Working Paper: NBER ID: w15529
Authors: Stephen Brown; William Goetzmann; Bing Liang; Christopher Schwarz
Abstract: Due to imperfect transparency and costly auditing, trust is an essential component of financial intermediation. In this paper we study a sample of 444 due diligence (DD) reports from a major hedge fund DD firm. A routine feature of due diligence is an assessment of integrity. We find that misrepresentation about past legal and regulatory problems is frequent (21%), as is incorrect or unverifiable representations about other topics (28%). Misrepresentation, the failure to use a major auditing firm, and the use of internal pricing are significantly related to legal and regulatory problems, indices of operational risk. We find that DD reports are typically performed after positive performance and investor inflows. We control for potential bias due to this and other potential conditioning. An operational risk score based on information contained in the DD reports significantly predicts subsequent fund failure and statistical performance characteristics out of sample. Finally we find that observed operational risk characteristics do not appear to moderate fund flow.
Keywords: Trust; Delegation; Hedge Funds; Operational Risk
JEL Codes: G2; K2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| operational risk (D80) | fund performance (G14) |
| operational risk (D80) | fund failure (G33) |
| Big 4 auditor usage (M42) | operational risk (D80) |
| past legal or regulatory problems (K20) | operational controls (L23) |
| operational risk characteristics (D80) | flow-performance relationship (E50) |
| misrepresentation of material facts (Y20) | future returns (G17) |
| misrepresentation of material facts (Y20) | fund failure (G33) |
| higher operational risk (G21) | fund failure (G33) |
| higher operational risk (G21) | poor performance (D29) |