Due diligence has come a long way since the financial crisis of 2008-2009. Indeed, back then, the due diligence process of one Southeast broker/dealer consisted of looking at what products other big b/ds were putting on their platforms and simply selecting these same products for its own platform, recalls Jonathan Henschen, a recruiter with Henschen & Associates in St. Croix, Minn. (Henschen declined to name the b/d.) “That's how cavalier these firms were about due diligence,” says Henschen, who works primarily with independent b/ds.
In some cases, the signing of selling agreements would even precede any formal due diligence process. For example, when IBD Williams Financial Group had an existing vendor bring in a selling agreement for a new product, executives would sign it, then the manager would send them the thirdparty due diligence, says Brent Barton, senior vice president of alternative investments. (Today, WFG conducts its own due diligence or outsources to another third party prior to signing the selling agreement.)
For obvious reasons, failing to conduct thorough due diligence before selecting a product was never a good idea and really doesn't cut it today. In the wake of the crisis, when so many products that were presented as conservative cash-like investments blew up, and following the blowups of so many managers including Madoff, financial advisors are more skittish than ever. And so are their clients. Regulatory oversight has increased as well, which means increased liability, accountability and resource requirements for advisors, says Scott Welch, senior managing director of investment research and strategy at Fortigent, the Rockville, Md.-based wealth management outsource provider.
The industry is responding to the changing dynamics. There's more of a focus on operational due diligence, rather than just relying on performance and track record, say analysts. Broker/dealers are building out their due diligence capabilities, outsourcing more, or spending more time and resources getting products approved. Alternative investments, such as limited partnerships and private placements, which tend to be illiquid and less transparent, have come under particular scrutiny, said industry analysts. Some firms have cut back on the number of products on their platforms, including alternatives, while others have tried to steer clear of alternatives altogether. Meanwhile, some advisors are taking a closer look at their broker/dealers' due diligence process or even seeking out other b/ds.
It's clear that we've entered the age of new due diligence.
Operational Due Diligence
One big shift: While quantitative assessments of investment managers are still very important, many firms are focusing more on qualitative assessments, also called operational due diligence, which can include verification of third-party administrators, audited financials, risk controls and background checks on key personnel, as well as verification of assets.
“Operational due diligence, prior to 2008, wasn't as high up on the list,” says Welch.
Neil Chelo, director of research at fund of hedge funds manager Benchmark Plus, which vets hedge fund managers very closely, says he spends a significant amount of time with managers before investing with them. For example, Chelo will spend an entire day with a portfolio manager or other key people at their trading desk, asking them to show him the process and to make sure it's repeatable.
“We'll go out of our way to get out of the conference room,” he says. “If we can't get that level of transparency, we simply don't invest.”
RIA Aspiriant had some exposure to a few hedge fund managers that blew up a few years ago. So in 2007, the firm decided to take operational due diligence into its own hands when it created its own funds of funds, which include hedge funds and private equity, says Jason Thomas, CIO and chief economist at the firm. Aspiriant hired outside consulting firm Albourne Partners to conduct the front- and back-office work.
Third-party firms have also gotten into the act, offering due diligence services to wealth managers. In May 2009, for instance, Duff & Phelps launched its Operational Risk Due Diligence practice, which provides third-party assessment of hedge fund managers' operating policies and procedures. “The new mantra has become trust but verify,” says Chris Franzek, managing director and leader of Duff & Phelps' Portfolio Valuation practice.
Prima Capital, which provides research, due diligence and advisory services for banks, b/ds, high-end RIAs and family offices, saw 42 percent year-over-year growth in its core advisory solutions business in 2010, according to Gib Watson, CEO. He forecasts 48 percent growth this year.
The key change Watson sees is a greater appreciation for the “deep dive” into an investment management firm, looking at the quality of the firm, its sustainability, the repeatability of the investment process, the communication pathways between managers and traders, compensation of the executives and equity ownership structure.
“The key is to identify the smartest guys in the room,” he says.
Broker/dealers Under the Microscope
Many broker/dealers have hired new staff to conduct due diligence. First Allied, for example, says that it created a new position last year of chief risk officer, hiring Mark Quinn to fill that slot, and authorized additional personnel on the due diligence team. Raymond James Financial added two people to its due diligence team in the last three years. At the end of 2010, Advisor Group (FSC Securities, Royal Alliance and SagePoint Financial) brought on Kevin Keefe, senior vice president of product development and research, to oversee due diligence of the firm's different product offerings. And Williams Financial Group's Barton has also been building out its due diligence process and team over the last few years, especially with alternatives. Five years ago, the firm had two people overseeing these investment strategies; now there are six on the team, and Barton expects this number to grow. The firm also hired a full-time compliance executive a year ago to conduct onsite visits.
Because broker/dealers are spending more time getting to know the managers and products they put on their platforms, it takes even longer for managers to get approved. In fact, Barton says WFG has tripled to quadrupled the amount of time it spends to get a product on the platform because of the additional documentation. For every product the firm approves, five to 10 products are turned down, he says.
For Raymond James, it takes six to nine months on average to get a new product on the b/d's platform, if added. Tarek Helal, vice president of product development and research of the Alternative Investments Group, says that about 300 different products come through the door in any given year, and only about five end up on the platform over that time.
First Allied has had to cut back on the number of products on its platform because the firm is going deeper in its relationships with managers. Marks estimates that since 2008, there are about 25 percent fewer products on the platform, although they still fill every product area.
Treading Lightly With Alternatives
Because so many blowups involved alternative or structured products, a lot of firms are shying away from the investments, says Henschen. Among those firms that have narrowed their selection of alternative products are J.W. Cole Financial, Independence Financial Group, Pacific West, Berthel Fisher Financial Services and Workman Securities Corporation, Henschen says. These firms did not return calls seeking comment.
“The amount of cutting back on alternatives can range from a few less products to a substantial cut where they now work with perhaps only half a dozen products,” he says. “Everyone is being much more detailed on due diligence on alternative investments realizing that there is little room for error. It could put them out of business.”
On the other hand, many investors are demanding more alternatives in their portfolios these days, with $22.9 billion flowing into alternative mutual funds last year, Morningstar reports. According to Morningstar's 2010 Alternative Investment Survey, 66 percent of advisors believe alternatives will become as important or more important than traditional investments over the next five years. And because they're looking for exposure in a more regulated structure, this has lead to the proliferation of new alternative mutual fund strategies. Net new assets flowing into these funds have grown from about $41 billion at the end of 2008 to about $98.6 billion at the end of 2010, according to Morningstar. Since the end of 2008, there have been 75 new alternative mutual funds launched. In May of last year, Raymond James offered a new discretionary model of 13 alternative mutual funds on its platform. Since then, assets in these strategies have grown to $120 million.
Since January 2009, Cambridge Investment Research has added 48 new alternative investment offerings to its platform out of demand from its advisors and clients. When Cambridge brings on a new advisor, the firm takes a close look at the recruit's alternatives exposure, to make sure nothing comes out of the woodwork later on. “If they've put 50 percent of a client's net worth in a non-liquid investment, that's not a good fit in our opinion,” says Jim Guy, first executive vice president and chief marketing officer. “When the tide goes out, you'll find out who's not wearing trunks.”
While avoiding alternatives can provide some risk controls, advisors will be competing with people with more interesting portfolios, says Fortigent's Welch. “Throwing up your hands is going to have an opportunity cost.”
Turning to the Home Office
Despite the fact that b/ds are working harder at doing adequate due diligence, most advisors aren't just taking their word for it. They are turning more to the home office to educate themselves about their firms' due diligence practices.
Tom Thornton, head of due diligence in Asset Management Services at Raymond James, says the firm holds four or five events a year now to educate advisors on what their due diligence team does. Some come to get ideas, but most come to get confidence in Raymond James' process for evaluating managers.
First Allied's Representative Advisory Council, a group of advisors who work with the firm, established a new Product Review Committee in August of last year that will work with the b/d's due diligence team through August 2011. Marks says the advisor voice was lacking in the due diligence process, and the firm wanted their input as practitioners. The firm will walk them through a day in the life of the due diligence team. The group will also provide feedback on products and services that can help advisors in the field.
Those that don't like what they see at their home office may be seeking out other b/ds that have a better history and track record of due diligence, says Guy. “We're recruiting in that category.”
Those advisors who don't have the time to focus on due diligence or can't get comfortable with their b/d's practices are becoming more conventional in their allocations, sticking to stocks, bonds, mutual funds and ETFs, says Guy. He believes the blowups and increased skepticism contributed to the explosion in the ETF space. (From April 2009 to April 2011, assets in U.S. ETFs have grown from about $535 billion to $1.1 trillion, according to the National Stock Exchange.) “I'm convinced that the advisor community responded by shifting the way they invest.”