Due diligence is a fashionable term at the moment as investors seek to avoid repeats of old mistakes. Bankers must not slacken off the new pressure to improve standards.

Due diligence is a term that is all the rage, as investors licking their wounds from the market turmoil or from fraudsters such as Bernard Madoff try to avoid future losses. A Google search on the term “due diligence” brings up 9.1 million items. As some shocking recent figures reveal, the need for investors to check and double-check before they commit money to a new venture has never been more important.

Laven Partners, an investment consultancy, has pointed to research by New York University’s Stern School of Business, showing that a large number of hedge funds are dishonest about legal or regulatory issues during due diligence investigations. The Stern School surveyed 444 due diligence reports, hardly a small sample. Some 41 per cent of funds surveyed misrepresented these issues, Laven said.

Unsurprisingly, Jerome Lussan, founder and chief executive of Laven Partners, stresses that it is not enough for investors to look only at the quantitative side of any checks that must be made.

"It is myopic to focus solely on the quantitative aspects of funds. It is the combination of investment analysis and operational analysis that provides the most complete picture of a fund. This study has illustrated the importance of examining informational conflicts and their impact on performance, risk and probability of fund failure,” he says.

“Through our due diligence work we have come across a number of problematic areas that are consistent with the ones described in the study. For example, we have noticed that some hedge fund managers mistakenly or otherwise, misrepresent their fund performance and asset flows and rarely reconcile pricing internally.

As he continued: "The majority of investors do not have sufficient internal resources to perform an appropriate level of due diligence. This increases the need for outsourced due diligence firms that assist investors in identifying fraud, operational weaknesses and potential negligence by hedge fund managers. Additionally, as sales-driven advice is still at the forefront of the industry, investors often invest in solutions which may be conflicted or have hidden fees.”

How true. Of course, consultants such as Laven Partners stand to benefit from a heightened focus on due diligence but that does not blunt the truth of what it says. As Mr Lussan pointed out to WealthBriefing recently, no amount of checks on the fine print of a hedge fund contract are any substitute for checks on the probity of managers and the financial strength of a company.

Investors, whether they are private bankers acting for a client or a client themselves, also cannot assume that any tightening of regulations on hedge funds and other types of fund will reduce the need for strong due diligence. One of the dangers, in fact, is investors taking a “the government will take care of it” mindset. As if to warn investors about this pitfall, there were fresh reports that the Securities and Exchange Commission, the US financial regulator, was repeatedly warned about Mr Madoff’s Ponzi scheme activities, for example, but did not take tough action for several years as the fraud gathered pace. One cannot assume that financial watchdogs will always bark at the first sound or sight of trouble, or even bark at all until it is too late.

The focus on due diligence inevitably rises during bad times but it is easy to let the discipline of sound financial management slide during prosperous times. Private bankers must not slacken on due diligence checks if or when economic conditions improve.