LO 72.7: Describe elements that can be included as part of a due diligence questionnaire. * 1
Properly designed due diligence questionnaires that are thoroughly and honestly answered by respondents can yield valuable information to a potential investor and may provide a list of concerns that need further assessment. The questionnaire should make the following inquiries:
1.
Inquiry into general information on the manager provides a starting point in the due diligence process. Examples of such information include: Confirmation of proper registration with regulatory authorities. Determination of ownership form (e.g., corporation) and structure.
Identification of key shareholders.
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Reference checks.
Business contact information.
Information on past performance.
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3.
6.
7.
8.
Fees. Inquiry into general information on the fund also is critical. Examples of general information that should be collected include:
Lockup periods. Redemption policies. Primary broker.
Fund director. Administrator. Compliance: auditor and legal advisor.
Financial: assets under administration, investment capacity, and historical Financial: assets under administration, investment capacity, and historical performance (also see financial statements).
Historical drawdown levels.
Inquiry into execution and trading as well as service providers may provide some insight on the speed and accuracy of transaction processing and the existence of related-party service providers, the latter of which may raise red flags with potential investors as discussed earlier.
Inquiry regarding the firms third-party research policy may be useful to determine a funds sources of research information, thereby allowing the assessment of the extent and quality of the due diligence performed by the fund in its investment process.
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 may help provide comfort that the fund and its managers have a desire to operate in an ethical manner and/or within the boundaries of the law.
Inquiry into the existence of information regarding disaster recovery and business continuity plans as well as insurance coverage and key person provisions may provide some assurance regarding the stability of the firm and, therefore, the safety of any invested funds.
Inquiry into the investment process and portfolio construction provides the potential investor with information required to make an informed decision whether the overall risk and return profile of the fund is consistent with the investors investment objectives.
Inquiry into risk controls such as leverage, liquidity, asset concentrations, portfolio diversification, and market risk factors give the investor a more complete picture of the investment risks and how the managers attempt to manage and mitigate them.
The existence of financial statements, especially if audited with an unqualified opinion, provide objective and historical financial information on the fund that can be used to assess performance. Information on the composition of the invested assets may also be helpful to the potential investor. Finally, interim statements (not necessarily audited) may provide more timely information to make a more current assessment of the fund by the potential investor.
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Topic 72 Cross Reference to GARP Assigned Reading – Mirabile, Chapter 12
Ke y Co n c e pt s
LO 72.1 Past fund failures can be attributed to poor investment decisions, fraud, extreme events, excess leverage, lack of liquidity, poor controls, insufficient questioning, and insufficient attention to returns.
LO 72.2 The due diligence process for assessing investment managers should include information on the investment background and reputation of the managers and past performance. In addition, there should be an assessment of the funds investment process, risk controls, operations, and business model.
LO 72.3 In evaluating a manager, investors should consider four broad themes including strategy (e.g., evolution, risk management, quantification, types of investments), ownership, track record (e.g., comparison with peers, independent verification of results), and investment management (e.g., manager interviews, reference checks, background checks).
LO 72.4 Criteria that could be used in assessing a funds risk management process includes risk (e.g., types, culture, quantification/models), security valuation, portfolio leverage and liquidity, tail risk exposure, risk reports, and consistency of the fund terms with the investment strategy.
LO 72.3 Performing due diligence on a funds operating environment focuses on:
Internal control assessment (i.e., qualifications and attitude of personnel, written policies and procedures, compliance system, counterparty risk, effectiveness of governance).
Documents and disclosure (i.e., confirmations with the funds legal counsel regarding
fund documents, corroborating terms of the offering memorandum, conflicts of interest, disclosure of risks, managers authority, managers reporting duties to investors, financial statements, and fees paid to the manager, net contributions/withdrawals by the general partner). Service provider evaluation.
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LO 72.6 Business model risk can be assessed by considering revenues and expenses (detailed examination), sufficiency of working capital, existence of budgets, computation of breakeven points, ability to increase investment asset base, existence of key person insurance, and existence of a succession plan.
Fraud risk can be assessed by considering the existence of related-party transactions, illiquidity, litigation, unreasonably high (stated) investment returns, personal trading by the manager of the same or similar securities as those held by the fund, and shorting transactions.
LO 72.7 Items to include as part of the due diligence questionnaire include general information on the manager and the fund, execution and trading, service providers, third-party research policy, compliance processes, existence and degree of involvement of in-house legal counsel, existence of anti-money laundering policy and procedures, existence of information regarding disaster recovery and business continuity plans, insurance coverage, key person provisions, details of the investment process and portfolio construction, risk controls, and information contained in the funds financial statements.
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Topic 72 Cross Reference to GARP Assigned Reading – Mirabile, Chapter 12
Co n c e pt Ch e c k e r s
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4.
3.
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.
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.
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.
Which of the following statements regarding the assessment of a funds risk management process is correct? A. The periodic valuation of a funds 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.
LisaTahara, 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 funds 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.
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Co n c e pt Ch e c k e r An s w e r s
1. B
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.
2. C
Investors should assess potential managers and their investment strategies with an objective and unbiased mind. They should not be unduly concerned with a managers 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.
3. B A returns attribution analysis could be performed to determine how a funds 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 in most, if not all, due diligence questionnaires.
4. D
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.
5. B 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.
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The following is a review of the Current Issues in Financial Markets principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Th e N e w Er a o f Ex pe c t e d C r e d i t Lo s s P r o v i s i o n i n g
Topic 73
Ex a m Fo c u s
This topic looks at how the accounting rules are changing to require banks and financial institutions to account for loans using expected credit losses (ECL) from the time of origination rather than waiting for specific events that suggest an ensuing high probability of losses. For the exam, understand the possible interaction between earlier provisions for loans and the impact on lending. Also, be able to compare and contrast the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB).
P r o v is io n f o r Ex pe c t e d Cr e d it Lo s s e s