Due Diligence - The Institutional Manager Selection Process

By EC Assets Research Team, Manager Research · Published 19 May 2026

Due Diligence — Due diligence is the systematic investigation of an investment opportunity before capital commitment. For alternative allocations, it splits into investment due diligence (strategy, performance, edge) and operational due diligence (controls, infrastructure, integrity).

Definition

Due diligence is the systematic investigation of an investment opportunity, manager, or counterparty before capital is committed. For alternative-asset allocations, it splits into two distinct disciplines that are operationally separate and require different expertise: investment due diligence (IDD), which assesses whether the strategy works and the manager has genuine edge, and operational due diligence (ODD), which assesses whether the firm has the controls, governance, and integrity to safeguard capital regardless of investment performance.

Both disciplines are required. A strategy with strong investment merit but weak operational controls can lose capital through fraud, operational error, or governance failure. A strategy with solid operational controls but weak investment edge will simply underperform expectations. Either alone is insufficient.

The institutional formalisation of due diligence accelerated dramatically after the 2008 Madoff revelations, when several large allocators were exposed for having failed to conduct meaningful operational diligence despite formal review processes. Post-2008, ODD became a non-negotiable component of institutional alternative-asset allocation, often conducted by specialised firms separate from the investment teams.

The Two Disciplines

The two strands of due diligence focus on different questions with different methodologies:

Investment Due Diligence Framework

IDD typically covers four dimensions:

Edge. What does this manager do that cannot be replicated by index ETFs or quantitative factor portfolios? The answer must be specific and articulable. Generic answers ("we have great research", "our team is excellent") are inadequate. Acceptable answers identify a specific structural advantage: domain expertise in a sector inaccessible to generalists, proprietary data not publicly available, structural execution advantage, or genuinely orthogonal alpha signals not captured by published factor models.

Capacity. Does the strategy scale, or will additional AUM dilute returns? A $200 million statistical arbitrage strategy becomes structurally different at $2 billion. Capacity analysis often matters more than current performance. The most common institutional error is allocating to managers who have grown past their natural capacity, where performance compresses while fees remain at scale rates.

Risk management. How does the manager control tail outcomes? IDD examines stop-loss frameworks, position-sizing rules, leverage constraints, correlation monitoring, and historical drawdown behaviour. The 2018 Volmageddon and 2020 COVID crash both exposed managers whose risk management proved inadequate under stress.

Consistency. Does the historical track record reflect the stated process? Track record analysis includes factor decomposition (is the alpha really alpha, or hidden beta to specific factors), regime analysis (does the strategy work across rate cycles, vol regimes, equity drawdowns), and key-person analysis (was the track record generated by current decision-makers or by people who have since left).

Operational Due Diligence Framework

ODD covers the non-investment infrastructure that protects capital regardless of strategy performance:

Fund governance. Independent fund directors with meaningful authority, separate from the investment manager. Single-director or related-party-only boards are red flags. Top-tier directors with proper insurance and clear fiduciary duties signal serious operational discipline.

Administrator independence. The administrator calculates NAV. If the investment manager controls or strongly influences NAV calculation, performance figures can be smoothed or misstated. Madoff's structure included no genuine third-party administrator. Modern ODD requires the administrator to be a top-tier firm (SS&C, Citco, Apex) with no related-party relationship to the investment manager.

Audit quality. Big Four auditor (Deloitte, PwC, KPMG, EY) is the institutional standard. Smaller auditors can be acceptable for smaller funds but require careful review. Auditor resignation or restatement history is a major red flag.

Custody and prime brokerage. Assets should be held in segregated accounts at independent custodians or prime brokers. Multiple prime brokers reduce single-counterparty risk. The 2008 Lehman bankruptcy made prime-broker diversification a baseline requirement.

Background checks. Principals, key employees, and the firm itself should have clean regulatory records. Specialist background-check firms (Kroll, Mintz Group) review criminal records, litigation history, civil judgments, regulatory actions, and reputational issues.

[!warning] Most famous hedge fund collapses had operational red flags identifiable in advance. Madoff's auditor was a three-person firm with one CPA; the structure included no independent administrator. LTCM's leverage exceeded 25:1 and was concentrated in a few highly-correlated relative-value positions. Galleon Group's edge required information sources that should have been identified through trade analysis. In each case, basic ODD frameworks would have surfaced material concerns. The investors who lost capital had either not conducted ODD or had treated it as a formality.

Reference Calls

Reference calls surface qualitative information not visible in documents. Standard practice includes:

• 5+ current LP references, chosen from the LP list (not pre-selected by the manager)
• 2+ former LP references, particularly those who redeemed
• 2-3 former employees from the past 3-5 years
• 2-3 counterparties (prime brokers, administrators, banks)
• 1-2 references from outside the financial industry who know the principals personally

The questions matter as much as the references chosen. Generic questions ("are they good") produce generic answers. Specific questions about edge, risk events, communication during stress, and operational responsiveness produce information that informs the allocation decision.

Common Misconceptions

"Brand-name managers don't need due diligence." Some of the most catastrophic alternative-asset losses came from brand-name managers (LTCM was Nobel-laureate run; Allied Capital was widely respected before its accounting issues surfaced). Brand reputation is not a substitute for verification.

"Due diligence is a documentation exercise." The documentation review is the smallest part. Site visits, reference calls, background checks, and structured interviews produce most of the information that drives decisions. Pure desk-based diligence is insufficient.

"Annual review is sufficient." Operational risk evolves. Key employees leave; auditors change; administrators get acquired; regulatory licenses expire; counterparties exit prime brokerage. Annual review captures only the changes within scheduled windows. Major institutions conduct continuous monitoring with quarterly check-ins on key operational indicators.