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Private Equity Operational Due Diligence Trends


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Corgentum Consulting's study on private equity operational due diligence.

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Private Equity Operational Due Diligence Trends

  1. 1. Private EquityOperational DueDiligence Trends - Navigating the Path Forward 1|Page
  2. 2. THE RISE OF PRIVATE EQUITYOPERATIONAL DUE DILGIENCEINTRODUCTION: STUDY APPROACH:Private equity has been in the news recently To analyze Limited Partner attitudes andof late. With U.S. presidential candidate Mitt trends with regard to performingRomneys past experiences at Bain Capital, it operational due diligence reviews of privatehas focused the U.S. discussion on the social equity funds, Corgentum Consultingand economic benefits of private equity conducted a survey of approximately 150including its effect on job creation. Limited Partners globally. The types ofRegardless of any social or political investors included in this study covered acriticisms, investors continue to invest in diverse cross section of private equityprivate equity funds. As allocations to investors ranging from ultra-high net worthprivate equity funds continues to increase, individuals to larger institutional too does the level of scrutiny investors The one requirement to be included in thisincorporate into this process. study was that the investors had either current investments in private equity, or hadSpurred perhaps by developments in other made an allocation to private equity withinparts of the alternative investment the past five years.spectrum, most notably hedge funds,investors have begun to look inward andexpand the scope of their own due diligenceprocesses. This study seeks to evaluateinvestor trends in performing operationaldue diligence on their private equityinvestments. Operational due diligencerefers to the process of analyzingoperational risks. Operational risks can bethought of in part, as those risks that are notpurely investment related in nature andarise from the daily management andbusiness operations of the fund. Theseoperational risks run the gamut fromtraditional back office trade operations tocounterparty and compliance related risks. 2|Page
  3. 3. THE CURRET LANDSCAPE:Current performance of operational due diligence Do you currently perform any operational due diliegnce on fund managers? 13% Yes 87% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%To analyze Limited Partner attitudes and conducted operational due diligence on fundtrends with regard to performing managers. As indicated above, the resultsoperational due diligence reviews, Limited indicate that the overwhelming majority,Partners were first asked if they currently 87%, currently perform some sort of operational due diligence.CURRENT OPERATIONAL DUE DILIGENCE APPROACHES : How do you perform operational due diligence? Combination of internal and external resources 14% Consultants 24% Internally 62% 0% 10% 20% 30% 40% 50% 60% 70%Those Limited Partners that indicated that therefore, were not dedicated tothey currently perform operational due operational due diligence alone. 24% ofdiligence were next asked how they perform investors responding indicated that theythis function. As outlined above, the bulk of utilize consultants. Within the consultantsinvestors, 62%, currently perform category, investors indicated an increase inoperational due diligence internally. the use of third-party operational due diligence consultants. However, in general,Those Limited Partners that performed the consultants which provided operationaloperational due diligence internally further due diligence also provided investmentindicated that the majority of the employees advice. Finally, 14% of respondents indicatedresponsible for overseeing operational due that they perform operational due diligencediligence had other responsibilities through a combination of a variety of(including investment analysis duties) and internal and external resources. 3|Page
  4. 4. OPERATIONAL RISK ATTITUDES:Private equity compared to hedge funds Which do you view as having more operational risks - hedge funds or private equity? Private equity 16% Hedge funds 84% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90%Investors were next asked about their Respondents clarified that reasons for thisopinion regarding the overall operational included hedge funds more frequent tradingriskiness of hedge funds as compared to activity as compared to private equity funds,private equity funds. As outlined above, an the increased attention from regulators onoverwhelming 84% of investors indicated insider trading activity and recent hedgethat they viewed hedge funds as having fund related frauds such as Bayou andmore operational risks as compared to Madoff.hedge funds.Resource allocation of operational due diligence to hedge funds versus private equity - Do you perform operational due diligence only on hedge funds (and not private equity funds)? No (on hedge funds and other funds including private 26% equity) Yes (only on hedge funds and not private equity) 74% 0% 10% 20% 30% 40% 50% 60% 70% 80%Those respondents that indicated they that they only perform such reviews oncurrently performed operational due hedge funds and not private equity funds.diligence, were then asked about whether This response agrees with the respondentsthey performed operational due diligence previous responses that they view hedgereviews of their hedge fund investments and funds as being riskier, and thereforenot their private equity fund investments. A requiring more operational due diligence, asvast majority, 74% of respondents, indicated opposed to private equity funds. 4|Page
  5. 5. Do you currently perform operational due diligence on private equity funds? No 32% Yes 68% 0% 10% 20% 30% 40% 50% 60% 70% 80%Of those 26% of investors that indicated currently perform operational due diligencethey performed operational due diligence on on private equity funds as well. As outlinedother funds in addition to hedge funds - above 68% of those in that group indicatedthese respondents were asked if they that that they did perform such reviews.ATTITUDES TOWARDS PRIVATE EQUITY OPERATIONAL DUE DILIGENCE Why do you not perform operational due diligence reviews of private equity funds? Others 4% Do not feel necessary going forward 11% I want to, but unsure how 16% Unsure of benefits 12% Have not previously in the past 57% 0% 10% 20% 30% 40% 50% 60%Those respondents that indicated that they 12% of investors were unsure as to thedid not perform operational due diligence benefits of performing such reviews, whileon private equity funds, but did perform 16% indicated that they wanted to performsuch reviews on hedge funds (i.e.- 74% of such reviews but were unsure how tothose that indicated Yes), were asked about proceed. 11% of respondents stated thattheir reasons for not performing such they do not feel private equity poses risksprivate equity reviews. A majority of which make such reviews necessary goingrespondents, 57%, indicated that they had forward. Finally, 4% indicated other reasonssimply not performed such reviews in the for not performing such reviews including apast and therefore, had not changed their lack of resources and a belief thatprevious procedures. government regulation supplants the need for such reviews. 5|Page
  6. 6. ANTICIPATION OF FUTURE TRENDS IN OPERATIONAL DUE DILIGENCE RESOURCE ALLOCATION Do you anticipate starting to perform operational due diligence reviews in the coming year? No 32% Yes 68% 0% 10% 20% 30% 40% 50% 60% 70% 80%Additionally, those 74% that responded they Investors indicated that the reasons fordid not perform operational due diligence likely starting to perform such reviewson private equity funds but did perform such includes a focus on performing a minimumreviews on hedge funds, were further asked amount of due diligence across all types ofif they anticipated performing such investments across their portfolios,operational risk review on private equity in increased pressure to perform such reviewsthe coming year. As outlined above, 68% of from individuals that they manage money onthem indicated they did anticipate starting behalf of and increasing concerns aboutto perform such reviews in the coming year. private equity risks in general. 6|Page
  7. 7. OPINIONS REGARDING IMPORTANT PRIVATE EQUITY OPERATIONAL RISKS What do you feel is the most important private equity operational risk? Others 4% Role of board of directors 6% Counterparty risk 8% Fraud 9% Traditional back office processes 17% Compliance / Governance 22% Valuation 34% 0% 5% 10% 15% 20% 25% 30% 35% 40%Regardless of whether or not investors counterparty risk was the most importantindicated that they performed private equity operational risk, while 6% indicated that theoperational due diligence reviews, role of the board of directors was the mostrespondents were asked what they felt were important risk. 4% of respondents indicatedthe most that they felt other risks wereimportant private the most important, includingequity operational the compensation of the fundrisks. The majority, manager, legal documentation34% of investors, risk, service providers andstated that they insurance coverage.believe thatvaluation was the Further clarifying theirlargest operational responses, investors indicatedrisk in private that in determining whichequity. This was followed by, 22% of operational risk factors were the mostrespondents who indicated that they felt important, they were influenced in part byCompliance / Governance was the largest the occurrence of recent events where fundsoperational risk. 17% indicated that had failed for primarily operational relatedtraditional back office procedures posed the reasons including fraudulent activity,largest operational risk to private equity. valuation concerns and counterparty risk. These responses, confirmed by the data,Interestingly, investors next indicated that suggest the continued presence of a so-concerns still persist related to fraudulent called Madoff Effect across not only hedgeactivity; with 9% of respondents indicating funds, but private equity as well, wherebythat fraud was the most important private investors tend to tailor their approachequity operational risk. 8% of respondents towards due diligence based on recentfelt that fraudulent activity. 7|Page
  8. 8. CONCLUSIONThe state of operational due diligence is in flux. Private equity Limited Partners are increasinglyaccepting the need to perform these types of operational risk reviews. Additionally, privateequity investors are broadening the scope and depth of such operational risk reviews. Insummary, the results of this survey indicate:  The majority of investors, 87% currently perform operational due diligence reviews of fund managers  Investors are currently allocating the bulk of their operational due diligence efforts towards hedge funds as opposed to private equity, but there is an increasing sentiment among investors to change this  Limited Partners anticipate performing more operational due diligence on private equity then they did in the past : - Approximately 50% of respondents indicated that they anticipate starting to perform such reviews in the coming year - 16% indicated that they want to implement operational due diligence programs in the future  In regards to operational risks, Private equity Limited Partners are most focused on valuation and compliance related risks  Limited Partners are still concerned with the potential for fraud in private equity: - 9% think its the most important operational risk  The presence of a Madoff Effect is not only applicable to hedge funds but extends to influence investor opinions of private equity operational due diligence as well.Operational risk evaluations will continue to remain an important part of the private equityinvesting process. Investors looking to develop or refine their operational due diligence programmay consider working with a third-party operational due diligence consultant such as Corgentum,to assist in this process to ensure all operational risks are fully vetted. 8|Page
  9. 9. ABOUT CORGENTUM CONSULTINGCorgentum Consulting is a specialist consulting firm which performs operational due diligencereviews of fund managers. The firm works with investors including fund of funds, pensions,endowments, banks and family offices to conduct the industrys most comprehensive operationaldue diligence reviews. Corgentums work covers all fund strategies globally including hedgefunds, private equity, real estate funds, and traditional funds. The firms sole focus onoperational due diligence, veteran experience , innovative original research and fundamentalbottom up approach to due diligence allows Corgentum to ensure that our clients avoidunnecessary operational risks. Corgentums Managing Partner, Jason Scharfman, is the author ofthe forthcoming Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuationand Documentation. The Web site is 9|Page