Due Diligence in Plain English: Questions Before You Invest

Due diligence is a process for testing what you think you know. It is not a single document or a guarantee of results. It is a disciplined review of the product, people, incentives, risks, and evidence. My name is Connor Houlihan, and for most of my career I was on the other side of that review, answering diligence questions from advisers and platform analysts about the funds I represented. This essay is the version I would hand to a friend who asked where to start.

Start with primary documents

Depending on the product, that may include a prospectus, fact sheet, audited financial statements, Form ADV, regulatory filings, or offering documents. Get the current versions, not the ones in the pitch deck. Read the definitions and footnotes, not just the headline numbers. The footnote that says “net of fee waivers that may be discontinued” or “performance of a predecessor vehicle” changes the meaning of the number above it.

For a mutual fund or ETF, the core set is the summary prospectus, the statutory prospectus, the statement of additional information, and the most recent annual and semi-annual reports. For an investment adviser, it is Form ADV Parts 1, 2A, and 2B, plus the Form CRS relationship summary. For a private offering, it is the private placement memorandum, the subscription documents, the partnership or operating agreement, and audited financials. I cover the fund documents in more depth in my longer guide to fund due diligence, and Form ADV in a separate essay.

Separate facts from forecasts

Historical performance describes what happened. It does not promise what happens next. Forecasts, target returns, and scenario analyses are assumptions that should be identified as such. When you see a number, ask which category it belongs to. A ten-year annualized return is a fact about the past. A “target” of 8 percent is a hope. A back-tested result is a model built after the data was known. All three can appear on the same page in the same font.

FINRA’s communications rule requires that broker-dealer marketing be fair and balanced, and it generally prohibits predicting or projecting performance. That standard is a useful one to borrow for your own reading. If a document would not pass it, ask why.

The questions, in order

It helps to ask in a fixed sequence, so that a good answer in one area does not distract from a missing answer in another.

1. People. Who makes the investment decisions? How long have they done it here, and where were they before? Who owns the firm? What happens if the lead person leaves? Are the people and the firm registered, and with whom?
2. Strategy. What does the product own or do, in one paragraph? What is the benchmark, and why that one? What market conditions should make it underperform? Has it drifted from the strategy described in its documents?
3. Terms. What does it cost, all in, including anything paid to intermediaries? Which share class or fee schedule applies to me, and why? How and when can I get my money out? Are there lock-ups, gates, redemption fees, or notice periods?
4. Performance. Is it audited or independently verified? Net or gross of fees? Is the track record from this vehicle or a predecessor? How did it behave in the worst periods, and does that match what the strategy description predicted?
5. Operations. Who is the custodian, administrator, auditor, and legal counsel? Are they independent of the manager? Can I verify them directly? How are assets valued, and by whom?
6. Documents. Does every claim made to me appear in a filed or audited document? Where the pitch and the prospectus disagree, the prospectus wins.

Checking the people: BrokerCheck and IAPD

This is the part most people skip, and it takes ten minutes.

FINRA BrokerCheck covers brokers and brokerage firms. For an individual, it shows registration and employment history for the past ten years, the qualification exams passed, current licenses, and a disclosure section covering customer disputes, regulatory actions, and certain financial and other reportable matters. It does not show exam scores or failed exams. Records stay available for ten years after a person leaves the industry. My own record is there, and I describe what it shows on my securities background page.

The SEC’s Investment Adviser Public Disclosure database (IAPD, at adviserinfo.sec.gov) covers investment adviser firms and their representatives. It holds the firm’s current Form ADV, the Part 2 brochures, the Form CRS, and disclosure history. It covers SEC-registered firms and most state-registered firms. Both databases are free, and they link to each other for people registered as both a broker and an adviser.

Read disclosures rather than counting them. A disclosure entry is a report, not a verdict. Some are customer complaints that were denied or settled without a finding. The questions are: what was alleged, how was it resolved, and is there a pattern? Then ask the person about it directly. A clear, consistent answer is informative. An evasive one is also informative.

If a person or firm says they are registered and you cannot find them in either database, stop until you can explain why.

Red flags

• Guaranteed or “target” returns presented without being labeled as assumptions.
• Pressure to decide quickly, or a deadline that keeps moving.
• Performance that cannot be matched to an audited statement or a filed document.
• A manager who also acts as custodian, or a custodian you cannot independently contact.
• Fees you cannot explain back to the person charging them.
• Inconsistencies between the pitch, the website, and the filed documents.
• Complexity offered as a reason not to answer a plain question.
• Reluctance to provide documents that a registered firm is required to provide anyway.

None of these is proof of a problem. Each is a reason to slow down and get the answer in writing.

What a written diligence file looks like

A useful diligence process leaves a written trail: what was reviewed, what remains uncertain, and what would change the conclusion. The simplest version is a single folder and a one- or two-page memo with these sections:

• Date and scope. What was reviewed and for what purpose.
• Documents. Each one listed with its date or version. Save the PDFs; websites change.
• People checked. Names, CRD numbers, the date each BrokerCheck and IAPD report was pulled, and a saved copy of each.
• Questions and answers. What was asked, who answered, and when. Note the ones that were not answered.
• Open items. What is still uncertain, and whether it is acceptable to proceed without resolving it.
• Decision and reasons. Yes, no, or not yet, and the two or three facts that drove it.
• What would change my mind. A manager departure, a change of custodian, a fee increase, a strategy drift. Name them now so you notice them later.
• Next review date. Diligence is not finished when the money moves.

The file is for you, not for the firm you are reviewing. Its purpose is to make your reasoning visible to the person you will be in two years, who will have forgotten why this seemed like a good idea. If that person can read the memo and still agree, the process worked.

Connor Houlihan
Connecticut