Due diligence in the advisory world is like an onion: the more layers you peel back, the more it's likely to stink. The goal, however, is to expose the stink and cook through it to satisfy both regulatory expectations and fiduciary obligations. But enough with bizarre food analogies…
Much like a client performs due diligence on an investment advisor before handing over his or her life savings, an investment advisor is tasked with performing due diligence on the various service providers that the advisor has retained on the client's behalf. Common targets of due diligence could be, for example, subadvisors, third-party money managers, custodians, executing broker-dealers, technology vendors or data aggregators. The list could easily go on, but is obviously specific to the business of the advisor.
All such third parties have the potential to directly or indirectly cause the clients harm (mismanage assets, go bankrupt, cause order-entry delays, fail to safeguard funds, expose non-public personal information, e.g.), which is why the regulators care.