Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation, and Documentation + Website

Praise For Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation, and Documentation "Scharfman provides helpful insight into this emerging area of private equity risk. His guide offers Limited Partners the potential to efficiently identify and evaluate private equity operational issues and avoid unnecessary risk. Similarly, it offers General Partners guidance as to best practices in light of institutional investors′ increasing demand for institutional–quality infrastructure and enhanced transparency." —Francis X. Frecentese, Managing Director, Global Head of Alternative Investments, Citi Private Bank "When it comes to private equity investing, operational risk has for too long been one of the most important, yet least understood, risk areas. This book is an excellent wake–up call to both Limited Partners and General Partners to bridge this gap. Scharfman does an excellent job of pulling the curtain back to explain the nuts and bolts of the back office procedures involved with actually establishing and running a private equity fund. By following the techniques outlined in this book, Limited Partners will be able to recognize and avoid key operations red flags during the due diligence process." —Kevin Chen, Chief Investment Officer, Anji Capital Management Private Equity Operational Due Diligence broadens the discussion surrounding operational risk assessment in private equity funds beyond the mere notions of "pass" or "fail" and fosters an increased discussion about the rights of Limited Partners to perform comprehensive operational due diligence reviews. Here you′ll discover: Legal documents and financial statement analysis techniques Case studies in operational fraud Methods to evaluate valuation, pricing documentation and risks, and illiquidity concerns The operational differences between private equity and real estate funds Private equity frauds throughout history A review of the key considerations when reviewing real estate funds Incorporating the results of operational due diligence reviews into the asset allocation process Ongoing operational monitoring techniques Monitoring role of advisory boards A companion website includes sample checklists and templates, spreadsheets, and links to the laws and regulations.

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

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 FINAlternatives.com. 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.