The Essentials of Due Diligence Verification
In the world of alternative investments, ensuring the accuracy of information isn't merely a suggestion; it's an imperative. Considering you're entrusting someone with your hard earned funds, it's crucial to adopt a "trust but verify" approach to your verification process, a topic I frequently discuss in my webinars.
Whether you're a newly accredited investor or seasoned investor, grasping the intricacies of due diligence verification can shield you from potential pitfalls, fraudulent schemes, or unnecessary risks. In this brief video, I delve into specific areas where you can conduct verification and provide guidance on how to carry them out effectively. You can also download the presentation I used below.
Key Highlights:
The significance of "Trust but Verify"
Definitions and practical steps for verification
Areas for Verification
Case study
“One of the key elements of alternative investment due diligence is verification. To ensure that what you are told is the truth, create an independent verification process that might consist of phone calls or site visits.”
Watch the full video.
Transcript
Chris: Hi, everybody. This is Chris Carsley from Kirkland Capital Group here to do another short informational webinar on a number of different subjects that we had covered last year through some longer webinars about due diligence. And there's just so many little nuances that so many people come back and ask.
Well, how do I really do that? One of the last ones we did was building networks. You know, how do we effectively build networks? And today, we're going to be talking about verification in Alternative Investment due diligence. You always hear people say, Hey, you should make sure you verify everything. Okay, well, what does that really mean?
And what are some of the key areas you guys should focus on? So let's just go ahead
dive into today's agenda. Um, you know, listen, you always hear trust, but verify. We're going to walk through some of those aspects, give a definition of verification. I think everyone probably understands that, but, uh, we'll, we'll, we'll walk through some of the nuances.
And then the importance of, you know, Well, if you choose not to verify a number of things that you're told how that might affect your, you know, your investment due diligence process and your outcome. And some of the areas will cover physical location, background checks, you know, alignments of the investment strategy and what you can do, you know, in the verification process for that and around attribution of performance.
And, you know, also, uh, verification of counterparties, uh, you know, some of the suppliers and service providers, you know, that's very important step. And then we've got one little, you know, case study that I think everyone has probably heard of that we'll walk through some of the nuances seeing as I was fortunate enough to talk to some of the people that were directly involved in that process and then we'll wrap this up.
next. Okay. Trust but verify. Okay. Well, you know, the key element, you know, of Alternative Investment due diligence, verification. You, I tell you what I do and then you, how do you know I'm telling you the truth? Well you don't. So you've got to find a way to create an independent verification process and some of that might be through phone calls some of that might actually be through you know an on-site visit.
Definition of Verification. Okay, well, we want to ensure that any data that we are supplied, any statements, or numbers, or anything that we receive from the manager, we have a way to go through and verify, prove that through some other third party source, and, you know, we'll run through some of those that could be useful to make sure you're being told the truth, um, and, you know, it's, uh, sometimes it can be tricky, it can be a lot of work, uh, to complete verification.
Next is, you know, Hey, the importance of investment, you know, due diligence, verification process. Well, if you decide not to actually, you know, verify your, uh, information that you're receiving and that you're reviewing, you can read through PPMs and you can look at performance numbers. How do you know any of it's real?
I mean, let me tell you, uh, I have seen a number of things throughout history of where. You know, people have massive leniency within their PPMs of style drift and performance numbers if you don't read the fine print and walk through some of the trades and understand like, hey, what happened at certain time periods, you can easily be misled.
So, um, if that, if you make a choice not to go through and do any verification, um, say through reference checks or something of that nature, Well, it can actually cause you to be involved in an investment that doesn't perform, uh, to the, to the likes of what you thought you were getting. You might have exposure to something in your portfolio that you, you know, weren't aware of, um, or worst case scenario, you've basically walked into a situation of where it could be a fraudulent situation.
Now, although that is. you know, rarer than the newspapers like to make, uh, appear, but you know, you also want to make sure you're in and own and have exposure to something that, you know, you, you expected and not something that all of a sudden you wake up a year later and you're wondering what do I, what do I actually own?
next is, hey, some of the areas of, of, you know, Verification. Physical location. Okay, this has kind of changed a little bit in COVID. Uh, not a lot of people have offices. Um, and if they do, they're not all in the same place. So you might have Traders and portfolio managers and heads of the company all in different locales.
It does make it very difficult to perform a physical location due diligence. It's kind of funny, I was looking at some due diligence questionnaires for some professional due diligence houses and you know, they still have like, hey, you know, part of the cost of doing that work is they've got to visit your physical office.
And I'm like, well, What if that office is in a couple different places? And especially nowadays with technology, some of those offices might be in other countries. Um, so really interesting times to see how people are, uh, you know, facilitating or Is it really that important, um, in certain instances to have a physical visit?
And are there other ways to now effectively verify? Um, I, I would still believe in certain instances, if you know, you could go, it's always great to sit down, walk through a trade with an actual trader, walk through the analysis of how they came up with a trade, you know, look the person in the eye. There's a value to that.
I'm not going to discount that. And so in today's age, um, some of that might be a little bit more difficult for an individual like yourself who doesn't have an entire due diligence team. And it's not what you do for a business. Um, and you know, it's not part of the expense of what you get done. You're just trying to, you know, Hey, is this a trustworthy manager?
I want this exposure in my portfolio. You know, how do I go through and verify something if I'm not going to physically visit Uh, a site. Now, with that said, you might identify where the partners are located. Maybe you may not see someone who's doing, um, you know, underwriting on a mortgage portfolio, but you can visit the lead partner who runs the team, and they can walk through a number of different things, and you can find those key persons.
of the fund, and make sure that you visit them physically, you understand who they are, you get meeting times, hopefully, you know, face time, um, you know, in person, where you can walk through and, and really, like I used to call it, the life of a trade. Walk through, hey, idea generation, all the way to when, you know, a trade is executed, and then exited, and then, you know, you know, attach that directly to performance, and, and see how that entire story unravels.
There's, there's, you know, that's very, very valuable process. Um, You know, like I said, uh, also one of the things that you used to do is, you know, who's in control of, you know, cash controls. One of the things, this is a little bit more controlled with modern technology and dual controls, but you know, if your manager, um, doesn't have dual controls, you definitely want to understand what's the physical security and the location of like where people can control wires and move money from.
That's a, it's a pretty big deal. It's something that when I was doing due diligence on funds. You definitely wanted to sit down and realize how is that secured? Is there, you know, a computer that, you know, is responsible for all wire activity? Is it in a secure place? I mean, there's multiple hedge funds that had a dedicated computer for sending out wires and only certain people could log in and it had dual control on it.
And I even ran into one fund that had it in an entirely locked room. Um, so no other, uh, uh, You know, computer or, uh, you know, portal out of that company could move money, except that one. So, um, you know, some people took it very, very seriously. Um, I'm not saying every fund has to do that, but you can get an idea of, you know, those, that's one of the key angles is the way you want to make sure who can move money, how they can move it and how that process is secured.
And, you know, how has that done? Um, you know, so it's, uh, that's another important aspect to think about. It's also good to just meet employees, you know, Get to see who works at the company and, you know, in today's age, like I said, sometimes that might be, you know, difficult, they could be spread out in a number of different ways, but in today's age, you can definitely jump on a zoom, spend some time, talk to those people, have them share screens and, and, and, and achieve a number of different things that you would do in person.
Um, with today's technology that certainly wasn't available. you know, even five, 10 years ago, especially when I was, uh, you know, gallivanting around the globe, looking at funds as well. next is your background checks. You know, you want to meet this team. That's great. If you can do it in person.
Um, another one is you've got to look at a situation where, okay, what are the backgrounds of the key people? What are the backgrounds of the employees? And two, what is the process and procedure that the company goes through with regards to their background checks of who they're hiring? Um, I generally haven't found it too much of a problem to be able to ask key people.
Hey, can you send me your background check? Do you have one available? Um, that's been, you know, sometimes you might have a little bit of a pushback on the, uh, you know, going through the verification process of, you know, trying to find an employee's background. It might be a little bit different. So you might, you know, you might get some pushback of where they may not be able to share that information.
You just have to deem to yourself, well, How important is that really? You know, you know, if you want to know all the employees, I think it's more important to really walk through that they have background checks, um, what they can share, if they can get authorization to kind of walk through one, you know, randomly, um, that would be great.
Definitely get the background checks on the keeper people who are, you know, running the shop and understand who they are. You can do some verification yourself. There's lots of different resources that you can jump into in today's age and, you know, find some pretty interesting stuff about people. Next is, you know, alignment of investment strategy.
the next two slides are really going to be kind of, uh, they're going to meld in with each other a little bit here. Um, when you're going through and doing verification of investment strategy and performance, you really, like I said earlier, you want to sit down, you want to walk through a trade, perhaps like in our book, you know, people, you know, hey, can I see the loan tape and walk through, uh, you know, some of the characteristics of a certain number of loans, you know, You know, is that available?
Is the manager sharing that with you? Obviously, you know, Verification. If people won't show you things and you don't have the ability to verify things, um, you should probably just get up and leave. I mean, I had one time I was visiting a hedge fund in New York and I wanted to verify a couple different things on some of the trades.
They said that that wasn't available. And I was like, okay, have a nice day. Um, of course they changed their MO because they were an emerging manager at that time. And they were like, Hey, let us get approval. Let's go. Talked to the CIO and the CFO and see if we can, you know, have an exception. Um, and you know, they did and we did, we did invest, but I mean, we were pretty draconian about that.
If you won't show us something or you can't show us something or you can't prove something that you say occurred, that's a, that's kind of a big red flag and there's lots of investments out there. So we just generally, generally move on. Um, yeah. So get that level of transparency, see those trades, make sure you can verify that to the level that you feel you understand what's being done and that the investments that you're being shown matches the strategy and the actions that they are supposed to be taking that they say they are, you know, it, does it match the, uh, objective of the PPM? Does it match what they say they're going to do in their marketing deck? Has it matched what you've been told in your interviews with, you know, you know, the different employees of the company? I mean, it's, it's, it, it, this is, this is probably an important aspect.
And I'll, I'll tell you the truth. Most of the time where we found something was fishy, wasn't really going through accounting. It wasn't really going through anything else. It was when we started to match up the say and the do on the investment strategy and the actual positions and going through and doing the analysis at a pretty granular level.
That's where things, you know, just started to fall apart. Um, you found out that they were often doing things that they didn't disclose or they had style drift that they didn't really ever talk about. Um, they were taking some risks that. Um, you know, you weren't aware of, and I mean, and maybe some of those risks worked out and the performance really did well, but it wasn't something that, you know, you know, that they really had a specialty in.
So maybe they got lucky. It wasn't a skill. It was a luck thing. You know, those are the important aspects of walking through at a granular level and really understanding the trades and how they transact that. And then being able to, you know, like in the next slide, you're going to look at in this area of where.
You know, that attribution and this is why I say these two slides sort of, you know, blend into each other's once you've scrutinized that and you know that investment performance and had that granular verification and walk through the life of the trade and seen the analysis and the idea generation and you know, the exits, um, and had proof of that.
You then can be like, wait a second, does this all match the performance they've shown and the timing of the performance? Um, and, and it's a good way to sort of create that say and do matching and you being able to walk through it a grain your level and have them, you know, verify that performance. Um, now obviously another way to really verify the performance is kind of falls into, you know, one of these last slides and this is, this is a super important piece.
A lot of people will say they work with people or they have access to people or oh this is my advisor or this is my you know fund admin and I kid you not we have literally tried to go in and verify and either we can't get authorization or when we call those people or somehow we already knew them I mean this is it's a small world so if you tell me you're working with somebody I might know some other fund that uses them and I get authorization to kind of call and Sometimes it's hard to get the okay to, Hey, do you work with this, um, you know, particular fund, but we've found people who said, Hey, I work with this group and you find out that they didn't actually work with them.
Um, so yeah, there was definitely something fishy going on there. Obviously we didn't invest in that fund. We just stopped pursuing the opportunity cause we were like, okay, that that's clearly broken. Um, but what to verify? Great. If you're going in and you're saying, let's. walk through and they've got a fund admin.
Great. Get authorization. You'll probably need this. And this is a key element of have the manager send out an email to the fund admin with you cc'd on it saying, Hey, can I get access to, uh, talk with this fund admin and, you know, verify a number of different things? And you're going to want to ask, obviously, do you work with this client?
How long have you worked with this client? What are the functionality that you perform? Can you walk me through high level process and procedure of your integration with them? You know, those are some of the things that you might want to ask. And when you actually, you know, get that done, great. You now have gone through and, you know matched up one of the service providers they work with and especially when it's a fund admin and you know those guys are calculating fees and you know going through uh every single uh you know bank transaction that occurs at the fund level you want to be able to have that third party check that box and say yes we actually do that we do that on a weekly or a monthly basis you know you can understand timing um because but if you Don't get that and the fund admins, Oh, we don't do that.
Well, those are good things to bring back to the manager and say, Oh, the fund admin said this actually doesn't happen. Um, okay. That's pretty important. You need to vet that out. Um, they may have prime brokers, you know, it's okay. Okay. I mean, you know, how much, you know, are you there again? Are you a client?
You know, you run short books, this, can you verify, you know, net exposures? you know, sort of match up what the third party believes it is and match up what is actually in the, um, um, you know, in being told to you by the fund. So, um, you know, call, confirm, get authorization from the fund manager, get that done.
And down below there, you can see there's, depending on the type of fund you're talking to, you can, you know, if they're audited, hey, I mean, obviously, hey, that's an important aspect. These guys are actually walking through financials and operations. Go through the audit partner, you know, talk to tax counsel, fund admins, banks, prime brokers, custodians.
You know, if they use leverage, I always thought one of the biggest things was like, listen, I need to understand the terms that you guys are using for your, uh, your leverage. I want to read your leverage document. I want to understand what's going on. what's going on in that document, you know, get authorization for that.
So that's one of the things that, you know, and, you know, Hey, you know, how long have you been working with them? You know, can I get, you know, get access to the loan documents? And then once you read the loan documents, you can go back and confirm that with, you know, the actual leverage provider. Um, and you know, there again, Securities Council.
Hey, do you guys file the Reg D's for this fund? You know, you're actually keeping up on ADVs depending on the nature of, you know, the type of regulations that need to be done, verifying that's being done and it's being done correctly. And then there's a third party involved in it and they say yes. So lots of important steps to consider when going through service providers, because as you know, if you've ever dove into any kind of fund, They're integral to a lot of moving pieces and there's a lot of overlapping circles into the entire operation of the fund and it allows you to really dive in and get that authorization and be able to ask questions, uh, both of the manager and of the third party.
So super important, take the time to do that. Um, you know, last little slide here, obviously this is, uh, you know, Mr. Madoff and his fund. Um, I talked about like this happened yesterday, um, but I know it was a while ago. I'm sure all of you know of this event. You've been around long enough. that in this particular case, uh, I knew a lot of people who actually went to go visit, um, Madoff's shop and they asked for trade details and, um, they, they weren't, um, they weren't given anything.
Uh, they were, you know, one group I knew was, uh, asked a lot of questions about their split strike options trades. And, you know, these were options specialists and they were like, Hey, let's dive into the trade. And. they were given the very high level of what the trade was. There was no trade details. They were told that they don't share anything.
Um, and they were basically in a roundabout way, escorted out the building. You know, one group I remember was like told to their face, Yeah, I just don't think this is an investment for you. You're not quite understanding what we do. Um, because they were asking too many questions. They wanted to get moved on.
I mean, that's like I said earlier, that's a good sign. If people won't tell you things and they won't be transparent, There's always another investment. Move on. I mean, don't, don't get caught up with the, oh, everyone's doing this or, oh, this is a big name and he makes lots of money. You know, don't get, don't get sucked in by those biases.
Uh, don't get sucked into the crowd mentality. Do your homework. And if you can't do your homework or people won't let you do your homework, well, maybe you'll miss out on a great trade, but you know what? You'll probably definitely miss out on some kind of problem. Um, I'm not going to dive too much into this.
I mean, there's even a Netflix, uh, uh, aspect of this, but everything that occurred from a number of people that tried to get information on Madoff, they just couldn't. They couldn't verify service providers. I know one group knew that they were trading options on billions of dollars, so they tried to find who was trading the options for Madoff, and in a roundabout way, they realized no one was really trading options for him.
Not in any kind of size and in the last couple of years, not at all. Um, so that was a huge red flag. You know, they went after the service providers of, Hey, this is a, this house is trading in tons of different options. Well, there's only so many people who clear that we should be able to verify, you know, who's clearing options for him.
And the two largest clearing houses couldn't actually, or wouldn't verify that they were doing any business with them. So big problem. Um, so that's a couple things going on there.
In conclusion, you know, in my last little video, I said, hey, build networks. Hopefully you guys got a chance to watch that. Use that network.
Get the information from the fund. One of the key documents you want to, you want to get from the fund is a due diligence questionnaire. If the fund you're looking at doesn't have one, um, It's a little concerning. It's, you know, unless it's a real small emerging manager who doesn't come from, you know, the actual business of money management, he may not have more, he may not have one built.
But they should probably go research that. It's pretty common knowledge. You can get it for free, uh, from the ILPA, uh, if you're a fund manager. Uh, you should think about a number of those questions because within a due diligence questionnaire, it will walk through a number of aspects of verification.
It'll walk through process and procedure of operations. It'll cover a number of different things that we've discussed. in this verification process, giving phone numbers, emails, and, you know, various steps and process that you can go through and verify, um, a number of different things for the fund. It'll be in that document.
So be sure to trust, uh, but also verify all the moving pieces. Um, so with that, I hope this was helpful. If there's any, uh, questions, I mean, I guess one little point there is, um, and I guess it's an important part, which is the next. little short video that I'm going to create is on non negotiables. Um, when you're verifying, hunt after those non negotiables.
I mean, if you have a list of things that are just automatic no's for you, well, great. Then make your life easy. Develop verification processes that match up with that, your non negotiables. And if you're not sure what non negotiables are, um, hopefully shortly I'll have another opportunity to do another short video on, uh, how to think about non negotiables and develop those for yourself.
And as always, if there's more questions on this topic or others, or you'd like further information about due diligence and alts, um, please don't hesitate to reach out. Thank you very much.
