The Value of Operational Due Diligence on Private Equity Funds
Posted on 16 Nov 2016
Why investors should perform as good (if not better) ODD when investing in PE
The recent case of Park Hill Group’s Andrew Caspersen can serve as a reminder against complacency by investors. Caspersen, a managing principal at the private equity advisory firm, invented a fictitious investment fund and bogus domain names and email addresses as part of an attempt to steal millions to fund his highly speculative personal options trading account. Pleading guilty, Caspersen was sentenced on 4 November to four years in prison.
In May 2014, the SEC warned that more than half of the private equity firms it had examined were engaging in serious compliance violations. The commission cited the unique “temptations and conflicts” of private equity executives, who face “lax” oversight from investors. Special scrutiny is also being placed over the fee policies of private equity firms who in the past have charged a myriad of fees without the appropriate disclosures.
Such scandals and warnings from the SEC have caused a paradigm shift for investors to search for better due diligence practices.
Past studies (e.g. CapCo, 2003; Christory et al., 2006) have shown that over half of fund failures are the result of operational breakdowns. Further, losses due to operational failures tend to be larger in magnitude than investment related losses. Despite this, operationally focused due diligence is often overlooked by investors when it comes to private equity managers. In this newsletter, Laven Partners discusses the importance and value of performing operational due diligence (ODD) when investing in private equity.
The Value of Operational Due Diligence
Due diligence is about understanding a manager’s internal operations to protect investors from losses resulting from operational failures or, in a worst-case scenario, fraud. This can be hard with limited resources and time. Nevertheless, minor violations that are overlooked or ignored can feed larger ones and foster a culture where practices or regulations are increasingly treated as ‘toothless guidelines’. ODD allows investors to select fund managers based on their assessment and clear understanding of the relevant operational risks, and thereby, improve the standard of their portfolios and avoid potential reputational damage and monetary loss.
A good ODD review should consider the fund’s commitment to regulations and industry best practice standards in relation to matters such as legal structures and documentation, service providers, personnel, risk management, IT and compliance.
ODD in Private Equity vs. Hedge Funds
Fund managers and GPs who demonstrate diligence within a spectrum of operational issues better position themselves to attract and retain investors. This applies to all types of funds, including private equity. Despite fundamental differences in investment operations, processes and the liquidity of investments, hedge fund and private equity managers face similar operational environments. Both are exposed to operational risks such as valuation, cash management and IT. Operational breaches can lead to the failure of firms, causing unrecoverable, material and reputational damage to investors. Investors who are subject to fiduciary obligations, should not accept any lower operational standards solely because of differences in strategy.
For instance, understanding how portfolio companies are due diligenced and investments approved provides insights into whether a consistent methodology is applied across investment types and sectors. Meanwhile, seeking to understand the deal making procedures and use of outside consultants provides detail on how much the firm relies on internal vs. external resources. And assessing the valuation practices provides an insight into the role of the GP, its departments and any independent valuation agents in the valuation process.
Despite the importance of documenting and verifying the controls (and oversight) of a private equity firm’s day-to-day operations, we often see private equity investors combine strategy due diligence with ODD. The ODD part of the review is typically light in scope and focuses primarily on the personnel and their individual experiences, leaving gaps in the verification and understanding of the day-to-day operations and for example, interactions between departments. While some claim that ODD is difficult without an existing fund as a target of the review, knowing the best practice standards and understanding the operations of other private equity firms provides a suitable, if not equal, benchmark.
While it is true that there are not as many established standards in relation to private equity operations compared to hedge funds, there is a clear evolution of standards addressing key issues relating to private equity practices. Bodies such as Invest Europe and ILPA have developed professional standards to ensure accountability, good governance and transparency within GPs, and these guides help set the standards for what investors should expect in operations. Equally, regulations can provide practical operational guidelines and requirements.
A detailed and well-scoped ODD process assists in detecting risks before any allocation is made. As allocations to private equity funds continue to increase, so should the level of scrutiny that investors incorporate into their process.
What’s more, we often see investors perform little ODD once a commitment has been made. Although private equity requires a longer capital lock-up and therefore thorough and detailed upfront due diligence, this does not take away the need for ongoing reviews. If a due diligence reveals critical operational red flags after the commitment has been made, investors still have options for remedies, such as asking the GP to implement changes, the ability to pursue liquidity in the secondary market, and at a minimum, mitigate any potential reputational risk.
Best practice standards and regulatory obligations continue to grow and evolve within private equity. Private equity investors have a fiduciary duty and owe it to their clients to perform due diligence, both investment and operational, on GPs and funds, and before and after the commitment of capital. Rigorous ODD should be applied consistently across all third-party asset manager relationships, regardless of strategy. Though the approach may need to be refined for private equity fund managers, the need for ODD nevertheless remains a constant.