Increasing Investors’ Trust Levels through Online Due Diligence

In the wake of the Bernie Madoff scandal, the press and the investment community have focused much of their attention on the list of Madoff’s victims. Victims of his included a number of high-profile, very successful firms and individuals. One of the reasons Madoff, and others like him, were able to continue their charade for so long is the fact that so many hedge funds, private equity firms, and other investment management firms have typically provided very little information, even to their biggest clients. As a result, clients don’t get suspicious when their money managers refuse to provide all but the most basic information about where their money is invested, and even that information is provided on a quarterly basis, so information could be as much as 90 days old by the time a client sees it.

One of the potentially most far-reaching effects of the Bernie Madoff scandal, and other (relatively) smaller scandals uncovered over the last year has been the newfound appreciation for openness by hedge funds, fund-of-funds, private equity firms, and other exclusive institutional investment companies. Now, clients are demanding more openness from their money managers, and unlike in the past, managers are increasingly reluctant to tell them no. After all, the number of people waiting to hand over millions of dollars to a hedge fund with a ‘we’ll tell you what we want you to know, when we want you to know it’ philosophy is a lot smaller than it used to be.

From the perspective of the hedge funds and other institutional investment firms, the Madoff et al scandals could not have come at a worse time. First, the drop in the markets caused investors to suffer what were usually large losses, and then generally bearish sentiment and the discovery of a $50 billion Ponzi scheme combined to make many investors reluctant to commit any additional investment dollars. At the same time, many firms are finding that clients insist on increased disclosure as a condition of doing business.

Investment Due Diligence – It’s Not Just for Regulators Anymore

An important, perhaps the most important, part of the investment process is due diligence. Indeed, events of the last 9 months have been a reminder that investors need to perform due diligence on every aspect of an investment strategy – not just the investment itself, but the brokerage firm, bank, accountant, and anyone else who might have access to or control over an investor’s money. Relying on the FBI or the SEC to do the job is not enough - an expensive lesson to learn for the victims of any of these shady con men.

For investment firms, increased disclosure – about investment strategies, personnel, and holdings - are likely to become a permanent part of the landscape. The upside for these firms is that providing this additional information to existing and potential clients is likely to result in increased confidence on the part of investors that they are giving their money to trustworthy people working at reputable firms. While placing a dollar value on these benefits is admittedly subjective, it is easy to believe that firms that provide this sort of disclosure to its clients will be able to get and keep clients more quickly and easily than those that do not.

Virtual Data Rooms - Increased Disclosure, Enhanced Security, and Lower Cost

Virtual data rooms – essentially, secure, online data repositories – enable professional investment firms the ability to communicate due diligence, performance, holdings and other information with increased security and convenience, and often at a lower cost, than traditional methods of emailing and overnight mail.

Virtual data rooms offer users several different layers of security. First, access to the VDR itself is controlled via the use of usernames and passwords. To access the VDR, an authorized user simply logs on to the appropriate website and enters his or her credentials. Virtual data room providers typically offer multiple levels of security within a virtual data room, so the user is then able to access only those files, folders, or security levels that the room administrator provides access to. For example, a prospective investor performing due diligence and is seeking information on performance, firm principals, etc. can be granted access to that information, but not proprietary information regarding investment holdings. Clients can be granted access to both sets of information, and firm employees can be have access to both sets of information, as well as internal firm documents.

In terms of logistics, virtual data rooms make document management much simpler in several ways. To begin with, because authorized parties can log on to the virtual data room from anywhere simply by using their web browser, documents are available 24 hours a day, 7 days a week. As a result, the need to email or overnight documents (and then re-email or re-overnight them if they get updated) can be almost eliminated, because documents are all located in one place and everyone always knows that they’re examining the latest version of a file; if a document is updated or changed, emails can be automatically sent out alerting everyone to the document change.

Virtual data rooms can simplify information sharing in the following ways:

» Due Diligence – Typically, when a potential investor wants to obtain information, whether the investor is interested in information on the investment firm, the firm’s principals, or a contemplated investment, an employee of the investment firm either sends an email containing the information, or a brochure or other printed document is sent via overnight mail to the investor. Both of these approaches are less than ideal – email is notoriously insecure, and can get lost in cyberspace, sent to the wrong person, etc., while using overnight mail is expensive and takes employees away from more productive activity.

» Performance & Investment Holdings Information – Rather than send every client an email or hardcopy statement containing confidential and proprietary information every 90 days, investment firms can set up a VDR containing this information. Both performance and investment holdings information can be updated as often as the investment firm’s management team prefers, including on a real-time basis, enabling clients to simply log in to the VDR at their convenience. In addition to making communication logistically easier, accountability is also increased, and liability generally reduced, with audit tools available in most virtual data rooms. VDR providers offer auditing and accountability tools that enable firms to know (and prove, if necessary) who accessed which documents, and when, so that in case of litigation involving disclosure issues, investment firms have the ability to prove that a particular party examined a specific document at a specific date and time. This is far more definitive than an email delivery receipt, or a receipt from an overnight mail company that typically proves nothing beyond the fact that the receptionist received a delivery.

Investment Due Diligence Summary

Virtual data room technology first appeared in the early 1990s. Adoption rates were slow at first, but in the last several years the technology powering VDRs has become very robust, and penetration rates have increased significantly. VDRs are now used extensively by financial and legal professionals to facilitate M&A transactions, corporate restructurings, and other financial and litigation-related matters. Because VDRs enable firms to communicate with clients so easily and securely, they are being used in an increasingly wide variety of applications. There is no upfront software or hardware required, setup is generally very easy and straightforward, and the security is the same as that used in online banking. Usage of VDRs is becoming increasingly widespread, and clients generally appreciate the increased trust and disclosure levels that they enable.