Greater back office due diligence on PE funds is a positive for the industry
Article

Greater back office due diligence on PE funds is a positive for the industry

19 April 2018

The focal point of institutional investors has changed over time with respect to how operational due diligence (ODD) or the risk assessment of non-investment functions is applied to private equity and real estate GP’s and Investment managers.

 Although a well-established process in hedge fund investing, it is still a relatively new discipline in the closed-ended space. Back in the 1990s, the shock waves that emanated from the implosion of Long Term Capital Management (LTCM) sent hedge fund investors into a tailspin.

Making sure history does not repeat itself

Terrified that if it could happen to LTCM then it could happen to anyone, institutions trained their sights on assessing hedge fund businesses more thoroughly, spanning the people, the processes, the IT systems. The aim was simple: to achieve a full understanding of the risk/return proposition on offer.

“In the PERE space, the back office of GP’s entrusted to manage and administer trillions of dollars of assets is still a very manual oriented function compared to the hedge fund industry which has seen automation of both the managers back office and its service providers,” says Ravi Nevile, Private Equity and Real Estate Portfolio Director at TMF Group.

“ODD is something that is typically undertaken by more sophisticated investors that have larger teams or specialist consultants they use.”

“Many of the larger PE/RE firms will have already had experience of this, but for smaller firms the ODD process will still be quite new to them. They are often surprised when they have large questionnaires to fill, or have to deal with onsite visits from investors who wish to understand how they operate.”

Today, PE managers of all sizes need to prepare themselves to deal with investor queries and have a heightened awareness of their overall operations and the service providers they use. Nevile thinks that trend will continue, “as we see more and more outsourcing, particularly among managers in the US”.

Questions to consider asking

Some of the questions that are important for investors to consider might include: How is the firm structured organisationally? What is the governance framework and how are decisions made? How are staff aligned with investors and how are they incentivised? This includes back-office staff as well as front-office staff How do the non-investment functions of the manager operate (Operations, Finance, Legal, Compliance, IT) and Are there sufficient controls in place to monitor the fund’s service providers and help the manager to implement the investment strategy?

As PE/RE managers often execute their fund strategies across different jurisdictions, investors will likely want to carry out a proper assessment and background check of the key investment and operations staff.

“Large institutional investors will carry out background checks on staff to determine if there are any regulatory red flags or whether there is any litigation to be aware of.”

“Ultimately, these relationships are like a marriage. Investors are allocating capital and locking it up for long periods of time. It therefore makes sense that sufficient due diligence is carried out across different disciplines, to get a clear sense of who that investor is going to be partnering with and whether there is a correct alignment of interests in place with the manager,” explains Nevile.

Fund structure and ODD

Assessing the fund structure is another important area when conducting ODD.

PE and RE funds tend to be general partner (GP) / limited partner (LP) partnerships versus company-type structures with shareholders and an independent board of directors. In terms of governance, investors might wish to determine the effectiveness of the Limited Partnership Advisory Committee (LPAC) and its current representatives. Although LPACs offer a stronger value proposition in terms of governance, they still come with fairly limited powers compared to an independent board of directors.

“The fact that there are more sophisticated investors partnering with some of the largest managers in the industry means that the Funds’ LPAC is gaining a stronger voice,” says Nevile. “It is imperative that a stronger control environment with respect to operational process and governance offsets the lack of independent oversight to ensure that the GP is as fully aligned as possible with each LP in the partnership.”

A big part of this process focuses on the manager’s operations, the systems, controls and processes that it has in place. What is done in-house and what is outsourced? How is accounting carried out? How are waterfalls and distributions calculated, reviewed, reported and paid? The fact remains that globally, nearly all of this is still done on spreadsheets.

“The largest investors will sit with managers to go through those procedures. There are systems like Investran and eFront for private equity and Yardi for real estate, where a lot of the processes and calculations can be automated, but there are still many operational elements that remain manual today. And investors need to understand those elements in detail,” adds Nevile.

Many times, operational issues arise not from the GP per se but the underlying portfolio companies. Fraud is all about control. The best GPs will be much closer to their portfolio companies and have significant controls in place around cash management, bank accounts and authorization. This can be a complex process as different jurisdictions have different rules and authorization protocols might change.

“The types of people and the organizational set-up can tell investors a lot. But that’s only possible if Investors take a thorough, methodical approach to evaluating not just the investment risks but  also the broader operational risks inherent with any GP relationship and assess if that level of risk is acceptable both in assessing a specific fund investment but also at an institutional or counterparty level.” says Nevile.

Minimize risk

Just as robust ODD on hedge funds is a way to minimize the tail risk – i.e. avoiding getting caught up in another LTCM blow-up – the same should also be true of PE/RE funds, which might appear more conservative in nature but are no less susceptible to operational failures.

“In the past, PE managers would potentially have had less interaction with their investors. That trend is changing. LPs, rightly, should be asking more questions of its  GPs. The level of effort and transparency is increasing and I think that is a positive for the industry,” concludes Nevile.

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This article was originally published by Property Funds World and Private Equity Wire.

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