It's Time for Long Only Due Diligence

7/2/19 12:11 PM

Ever heard of TISE - The International Stock Exchange? Neil Woodford, the manager of the now suspended £3.7 billion LF Woodford Equity Income Fund has. Woodford "listed" some of the Income Fund's private company holdings - including the cold fusion energy play Industrial Heat - on the Guernsey based TISE. Through this manoeuvre, Woodford was able to treat the Fund's holdings in TISE listed companies as public, not subject to the UCITS rule that a fund may hold no more than 10% of assets in illiquid, private securities. The snag, per Citywire? None of the securities ever traded one share following their "listing". Clearly, it's time for due diligence to meet the long only world.

And, of course, Woodford is not the only example. A year ago, GAM shocked the industry by suspending Tim Haywood, one of its most senior investment professionals (and previously the CEO of Augustus, a money manager bought by GAM back in 2009). Since then, per Bloomberg, GAM has seen outflows of almost $25 billion, of which $11 billion related to the liquidation of Haywood's Absolute Return Bond Funds. Per the FT, Haywood was suspended "in a move that centred on his alleged conduct in purchasing illiquid bonds, many of which were linked to an Indian industrialist and an Australian financier".

Meanwhile, H2O, an asset manager owned by the French bank Natixis, has come under pressure after Morningstar suspended rating on the firm's $2.5 billion Allegro fund. In a rebuttal reported by Bloomberg, H2O's team defended their "deep value strategy". However, Bloomberg also noted that H2O had "allocated more than 1 billion euros to bonds issued by European companies connected to the controversial German financier Lars Windhorst."

A quick review of H2O's website provides access to the June 19, 2018 Allegro financial statements, which show on balance sheet assets of 10.7bn Euro, against capital of 1.3bn. Clearly pretty sophisticated for a daily liquidity fund.

Looking further back, Capita, the business purchased by Link and now operating as the Authorized Corporate Director of Woodford Equity Income Fund, had other problems: in 2012, Capita paid £32 million towards a £54 million payment scheme for investors hit by the Arch Cru fund scandal. Five years later, the company paid £66 million for those hit by the collapse of the Connaught fund. 

As a final example Invesco Perpetual - at the time the UK's largest retail money manager, and Woodford's prior employer, was fined £18 million in 2014 due to a range of compliance and accounting problems, which included:

The FCA found £1bn-worth of leveraged trades were carried out by Invesco fund managers, using complex derivatives, without disclosing the risk to small investors.

Regulators found that one in 11 trades in the company's popular bond funds were not recorded on the day of execution, with one taking up to 27 days to reach the books, raising the risk that the daily valuation of the funds would be inaccurate.

The FCA also found that the firm breached rules on diversification designed to ensure that investors were not excessively exposed to any individual company. Funds are not allowed to hold more than 5% of their money in the shares of any one company, yet Invesco Perpetual not only exceeded this limit but carried on buying after the rule breach.

What does this mean for investors?

First, Woodford is a detailed case study across multiple diligence topics, which we will explore in more detail in subsequent posts:

  • UCITS rules around liquidity - case study around "listings" and related party transfers
  • Financial statement review case study
  • Governance and compliance: conflicts of interest and the role of the Authorized Corporate Director in UK fund structures.

More fundamentally, irrespective of asset class, asset owners now recognize the requirement to implement consistent, evidenced and auditable diligence programs across all their third party asset manager relationships.

Operational diligence is no longer just about hedge funds with, perhaps, some work on PE. The topics below evidently apply to all external managers, including long only stocks and bonds:

Reputational Diligence (manager and key professionals)

  • Regulatory filing analysis (especially in respect of regulatory sanctions)
  • Legal actions
  • Watchlist database review
  • Media review

Business Risk of the Management Company

  • Corporate history and ownership, with a focus on conflicts of interest
  • Products offered and assets under management - growing or declining?
  • Headcount - growing, decreasing, reasons for any senior departures?
  • Compliance procedures - regulatory oversight and internal compliance effectiveness?
  • Information technology - systems, BCP and cyber

Legal Risk of the Fund

  • Jurisdiction and structure
  • Terms and conditions, notably redemption frequency and gating provisions
  • Governance and oversight - effectiveness and conflicts?
  • Fees and expenses

Operational Risk of the Control Environment

  • Asset existence - have I got what I say I've got?
  • Asset valuation - is it worth what I say it's worth?
  • Cash movements - can anyone steal the money?
  • External oversight over accounting and reconciliation (is an administrator appointed; if so are they independent and is their work effective?)
  • Audited financial statement review

Risk Management Diligence

  • Portfolio composition: Leverage and liquidity, with a key focus on any liquidity mismatch
  • Risk systems and personnel
  • Risk management procedures


  • Management company ESG characteristics
  • Integration of ESG into the investment decision making process

Third party asset managers are vendors in the asset owner's supply chain. Long only managers may offer services through managed accounts, private funds or public funds: but in all cases, institutional investors now require systematic, consistent and comparable due diligence information.

Investor due diligence policies, and long only managers' due diligence responses, will evolve to reflect this new normal.

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