Trust and Delegation

Due to imperfect transparency and costly auditing, trust is an essentialcomponent of financial intermediation. In this paper we study acomprehensive sample of due diligence reports from a major hedge funddue diligence firm. A routine feature of due diligence is an assessmentof integrity. We find that misrepresentation about past legal andregulatory problems is frequent (21%), as is incorrect or unverifiablerepresentations about other topics (28%). Misrepresentation, the failureto use a major auditing firm and the use of internal pricing aresignificantly related to legal and regulatory problems, indices ofoperational risk. Due diligence (DD) reports are costly and are onlyperformed when a fund is seriously considered for investment. It isimportant to control for this conditioning which would otherwise biascross-sectional analysis. We find that DD reports are typically issuedon high return funds three months after the historical performance haspeaked. DD reports are also issued at the point of highest cash flowinto the fund. This pattern is consistent with return chasing behaviorby institutional hedge fund investors.