Poor Investment Decisions: A series of bad decisions or a single calculated risk that backfired.

• Fraud: Occurs in various forms:

  • Accounting: Misstating book values or income.

  • Valuation: Misstating market values of assets.

  • Theft: Stealing funds directly.

• Extreme Events: Unexpected, low-probability events (e.g., market crashes).

• Excessive Leverage: Magnifies both gains and losses, leading to significant failures.

• Lack of Liquidity: Inability to meet capital withdrawals and redemptions.

• Poor Controls: Lack of supervision leading to excessive risk-taking.

• Insufficient Questioning: Dominant members or fear of voicing concerns in committee settings.

• Insufficient Attention to Returns: Overcompensating with excessive controls, leading to high expenses and low returns.

Practice Questions: Q1

Q1. Based on historical evidence, which of the following factors is least likely to result in the eventual failure of a hedge fund?
A. Excessive controls in place.
B. Taking on more systematic risk.
C. Making decisions in a committee setting.
D. Materially misstated financial statements.

Practice Questions: Q1 Answer

Explanation: B is correct.

If a fund takes on more systematic risk (i.e., regular market risk), it is less likely to result in a failure unless there is a significant market downturn. Taking on more unsystematic risk, however, is more likely to result in a failure. Excessive controls to reduce operational risk may be a good idea but may also result in excessive expenses and insufficient returns, thereby leading to a possible failure of the fund.
In a committee-style decision-making process, there may be a dominant member who sways the decision and/or members who are afraid to voice any valid concerns. Materially misstated financial statements are a form of accounting fraud, which significantly increases the risk of the eventual failure of a fund.

Topic 2. Due Diligence Elements

• Due diligence on investment managers requires assessing the manager's background, reputation (education, employers), past performance, fund structure, and investment strategy, though these factors alone are insufficient.
• Investors should review the fund's prospectus or offering memorandum and conduct attribution analysis to determine whether returns resulted from manager skill, luck, or external factors, and whether returns aligned with risk taken.
• Evaluating the fund's operations and business model is critical, including whether internal controls and policies are robust enough to preserve investor funds and detect or prevent fraudulent activities.
• Key operational considerations include segregation of duties between front and back office, approval limits for large transactions, asset valuation processes and frequency, fee structures, additional fees beyond thresholds, and redemption limitations or blackout periods.
• Investors must maintain objectivity and avoid being influenced by a manager's past successes, focusing instead on comprehensive assessment of risk controls, investment processes, and operational safeguards.

Practice Questions: Q2

Q2. In performing due diligence on a potential investment manager, which of the following factors is the least important for the investor to consider?
A. Risk controls.
B. Business model.
C. Past performance.
D. Investment process.

Practice Questions: Q2 Answer

Explanation: C is correct.

Investors should assess potential managers and their investment strategies with an objective and unbiased mind. They should not be unduly concerned with a manager’s past successes given that past performance is not always indicative of future performance. Risk controls, the business model, and the investment process are all fundamental parts of the due diligence process.

Topic 3. Manager Evaluation

• The prcocess of manager evaluation can be broken down into four areas including strategy, ownership, track record, and investment management.

• Strategy

  • Key strategy questions include the manager's investment style (growth vs. value), current trends or sector specializations, portfolio turnover and liquidity levels, and how holdings have been rebalanced over the past year.
  • Investors should assess risk management mechanisms for limiting losses, the use of quantitative analysis and modeling, and whether short sales are used for profit generation or hedging purposes.
  • Understanding derivative usage (hedging vs. speculation), trade execution processes, private security investments, and the balance between current returns versus long-term growth is essential.
• Ownership: Ownership interests by investment team members (traders, portfolio managers, research analysts) help align their interests with investors and can attract and retain quality staff to sustain strong returns.
• Track Record:
  • ​Performance evaluation should compare the manager and fund against peers and similar investment philosophies, verify whether past performance has been third-party audited, and assess returns during market downturns.
  • Investors should determine if sufficient performance history exists for trend and attribution analysis, evaluate returns relative to asset size, and confirm whether the investment team that generated past results remains employed.
• ​Investment Management: Key interview questions should explore the manager's investment strategy for generating excess returns and how the manager coped with challenging market periods.

Topic 4. Manager's Due Diligence

• Reference Checks
  • Former employers: Assess whether the manager was a leader or follower, proactive or reactive, and a team player or individualist.
  • Current and former colleagues, clients, and independent parties: Ensure consistency in reviews, and if mixed reviews emerge, follow up for explanations or obtain clarification from the manager.
  • Current and former investors: Understand their positive and negative investment experiences with the manager.
• Background Checks
  • Obtain comprehensive background check reports on the manager and review Form ADV filed with the SEC and state securities authorities, which contains information about the business, fees, services, conflicts of interest, and key personnel backgrounds.
  • Verify the manager's integrity by examining public databases and the SEC website for any past or current litigation or criminal behavior.
  • Assess the manager's personal financial responsibility by examining personal credit reports and bankruptcy reports.
  • Verify the accuracy of the manager's stated representations by inquiring with auditors and brokers currently or previously working with the manager.
  • Determine the extent of the manager's involvement in any related party transactions.

Practice Questions: Q3

Q3. Lisa Tahara, FRM, is considering an institutional investment in a hedge fund that has experienced volatile and generally positive returns in the past. Which of the following considerations about the fund’s track record is least relevant for consideration in her investment decision?
A. Size of investment assets.
B. Absolute level of past returns.
C. Verification of returns by a third party.
D. Employment continuity of the investment team.

Explanation: B is correct.

The absolute level of past returns is least relevant here given the volatile returns in the past. Also, past returns are not an assurance of similar returns in the future.
The relative level of returns is more important than the absolute level. Verification of returns by a third party provides assurance that the return calculations were computed fairly and accurately by the fund. It is relevant to ascertain whether most or all of the staff on the investment team that generated the past results are still currently employed by the fund. It provides some (but not absolute) assurance that similar returns may be generated in the future.

Topic 5. Risk Management Evaluation

• Risk:

  • Assess applicable systematic risk factors and unsystematic risk factors.

  • Determine whether written policies and procedures exist for measuring and monitoring risk, and whether a risk committee receives such measurements and reporting frequency.

  • Evaluate the risk management culture, and the management and mitigation of the firm's risks.

  • Assess information technology resources used to quantify risks, including their reliability and consistency in measurements between traders and portfolio managers.

  • Identify the existence and structure of risk models, including their inputs, assumptions, robustness and testing rigor.

• Security Valuation:

  • Identify the proportion of fund assets that are objectively valued through reliable market prices versus those subjectively valued by brokers or through simulation.
  • Examine the independence of valuations, determining whether they are performed by the fund administrator (more independent) or fund manager (less independent).
  • Determine if prices may be overridden for valuation purposes, by whom, and whether documentation or an approval process exists.

• Portfolio Leverage and Liquidity:

  • Assess the sources of leverage as well as current and historical leverage levels.
  • Calculate current liquidity levels and observe changes over time, particularly relevant for assessing portfolio investment capacity and ability to accept additional capital.
  • Recognize that excessive leverage and/or illiquidity within a stated investment strategy could generate returns significantly different than expected, requiring adjustments in expected return assumptions.

Topic 5. Risk Management Evaluation

• Exposure to Tail Risk:

  • ​Analyze fund information to determine whether the return distribution exhibits skewness or kurtosis.

  • Discuss tail risk possibility with the manager and determine whether the manager has sufficiently mitigated the risk or whether further investor action is required.

• Risk Reports:

  • ​Review risk reports prior to investing in the fund, and ensure investors receive these reports regularly (monthly, quarterly, or annually) from in-house or third-party sources.

  • Analyze key risk metrics and compare them to similar funds for benchmarking purposes and identifying any unusual risks in the fund.

• Consistency of the Fund Terms with the Investment Strategy: 

  • ​Examine the general fee structure and determine whether it is consistent with similar funds.

  • Identify the existence of any additional fees after specific thresholds (e.g., high-water mark, hurdle rate).
  • Evaluate whether high fees are justified for managers generating market alpha (fair) as opposed to beta (unfair).
  • Identify the existence of any limitations or blackout periods on redemptions.

Practice Questions: Q4

Q4. Which of the following statements regarding the assessment of a fund’s risk management process is correct?
A. The periodic valuation of a fund’s securities is best performed by the fund manager.
B. The existence of written policies and procedures for internal controls is useful in measuring and monitoring risk.
C. The risk reports received by investors are preferably prepared by a third-party risk provider instead of by the fund itself.
D. The key requirement for information technology resources used to quantify the risks is that they measure items consistently.

Practice Questions: Q4 Answer

Explanation: D is correct.

It is very important for the information technology resources used to quantify risks to measure items consistently. Securities valuation is an important and potentially subjective task, therefore, independence and objectivity is critical. Policies and procedures tend to be general and only demonstrate the intention to have a strong control environment. Their existence alone provides little assurance that they are properly measuring and monitoring risk. In general, the reporting of risk measures is a more objective task and as a result, there is little or no preference for the reporting to be done internally or externally.

Module 2. Operational Due Diligence

Topic 1. Internal Control Assessment

Topic 2. Documents and Disclosure

Topic 3. Service Provider Evaluation

Topic 4. Business Model Risk

Topic 5. Fraud Risk

Topic 6. Due Diligence Questionnaire

Topic 1. Internal Control Assessment

• The key areas involved when performing operational due diligence on a fund include:

  • Examine the qualifications and attitudes of personnel, including whether the CEO supports controls and compliance, and assess if internal control staff have sufficient technical experience and proper training to perform compliance duties effectively.
  • Verify that back and middle office managers possess adequate experience in supervisory duties, and conduct background checks on critical internal control staff members.
  • Review the fund's policies and procedures covering trading, derivatives usage, and transaction processing, recognizing that these documents are often general and only demonstrate intent rather than actual compliance or effectiveness.
  • A proactive audit report and opinion on the effectiveness of controls is a positive indicator and should be reviewed if available.
  • Examine the in-house or outsourced compliance system, including the code of ethics (if one exists) and any restrictions on employee trading and related-party transactions.
  • Investigate how the fund manages counterparty risk from OTC derivatives and other counterparties, including whether risk is mitigated by using multiple counterparties and if counterparties are monitored daily.
  • Assess the effectiveness of corporate governance throughout the organization, including whether internal control breaches are followed up with appropriate remedial actions to prevent future recurrence.

Topic 2. Documents and Disclosure (...Continued)

• As part of due diligence process, investors must:
  • Determine if the manager can be indemnified for actions outside of fraud, gross negligence, or malicious intent, and review the manager's reporting duties to investors regarding audited financial statements and tax treatment disclosures.
  • Ensure the audit opinion is unqualified and examine the balance sheet and income statement for consistency with the fund's investment strategy.
  • Review audited footnotes carefully for detailed information on contingent liabilities, related-party transactions, and other key items not fully disclosed in the financial statements.
  • Scrutinize and recalculate fees paid to the manager, corroborate them with the offering memorandum, and specifically verify any incentive fees paid during loss years.
  • Check the level of net contributions to the fund by the general partner and question any fund withdrawals made by the manager.

Topic 2. Documents and Disclosure

• As part of due diligence process, investors must:
  • Confirm with the fund's legal counsel its involvement in preparing original fund documents and subsequent revisions, verify if the law firm remains as legal counsel, and physically check documents for any unauthorized changes after the dated version.
  • Corroborate offering memorandum terms by examining Form ADV, subscription agreement, and investment management agreement for consistency, particularly regarding fees, redemption rights, liquidity, and lockup provisions.
  • Scrutinize disclosed conflicts of interest carefully, as lack of clarity may be a red flag warranting further discussion with the manager or requiring independent verification.
  • Examine risk disclosures for clarity and sufficiency, as overly general or irrelevant risk factors may indicate inadequate disclosure and warrant further investigation.
  • Assess the extent of the manager's authority, including whether provisions are broad (potentially riskier) or specific, and whether limitations exist on leverage or sector/security concentration.

Topic 3. Service Provider Evaluation

• A fund may hire third-party service providers for trade execution, information technology, valuation, verification, and asset safeguarding.

• Assessment Steps

  • Examine the internal control letters issued by the service provider's auditors and its audited financial statements.

  • Perform further due diligence through in-person discussions regarding the service provider's role.

Topic 4. Business Model Risk

• Evaluating business model risk involves assessing whether managers know how to operate the business as well as generate high returns. Typical risks leading to failure include a lack of cash/working capital, a lack of a succession plan, and excessive redemptions.

• Business model risk can be assessed by:

  • Examining the nature of revenues (stable, recurring, or one-time) and expenses (if they can be reduced or are increasing uncontrollably).

  • Calculating the percentage of revenues from variable incentive/performance fees (which may not materialize in market downturns).

  • Assessing the significance of the gap between management fees (revenue) and operating expenses.

  • Considering the sufficiency of working capital (especially cash) to cover revenue shortfalls or expense overages.

  • Determining how frequently budgets are created and for what period.

  • Determining the fund's breakeven points in terms of assets under management and required performance level, and comparing them to actual and projected amounts.

  • Ascertaining if there is sufficient personnel or capacity to increase the fund's investment asset base.

  • Ascertaining the existence of key person insurance and a succession plan.

  • Ascertaining if there is sufficient personnel or capacity to increase the fund's investment asset base.

  • Ascertaining the existence of key person insurance and a succession plan.

• Ascertaining if there is sufficient personnel or capacity to increase the fund's investment asset base.

• Ascertaining the existence of key person insurance and a succession plan.

Topic 5. Fraud Risk

• Fraud risk can exist even with extensive due diligence. A fund's fraud risk can be assessed by determining the existence of the following factors:

  • Frequent related-party transactions, including trading through a related-party broker or using a related-party valuator.

  • Frequent instances of illiquidity, especially significant concentrations of illiquid investments valued only by the manager.

  • Frequent litigation as a defendant, especially regarding claims of fraud.

  • Unreasonably high (stated) investment returns.

  • Frequent personal trading by the manager of the same or similar securities as those held by the fund.

  • Frequent shorting transactions.

• ​Fraud risk may be mitigated by:

  • Checking the SEC website for any prior regulatory infractions.

  • Checking court records for any prior litigation and bankruptcy records for examples of financial irresponsibility.

  • Inquiring with service providers for assurance over their competence and independence from the manager.

  • Performing extensive background checks on the manager.

Topic 6. Due Diligence Questionnaire

• The questionnaire should include inquiries into:

  • General Information on the Manager: Confirmation of proper registration with regulatory authorities, determination of ownership form and structure, identification of key shareholders, reference checks, information on past performance and business contact information.

  • General Information on the Fund: Fees, lockup periods, redemption policies, primary broker, fund director, administrator, compliance (auditor and legal advisor), financial (assets under administration, investment capacity, and historical performance, including financial statements) and historical drawdown levels.

  • Inquiry into execution and trading as well as service providers

  • Inquiry regarding the firm’s third-party research policy

  • Inquiry regarding compliance processes, the existence and degree of involvement of in-house legal counsel, and the existence of anti-money laundering policy and procedures

  • Inquiry into the existence of information regarding disaster recovery and business continuity plans as well as insurance coverage and key person provisions

  • Inquiry into the investment process and portfolio construction

  • Inquiry into risk controls such as leverage, liquidity, asset concentrations, portfolio diversification, and market risk factors

Practice Questions: Q1

Q1. Which of the following items is least likely to be included as requested information on a due diligence questionnaire?
A. Insurance coverage.
B. Returns attribution analysis.
C. Disaster recovery procedures.

D. Anti-money laundering policy.

Practice Questions: Q1 Answer

Explanation: B is correct.

A returns attribution analysis could be performed to determine how a fund’s returns were generated. Return attributions are not generally part of a due diligence questionnaire but such an analysis could subsequently be performed based on some of the information received from the questionnaire. The other items (insurance coverage, disaster recovery procedures, and anti-money laundering policy) are all standard items that would be found inmost, if not all, due diligence questionnaires.