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

Preface xiii
<p>CHAPTER 1 Introduction to Private Equity Operational Risk 1</p>
<p>Introduction to Operational Risk 1</p>
<p>Operational Risk Compared to Operational Due Diligence 3</p>
<p>What Is Operational Due Diligence? 4</p>
<p>Operational Due Diligence in the Field of Private Equity 8</p>
<p>Operational Due Diligence as Distinguished from Operational Management of Portfolio Companies 9</p>
<p>Timing of Operational Due Diligence in the Investing Process 10</p>
<p>Operational Due Diligence Process 13</p>
<p>Historical Perspectives of Private Equity Operational Risk 16</p>
<p>Items Typically Covered during the Operational Due Diligence Process 23</p>
<p>Core versus Expanded Operational Due Diligence Reviews 25</p>
<p>Shared Commonalities between Private Equity and Real Estate Operations Risk 30</p>
<p>Differences in Operational Risk Factors between Private Equity and Real Estate 32</p>
<p>Country– and Industry–Specific Risk Considerations 33</p>
<p>Investment and Operational Due Diligence: Nexus or Blurred Lines? 39</p>
<p>Differences and Similarities with Hedge Fund Operational Due Diligence 40</p>
<p>Notes 49</p>
<p>CHAPTER 2 Importance of Operational Due Diligence for Private Equity Funds 51</p>
<p>Understanding the Goals of the Operational Due Diligence Process 52</p>
<p>Common Arguments against Operational Reviews of Private Equity Funds 55</p>
<p>Common Arguments in Favor of Performing Operational Reviews of Private Equity Funds 75</p>
<p>Conclusion 82</p>
<p>Notes 82</p>
<p>CHAPTER 3 Beginning the Operational Due Diligence Review: Core Issues 85</p>
<p>Goal Self–Assessment 85</p>
<p>Designing an Operational Due Diligence Program for Private Equity 87</p>
<p>When Does the Operational Due Diligence Process Begin? 101</p>
<p>Signaling Effects of Operational Flags 104</p>
<p>Requesting and Collecting Documentation 104</p>
<p>Nondisclosure and Confidentiality Agreements 106</p>
<p>Document Collection: What Documents Should Investors Request? 113</p>
<p>Document Collection Negotiation Techniques: Avoiding a Pass–the–Buck Environment 117</p>
<p>Document Collection: Hard Copy or Electronic? 119</p>
<p>Fund Manager On–Site Due Diligence Considerations 125</p>
<p>Key Risk Consideration Areas to Cover 128</p>
<p>Conclusion 133</p>
<p>Notes 133</p>
<p>CHAPTER 4 Additional Operational Due Diligence Considerations: An Expanded Analysis 135</p>
<p>Core Issues versus Expanded Analysis 135</p>
<p>Compensation Structures 138</p>
<p>Introduction to Private Equity Fund Fees 139</p>
<p>Manager Investment in Funds 140</p>
<p>Evaluating Service Providers 141</p>
<p>Additional On–Site Visit Considerations: Negative Operational Due Diligence 148</p>
<p>Additional On–Site Visit Considerations: Interview Techniques and Question Design 150</p>
<p>Asset Raising and the Use of Placement Agents and Third–Party Marketers 159</p>
<p>Cash Management and Controls 162</p>
<p>Business Continuity and Disaster Recovery 165</p>
<p>Understanding the Trade Life Cycle Process 168</p>
<p>Legal, Compliance, and Regulatory Risks 171</p>
<p>Insurance 173</p>
<p>Technology and Systems 174</p>
<p>Tax Practices 175</p>
<p>Diagnosing and Mitigating Reputational Risk 177</p>
<p>Conclusion 179</p>
<p>Notes 179</p>
<p>CHAPTER 5 Valuation Techniques, Methodologies, and Standards 181</p>
<p>Limited Partner Distinction between Fund Level and Portfolio Company Valuation Approaches 181</p>
<p>Valuation Considerations for Newly Formed Funds 182</p>
<p>Introduction to Valuation 182</p>
<p>GIPS Statement on Private Equity 183</p>
<p>IPEV Guidelines 185</p>
<p>FAS 157 189</p>
<p>Use of Third–Party Valuation Consultants 191</p>
<p>Valuation Output Process Documentation 194</p>
<p>Valuation Committee Review Scope 196</p>
<p>Additional Limited Partner Valuation Considerations 197</p>
<p>Conclusion 197</p>
<p>Notes 198</p>
<p>CHAPTER 6 Legal Due Diligence 199</p>
<p>Operational Due Diligence Specialists versus Generalists 199</p>
<p>Common Private Equity Fund Structures 201</p>
<p>Understanding the Private Placement Memorandum 201</p>
<p>Common Document Risk Assignment Terms 206</p>
<p>Exculpation and Indemnity 206</p>
<p>Trends in Indemnification and Exculpation Clauses 217</p>
<p>Other Legal Documents Considerations 227</p>
<p>Conclusion 228</p>
<p>Notes 228</p>
<p>CHAPTER 7 Financial Statement Due Diligence 233</p>
<p>Audit Standards 233</p>
<p>Accounting Standards 235</p>
<p>Other Financial Statement Formats 237</p>
<p>Considerations That Are Unique to Private Equity and Real Estate Financial Statements 241</p>
<p>Understanding Financial Statement Sections 244</p>
<p>Other Financial Statement Sections 245</p>
<p>Understanding FAS 157 251</p>
<p>Conclusion 254</p>
<p>Notes 254</p>
<p>CHAPTER 8 Distinguishing the Assets Class: Real Estate Specific Concerns 257</p>
<p>Real Estate Trade Flow Process 257</p>
<p>Sample Real Estate Process 258</p>
<p>Real Estate Valuation 262</p>
<p>Monitoring Conflicts of Interest 266</p>
<p>Fraud Considerations: Mortgage Fraud and Straw–Man Borrowers 269</p>
<p>Understanding Real Estate Fund Fees 270</p>
<p>Property Holdings Legal Considerations 271</p>
<p>Conclusion 272</p>
<p>Note 273</p>
<p>CHAPTER 9 Putting It All Together: Asset Allocation and Ongoing Monitoring 275</p>
<p>Incorporating the Results of Operational Due Diligence into Asset Allocation 276</p>
<p>Evolution of Minimum Operational Risk Regime (MORR) 283</p>
<p>Operational Risk Correlations to Portfolio Transaction Frequency 285</p>
<p>Operational Lift–to–Drag Ratio 286</p>
<p>Negotiating Private Equity Side Letters 290</p>
<p>Ongoing Monitoring: Operational Due Diligence Monitoring for Private Equity Funds 292</p>
<p>Conclusion 296</p>
<p>Appendix: Mathematical Conepts 297</p>
<p>The Derivative 297</p>
<p>The Chain Rule 298</p>
<p>The Second Partial Derivative Test 299</p>
<p>Notes 300</p>
<p>CHAPTER 10 Boards, Committees, and Activism 301</p>
<p>Private Equity Fund Advisory Boards 301</p>
<p>Different Types of Advisory Boards: Limited Partners versus Pure Advisors 302</p>
<p>Ongoing Operational Due Diligence Monitoring Advisory Benefits 303</p>
<p>Balancing the Role of Inner Circle versus Broadly Representative Advisory Boards 305</p>
<p>Advisory Board Criticisms: Crowding Out, Power Aggregation, and Redundant Board Layers 306</p>
<p>Information Flow Considerations from Underlying Portfolio General Partner to Limited Partners 307</p>
<p>Limited Partner Due Diligence Considerations for a Private Equity Fund of Funds 308</p>
<p>Additional Private Equity Advisory Board Considerations 311</p>
<p>Conclusion 313</p>
<p>Notes 313</p>
<p>CHAPTER 11 Case Studies and Scenarios 315</p>
<p>Case Studies 315</p>
<p>Hypothetical Scenarios 326</p>
<p>Notes 335</p>
<p>CHAPTER 12 Trends and Future Developments 341</p>
<p>Use of Third–Party Administrators 341</p>
<p>Increased Focus on Material Nonpublic Information in the United States 345</p>
<p>Increased Reliance on Audit–Type Certifications 348</p>
<p>Increased Use of Operational Due Diligence Consultants 350</p>
<p>Pooling Operational Due Diligence Resources among Multiple LPs 352</p>
<p>Operational Benchmarking 353</p>
<p>ILPA Guidelines 354</p>
<p>From Self–Regulation to Mandatory Registration 355</p>
<p>Impact of Dodd–Frank on Operational Due Diligence 356</p>
<p>Conclusion 357</p>
<p>Notes 358</p>
<p>About the Author 359</p>
<p>About the Website 361</p>
<p>Index 363</p>