Addressing the unique aspects and challenges associated with performing operational due diligence review of both private equity and real estate asset classes, this essential guide provides readers with the tools to develop a flexible comprehensive operational due diligence program for private equity and real estate. It includes techniques for analyzing fund legal documents and financial statements, as well as methods for evaluating operational risks concerning valuation methodologies, pricing documentation and illiquidity concerns.
- Covers topics including fund legal documents and financial statement analysis techniques
- Includes case studies in operational fraud
- Companion website includes sample checklists, templates, spreadsheets, and links to laws and regulations referenced in the book
- Equips investors with the tools to evaluate liquidity, valuation, and documentation
- Also by Jason Scharfman: Hedge Fund Operational Due Diligence: Understanding the Risks
Filled with case studies, this book is required reading for private equity and real estate investors, as well as fund managers and service providers, for performing due diligence on the noninvestment risks associated with private equity and real estate funds.
Table of Contents
Preface xiii
CHAPTER 1 Introduction to Private Equity Operational Risk 1
Introduction to Operational Risk 1
Operational Risk Compared to Operational Due Diligence 3
What Is Operational Due Diligence? 4
Operational Due Diligence in the Field of Private Equity 8
Operational Due Diligence as Distinguished from Operational Management of Portfolio Companies 9
Timing of Operational Due Diligence in the Investing Process 10
Operational Due Diligence Process 13
Historical Perspectives of Private Equity Operational Risk 16
Items Typically Covered during the Operational Due Diligence Process 23
Core versus Expanded Operational Due Diligence Reviews 25
Shared Commonalities between Private Equity and Real Estate Operations Risk 30
Differences in Operational Risk Factors between Private Equity and Real Estate 32
Country- and Industry-Specific Risk Considerations 33
Investment and Operational Due Diligence: Nexus or Blurred Lines? 39
Differences and Similarities with Hedge Fund Operational Due Diligence 40
Notes 49
CHAPTER 2 Importance of Operational Due Diligence for Private Equity Funds 51
Understanding the Goals of the Operational Due Diligence Process 52
Common Arguments against Operational Reviews of Private Equity Funds 55
Common Arguments in Favor of Performing Operational Reviews of Private Equity Funds 75
Conclusion 82
Notes 82
CHAPTER 3 Beginning the Operational Due Diligence Review: Core Issues 85
Goal Self-Assessment 85
Designing an Operational Due Diligence Program for Private Equity 87
When Does the Operational Due Diligence Process Begin? 101
Signaling Effects of Operational Flags 104
Requesting and Collecting Documentation 104
Nondisclosure and Confidentiality Agreements 106
Document Collection: What Documents Should Investors Request? 113
Document Collection Negotiation Techniques: Avoiding a Pass-the-Buck Environment 117
Document Collection: Hard Copy or Electronic? 119
Fund Manager On-Site Due Diligence Considerations 125
Key Risk Consideration Areas to Cover 128
Conclusion 133
Notes 133
CHAPTER 4 Additional Operational Due Diligence Considerations: An Expanded Analysis 135
Core Issues versus Expanded Analysis 135
Compensation Structures 138
Introduction to Private Equity Fund Fees 139
Manager Investment in Funds 140
Evaluating Service Providers 141
Additional On-Site Visit Considerations: Negative Operational Due Diligence 148
Additional On-Site Visit Considerations: Interview Techniques and Question Design 150
Asset Raising and the Use of Placement Agents and Third-Party Marketers 159
Cash Management and Controls 162
Business Continuity and Disaster Recovery 165
Understanding the Trade Life Cycle Process 168
Legal, Compliance, and Regulatory Risks 171
Insurance 173
Technology and Systems 174
Tax Practices 175
Diagnosing and Mitigating Reputational Risk 177
Conclusion 179
Notes 179
CHAPTER 5 Valuation Techniques, Methodologies, and Standards 181
Limited Partner Distinction between Fund Level and Portfolio Company Valuation Approaches 181
Valuation Considerations for Newly Formed Funds 182
Introduction to Valuation 182
GIPS Statement on Private Equity 183
IPEV Guidelines 185
FAS 157 189
Use of Third-Party Valuation Consultants 191
Valuation Output Process Documentation 194
Valuation Committee Review Scope 196
Additional Limited Partner Valuation Considerations 197
Conclusion 197
Notes 198
CHAPTER 6 Legal Due Diligence 199
Operational Due Diligence Specialists versus Generalists 199
Common Private Equity Fund Structures 201
Understanding the Private Placement Memorandum 201
Common Document Risk Assignment Terms 206
Exculpation and Indemnity 206
Trends in Indemnification and Exculpation Clauses 217
Other Legal Documents Considerations 227
Conclusion 228
Notes 228
CHAPTER 7 Financial Statement Due Diligence 233
Audit Standards 233
Accounting Standards 235
Other Financial Statement Formats 237
Considerations That Are Unique to Private Equity and Real Estate Financial Statements 241
Understanding Financial Statement Sections 244
Other Financial Statement Sections 245
Understanding FAS 157 251
Conclusion 254
Notes 254
CHAPTER 8 Distinguishing the Assets Class: Real Estate–Specific Concerns 257
Real Estate Trade Flow Process 257
Sample Real Estate Process 258
Real Estate Valuation 262
Monitoring Conflicts of Interest 266
Fraud Considerations: Mortgage Fraud and Straw-Man Borrowers 269
Understanding Real Estate Fund Fees 270
Property Holdings Legal Considerations 271
Conclusion 272
Note 273
CHAPTER 9 Putting It All Together: Asset Allocation and Ongoing Monitoring 275
Incorporating the Results of Operational Due Diligence into Asset Allocation 276
Evolution of Minimum Operational Risk Regime (MORR) 283
Operational Risk Correlations to Portfolio Transaction Frequency 285
Operational Lift-to-Drag Ratio 286
Negotiating Private Equity Side Letters 290
Ongoing Monitoring: Operational Due Diligence Monitoring for Private Equity Funds 292
Conclusion 296
Appendix: Mathematical Concepts 297
The Derivative 297
The Chain Rule 298
The Second Partial Derivative Test 299
Notes 300
CHAPTER 10 Boards, Committees, and Activism 301
Private Equity Fund Advisory Boards 301
Different Types of Advisory Boards: Limited Partners versus Pure Advisors 302
Ongoing Operational Due Diligence Monitoring Advisory Benefits 303
Balancing the Role of Inner Circle versus Broadly Representative Advisory Boards 305
Advisory Board Criticisms: Crowding Out, Power Aggregation, and Redundant Board Layers 306
Information Flow Considerations from Underlying Portfolio General Partner to Limited Partners 307
Limited Partner due Diligence Considerations for a Private Equity Fund of Funds 308
Additional Private Equity Advisory Board Considerations 311
Conclusion 313
Notes 313
CHAPTER 11 Case Studies and Scenarios 315
Case Studies 315
Hypothetical Scenarios 326
Notes 335
CHAPTER 12 Trends and Future Developments 341
Use of Third-Party Administrators 341
Increased Focus on Material Nonpublic Information in the United States 345
Increased Reliance on Audit-Type Certifications 348
Increased Use of Operational Due Diligence Consultants 350
Pooling Operational Due Diligence Resources among Multiple LPs 352
Operational Benchmarking 353
ILPA Guidelines 354
From Self-Regulation to Mandatory Registration 355
Impact of Dodd-Frank on Operational Due Diligence 356
Conclusion 357
Notes 358
About the Author 359
About the Website 361
Index 363
