As allocation strategies evolve, so too must approaches to manage diligence
By Shlomo Mirvis , Intelligo Group
Published: 21 March 2022
Public pensions, foundations, endowments, and sovereign wealth funds are the gatekeepers of institutional capital. They decide which managers are allocated billions of dollars to support retired workers, education, medical research, the arts and more. CIOs and investment committees rightly look at these managers’ historic performance to help ensure they deliver strong risk-adjusted financial returns. But how closely do they examine human capital risk when making allocation decisions?
According to a survey from Seward and Kissel, 42% of investors are planning to allocate more to alternative strategies this year— especially private equity, private credit, and venture capital strategies. About 86% of respondents are already directly investing with outside fund managers, showing the fervent interest in alternatives. Ironically, however, while institutions are active in mandating their fund managers to closely diligence each investment opportunity, the vetting that institutions perform of their fund managers is often softer and more improvised.
Now, more than ever, the conduct of the executives leading the fund managers you do business with can negatively impact your own reputation and even the performance of the investment itself. Yet there are far more data points and jurisdictions to cover to gain a full view of that conduct. Limited partners (LPs) need to integrate sophisticated risk intelligence into their allocation decisions for holistic due diligence that protects the institutions they represent.
The outset of the relationship
Background checks that expose red and yellow flags on fund manager personnel are a critical step in the due diligence process. The competition to access high-returning funds is intense, and the background check process as it is conducted in legacy systems today is complicated, non-transparent and requires a lot of time and resources when using traditional methods. Many LPs will view this issue as a balance between due diligence and availing themselves of maximum investment opportunities. But that doesn’t need to be so.
Of course, some nuance is required. For example, it is not unusual to have background checks flag a high volume of bankruptcy cases. However, involvement in bankruptcy cases is part and parcel with being a distressed credit investor. False positives like this grow much higher in volume when the funnel is opened wide and create potential bottlenecks in the process. More sophistication is required of due diligence platforms—both to reduce those false flags, and to be able to contextualise data points that may be natural to the asset class, segment, or sector in scope. It also illustrates why the integration of AI is crucial to the advancement and evolution of these platforms. It can automatically ‘learn’ what is and is not important for each situation, and elevate the most important developments as priorities.
Investors need new technology that can deliver deeper insights in hours or days, not weeks. They also need to use a more collaborative and transparent process that allows a primary user to share the information with all relevant stakeholders. New software platforms use AI to scan tens of thousands of data sources at 4X the speed of traditional background checks and identify what matters.
Potential risks to not performing background checks
Some assume that individuals in large investment firms are above suspicion, but the reality is that in 2020, 72% of Intelligo searches found “yellow flags”, like being a subject being sued multiple times over a short period, gaps in employment history or jobs not listed on their resume. We’ve seen everything from investment professionals flagged for being involved in foreign corruption scandals to a breach of contract lawsuit to even seeking to launder money oversees and poison a witness! With an ever-growing range of sources for AI-powered platforms to cull from, we are flagging bad behaviour from a wider range of potential adverse events than ever before.
The challenge of performing proper due diligence does not end with the initial manager selection process; indeed, it is just the beginning. Even the most carefully compiled risk intelligence report is only current on the day it was compiled.
The prudent investor throughout the term of their investment continues to perform due diligence, monitoring for new behaviors that cause concern. New due diligence technology can alert users to new information, on companies or individuals, that could come to light and significantly alter the impression of an earlier background check. This allows for investors to take immediate actions that can reduce the future risk of any allocation or manager relationship. The time and resources lost to frequent, static background checks that are processed once per year or even once per six months are significant and do not offer the same coverage or peace of mind compared to AI-enabled monitoring.
As institutional allocators do more direct investing in private markets, they have a great impetus to protect the assets of their constituents, to help ensure the long-term financial security for academic institutions, charitable foundations, pension participants and others. More than ever before, reputational issues can have a disastrous impact on the trust constituents have in an LP allocator’s manager selection and broader decision-making ability, and it is incumbent on LPs to enhance the due diligence on the firms they partner with so that it meets or exceeds the diligence those firms due on the actual investments.