JASON A. SCHARFMAN is a Managing Partner at Corgentum Consulting. He performs operational due diligence reviews of hedge funds, private equity, and real estate funds on behalf of institutional investors, pensions, high net worth individuals, and ERISA plans. Prior to forming Corgentum, he was the Director of Operational Risk at Graystone Research (Morgan Stanley). As Director, he was responsible for managing global operational risk assessment for all U.S., Asian, and European funds. His articles have appeared in Pension & Investments and [...]. He also teaches a course at New York University, has consulted with the U.S. House Judiciary Committee on the subject of hedge fund and private equity regulation, and provided training to financial regulators on the subject of hedge fund and private equity due diligence.

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 Conepts 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