Thoroughly vetting a prospective investment requires looking beyond the numbers and into the managers’ history and maintaining ongoing monitoring, according to Ken Springer, president of Corporate Resolutions. “It’s not what they tell you, it’s what they don’t,” he told ThinkAdvisor on Thursday.
Corporate Resolutions works with institutional investors like private equity firms, pension funds, fund of funds, family offices and other investors to uncover information that may not be public record or is difficult to find.
“They want to see what’s not in the 10-Ks and 10-Qs that they need to know,” Springer said. “It’s all about can you really trust people?”
He noted that “a lot of the institutional investors didn’t get ensnared by Bernie [Madoff] because they had their best practices already in place. People are doing more of that because people have gotten smarter” about due diligence.
Springer founded Corporate Resolutions in 1991 after serving as a special agent investigating fraud and financial crimes for the FBI. He said that when his firm does background checks on management, what they typically find is that they were involved with other businesses that they didn’t disclose or indications of other financial stress.
Even if an investment’s management team looks good during an initial investigation, he said, its circumstances might change.
“They have financial problems, make other poor investments, sometimes [they get] divorced,” Springer said. “Let’s say you’re investing in a hedge fund and all of a sudden a manger divorces. You’re expecting she or he is sitting in front of their Bloomberg machine all day and they’re not; they’re not focused, they’re taking care of the kids or going to divorce court. [Investors] want to know about those things up front.”
A manager who recently left a fund should also be investigated to see if it’s due to divergence from the strategy, he said.
In addition to investigating instances of material nondisclosure, Springer warned that investors should be cautious of “problematic patterns of lawsuits.” Advisors know that an investment’s past performance is not a guarantee of future results, but Springer noted that when it comes to those patterns of lawsuits, “past history is often indicative of future performance.” He said, “You want to see if everyone that a company does business with sues people or they’ve been sued for breach of contract or something else.”
“If everyone they’re doing business with gets sued or sues them, what makes you think you’re not going to” be sued as well, he asked.
Following the Sarbanes-Oxley Act, many companies have implemented whistleblower hotlines, Springer said. “They want an opportunity to fix it, make it right, so that an employee doesn’t have to file a lawsuit, doesn’t have to go to the media.”
Institutional investors are aware of the importance of extensive due diligence, Springer said, but “banks sometimes have a short memory. We had the bank crisis in ’88 and again in 2005, and they kind of quickly forget the past and want to do deals for the future.
“But I think a lot of institutional investors are taking it very seriously. Our business has grown dramatically over the last five years, and I think that’s because people understand this is a necessary part of the due diligence process.”
Investing in startup companies can be particularly difficult. “Many times people are invested in the concept,” Springer said, “but they don’t really know” the business or the people involved.
Emerging markets can present another challenge for companies trying to do an investigation due to limited availability of information, Springer said.
He stressed the importance of speaking face-to-face with the people associated with a potential investment. “Everyone thinks the internet is a great tool, and it is a great tool,” Springer said, “but there’s so much information that’s not there. The critical character factors you need to look at aren’t necessarily on the internet.”
“Right to be forgotten” laws that allow individuals to request certain information be scrubbed from internet searches are another obstacle to fully understanding who you’re about to do business with. “There’s companies like Reputation.com; what Google puts on the first page of [search results], Reputation.com puts on the last page.” A simple internet search can give people a “false sense of security,” Springer said.
Social media can be a useful way to “get a good read on someone,” he said, “but you still have to do that independent validation.”
— Read Don’t Give Stocks a Due Diligence Pass They Don’t Deserve on ThinkAdvisor.