Financial fraud is on the rise. Here’s the key that many due diligence managers may be missing.
In 2018 the rate of fraud cases discovered by the SEC rose 10% compared to previous years. Specifically, law enforcement regarding investment advisers rose by 38%. The Harvard Law Forum attested to the fact that the SEC is taking an expanded approach in the litigation of fraudulent activity. And with the emergence of many recent examples of fraud (such as this RIA, a wire fraud case that stole $360 million, or a firm that defrauded 8,400 investors — most of whom were senior citizens) it’s incumbent on all of us to question:
Why is there a sudden rise in fraud? Has an excess of fraudsters emerged or is there a deeper societal shift that calls for new contextual knowledge and behavior?
Recent trends show that it’s easier than ever to create fictional companies and returns, among other collaborating materials. In fact, a few months ago the SEC produced a fraudulent site to highlight just how easy it is to present the illusion of an up-and-coming, promising investment.
It is for that reason, among others, that we argue the uptick in fraud is correlated with the proliferation of data. And it’s directly affecting your due diligence.
Here’s how the excess of data is impacting due diligence and affecting fraud:
1) Nothing can be taken at face-value
Today it’s easier than ever to give the appearance of running a successful investment fund, when in fact masking a Ponzi scheme or other fraudulent activity. Take for example the SEC’s case against the Woodbridge Group, which was publicized last week. The investment firm defrauded investors with a Ponzi scheme. As The Economist notes, data trumps oil as the hottest commodity and it’s easier than ever to both access and manipulate data. As such, today the pressures placed on operational due diligence managers are growing. It takes more than a keen eye to review data, but a deep dive into a fund manager’s or company’s background to gain insight into their character.
Given that data can easily be manipulated, an increasing amount of sources needs to be reviewed to conduct comprehensive due diligence. Institutional investors are requesting an ever-increasing amount of data on their fund managers and, on average, spend 40 days running due diligence on a new manager and 21 days on a manager they have a prior relationship with (2018 Private Markets Due Diligence Survey).
2) Context is king
The proliferation of data brings an excessive amount of noise to background checks. For example, perhaps you’re reviewing a background check that found that the fund manager you’re researching got a DUI in 1998. Should you care?
Background checks that simply present a regurgitation of data are confusing and offer marginal insight into the risks associated with the investment. Especially when considering the scope of these reports, which consist of court records, social media activity, property deeds, mortgage documents, liens, media, regulatory filings, and more. But, sometimes a seemingly innocent adverse piece of data really gives insight to the nature of the fund manager or company you’re reviewing. For example, Manual Henriquez, a prominent individual that bribed his daughter’s way into college, had been involved in a number of court cases, including one filed against him by his wife for domestic violence. Properly assessing these red flags would’ve demonstrated a strong character flaw to investors giving them insight not to allocate their money with Henriquez, even prior to the recent scandal’s emergence. Industry benchmarks, as well as your firms’ own considerations, can determine what data should be considered a red or yellow flag.
3) Thorough due diligence may feel like looking for a needle in a haystack
Many assume that the accessibility of data means that due diligence should be a lot simpler than it once was. However, as the proliferation of data has grown, so too have the expectations placed upon due diligence teams. The sheer number of databases, files, and digital sources one must review has become a heavy burden to bear. In order to truly uncover every stone and adequately evaluate an individual or company, supplementary information, such as nicknames, aliases, or maiden names must be researched too; the number of searches a due diligence analyst must run is exponential.
Leveraging technology can help operational due diligence managers in their search for achieving transparency. In the same manner that AI is being leveraged among health care professionals to detect early-stage illnesses, AI can sift through thousands of data-sets to offer a thorough and accessible background check.
The explosion of data calls for heightened contextual intelligence when it comes to your due diligence
Due diligence is now, more than ever, an essential component to mitigate investment risk, and ultimately fraud. The data found when conducting operational due diligence can give insight into the character of the person or company you may be investing in. And today it is unfortunately easier than ever to manipulate that data on the surface.
In order to truly mitigate risk, one must dive deep into the data to connect the dots. Yet, as the number of data-sets grows it is behoove of due diligence professionals to leverage technology so that they can accurately match correlating information with the accurate person or company. As earlier discussed, advanced technology helps give direction to the context and significance of the data.
It is with these tactics that we can tap into the power that the proliferation of data offers to determine meaningful insights and leverage our background checks as a tool to successfully stunt the growth of fraud. In this manner, we leverage data to enhance trust and mitigate investment risk