Diligent Enough?

Investment decisions require ongoing due diligence. By Yuliya Oryol at Nossaman and Jeremy Wolfson, CIO of Los Angeles Water and Power Employees’ Retirement Plan

U.S. public pension systems – under tremendous pressure to generate high returns to cover future obligations – must continue to press their financial advisors to provide ongoing due diligence.  Failure by advisors to conduct sufficient due diligence at every stage of the investment process may not only lead to significant losses to the pension systems and their beneficiaries, but also result in litigation against the advisors for breach of their fiduciary duties.


Over the last decade U.S. public pension systems have come under intense pressure to abandon traditionally conservative investment portfolios in exchange for taking on more risk in an attempt to compensate for the shortfalls between assets held and projected future benefit obligations. To confront the risk of becoming underfunded, public institutional investors have dramatically increased their asset allocation to private equity funds, real estate funds, hedge funds, and funds of funds in much the same way that private endowments and foundations have been lured to riskier investments as a means for diversification and higher returns.

Public institutional investors, whether managing small or sizable portfolios, typically do not make investment decisions on their own.  Rather, they retain financial advisors and consultants to recommend appropriate levels of allocation to different financial products and investment vehicles.

Public pension systems’ staff and board members have come to rely on advisors to not only recommend appropriate levels of asset allocation and investment in specific funds, but to also conduct the necessary due diligence on their behalf.  If advisors fail to conduct appropriate and sufficient due diligence at every phase of the investment process, investors could face major losses.  Requiring advisors to sustain continued due diligence throughout the investment process can help public institutional investors avoid or, at least, minimize losses, even in challenging financial climates.

The Advisors’ Role

Investment in alternative investment funds requires a high level of due diligence which public pension systems’ staff normally cannot perform on their own.  Instead, the staff and the board of directors depend significantly on advisors.  Prior to recommending an investment in a fund to staff and board members of a public institutional investor, advisors typically will meet with fund managers, review the fund’s marketing materials, and conduct independent research as to the fund’s performance in order to determine if the investment opportunity is appropriate for its client’s portfolio.  Advisors review specialized databases for information on fund performance, investment terms, fundraising related information, top quartile results, firm stability, turnover, and changes in strategy over time.  Furthermore, advisors also monitor the type of investments made by large public pension systems.  This is an interactive process which must invariably include reference checks, in-person interviews, and on-site meetings.

Public institutional investors’ staff and board members have no other option but to rely heavily on their advisors to conduct due diligence for a number of different reasons.  First, fund level information is not easily accessible to public institutional investors.  Second, public institutional investors’ staff members – particularly those at smaller pension systems – are largely unable to perform extensive due diligence on their own.  Third, agency budgets, which have shrunk significant in the last several years, may preclude a sufficient number of investment professionals.

Furthermore, investment staff may not have the necessary training or expertise to review sophisticated models or data, or to conduct verification of regulatory and/or legal problems relating to performance.  Lastly, the sheer volume of investments in a given period may be too much for staff to handle and monitor the various manager relationships.  Because public pension systems have neither the budgets nor compensation in line with private industry, it seems certain that public institutional investors will continue to rely on advisors to conduct due diligence on their behalf.

The Potential Pitfalls

Despite the extensive due diligence process most advisors perform, they undoubtedly make recommendations based not just on objective and independent research but also based on referrals and pre-existing relationships.  Public pension systems relying on advisors’ recommendations may be unaware of the relationships between the advisors and the recommended funds.  Since funds are restricted from generally soliciting and openly marketing to non-qualified investors, the funds rely heavily on referrals as a prime distribution channel.  Funds have relationships with advisors, consultants, and third party placement agents.  These parties make recommendations to their institutional investor clients in part based on these relationships with the funds.

Most fund investors, both public and private, are well aware that private equity and hedge funds generally lack basic levels of transparency and offer less information than other more regulated investment vehicles such as mutual funds.  Public pension systems have complained for years about limited access to performance statistics, information about fund’s auditors, trading models, pricing policies, self-administration, and custody.  Lack of transparently necessitates a reliance on advisors to conduct thorough and comprehensive due diligence.  For this reason, it is critical that advisors conduct sufficient due diligence at every stage of the investment process – even when recommending an investment in a fund based on prior relationships and trust placed in the fund’s principals.  Failure to do so may result in significant losses to the pension systems and their beneficiaries.

According to an NYU Stern’s School of Business study, 1 in 5 hedge fund managers misrepresented their fund or its performance to investors during formal due diligence investigations.   The study used data from 444 due diligence reports commissioned by investors between 2003 and 2008, covering some of the most prominent hedge funds in operation today – those funds with up to $8 billion in assets under management and managers with average experience of 19 years in the industry.  The study’s authors noted managers most commonly misrepresent the amount of money under management, the fund’s performance, and the funds’ regulatory and legal histories.  Managers also misrepresented years of experience and, in some cases, even their criminal records.  Astonishingly, the study found misrepresentations or inconsistencies in approximately 42% of the due diligence reports reviewed.  Furthermore, the study found 21% of managers verbally stated incorrect information.

Due diligence conducted by advisors only prior to the investment recommendation stage is insufficient without extensive follow-up thereafter, no matter how appropriate the investment recommendation may have been initially.  Prior to approval and execution of investment documents, the investment process typically includes meeting with advisors, analyzing the advisors’ reports and recommendations, conducting meetings and conference calls with the fund, presenting the recommendation to the board of directors, and reviewing the fund documentation by staff and/or outside legal counsel.  Advisors and consultants need to stay continually involved in the investment process.  For many public pension systems, the investment process can take anywhere from three to nine months to complete – a considerable interval during which fund level information can easily change because of losses due to market conditions, regulatory investigations, law suits, etc.  An advisors’ failure to stay involved at every phase of the investment process can be disastrous to the public pension systems they represent.  Fiduciary obligations to the public pension systems also require continued monitoring of the funds.


Due to the nature of the business and restrictions on solicitation, funds understandably must rely on relationships with advisors to recommend their funds to public investors.  However, it is imperative that advisors still conduct intensive due diligence regardless of the relationship, level of trust, the fund’s reputation, or performance history.  And public institutional investors need to hold their advisors more accountable.  Public investors should insist that aggressive due diligence of the funds and their principals be conducted at every stage of the investment process, not just from the initial recommendation and document execution, but throughout the term of the investment.  If advisors do not conduct extensive due diligence, as part of the financial advisory services offered to their clients, then they fail to provide the type of services needed to help their clients obtain the best possible returns and expose their clients to significant risk.  Failure to perform adequate due diligence may result in not only monetary losses but also possible law suits against advisors as a means for investors to recoup some of these losses.

Yuliya Oryol is a partner and co-chair of the corporate practice group at Nossaman. Jeremy Wolfson manages the investment section of the Los Angeles Water and Power Employees' Retirement Plan.