For decades investors and managers have played an endless tug of war regarding transparency during the due diligence process. The value of the data disclosed by managers is still an area of research for experts in the field, especially as investors seek to streamline how they assess potential managers.
In December 2020, Keith Black, managing director, content strategy, for the Chartered Alternative Investment Analysts’ (CAIA) Association, and Mark S. Rzepczynski, the founder of AMPHI Research, presented to a conference of CAIA members the results of a survey about the due diligence process. The survey solicited the opinions of both investors and managers (233 of the former and 111 of the latter responded). The conclusion, simply stated, is: quality beats quantity.
Somewhat less simply put, the bullet points are these:
- Alternative investment manager selection is a complicated process, not captured through “specific empirical measures of skill.”
- Skill assessment for alternative investment is much more complicated than skill assessment for traditional investments.
- Qualitative factors for alternative investment manager skill assessment are as or more important than quantitative measures.
- The operational due diligence of manager business risk can override the assessment of investment skill.
- The selection process must be tailored to the strategy being reviewed.
The investors among respondents were weighted toward the high end of the AUM scale. Half were associated with firms with over $10 billion in assets. Most of these investor participants had a good deal of exposure to alternatives, with 70% acknowledging that 10% or more of their total AUM is in alternatives. For 15%, that allocation figure was 50% or more.
The manager selection process
The respondents offered a surprisingly wide range of views even in response to the simple-sounding question: how many months or years does the selection process typically take? The most common response was: 3 to 6 months. That represents about one-third of the answers. Fourteen percent find it takes less time than that, which leaves half of the respondents saying it takes more, although again there is a range as to how much more, with the deliberative outliers saying it takes beyond three years.
Another wide range appears in response to the question: how standardized (or customized) is the due diligence questionnaire? While 13% say it is all standardized, 22% say it is all customized, with the remaining 65% falling into the three baskets of possibilities between. The single most common answer (27%) being that it is between 25% and 75% standardized.
Quantity and quality
Dividing performance factors into three sorts (quantity, quality and operational), the AMPHI Research/CAIA survey then asked which type is most important in due diligence, on a strategy-by-strategy basis. For some funds (including traditional equity, traditional debt, and CTA/hedge funds) the answer is: quantitative factors. They were deemed most important in those instances by 54%, 59%, and 69% of those questioned, respectively. For others, (including venture capital, private equity, and global macro hedge funds) the answer is: qualitative factors. They were deemed most important by 78%, 71%, and 52% respectively. Operational, on the third hand, never seems to break the 20% barrier. That is the percentage of respondents who believe it is the most important factor for systematic hedge funds.
It is generally understood — and has been understood at least since the failure of the Bayou hedge fund group in 2005 — that operational due diligence (ODD) is important and should be kept separate from investment due diligence. So the joint AMPHI/CAIA survey asked: What is the likelihood that ODD will override investment due diligence? The results came out thus: very likely (11%); likely (28%); neither likely nor unlikely (32%); unlikely (26%); and very unlikely (3%).
A final point
The survey also looks into the distinction between the perceptions of the two groups involved, investors and managers, the conductors and the targets of all this diligence. Managers generally do value quantitative factors more highly than investors. They also tend to believe that portfolio managers and analysts have more sway with the investors’ decisions than in fact they do. Investors report that most decisions are made by committee.