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Alternative Market Briefing

The three major changes in due diligence

Thursday, July 14, 2022

amb
Chris Addy
B. G., Opalesque Geneva:

Founded in 2006 and headquartered in Montreal, Castle Hall is the largest dedicated due diligence (DD) firm globally. Earlier this year, Castle Hall launched DiligenceExchange, a digitised DDQ platform - and a product of more than a decade of groundwork.

The migration to a platform "is the logical and much-needed technological leap for operational due diligence," says Chris Addy, founder and CEO of Castle Hall, who was on the new Opalesque.TV series BRIGHT MINDS recently.

Due diligence has changed a lot, he says. "I did my first due diligence review in my career before Castle Hall back in 1997, asking asset managers questions about their operational controls and procedures. The key watershed moment was 2008. Before that, operational due diligence was focused on hedge funds and it was very much optional."

As a result of the financial crisis of 2007-2008, as well as Bernie Madoff, an American fraudster and financier who ran the largest Ponzi scheme in history and was sentenced to 150 years in prison in 2009, due diligence on public market hedge funds has become a mandatory, well-established, and relatively mature process.

"Since the GFC, there have been some other significant changes," Addy continues. Due diligence was traditionally a static point-in-time process that was really based on a report. So at the point that an investment was made, a new manager was proposed for introduction into the portfolio, we would say, well, do we have the due diligence on that manager, when we're underwriting that new investment."

The first major change in DD is that it has moved from static to dynamic; from a point in time to a continuum.

The move to a process of active ongoing monitoring is one of the key changes for due diligence, he explains. Due diligence is, first of all, not only about completing diligence when a new manager is introduced into the portfolio, it's about monitoring and maintaining oversight over all of the existing relationships, and then maintaining an awareness of things that are changing with respect to a manager's circumstance, their fund, their operations, and their business.

"The first rule of due diligence is; don't be surprised," he says. "So it's a really good idea to be able to keep in touch with what's happening with an asset manager, what is changing."

The second major change in DD is the enlargement of asset classes. DD was traditionally about hedge funds, "it was a narrow domain in the specific niche of public market alternatives. But ultimately for an asset owner, for a large institutional investor, a pension fund, a sovereign wealth fund, or a superannuation fund, they are fiduciary, they are delegating their asset management process when they elect to invest with a third-party asset manager. Irrespective of the asset class, the asset owner needs to have an understanding and an ability to make sure that they are not being exposed to undue risk as a result of their investment with a particular asset firm, wherever they may be in the world. So DD is now done across all asset classes."

Castle Hall has completed a majority of its work on private market funds, private equity as well as real estate, infrastructure, venture capital, and private credit. The firm also does an increasing amount of work on long-only structures either through public or private funds as well as through managed accounts.

"There is a need for a calibrated flexible approach to due diligence and that's a further move away from that traditional one-size-fits-all of "where is my report"."

The third major change in DD brings together those two themes.

Traditionally, due diligence could be done from anywhere in the world as long as you had a laptop. It was a very manual boutique process. But completing due diligence on potentially hundreds of asset manager relationships across multiple asset classes requires technology. So Castle Hall, over a decade-long initiative, has adopted FinTech and brought technology solutions to support every aspect of due diligence, from the initial allocation through to the ongoing monitoring, through to the identifier identification of risks.

"We really believe that FinTech is the key to a modern forward-looking due diligence approach. Ultimately, it's the institutional approach to due diligence," he says.

Over time, operational DD has become duplicative, inefficient - and costly. Managers / GPs consistently report that two thirds or more of investor DDQ / RFP requests overlap and duplicate the same topics. Castle Hall's new DiligenceExchange platform fixes these problems.

Castle Hall also conducts its own DD work, including "trust but verify" anti-fraud checks such as service provider verifications.

You can watch the whole interview on Opalesque TV here.

You can also get free access to Castle Hall's DiligenceExchange here: https://bit.ly/DXCInfo

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