The Art, Science & Accountability of Due Diligence
“Investment due diligence is both an art and science.” Many readers have probably heard or read that statement before. Without a doubt, due diligence requires evaluating both qualitative and quantitative factors, with the former often requiring more subjective judgement than the latter. Yet, while quantifiable metrics such as performance and fees can be objectively compared and benchmarked, how should we evaluate the more subjective qualitative aspects like investment philosophy or decision-making process? More importantly, how can clients be confident that their advisor is thoroughly reviewing these factors before making an investment recommendation?
When it comes to alternative and private market investments, the “art and science” approach to due diligence is especially prevalent. Advisors may say that, after having reviewed hundreds, even thousands, of prior investments, they now have a good “feel” for what sets a good deal apart. However, experience, or using common sense analysis, is simply not enough. It certainly helps, but where’s the accountability in that? If an advisor chalks up poor performance to bad luck, how can clients be assured that red flags weren’t present ahead of time, even in areas that might be viewed as judgement calls? No advisor is going to get every investment selection right, and while qualitative due diligence may be more art than science, this should not exempt a fiduciary from establishing written due diligence best practices. Even without formulas or established benchmarks, advisors can still document policies and procedures that address the qualitative analysis of due diligence.
Establishing Accountability with Written Due Diligence Policy & Practices
SineCera Capital’s due diligence manual establishes criteria and steps for assessing both an asset manager’s investment philosophy and their decision-making process. With respect to philosophy, it is important to understand if the underlying investment rationale is credible and how a manager anticipates capitalizing on those factors. For example, a value-add real estate manager believes they can generate attractive returns by purchasing underpriced properties and then, through capital and operational improvements, increase cash flow and/or resale value. This philosophy requires a review of how the manager values target properties, understanding why this perceived mispricing exists, and assessing if their value-add strategy has the potential to meet projected returns.
It’s in the Details
As a best practice, we seek to not only determine if an investment philosophy is credible but also consistent. If it has evolved over time, we seek to determine if those changes were caused by ad hoc reactions to performance and/or investor redemptions; knee jerk reactions like those indicate a lack of consistency and conviction. If changing market dynamics warrant a reevaluation of an investment philosophy, then it’s important to discuss with the manager—before making an investment—how those changes could impact client portfolios.
When reviewing a manager’s decision-making process, it’s important to evaluate all key individuals involved, their level of involvement, and assess whether they have the requisite experience to execute the strategy. Background checks are essential, but perhaps one of the most telling indicators is discussing how those key individuals performed in adverse markets. Asset managers, just like the advisors that hire them, occasionally make investment decisions that lead to periods of underperformance. How they choose to address those situations is often quite telling. In our view, a response that is dismissive, or one that altogether rejects responsibility, is a red flag. As an advisor, we are fiduciaries of our client’s assets, and we expect to hire asset managers that own their responsibility as stewards of capital.
Creating Investment Policy Statements: Due Diligence is Not One-Size-Fits-All
The next step in creating a reputable due diligence process is creating an Investment Policy Statement (IPS) for each client. When it comes to identifying good investments, there is no such thing as a one-size-fits-all approach. Beyond screening an investment’s merits on a standalone basis, it’s important to evaluate its purpose in a client’s portfolio. Purpose-driven investments (not to be confused with ESG or impact investing) are defined by how and when they will provide the cash flow needed to meet a client’s objectives. At the end of a day, every investment SineCera Capital recommends shares the same client-specific goal: to provide the amount of income needed, at the time it’s needed, to meet clients’ lifestyle goals.
Advisors need to acknowledge that, as fiduciaries, the buck stops with them. Establishing written investment due diligence policies and client-specific Investment Policy Statements are crucial to building a reputable practice. Discussing those documents with current and potential clients also goes a long way in establishing clarity and building confidence in your business model. When part of that business model includes due diligence, particularly on private market investments, experience alone is never sufficient.
If you’d like to discuss further or learn more about SineCera Capital’s due diligence policies and best practices, please contact us.
Best Regards,
Adam J. Packer, CFA®, CAIA®
Chief Analyst | SineCera Capital