Corgentum Consulting recently attended the GAIMOps Cayman conference. At the conference there were a number of very interesting discussions centering around the field of operational due diligence. While the majority of the conversation focused around topics germane to hedge fund operational due diligence, there was some discussion of operational due diligence techniques for other asset classes as well. As an example, Corgentum Consulting Managing Partner Jason Scharfman led a panel focused on private equity operational due diligence techniques for Limited Partners.
Private equity operational due diligence LP sentiments -
At that panel a poll of the Limited Partners (“LP”) in the audience expressed that there has been a marked increase in the resources devoted to operational due diligence on private equity funds. In regards to operational due diligence approaches employed for private equity, another general LP sentiment was that in the initial stages of the ODD process, regardless of the fund or asset type (i.e. – hedge funds or private equity), there is commonality among due diligence approaches. After the initial ODD work has been begun, that is the ODD work that is somewhat fund / asset class agnostic, LP’s in general then stated that they then attempted to tailor their private equity operational due diligence work focused around issues that have corollaries to their hedge fund work.
LP Thoughts on Similarities and Differences Between Hedge Fund and Private Equity ODD -
As an example of the similarities between hedge fund and private equity operational due diligence work, the panel discussed the ways that an investor would analyze trade processing at a hedge fund versus private equity. Hedge fund trade processing analysis is similar to private equity deal flow analysis from idea inception through to reconciliation. The panel expressed a sentiment that for private equity, ODD analysis would hopefully include an increased focus on operations oversight despite the general convention that PE funds “trade” less than hedge funds.
Turning to the differences between private equity and hedge fund operational due diligence, the panel cited the example of valuation oversight. A general consensus among the LP’s in attendance was that they were less accepting of the self-administered PE model for new fund launches (i.e. – no operating history) but were still accepting of it for new vintage funds.
LP’s Want Deeper PE Dives -
At the panel LP’s also expressed a growing trend of putting more pressure on General Partners (“GP”) for deeper dive upfront due diligence. The reasons for this was, in part, because there is less ongoing monitoring that typically occurs for PE funds as compared to hedge funds.
Examples of such deeper dive work could include walkthroughs of valuations for vintage fund positions. Additionally, as part of a broader scope and deeper dive initial PE ODD reviews, some LP’s also stated that they are performing background investigations on more people as compared to hedge funds before they invest in a particular PE firm. The motivation for this was because they want to be sure to have a higher level of conviction because of the general current state of more lax LP ongoing monitoring efforts as compared to hedge funds.
LP Focus on GP skin in the game -
Finally, another area of focus was the calculation of the GP investments in funds. The panel discussed the different ways in which sophisticated GP’s may attempt to manipulate the calculation of the their investments in the funds. One model which was discussed included where a GP commits to put capital equivalent to a certain pre-defined percentage (i..e- X%) of the fund. However, the management fee for the fund could be structured in such a way that the GP could effectively utilize the management fee accrued to count towards the X% requirements. Under this model there are valid LP concerns with regards relating to the potential manipulation or double counting of this accrual. LP’s expressed similar concerns relating to the increasing cropping up of these types of somewhat complicated and potentially surprising terms.
Operational due diligence on asset classes other then hedge funds continues to be an evolving field. While there are some similarities between some of the basic operational due diligence approaches employed across all asset classes and fund types, certain asset class specific risks need to be evaluated for each different fund type. As discussed during the GAIMOPs Cayman conference private equity is an example of such an area that presents its own unique challenges.
For more guidance on the subject of private equity operational due diligence readers can reference Corgentum Consulting Managing Partner Jason Scharfman’s book entitled, Private Equity Operational Due Diligence : Tools to Evaluate Liquidity, Valuation and Documentation. Additionally, LP’s who are seeking guidance with regards to private equity operational due diligence techniques are invited to contact Corgentum to learn more about our operational review services in this area.