The rule for investment (and for life) used to be: “Look before you leap”. But only a few years ago, the word ‘look’, in this context, implied a reassuring glance more than an in depth observation. And the glance was almost always at the numbers. During the 1990s and the early years of the new millennium, investors were almost exclusively focused on performance and the likelihood of a good series of numbers continuing. Quantitative measures were the order of the day and the regularly voiced concerns were about the possibility of style drift (an unheralded change in investment direction), about capacity and – from time to time – about gearing or leverage. Of course different financial environments give rise to different rules and ways of doing things. Indeed it may always be the case that an increase in regulatory supervision will follow rather than anticipate financial problems or crises. Thus the current banking crisis has prompted a raft of potential new rules, indeed laws – and not only for banks but for the alternative investment community as well.

Many of these rules and the new, much broader due diligence obligations this article describes, are about process rather than about strategy or indeed performance issues, but it is fair to mention that the majority of the hedge fund collapses of the 1990s were performance- rather than process-led. LTCM famously collapsed because of over-leverage in a Russian fixed-income market resolutely going in the wrong direction. Four years earlier Michael Steinhardt – along with George Soros and Julian Robertson, one of the first hedge fund superstars – was caught flat-footed by an unexpected change in the Fed’s interest rate level (and direction) and his investors barely survived the experience. But, to repeat, these and other debacles were strategy-led, arising perhaps from excessive gearing or excessive arrogance; there was no suggestion of middle or back-office failures or, worse, planned criminality. But then, Bernie Madoff was also operating in the 1990s and, for today’s post-Madoff investors, the thought of being too polite to ask about the quality of the behind-the-scenes operation is risible. The combination of recent cases of fraud and the current climate of low or negative market returns has spurred investors of all types to conduct more detailed and intensive reviews of the firms they choose to entrust with their assets. So the notion of ‘look’ has been replaced by an almost forensic level of research and analysis extending far beyond the close confines of the fund and its manager.

Today, investors also take a hard look at a fund’s internal operations and infrastructure as well as the service providers these firms interact with. This new, broader analysis opens up a fund’s entire operational landscape so investors can review items such as reconciliation practices, exposure monitoring, technology practices and disaster recovery, valuation procedures and counterparty reconciliations. The service providers the manager works with, the prime brokers, accountants, lawyers, custodians, administrators and occasionally others such as cash managers (remember Sentinel?) are now seen as a key point in the due diligence process. For example, investor due diligence may now include a complete review of a fund’s auditor, administrator and the trading counterparties they are using. The issues that arose out of the Lehman bankruptcy certainly emphasised the importance of counterparty management and the necessity to limit exposure of the funds.

From a fund manager’s perspective, this expansion of the investor’s due diligence boundaries necessarily leads to a change of emphasis internally. As stated, managers used to be exclusively concerned with performance, believing that if the numbers were strong everything else would look after itself. Some of them would have taken a dim view of enquiries about the quality or efficiency of their back-office systems and administrative support. Today, compliance and overall risk management require equally as much due diligence attention as the front office investment strategies. And the manager who wants to attract significant investment must assure the investor firstly that there is a compliance control network in place that actively monitors fund activity (as opposed to simply reviewing data after the fact), and secondly, that the firm has appropriate risk measurement practices in place.

Compliance