Private Equity Operational Due Diligence

Tools to Evaluate Liquidity, Valuation, and Documentation

Jason A. Scharfman

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118237472
• Edition: 1
• Topic: Commerce
• Subtopic: Private Equity

A step-by-step guide to develop a flexible comprehensive operational due diligence program for private equity and real estate funds

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.

CHAPTER 1

Introduction to Private Equity Operational Risk

Private equity investing is a unique asset class that can offer a number of attractive benefits to investors. Compared to more traditional investments, some of the benefits associated with private equity investing can include the ability to focus on long-term capital growth with higher uncorrelated returns. Despite these benefits, as is the case with any asset class, private equity investing is also fraught with a number of unique risk sets and challenges that investors must consider. These risks can include traditional investment-related risks such as style drift, excessive risk taking, and overall poor performance. When investing in private equity, investors are also exposed to a series of what may be thought of as risks that are not purely related to investments. These risks have become commonly grouped together under the moniker of operational risks. But what exactly is this mysterious risk category known as operational risk?

INTRODUCTION TO OPERATIONAL RISK

Noninvestment-related risks can be often grouped into different categories due to certain shared similarities. These noninvestment risks also go by many names depending on with whom you are speaking. Some may refer to these noninvestment related risks as fat-tail risks. The term fat-tail risks is used due to the severe effects that these risk may have, coupled with the perceived infrequency with which they actually cause damage. Others may use the terms business risk or organizational risk. The term that most individuals who focus on analyzing and monitoring these risks have settled on in recent years is operational risk.

The concept of operational risk is not unique to the world of private equity. Indeed, it is not even unique to asset management or the financial industry in general. Concerns related to risk management falling under the heading of operational risk are present across a number of industries that have nothing whatsoever to do with the business of investing or managing money. The FAA System Safety Handbook for pilots has a section dedicated to Operational Risk Management (ORM) and defines the goals of ORM as “protecting people, equipment, and other resources, while making the most effective use of them.”1 In the medical field, surgeons have procedures in place to mitigate literal operational risk, to prevent mistakes such as wrong-side surgery when conducting actual operations on patients.2

With such a well-developed field spanning multiple disciplines, why in recent years has there been a flurry of interest in a subject that is supposedly so well fleshed out? After all, with a large body of research on operational risk in other fields not related to asset management or private equity, could a discussion of operational risk and due diligence in a private equity context actually yield anything new? While the field of private equity investing has continued to increase in complexity and specialization, the issues of operational risk and due diligence areas applicable to private equity as they are in other fields. This ambivalent situation can perhaps be best summed up by a comment that Pablo Picasso is rumored to have made following a viewing at Lascaux Cave of some of the earliest prehistoric cave paintings ever discovered: “We have invented nothing.”

Regardless of the field or context in which operational risk is being discussed, often times it seems both practitioners and academics alike have a difficult time pinning down an appropriate definition of this broad topic. Part of this problem perhaps stems from the typically broad number of topics and disciplines that operational risk generally encompasses. Within the financial and specifically asset management world, defining operational risk is often a contentious exercise at best. Indeed, as Chapter 2 discusses in more depth, many in the asset management world and private equity communities in particular, may not even see a real need to devote material resources toward analyzing operational risk in private equity funds.

Indeed, why bother attempting to develop a definition of something if there is a commonly held belief that the very thing attempting to be defined is not itself of any consequence? Stated plainly, as the reader may be able to gather from the title of this book, operational risk not only matters but should be of paramount importance to any investor even considering investing in private equity. As an aside, for those in the private equity community who may disagree with this statement, I invite them to read this book, fully consider the benefits of developing a private equity operational risk assessment program and ultimately think about whether or not they would find making a more informed decision (e.g., a decision based on an understanding of not only the investment risks of a particular private equity investment, but the operational risks as well) to be the most prudent course by which to proceed. Ultimately, more informed investors tend to make better investment decisions and realize fewer losses due to operational risks.

Within the private equity world, there are any number of factors that can fall into the category of operational risks. Common operational risks are outlined in Exhibit 1.1.

EXHIBIT 1.1 Common Private Equity Operational Risk Categories

Risk Category
Cash controls
Trade life cycle processing
Valuation
Transparency and fund reporting
Liquidity management
Technology and systems
Legal and compliance
Counterparty oversight
Quality and roles of service providers
Business continuity and disaster recovery

The list of common private equity operational risks in Exhibit 1.1 are the general risks that come to most individuals’ minds when they first hear the term operational risk. As this chapter discusses in more detail, the operational risk category lacks a true universal definition. Within the private equity world, there is no operational risk rule book. Furthermore, no private equity legislation, regulatory guidance, or other laws describe what falls under the term operational risk and it is therefore usually defined by what is covered by the operational due diligence process. As such, in a private equity context, operational risk is very much a term whose definition is driven by the market. Investors, fund managers, and private equity service providers alike are effectively left to their own devices in some regards to come to terms with this concept. That being said there are certain risk factors, as discussed throughout this book, which most in the private equity community would group into the category of operational risk. It is upon this foundation that we will begin to place the building blocks of the discussion of the operational due diligence process.

OPERATIONAL RISK COMPARED TO OPERATIONAL DUE DILIGENCE

Now that we have introduced a basic understanding of what is commonly meant by operational risk we can next focus on operational due diligence. The two terms are occasionally used synonymously in practice; however, there is a distinction between the two. The term operational due diligence is correctly utilized when employed to refer to the processes of gathering data about a particular private equity fund. The type of data collected during the operational due diligence process is operational risk data. After this data has been collected during the operational due diligence process, an investor then can perform an analysis of this data to come to a determination as to the amount of operational risk present at a particular private equity fund. This analysis stage, as compared to the data collection stage, is also typically considered to be a part of the operational due diligence process.

Operational due diligence can be thought of as the process of performing due diligence on these operational risks. But this definition does not really tell us much. So, what exactly do those in the private equity community mean when they refer to operational risk and operational due diligence?

WHAT IS OPERATIONAL DUE DILIGENCE?

With the basic understanding now in place we can now begin to think about what exactly operational due diligence actually entails within a private equity context. Operational due diligence is a peculiar subject. Indeed the acronym that is commonly used in the industry is “ODD,” although this book will use “ops dd.” Many investors and fund managers may have a general idea about what operational due diligence encompasses. Some investors may even think operational due diligence to be limited to the seemingly easy-to-diagnose areas such as post-trade analysis and other back-office processes. Any such risks would certainly be obvious to detect for anyone who devoted the time to take a look—they are hiding in plain sight. While these statements are certainly overgeneralizations, they definitely contribute to the understanding of what encompasses operational due diligence.

What is less obvious perhaps is that while each individual's exact notions of what is meant by operational due diligence may vary, the range of variations can be quite wide. This is one of the reasons why operational due diligence is a multifaceted and fairly deep field of due diligence and lacks one universal definition that would sum up all of these aspects into one unique package. The lack of a universal definition is brought even more into focus in the complex work of alternative investments.

Under the broad umbrella category of alternative investments, it is even more difficult for investors and fund managers to explain how operational due diligence processes may vary among different types of investments such as hedge funds and private equity investing. It is the latter category, private equity, upon which this book will focus. By introducing the various related concepts, due diligence techniques and approaches, as well as trends in this field, this book attempts to provide guidance toward fostering a more complete understanding for the parties involved in private equity investing, including investors, fund managers, and private equity service providers of what the field of a robust operational due diligence program entails. Perhaps this will foster a more universal definition of the term among members of the private equity community.

But perhaps we are getting ahead of ourselves. As intimated earlier, the world of private equity is a category of alternative investing unique unto itself, replete with its own series of challenges and opportunities. This uniqueness and the general ways in which investors and fund managers may have approached the concept in the past have developed into a situation in which, among most individuals in the private equity community, operational due diligence in the private equity world tends to be an amorphous concept.

Focus on Fraud Detection

When many private equity investors first hear the term operational due diligence, they may immediately begin to focus on fraud detection. Indeed, when first beginning to think about the subject of items that may influence the ultimate investment decision other than purely investment-related concerns, there is a strong temptation for investors to focus on concerns related to fraud in the management of a private equity fund. Certainly, this is understandable for several reasons.

Due to the fat-tailed risks associated with fraud it is certainly reasonable, and from a pragmatic standpoint logically prudent, that due diligence surrounding potential issues of fraud should be of penultimate concern during every stage of the entire due diligence process. Private equity investors logically want to avoid all losses, but losses due to fraud can leave a particular sting and any potential recovery from such losses is often a sticky business. When an asset management fraud occurs it can generally lead to total losses with little hope for recovery. Indeed if recovery by defrauded investors does occur it is often only after a long extended process steeped in legal costs. Moreover, any recovery process typically only results in partial recovery because the capital “pie” to be divided does not meet the needs of all investors. Of course, there are rare exceptions in which investors recoup the entire amount of their initial investment.

Additionally, in the wake of a series of frauds, Ponzi schemes, and the like, in the alternative investment arena concerns related to fraud are still at the relative forefront of the general investment collective consciousness. Furthermore, regardless of whether a private equity fund manager has a long track record of stellar performance, coupled with experienced well credentialed professionals and a highly compelling investment thesis for a fund—if the entire thing is a fraud—none of the other due diligence that may have been performed regarding the merits of the investment strategy (i.e., investment due diligence) and the quality of the manag...