NISM-Series-XIX-A: Alternative Investment Funds (Category I and II) Distributors Certification Workbook

Chapter 8: Fund Due Diligence – Investor Perspective (Part 2 of 5)

Evaluating the Fund Manager & The Importance, Scope, and Uniqueness of Fund Due Diligence

Since Alternative Investment Funds (AIFs) represent privately pooled, comparatively illiquid, and long-gestation investment vehicles, investors cannot rely on standard market-clearing prices or public disclosures. Selecting the right AIF is primarily a function of selecting the right investment manager. Therefore, a prospective investor—frequently assisted by a professional distributor—must execute a highly structured Fund Due Diligence (FDD) process.

This study guide—Part 2 of our 5-part series—covers the qualitative and quantitative methodologies for evaluating the fund manager (Section 8.3), details why independent due diligence is crucial (Section 8.4), and examines the unique scope and operational pillars of AIF due diligence (Section 8.4.1).

1. Evaluating the Fund Manager (Section 8.3)

In the alternative investment paradigm, the investment manager (often organized as an Asset Management Company or AMC) is the single most important factor driving fund outcomes. Unlike public equities, where investors can easily trade in and out of active strategies, an AIF investor is locked into a multi-year partnership with the manager.

The Danger of Adverse Selection

Because AIF marketing is privately negotiated and lacks day-to-day public reporting, manager selection is highly complex. If not executed with professional rigor, investors face the risk of adverse selection. This risk manifests in two primary ways:

1. Sub-optimal financial returns due to a manager’s lack of sourcing capability, poor deal structuring, or weak exit execution.
2. Moral hazard and governance failures where the investment manager's incentives diverge from those of the limited partners (LPs).

To mitigate these risks, manager evaluation must move beyond simple historical return tables and instead employ a multi-dimensional assessment framework.

The Six Key Evaluation Criteria

According to the NISM curriculum, investors must evaluate prospective fund managers against six fundamental criteria:

1. Fund Management Experience in Earlier Assignments:
   • Focus: The length, depth, and quality of the manager's institutional experience in managing alternative pools of capital. First-time managers without institutional backing are heavily scrutinized compared to seasoned industry veterans.
2. Performance Track Record in Delivering Returns:
   • Focus: Assessing the manager's historical capacity to deliver consistent absolute returns. Investors analyze gross performance (at the underlying asset level) and net performance (actual returns delivered to investors after fees, expenses, and carry).
3. Specific Expertise in the Proposed Fund / Scheme’s Investment Strategy:
   • Focus: Ensuring the manager's background directly matches the targeted strategy. For instance, a successful public market fund manager may lack the specialized skills required to structure unlisted mezzanine debt or negotiate early-stage venture capital term sheets.
4. Expertise in Exit Management and Successful Exits in the Past:
   • Focus: In close-ended Category I and II AIFs, paper gains are meaningless without realization. The manager must demonstrate a verifiable history of orchestrating timely, profitable exits through Initial Public Offers (IPOs), strategic trade sales, or sponsor buybacks.
5. Past Litigations, Write-downs, Write-offs, and Liquidations:
   • Focus: Analyzing earlier distress events. While write-downs are common in high-mortality venture investing, a pattern of complete write-offs or forced liquidations points to systemic underwriting or monitoring deficiencies.
6. Regulatory Compliance, Conflicts, and Conduct History:
   • Focus: Verifying instances of regulatory non-compliance, active litigation with investee companies, or strained investor relations. This provides deep insights into the manager's ethical standards and operational integrity.

The Distributor's Value-Add in Manager Selection

While established, top-performing fund managers are highly sought after and frequently oversubscribed, finding and onboarding them is highly competitive. Commencing relationships with new or lesser-known managers carries high search costs and perceived uncertainty regarding fund closure.

This is where professional distributors add immense value:

• Broad-basing the Portfolio: Distributors identify and present promising, niche AIF schemes launched by rising, lesser-known managers who match the investor's unique risk profile.
• Mitigating Search Costs: By performing the initial screening, distributors allow investors to look beyond "household names" and discover unexploited alpha opportunities, helping deepen and institutionalize the broader Indian AIF industry.

2. Importance of Fund Due Diligence (Section 8.4)

Fund Due Diligence (FDD) is defined as the process of investigation and evaluation, performed by investors, into the details of a potential investment, such as an examination of operations and management and the verification of material facts.

Why FDD is Crucial in the AIF Space

Unlike retail mutual funds, which are heavily standardized and strictly regulated regarding asset allocation, AIFs operate with highly flexible mandates.

• The Sophisticated Investor Mandate: Because AIFs are marketed privately through private placement routes, the regulatory framework presumes that subscribers are "informed, sophisticated investors". This presumption shifts the burden of risk management directly onto the investors. Investors are legally and commercially expected to conduct their own exhaustive due diligence to protect their committed capital.
• The "Appropriateness" vs. "Investment-Worthy" Boundary: A distributor’s primary role is to evaluate suitability and appropriateness—ensuring the product matches the client's risk-return profile. However, the final investment decision must always rest on the investor’s own independent FDD, which verifies the accuracy of the manager’s claims and inspects the operational machinery of the AMC.

Distributor Assistance in FDD

Distributors are legally obligated to facilitate this due diligence process by:

• Ensuring prospective investors receive comprehensive, unmanipulated disclosures.
• Sourcing critical documentation from the fund house, including the Private Placement Memorandum (PPM), Trust Deeds, and Investment Management Agreements.
• Coordinating direct solicitation and technical discussions between the investor’s due diligence team and the investment manager's offices.

3. Scope and Uniqueness of AIF Due Diligence (Section 8.4.1)

Conducting due diligence on an AIF is fundamentally different from auditing listed assets. Because unlisted asset data is private, the process is highly subjective, relying heavily on qualitative judgments and structural verification.

Core Information Challenges

• The PPM as the Primary Source: Because public historical data is non-existent, the fund's Private Placement Memorandum (PPM) serves as the foundational text for FDD. Investors must supplement the PPM by demanding custom questionnaires, historical audited accounts of the AMC, and direct access to the deal team.
• The Subjectivity Dilemma: FDD relies on cross-referencing and background checking. Due to a lack of public comparables, this analysis can become highly subjective.
• The "Track Record" Catch-22: Because of strict quantitative checklists, investors often automatically avoid newer, high-potential AIFs. This is not because their fundamentals are flawed, but simply because a first-time manager cannot provide tangible historical evidence of multi-year portfolio performance.
• Sectorship Gestation Disparity: In sectors like infrastructure, a manager may possess world-class sourcing expertise. However, due to macro policy shifts or long gestation cycles, they may lack a completed historical "exit track record," leading conservative FDD processes to erroneously reject them.

The "Institutional Herding" Fallacy

A frequent error in AIF due diligence is comfort-driven herding. When a large, reputable institutional investor (such as a global pension fund or sovereign wealth fund) commits capital to an AIF, smaller investors often assume that "due diligence has already been done" and skip their own FDD.

The NISM curriculum strongly warns against this practice:

• Customized Outcomes: Every institutional investor has unique, highly specific tax structures, liability timelines, liquidity requirements, and expected legal protections.
• No Proxy for Due Diligence: An AIF structure that is perfectly suited to a foreign sovereign fund's long-term tax treaty may be highly inefficient or risky for a domestic corporate treasury or high-net-worth individual.

4. The Four Pillars of a Structured FDD Approach

To overcome subjectivity and standardize the evaluation process, sophisticated investors structure their AIF due diligence around four operational pillars:

5. Important Terms and Glossary

• Adverse Selection: A market scenario where an investor selects a sub-optimal fund manager due to asymmetric information, resulting in poor returns or moral hazard.
• Fund Due Diligence (FDD): The rigorous process of qualitative and quantitative investigation performed by investors to verify the operational, legal, and financial facts of an AIF before committing capital.
• Institutional Herding: The behavioral bias where investors skip independent due diligence, falsely assuming that a fund is safe simply because a large institutional player has committed capital.
• Quantitative Selection Template: A set of standardized objective criteria (e.g., tenure, drawdown schedule, hurdle rate) used to filter and shortlist compatible AIF schemes.
• Investment Committee (IC): The governance body within an AMC responsible for analyzing and providing final approvals or vetoes for proposed portfolio investments.

6. Key Exam Takeaways

• Manager Selection vs. Mechanical Checklists: Manager evaluation cannot be purely quantitative; it requires deep qualitative assessments of exit expertise, organizational staffing, and litigation history.
• The Sovereign Investor Fallacy: Investors must never rely on another institution's capital commitment as a proxy for their own due diligence, as tax, legal, and liability needs differ wildly between entities.
• Distributor’s FDD Boundary: Distributors assess suitability (appropriateness), but the investment-worthy determination remains the sole fiduciary responsibility of the investor through independent due diligence.
• FDD Information Sources: Due to the private nature of AIFs, the Private Placement Memorandum (PPM) is the primary due diligence document, which must be verified through cross-referencing and AMC interviews.

7. Practice Questions

Question 1

The behavioral bias where an investor waives their independent due diligence process because a reputable global pension fund has already committed capital to the AIF is known as:

a) Adverse Selection
b) Institutional Herding
c) Moral Hazard
d) Key Man Attrition

Question 2

Which of the following represents the primary qualitative risk where asymmetric or incomplete information leads an investor to select an incompetent or conflicted fund manager?

a) Systematic Market Risk
b) Passive Alpha Decay
c) Adverse Selection
d) J-Curve Deficit

Question 3

During an Investment Process Review as part of the four pillars of AIF due diligence, which of the following is an investor primarily auditing?

a) The physical cash management system of the custodian bank
b) The personal tax returns of the sponsor’s directors
c) The deal-sourcing pipeline, filtration metrics, and Investment Committee decision-making workflows
d) The historical tracking error of public market surrogate indices

Question 4

In the context of evaluating a fund manager's track record, "Net IRR" differs from "Gross IRR" because:

a) Net IRR is calculated before accounting for portfolio company write-downs
b) Net IRR accounts for all management fees, operational expenses, and carried interest charged to the investors
c) Net IRR is a simple absolute return metric that ignores the compounding time value of money
d) Net IRR is only computed upon the final winding up of the trust

Answer Key & Explanations

1. Correct Answer: b)
   Explanation: Institutional herding is the fallacy where investors take comfort in a large institution's presence, ignoring the fact that different investors have highly customized tax, regulatory, and liability requirements that require independent due diligence.

2. Correct Answer: c)
   Explanation: Adverse selection occurs when an investor makes an suboptimal manager choice due to a lack of rigorous, qualitative due diligence, resulting in poor returns or misaligned incentives.

3. Correct Answer: c)
   Explanation: An Investment Process Review examines the entire operational loop of a transaction—spanning deal-sourcing, Investment Committee screening, veto processes, and risk checks before capital is deployed.

4. Correct Answer: b)
   Explanation: Gross IRR measures returns at the underlying portfolio asset level before fees, whereas Net IRR reflects the actual compounded returns received by the investors after deducting AMC fees, operating expenses, and performance carry.