Operational due diligence: identify red flags before committing to an alternative investment

Kris Shergold, Client Partner at SEI Investments, highlights the key features of a good operational due diligence process.

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The story broken by the Miami Herald on JES Capital1 highlights how important it is for institutional investors to conduct thorough operational due diligence (ODD) for all alternative investments, including private equity. In this case, allegations claim JES forged signatures on subscription agreements totalling USD $95 million (roughly £68 million) to secure a subscription line of credit.

While subscription credit facilities are commonplace, they do expose limited partnerships (LP) to risk. As the National Law Review2 notes, “In the JES case, the key question is who ultimately bears responsibility for repayment of the fund’s debt. If there are genuine investors in the fund, then under typical documentation such investors will be obligated for the debt of the fund on a pro rata basis up to the amount of their unfunded capital commitments. This would depend on the exact wording of the fund’s limited partnership agreement, but it is not unusual for investors to be required to fund drawdown notices without set-off, counterclaim or defense.”

Prospective LPs can mitigate the risk of investing in a potential fraudulent situation by performing a thorough operational due diligence. By vetting the operating infrastructure of the fund, the investor will identify inadequate internal processes or red flags that may foreshadow potentially nefarious behaviour. For JES, a background check likely would have found that Elliot Smerling filed for bankruptcy in 1993.

By vetting the operating infrastructure of the fund, the investor will identify inadequate internal processes or red flags that may foreshadow potentially nefarious behavior.

What does a good diligence process consist of?

A good diligence process includes a review of manager documents and policies to gain an understanding of operations, valuation policy, lifecycle of a trade, IT infrastructure and compliance. Once the ODD team understands the basic operating setup, it should conduct meetings with key personnel including the chief financial officer (CFO), chief compliance officer (CCO), chief operating officer (COO) and head of trading to determine the institutional quality of operations. The objective of these meetings is to ensure implementation of written policies, adequate internal controls and proper segregation of duties.

The ODD team should study changes in assets under management, capital commitments, the ownership structure, key hires and departures, compensation structures, strategic plans and other material issues.

Key ODD questions include:

  • Are any of the terms in the offering memorandum outside industry standard?
  • What are the details of key vendor relationships?

A thorough examination includes a background check on the manager and key employees, and verification of third-party service provider relationships. Operational due diligence should not stop after the initial diligence. In addition to an annual review, ODD consists of ongoing manager monitoring including an investigation of any updated documents, regulatory filings and audited financial statements.

Operational due diligence for LP investments in private equity funds is catching up to more refined checklists for hedge funds. In 2018, the Institutional Limited Partners Association, which is focused on private equity, issued a revised 29-page Due Diligence Questionnaire3. A completed DDQ is not a rubber stamp. Diligence starts here, but red flags should be probed and background checks conducted to avoid ill-fated investments.

The challenge for many institutional investors is lack of sufficient resources or expertise to properly perform operational due diligence. Fortunately, there are providers with both the scale and know-how to do this critical review.

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