What does good due diligence look like?

Fraser Donaldson – Insight Analyst (Investments)

We have had the UK regulators issuing guidance on due diligence and endless speculation and scepticism in the financial press about what MiFID ll will bring to the table in terms of what will be required from all parties to satisfy regulation and more importantly to achieve the highest possible likelihood of good client outcomes.

For me, good due diligence is good due diligence. This has never changed. All the regulators are trying to do is to remind us all what this is and to ensure that rules are in place to make this possible. We should always have it in mind that inadequate due diligence can lead to unsuitable advice to clients, and in some circumstances poor client outcomes.

Good due diligence should always start with knowing your client, or knowing your client segments. At its simplest, due diligence is finding out about the firm providing the product or service and then finding out about the proposition itself. It is then a matter of exercising your professional judgement as to whether your findings are acceptable to both you and your client. If you do not ‘know your client’, part of this exercise will inevitably be flawed.

In terms of what good due diligence looks like, it should be common sense. Adviser businesses will have certain questions about firms they are considering doing business with, and clients will have certain questions about what is going to happen to their invested capital and what their expectations should be from initial investment, through the investment journey and finally in terms of expected outcomes.

Common sense or no, it never hurts to have a refresher on what is expected and to go back and review processes and either tick the box that all is good or see if improvements can be made. The discretionary market continues to evolve and information that may not have been available a couple of years ago may well now be more freely available. For instance, we are seeing firms being much more transparent in terms of charging and performance than they were just two or three years ago.

So, what does good due diligence look like?

The adviser firms we do research for, tend to break this down in to three areas:

• The firm
• The proposition
• Contractual arrangements

Contractual arrangements:

Before looking any further at a firm and the propositions it has to offer, establishing the potential contractual arrangements should be first on the list. The regulators do not specify which parties should take responsibility for which elements of the arrangement, only that all bases are covered and the client is fully aware of who is responsible for what.

It will be a given that the discretionary firm is responsible for following the investment mandate it has set or been set by the client. What is less clear however, and should be established at outset, is which party takes responsibility for the suitability of the investment. In the case of pre-constructed managed portfolio services it is likely to be the adviser as they have to match the client to the portfolio. For bespoke portfolios it is open to discussion.

Some bespoke portfolio managers insist on taking responsibility, hence the client meetings and discussions. Others prefer to leave the final responsibility with the adviser – although this sounds like a cop-out, some advisers prefer it this way and see it as part of their job. Others will give the option to choose, occasionally making an additional charge to take on the responsibility for suitability.

However the arrangements are structured, it is important to know where you and your client stand from a contractual point of view, should things go wrong and not work as well as expected.

The Firm:

There are potentially many elements to this aspect of due diligence, but they all really boil down to being confident that the firm can deliver client outcomes as expected. Without going in to too much detail, elements to consider should include:

• Financial Strength and resource: does the firm have the resource and backing to deliver on the service promised. Perhaps a little tricky to get a definitive answer, but assets under management and perhaps more importantly growth in assets will give clues. Having a wealthy ‘parent’ could be a positive indicator, but a judgement also has to be made on how important the discretionary arm is to the Group as a whole. Big is not necessarily beautiful !
• Importance of the adviser community as a distribution outlet: A measure of percentage of new business being distributed through advisers as well as actual assets will give a steer on this one.
• Governance: what processes, procedures and checks are in place to ensure that the services promised are delivered in a fashion that is to the benefit of the client.
• Adviser support: Does the firm have a dedicated marketing/sales resource for dealing with the adviser market.
• Information: Will the firm provide you with answers to all your questions, provide data in the format requested, and in a timely manner? Remember, the regulators suggest that if data that is going to help you in your due diligence cannot be provided as requested, it is a valid reason for dismissing them from your considerations
• Investment team breadth of expertise and experience: Does this match the portfolio options being offered

And do not forget the softer issues. Almost as important as the above is a judgement on the ease of doing business. Subjective it might be, but there is a good chance the chosen DFM firm will be looking after a great deal of your client’s money, hopefully for a considerable length of time. It is important that you can work with them on a daily basis not only in an efficient manner, but also on good terms.

The proposition:

Perhaps the most obvious area of due diligence. The FCA’s final guidance paper FG 12/16 (Assessing suitability: Replacement business and centralised investment propositions) helpfully outlines some of the fundamental due diligence that is expected. This includes:

• Terms and conditions
• Charges: dig deep here. Do not simply rely on the published headline annual charge. There may be transaction fees, performance fees and potentially a long list of other administrative fees. Look at the charges levied by underlying funds, particularly if they are in-house funds.
• The range of tax wrappers that the proposition is available through (eg SIPP, offshore bonds, ISA’s)
• Performance: make sure you are comparing on a like for like basis

Other elements that also need to be taken in to consideration would also include:

• Range of underlying assets that are used to construct portfolios: May be too sophisticated (or not sophisticated enough) for the client
• Style of investment: risk targeted or return focussed
• A clear statement of investment approach (capital protection, capital growth, income etc)
• Does the investment approach match your own investment beliefs: For example would you or your client be happy with a portfolio of trackers?

There are of course many other aspects to a good due diligence process some of which will not have been mentioned in this article, but the key is to answer all your own questions as well as put yourself in the clients’ shoes and answer all theirs.

While MiFID ll is just around the corner and will be greeted with a great deal of reluctance and scepticism, the good news is that providers will be compelled to provide a great deal of the information, perhaps where they have been reluctant to in the past. Regulation, it is not all bad news!