Trust and Delegation

Abstract

Due to imperfect transparency and costly auditing, trust is an essential component of financial intermediation. In this paper we study a comprehensive sample of due diligence reports from a major hedge fund due diligence 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. Due diligence (DD) reports are costly and are only performed when a fund is seriously considered for investment. It is important to control for this conditioning which would otherwise bias cross-sectional analysis. We find that DD reports are typically issued on high return funds three months after the historical performance has peaked. DD reports are also issued at the point of highest cash flow into the fund. This pattern is consistent with return chasing behavior by institutional hedge fund investors.