Operational due diligence

Investment due diligence asks whether the strategy makes money. Operational due diligence asks whether you will get the money the strategy makes. They are different questions, they need different people, and the second one has ended more funds than the first. A manager can be right about every position and lose your capital through a valuation policy, an administrator or a signature.

The split matters institutionally. Operational due diligence should carry a veto that the investment team cannot override, and should be run by people whose compensation does not depend on the allocation being made. Where the same analyst does both, the operational work becomes a formality with a checklist attached.

Which four external parties should you check?

Four external parties stand between a manager and your money, and each one exists to remove a discretion the manager would otherwise hold. Work the stack in this order, because a failure at the top makes the ones below it unverifiable.

• The auditor. Confirms the financial statements. Ask what else the firm audits, whether the opinion has ever been qualified, and whether the auditor was changed and why. A two-partner firm auditing one fund is not independence, it is an invoice.
• The administrator. Strikes the net asset value. The question is not whether an administrator exists but whether it calculates the valuation or merely reviews one the manager sends it. Those are different jobs and the second one is not administration.
• The prime broker and the custodian. Hold the assets. Ask whether the custodian is affiliated with the sponsor, whether assets are segregated, and what would happen to your position if the prime broker failed.
• The valuation agent. For anything without an observable price, somebody must mark it. Where that somebody is the person paid on the mark, the fee is a self-assessment.

How do you assess valuation policy and continuity risk?

Read the valuation policy next, and read it for what it permits rather than what it promises. A policy that allows "manager discretion where no observable price exists", with no escalation, no independent check and no stated methodology, is not a policy. Three questions settle most cases. Ask what share of net asset value is Level 3, then who marks it and whether they are independent of the fee, then what happened the last time a Level 3 position was sold at a price far from its last mark and whether that sale was disclosed.

Key-person and continuity risk closes the walk. Who must remain for the strategy to work, what does the limited partnership agreement do if they leave, and has anyone actually tested the business-continuity plan? A key-person clause that suspends the investment period is worth more than one that merely requires notification.

What are the ten recurring red flags?

Ten findings recur often enough to be worth carrying as a list. Any one of them justifies more work; two together justify walking away.

1. The administrator reviews rather than calculates the net asset value.
2. The auditor is small, new, related to the sponsor, or has been changed without a stated reason.
3. Level 3 positions exceed a tenth of net asset value and are marked by the investment team.
4. Cash movement requires one signature, or the manager holds the ability to move client assets without a second party.
5. Performance fees crystallise annually in cash with no clawback and no deferral.
6. Reported returns show a first-order autocorrelation above about 0.3 in a strategy that trades liquid instruments.
7. A month with a suspiciously small loss sits between two large gains, or the return distribution has more months just above zero than the strategy's own volatility implies.
8. Side letters exist and their terms are not disclosed to you.
9. The manager's own money in the fund is described but never evidenced.
10. Personnel turnover in the finance and operations functions runs well above the investment team's.

Item 3 is the one that converts directly into money, and Worked Example 5 does the conversion: a fund holding 18% of its net asset value in Level 3 positions that deserve a 20% haircut overstates that net asset value by ₹30.24 crore, or 3.73% of what the fund is really worth, and crystallises ₹6.05 crore of performance fee on a gain that does not exist. When the mark reverses, the high-water mark protects the manager's future fee and returns none of the cash.

{
  "skill": "Screening a manager's reported return series and offering documents for operational red flags",
  "use": "Use an assistant to compute the statistical screens on a return series you supply (first-order autocorrelation, skewness, excess kurtosis, the count of small-positive months) and to extract the named service providers, the valuation policy language and the fee crystallisation terms from the offering memorandum you attach, so that a first pass across a shortlist takes an hour rather than a week.",
  "tools": ["Document AI grounded on the offering memorandum, the audited financial statements and the due-diligence questionnaire you already hold", "Chat assistants with code execution for the return-series statistics", "The regulator's own register for verifying registration and the auditor's standing"],
  "prompt": "Two tasks. First, from this monthly return series compute: mean, sample standard deviation, skewness in both the moment and sample-adjusted conventions, excess kurtosis in both, first-order autocorrelation, maximum drawdown of the compounded path, and the count of months whose return falls between 0.0% and +0.5%. State every convention you used. Second, from the attached offering memorandum and audited statements, extract verbatim: the named auditor, administrator, prime broker and custodian; the sentence describing who calculates net asset value; every sentence describing the valuation of positions without observable prices; the fee crystallisation and clawback terms; and the key-person clause. Quote each one and give its page number. List separately anything I asked for that the documents do not contain.",
  "verify": "Trace every extracted quotation to its page yourself, because document AI misreads dense legal text and an omitted negation reverses a clause. Match the service-provider names against the regulator's register and the auditor's own client list rather than against the model's recollection. Recompute the autocorrelation and skewness independently before either enters a memo. Date-check the financial statements against the period the return series covers. The list of things the documents do NOT contain is the most valuable output here, and it is the one an assistant is least reliable at producing, so build it yourself from your own questionnaire.",
  "diy": "You must be able to read a valuation policy and say, unprompted, which discretion it leaves with the manager and what would have to be true for that discretion to be abused. No tool does that, because the answer depends on the strategy's own instruments. You must also be able to convert a marking error into overstated net asset value and overpaid performance fee by hand, which is the arithmetic the gate tests.",
  "market": "IN"
}