Investor beware: The trouble with due diligence
ABP's recent lawsuit against Goldman Sachs highlights a number of unresolved questions over due diligence, Shayla Walmsley writes.
The news that Dutch civil service pension scheme ABP is suing Goldman Sachs over claims of a mis-sold collateralised debt obligation (CDO) raises questions over what counts as adequate due diligence. The €246bn scheme - which has already sued Credit Suisse, Deutsche Bank and JPMorgan over the same issue - alleges in a complaint filed in New York that the bank knew the product was considerably riskier than it let on to investors.
The outcome of the case is by no means a foregone conclusion. Last June, JPMorgan agreed a $153.6m (€116.8m) settlement with the SEC over claims it failed to disclose an interest to investors, including the manager of the General Motors pension fund. But an earlier UK case involving a CDO issued by Barclays Bank found against an Italian institutional plaintiff on the grounds that the latter was plenty capable of assessing the risks in the contract it had signed.
Even leaving aside the legal implications of a sub judice case, what can pension funds be expected to know about not only the products they invest in but the people they hire to help them do the investing?
Patrick McCoy, head of investment advisory at KPMG, has been critical of pension funds' tendency to appoint fiduciary managers based not on due diligence but on existing relationships with consultants.
"It would be logical and best practice to look round the market and see what's out there," he said. "It would also demonstrate that they were doing a good job of due diligence. But pension funds tend to place a lot of trust in existing consultants and are more willing to extend the range of services 'a little bit more' when in fact it's a lot more."
Leaving aside the fact that to outsource risk mitigation is to create another category of risk, for better or worse, the trustees already in place take their responsibilities seriously. Despite his criticisms of some pension funds' sometimes blasé attitudes towards outsourcing, McCoy claims most trustees resist handing over responsibility because they want to keep control over what they are ultimately responsible for. "They don't want to delegate responsibly too far away," he said. "That's the key issue for them."
Yet a report published last September by private equity data firm Preqin found that pension funds were increasingly likely to outsource infrastructure investment, including due diligence, to consultants in a bid for "professionalisation".
This intermediation of consultants, at least in the UK, makes the chain of assessment difficult to pick out. "Fund managers assess the assets, we assess them, and trustees make a decision one way or the other," said Towers Watson senior investment consultant Douglas Crawshaw. "Trustees expect us, when we make recommendations, to have done the due diligence - that's what they're paying us to do. They expect us to give us the right advice, but the trustees remain the trustees."
David Collinson, co-head of business origination at the Pension Corporation, likewise argues that it is trustees' responsibility to make sure the job gets done.
"If the trustees of a pension scheme are advised to buy a building in central London and they buy it, the fact they hired lawyers to do due diligence doesn't mean the lawyer takes on the investment risk - even though the pension scheme might seek financial compensation when the lawyer does a poor job of the due diligence," he said.
On the other hand, he said, all financial institutions, including pension funds, are working harder to justify their decisions - with potentially negative implications. Collinson compared it with prescribing medicine in the US, where a doctor may believe a particular drug to be the best treatment for a patient, but will not prescribe it unless it is widely used.
"The best decision might not be taken because decision-making will not be based on rational criteria," he said.
In any case, would stuffing pension fund trustee boards with independent experts - a trend more common outside the UK - make much difference? Richard Butcher, managing director of Pitman Trustees, points out that, in the UK, only 40% of pension fund boards include professional independent trustees - up from 15% a couple of years back, but still a meagre percentage. He claims the fact decisions go wrong relatively infrequently has more to do with industry self-regulation than pension fund due diligence.
"Trustee boards tend to defer to where they believe the expertise is, though more vocal trustees - whether expert or not - tend to carry decisions," he said. "In any case, there's no template for a professional trustee other than 'I like him and he seems to be doing a good job'."
He adds: "I can tell you that in only a very small minority of our appointments has due diligence been done on us. Pension funds will negotiate on fees, and they'll want to know if we have insurance. They're less interested in whether we're fit and proper because there is no objective measure for it."