What due diligence actually checks

Graduate · enrolled learners

This lesson opens with SAC Capital and Steven Cohen, 2013.

What happened

SAC Capital Advisors, run by Steven Cohen, was for years one of the most successful hedge funds in the world, posting returns so consistently strong that they drew large sums of outside investors' money, and the returns were, as reported, real. But in November 2013 the companies that managed SAC agreed to plead guilty to fraud charges over their employees' insider trading, to pay 1.8 billion dollars (a 900 million dollar criminal fine and a 900 million dollar forfeiture, counting 616 million dollars SAC had already agreed to pay the SEC), and to stop managing outside money, after a handful of its employees had pleaded guilty; Cohen himself was not criminally charged. That happened because part of the edge behind those returns came from illegal inside information rather than from lawful, repeatable analysis. The numbers were genuine; the process that produced them, in part, was not something that could be disclosed, defended, or lawfully repeated, so a track record that looked like proof of extraordinary skill was, on inspection, partly proof of an illegal edge. Due diligence exists precisely to ask how a return is generated, not just whether it is real, and the SAC case is what that question, taken seriously, is meant to surface: a strategy whose true source cannot survive being examined. The returns passed the test of being real and failed the test that matters more, of being produced by something legal and repeatable.

The decision point

Due diligence does not merely verify that a track record's returns are real; it checks how those returns are produced, whether the strategy is what it claims to be, whether the edge is legal and repeatable, and whether the operations, valuation, and controls behind it are sound, because a return that is genuine but produced by an illegal or unrepeatable edge fails due diligence even though the numbers are true. SAC Capital is the case: a fund with real, extraordinary returns pleaded guilty to insider trading and paid about 1.8 billion dollars, because part of its edge was illegal inside information, so its record proved a source that could not survive scrutiny. This is what due diligence actually checks, and it is why a track record is the how and not just the how much: verifying that returns happened is the easy, shallow test, while establishing how they were generated, and whether that process is legal, disclosable, and repeatable, is the deep test a serious record must pass. A return from an edge that cannot be examined, insider information, an undisclosed risk, a one-time circumstance, is not evidence of durable skill but of something that ends the moment it is understood, so a record built on it is a liability waiting to be found. So the discipline, for the trader building a record and the investor examining one, is to focus on how the returns are made: to demand a strategy that is what it claims, an edge that is legal and repeatable, and operations sound enough to withstand inspection, because SAC shows that real returns can rest on a process that destroys the fund once due diligence, or a prosecutor, asks the question the numbers alone never answer.

Recorded loss

$1,800,000,000

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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