If you were a client of Access International Advisors, which lost a lot of money with Bernie Madoff, then you would have been told that they "conducted thorough due diligence when selecting outsider fund managers". Which might have been reassuring, until you found out what that "thorough due diligence" comprised:
Candidates had to undergo a handwriting test with a graphologist and Access would often hire private investigators to check the background of executives.
Clearly, some firms’ ideas of "thorough due diligence" leave something to be desired. And so Jason Scharfman, of Corgentum, has put together a list of 10 questions every investor should ask about the due diligence being performed on their behalf.
Seriously: ask these questions. Doing so isn’t rude; in fact, it barely scratches the surface of the questions your advisor should be asking of the people managing your money. But if all of the questions are answered to your satisfaction, you’ll sleep much better at night.
Most of the questions have obvious "right" answers: yes, you want a separate due-diligence process to be performed on operational risk, rather than that being lumped in to the investment-risk process. Yes, you want a hedge fund’s service providers — it’s auditors, etc — investigated as well. That sort of thing. But question #8, about whether the due-diligence process was done in-house or whether it was outsourced, didn’t have such an obvious "right" answer, so I asked Jason what to look for. He replied:
In a perfect world my preferred answer to number 8 would be to see an advisor
who does everything in-house. That being said, most advisors (i.e. fund of
funds) do not have the internal capabilities to really do a detailed job on
such things as background investigations which certain firm’s specialize in.
In such a case working in conjunction with an external ("outsourced")
vendor would not necessarily be bad in and of itself. The key to me is to
see an advisor which takes the work of an outsourced organization and
further analyzes it/digests it as part of their entire hedge fund due
diligence rather than simply relying whole-heartedly on the outsourced work
and moving on.
But the most important question, I think, is #10:
Previous Examples – Can your advisor cite recent examples of hedge fund managers they have ever not hired (or fired) because of items uncovered during the due diligence process?
Due diligence should never be a rubber stamp, or a marketing tool: it should be an important part of choosing hedge-fund managers. You want the possibility of missing out on a great fund because it failed the due-diligence process. And you certainly don’t want to see any fund managers getting a free pass, as Bernie Madoff did with Access’s Patrick Littaye:
The relationship with Mr. Madoff, which for Mr. Littaye dated to the mid-1980s, wasn’t subject to the same rigor, in part because of Mr. Madoff’s reputation on Wall Street. "Of course we made an exception with Mr. Madoff," says Mr. Littaye. "I can’t imagine asking him to pass a handwriting test."
Maybe there should be a question #11 on the list: have any of your fund mangers not had full due diligence performed on them?
Update: Pelorus Advisors goes into detail on the subject of investor capital account due diligence: can you be sure that your hedge fund is calculating your payout correctly?