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It is time to give due diligence pros their due

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By Mark Elzweig
Mark Elzweig and Nancy Miller

January 29, 2007 6:01 am ET

Due diligence departments, the first line of defense in risk assessment, are suffering a severe labor shortage.

We predict that the shortage will continue until Wall Street designs a more compelling career path for due diligence analysts, with better compensation, broader responsibilities and more training.

Due diligence is invisible to the investing public, but the role is more critical than ever. Aging baby boomers are focusing more and more on retirement.

Most have entered the savings game fairly late and are anxious to sock away more assets for big returns. Many are gaining access to institutional management through fee-based programs such as separately managed accounts.

Institutions seeking new ways to find alpha are betting on alternative investments, including hedge funds, private equity and real estate.

This makes John Q. Public more vulnerable to investment missteps than ever before, through personal and work savings plans.

Witness the San Diego County Employee Retirement Association pension fund, which invested $175 million in Amaranth Advisors LLC, an ill-fated Greenwich, Conn.-based hedge fund. Previously, only those deemed wealthy enough to lose money would have access to funds such as Amaranth. Now almost everyone is exposed.

Pay, career path limited

Main Street needs to know that due diligence is up to the job. The easiest component of the due diligence problem to fix is compensation. Firms not only can raise pay packages but can offer deferred compensation and other incentives to key players — just as they do for top financial advisers.

In general, traditional analysts aren’t as well paid as other product or investment executives who have similar training, usually a master’s degree in business administration or a chartered financial analyst mark. The career path is often limited.

Turnover is so high that one fund-of-funds manager said he can’t remember the names of the analysts who visit. One major Wall Street firm saw half of its staff turn over last year.

We see many analysts playing hopscotch from firm to firm for incremental pay raises. Many leave the field altogether for product management or marketing positions, which pay significantly more.

But compensation is just one part of the story. Insatiable demand and a limited career path are the other key elements.

Analysts who specialize in alternative investments — including hedge funds, real estate and private equity — can earn considerably more than traditional analysts and certainly are on a par with product people. But research departments still are desperate to find and train these individuals.

In fact, it turns out that two very different types of due diligence people are needed to assess thoroughly the risk of firms that invest in private equity, real estate or hedge funds.

“Ten years ago, maybe longer, there was always the due diligence that you did on the investment documents. But for the most part, they were with well-established firms. You didn’t have to do too much due diligence on [Boston-based] Putnam [Investments] as a firm,” said Donn Reinelt, director of business development with Sciens Hedge Fund Management LLC of New York. “Now with hedge funds, it’s a different world. It’s much more important to understand who is really running this company. Who are the key players, and who are the board of directors?” Mr. Reinelt said that hedge funds are like small-

capitalization stocks — harder to assess.

“Many of the 9,000 hedge funds will not be around 10 years from now,” he added. That business risk easily spooks investors. That explains in part the rapid demise of Archeus Capital Management LLC, a New York-based hedge fund that crumpled when its reports to investors became irregular.

Due diligence executives are addressing that issue. Both investment and business analyst teams boast increasingly sophisticated training in investment management, technology, compliance and operational issues. “On the fund-of-funds and hedge funds side, we are seeing more advanced degrees and more of the Goldman Sachs rocket scientist,” said Ricardo Cortez, president of the private-fund group at The Torrey Funds in New York.

All this should help to protect investors, but not until Wall Street can hire enough analysts to interpret the information coming in — and not just the data but the unquantifiable human factor. How can anyone assess how well a trader in his 30s will do? These individuals haven’t seen real market crises. Nor have many of the due diligence analysts kicking the tires.

Training groups adjusting

Professional-training groups are responding to the changing investing conditions. The CFA Institute, an association of investment professionals in Charlottesville, Va., is bumping up the weighting on its certification exam on alternative investments to between 7% and 8%, from about 5%, said Robert Johnson, managing director.

The institute also is seeing explosive growth in CFA candidates, with year-over-year 2006 growth of 32% to 86,546 worldwide. But only one-third of those candidates are based in the United States, Mr. Johnson said.

The Chartered Alternative Investment Analyst Association, a seven-year-old group in Amherst, Mass., said that about 1,800 applicants worldwide signed up to take its test last year, more than double the total from a year earlier. Only 5% of those candidates identified themselves as due diligence analysts. (The CFA Institute doesn’t break out manager research candidates.)

Wall Street, trade groups, training programs and graduate schools need to address the shortage of due diligence analysts and how to make manager research a more attractive career, especially for top performers. And that is the final piece of the puzzle. To attract good people, compensation and training must put talented executives on an attractive career path. Until that time, the investing public remains too vulnerable to the whims and weaknesses of the asset management world.

Mark Elzweig is president of Mark Elzweig Co. Ltd., an executive search firm based in New York. Nancy Miller, a financial writer, is director of client services.

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