Private equity operational due diligence, + website tools to evaluate liquidity, valuation, and documentation PDF room

Contents Cover Series Title Page Copyright Dedication Preface CHAPTER 1: Introduction to Private Equity Operational Risk INTRODUCTION TO OPERATIONAL RISK OPERATIONAL RISK COMPARED TO OPERATIONAL DUE DILIGENCE WHAT IS OPERATIONAL DUE DILIGENCE? OPERATIONAL DUE DILIGENCE IN THE FIELD OF PRIVATE EQUITY OPERATIONAL DUE DILIGENCE AS DISTINGUISHED FROM OPERATIONAL MANAGEMENT OF PORTFOLIO COMPANIES TIMING OF OPERATIONAL DUE DILIGENCE IN THE INVESTING PROCESS OPERATIONAL DUE DILIGENCE PROCESS HISTORICAL PERSPECTIVES OF PRIVATE EQUITY OPERATIONAL RISK ITEMS TYPICALLY COVERED DURING THE OPERATIONAL DUE DILIGENCE PROCESS CORE VERSUS EXPANDED OPERATIONAL DUE DILIGENCE REVIEWS SHARED COMMONALITIES BETWEEN PRIVATE EQUITY AND REAL ESTATE OPERATIONS RISK DIFFERENCES IN OPERATIONAL RISK FACTORS BETWEEN PRIVATE EQUITY AND REAL ESTATE COUNTRY-AND INDUSTRY-SPECIFIC RISK CONSIDERATIONS INVESTMENT AND OPERATIONAL DUE DILIGENCE: NEXUS OR BLURRED LINES? DIFFERENCES AND SIMILARITIES WITH HEDGE FUND OPERATIONAL DUE DILIGENCE CHAPTER 2: Importance of Operational Due Diligence for Private Equity Funds UNDERSTANDING THE GOALS OF THE OPERATIONAL DUE DILIGENCE PROCESS COMMON ARGUMENTS AGAINST OPERATIONAL REVIEWS OF PRIVATE EQUITY FUNDS COMMON ARGUMENTS IN FAVOR OF PERFORMING OPERATIONAL REVIEWS OF PRIVATE EQUITY FUNDS CONCLUSION CHAPTER 3: Beginning the Operational Due Diligence Review: Core Issues GOAL SELF-ASSESSMENT DESIGNING AN OPERATIONAL DUE DILIGENCE PROGRAM FOR PRIVATE EQUITY WHEN DOES THE OPERATIONAL DUE DILIGENCE PROCESS BEGIN? SIGNALING EFFECTS OF OPERATIONAL FLAGS REQUESTING AND COLLECTING DOCUMENTATION NONDISCLOSURE AND CONFIDENTIALITY AGREEMENTS DOCUMENT COLLECTION: WHAT DOCUMENTS SHOULD INVESTORS REQUEST? DOCUMENT COLLECTION NEGOTIATION TECHNIQUES: AVOIDING A PASS-THE-BUCK ENVIRONMENT DOCUMENT COLLECTION: HARD COPY OR ELECTRONIC? FUND MANAGER ON-SITE DUE DILIGENCE CONSIDERATIONS KEY RISK CONSIDERATION AREAS TO COVER CONCLUSION CHAPTER 4: Additional Operational Due Diligence Considerations: An Expanded Analysis CORE ISSUES VERSUS EXPANDED ANALYSIS COMPENSATION STRUCTURES INTRODUCTION TO PRIVATE EQUITY FUND FEES MANAGER INVESTMENT IN FUNDS EVALUATING SERVICE PROVIDERS ADDITIONAL ON-SITE VISIT CONSIDERATIONS: NEGATIVE OPERATIONAL DUE DILIGENCE ADDITIONAL ON-SITE VISIT CONSIDERATIONS: INTERVIEW TECHNIQUES AND QUESTION DESIGN ASSET RAISING AND THE USE OF PLACEMENT AGENTS AND THIRD-PARTY MARKETERS CASH MANAGEMENT AND CONTROLS BUSINESS CONTINUITY AND DISASTER RECOVERY UNDERSTANDING THE TRADE LIFE CYCLE PROCESS LEGAL, COMPLIANCE, AND REGULATORY RISKS INSURANCE TECHNOLOGY AND SYSTEMS TAX PRACTICES DIAGNOSING AND MITIGATING REPUTATIONAL RISK CONCLUSION CHAPTER 5: Valuation Techniques, Methodologies, and Standards LIMITED PARTNER DISTINCTION BETWEEN FUND LEVEL AND PORTFOLIO COMPANY VALUATION APPROACHES VALUATION CONSIDERATIONS FOR NEWLY FORMED FUNDS INTRODUCTION TO VALUATION GIPS STATEMENT ON PRIVATE EQUITY IPEV GUIDELINES FAS 157 USE OF THIRD-PARTY VALUATION CONSULTANTS VALUATION OUTPUT PROCESS DOCUMENTATION VALUATION COMMITTEE REVIEW SCOPE ADDITIONAL LIMITED PARTNER VALUATION CONSIDERATIONS CONCLUSION CHAPTER 6: Legal Due Diligence OPERATIONAL DUE DILIGENCE SPECIALISTS VERSUS GENERALISTS COMMON PRIVATE EQUITY FUND STRUCTURES UNDERSTANDING THE PRIVATE PLACEMENT MEMORANDUM COMMON DOCUMENT RISK ASSIGNMENT TERMS EXCULPATION AND INDEMNITY TRENDS IN INDEMNIFICATION AND EXCULPATION CLAUSES OTHER LEGAL DOCUMENTS CONSIDERATIONS CONCLUSION CHAPTER 7: Financial Statement Due Diligence AUDIT STANDARDS ACCOUNTING STANDARDS OTHER FINANCIAL STATEMENT FORMATS CONSIDERATIONS THAT ARE UNIQUE TO PRIVATE EQUITY AND REAL ESTATE FINANCIAL STATEMENTS UNDERSTANDING FINANCIAL STATEMENT SECTIONS OTHER FINANCIAL STATEMENT SECTIONS UNDERSTANDING FAS 157 CONCLUSION CHAPTER 8: Distinguishing the Assets Class: Real Estate–Specific Concerns REAL ESTATE TRADE FLOW PROCESS SAMPLE REAL ESTATE PROCESS REAL ESTATE VALUATION MONITORING CONFLICTS OF INTEREST FRAUD CONSIDERATIONS: MORTGAGE FRAUD AND STRAW-MAN BORROWERS UNDERSTANDING REAL ESTATE FUND FEES PROPERTY HOLDINGS LEGAL CONSIDERATIONS CONCLUSION CHAPTER 9: Putting It All Together: Asset Allocation and Ongoing Monitoring INCORPORATING THE RESULTS OF OPERATIONAL DUE DILIGENCE INTO ASSET ALLOCATION EVOLUTION OF MINIMUM OPERATIONAL RISK REGIME (MORR) OPERATIONAL RISK CORRELATIONS TO PORTFOLIO TRANSACTION FREQUENCY OPERATIONAL LIFT-TO-DRAG RATIO NEGOTIATING PRIVATE EQUITY SIDE LETTERS ONGOING MONITORING: OPERATIONAL DUE DILIGENCE MONITORING FOR PRIVATE EQUITY FUNDS CONCLUSION APPENDIX 9A: Mathematical Concepts THE DERIVATIVE THE CHAIN RULE THE SECOND PARTIAL DERIVATIVE TEST CHAPTER 10: Boards, Committees, and Activism PRIVATE EQUITY FUND ADVISORY BOARDS DIFFERENT TYPES OF ADVISORY BOARDS: LIMITED PARTNERS VERSUS PURE ADVISORS ONGOING OPERATIONAL DUE DILIGENCE MONITORING ADVISORY BENEFITS BALANCING THE ROLE OF INNER CIRCLE VERSUS BROADLY REPRESENTATIVE ADVISORY BOARDS ADVISORY BOARD CRITICISMS: CROWDING OUT, POWER AGGREGATION, AND REDUNDANT BOARD LAYERS INFORMATION FLOW CONSIDERATIONS FROM UNDERLYING PORTFOLIO GENERAL PARTNER TO LIMITED PARTNERS LIMITED PARTNER DUE DILIGENCE CONSIDERATIONS FOR A PRIVATE EQUITY FUND OF FUNDS ADDITIONAL PRIVATE EQUITY ADVISORY BOARD CONSIDERATIONS CONCLUSION CHAPTER 11: Case Studies and Scenarios CASE STUDIES HYPOTHETICAL SCENARIOS CHAPTER 12: Trends and Future Developments USE OF THIRD-PARTY ADMINISTRATORS INCREASED FOCUS ON MATERIAL NONPUBLIC INFORMATION IN THE UNITED STATES INCREASED RELIANCE ON AUDIT-TYPE CERTIFICATIONS INCREASED USE OF OPERATIONAL DUE DILIGENCE CONSULTANTS POOLING OPERATIONAL DUE DILIGENCE RESOURCES AMONG MULTIPLE LPS OPERATIONAL BENCHMARKING ILPA GUIDELINES FROM SELF-REGULATION TO MANDATORY REGISTRATION IMPACT OF DODD-FRANK ON OPERATIONAL DUE DILIGENCE CONCLUSION About the Author About the Website Index Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to ecommerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com resources aimed at vetting compliance with such regulations CONCLUSION This chapter provides an overview of developing trends regarding operational risk in the private equity industry The trends that this chapter discusses originate not only from external sources such as regulations, but also directly from private equity funds and investors Often these trends influence all three groups directly An example of such a recent trend that has repercussions for all three groups is the increased focus on material nonpublic information in the United States Other examples of trends discussed in this chapter that have more direct effects on the relationship between GPs and LPs are the increased use of third-party fund administrators and increased reliance on audit-type certifications This chapter also provides a discussion of the increased use by LPs of operational due diligence consultants and the ILPA guidelines Finally, this chapter provides a discussion of legal-and compliance-related trends, including a trend toward requiring mandatory regulatory registration for private equity funds and the impact of Dodd-Frank It is especially important for LPs to be cognizant of such trends when developing and maintaining an effective private equity operational due diligence program By remaining aware, LPs will be more likely to effectively gauge not only how GPs plan for such change, but also how they adapt their operations to address investors’ present and future concerns NOTES See, for example, United States v Carpenter, 484 U.S 19 (1987); United States v O’Hagan, 521 U.S 642 (1997) See Fiona Gaskin, “Goodbye SAS 70, Hello ISAE 3402?,” http://download.pwc.com/ie/pubs/pwc_goodbye_sas_70_isae_3402.pdf Institutional Limited Partners Association, “Private Equity Principles, Version 2.0,” January 2011 Institutional Limited Partners Association, “ILPA Publishes Updated 2011 Private Equity Principles and First Standardized Reporting Industry Template to Help Enhance the Private Equity Asset Class Globally,” January 11, 2011, http://ilpa.org/index.php?file=/wp-content/uploads/2011/01/Principles-Version2.0-Press-Release.pdf&ref=http://ilpa.org/principles-version-20/&t=1316768530 About the Author Jason A Scharfman is the Managing Partner of Corgentum Consulting, a provider of comprehensive operational due diligence reviews of alternative investments including hedge funds, private equity, real estate, and funds of hedge funds He is recognized as one of the leading experts in the field of operational due diligence and is the author of Hedge Fund Operational Due Diligence: Understanding the Risks (John Wiley & Sons, 2008) Mr Scharfman has participated in operational due diligence reviews of over 200 private equity and real estate funds of multiple strategies across the globe, including REITs, clean-tech funds, direct property holdings, multiyear vintage funds, Asian infrastructure funds, Eastern European utility and infrastructure funds, commodity funds (timber, oil, gold, etc.), and private equity funds of funds Before founding Corgentum, he oversaw the operational due diligence function for Graystone Research at Morgan Stanley and was a senior member of a team that oversaw all of Morgan Stanley's operational due diligence efforts for hedge funds, private equity, real estate funds, and funds of hedge funds Prior to joining Morgan Stanley, he held positions that focused primarily on due diligence and risk management within the alternative investment sector at Lazard Asset Management, SPARX Investments and Research, and Thomson Financial Mr Scharfman received a BS in Finance with an additional major in Japanese from Carnegie Mellon University, an MBA in Finance from Baruch College's Zicklin School of Business, and a JD from St John's School of Law He holds the Certified Fraud Examiner (CFE) and Certified in Risk and Information Systems Control (CRISC) credentials and has consulted with the U.S House Judiciary Committee on the subject of hedge fund and private equity regulation Additionally, he has provided training to financial regulators on the subject of hedge fund and private equity due diligence Mr Scharfman has served as a consultant and expert in hedge fund and private equity litigation, and has lectured on the subject of alternative investment operations and operational risk as an adjunct professor at New York University He has written extensively on the subject of operational due diligence and travels and speaks worldwide on hedge fund operational risks About the Website This book includes a companion website, which can be found at www.wiley.com/go/privateequityduediligence This website features a number of useful spreadsheets and templates which investors can utilize to assist them in performing operational due diligence reviews of private equity funds This website also includes links to laws and regulations that are cited in the book The password to enter this site is: Scharfman Index A AA Capital fraud Accessory liability Actual fraud See Fraud Administrator ADV See Form ADV Advisory board Agape World Allianz SE Alternative Investment Fund Managers Directive (“AIFMD”) Alternative investments Amazon.com American Research and Development Corporation (ARDC) Assembly Bill 1743 Asset allocation Assets under management (AUM) Audit materiality Audited financial statements See Financial statements Auditor B Background investigation Bad faith Baden v Societe Generale Balance sheet See Financial statements Barings Bank Barlow Clowes International Ltd (In Liquidation) v Eurotrust International Limited Basel Committee on Banking Supervision Benchmarking See Operational Benchmarking Berman, Todd Blackstone Group Board of directors Boesky, Ivan British Venture Capital Association (BVCA) Broker-dealer Bullmore v Ernst & Young Cayman Islands Business continuity and disaster recovery planning (BCP/DR) Business risk See Operational risk C Cadbury Commission California Public Employees’ Retirement System (CalPERS) California State Teachers’ Retirement System (CalSTRS) Carlyle Carnegie Steel Company Carnegie, Andrew Carried interest Cash oversight, management and transfer controls Cayman Islands Channel Islands Chartwell Investments Chief Compliance Officer Chief Financial Officer Chief Operating Officer Chief Technology Officer Cliff vesting See Compensation structures Committee of Sponsoring Organizations (COSO) Committee of Wise Men Compensation structures Compliance Infrastructure Manual Compton, Carl Confidentiality agreement Conflicts of interest Continental Airlines Cooke, Jay Core operational due diligence process See Operational due diligence Core operational due diligence process See Operational due diligence Corgentum Consulting Benefits of operational due diligence case studies Increased use of operational due diligence consultants Operational due diligence process documentation Operational benchmarking Operational due diligence frameworks analysis Trends in indemnification and exculpation clauses Cosmo, Nicholas Counterparty oversight Counterparty risk See Counterparty oversight Country specific risks Credit Mobilier Crossover funds Custodian Custody Custody Rule Customer relationship management (CRM) systems D Dedicated framework Department of Justice Deutsche Bank Digital Equipment Company Director liability Directors’ and officers’ liability coverage (D&O) Discovery Dishonesty Distressed debt investing funds Dixon, Roy, Jr Dodd-Frank Wall Street Reform and Consumer Protection Act Dom, Telonge Domino's Pizza Doriot, Georges, General Draper Gaither and Andersen Dreier, Marc Drexel Burnham Lambert Due diligence equation Due diligence file Due diligence questionnaire (DDQ) E EBITDA Effectively connected income (ECI) Enron Equity ownership model Errors and omissions (E&O) insurance EU passport European Association for Investors in Non-listed Real Estate Vehicles (INREV) Exculpation and Indemnity Exception to History of Uses in private equity offering memoranda Exculpation See Exculpation and Indemnity Exogenous risks Expanded operational due diligence process See Operational due diligence Expert research networks F FAA System Safety Handbook Fair value See Valuation FAS 157 FASB ASC 820 Fat-tail risk Defined Relation to fraud detection Financial Accounting Standards Board (FASB) Financial Highlights Financial Institutions Reform, Recovery and Enforcement Act of 1989 Financial statements Audit standards Due diligence on Review of in core process Sections Firm and employee reputation Foreign Corrupt Practices Act Form ADV Form PF Fraud Applicable to exculpation and indemnity Benefits of case studies in Case studies in Detection of Investor recovery from Levels of Private equity fund failure considerations due to Fraud in fact See Fraud Fund Administrator See Administrator Fund advisory board See Advisory board Fund reporting G Galleon Group Geithner, Timothy General Counsel General Partner (GP) Defined Distinction in valuation approaches Relation to advisory boards Information flow with Limited Partners Generally Accepted Accounting Principles (GAAP) Convergence with IFRS U.S GAAP U.K GAAP Generally Accepted Auditing Standards (GAAS) Global Investment Performance Standards (GIPS) See Valuation Goldman Sachs Goldstein, Philip Graham v Allis-Chalmers Mfg Co Greenbury Committee Gross negligence Guernsey Guidelines for Disclosure and Transparency in Private Equity See Walker Guidelines H Hampel report Harvard Health care fund Hedge Clauses Hedge fund operational due diligence Differences with private equity operational due diligence Similarities with private equity operational due diligence Hedge fund Registration Rule Hedge Fund Transparency Act High Voltage Engineering Corporation Human capital Hybrid framework I ILPA See Institutional LPs Association (ILPA) Guidelines In pari delicto Indemnity See Exculpation and Indemnity India private equity funds Industry specific risks Information barrier Information security Information silo Information technology (IT) See Technology and systems Information technology consultants Informed operational opinion formation Institutional LPs Association (ILPA) Guidelines Insurance coverage International Auditing Standards (ISA) International Business Machines (IBM) International Financial Reporting Standards (IFRS) International Private Equity and Venture Capital Valuation (IPEV) Guidelines Discount cash flows or earnings (of underlying business) approach Discounted cash flows (from the investment) Industry valuation benchmarks approach Multiple valuation methodology Net assets approach Price of recent investment approach International Standard of Assurance Engagements (ISAE) 3402 Interval funds Investment Adviser Investment Advisers Act of 1940 Investment decision making authority model Investment due diligence Comparison to operational due diligence Defined In shared due diligence framework Integration with operational due diligence Process timing Relation to fraud detection Resource allocation versus operational due diligence Role in private equity decision-making process Stages of analysis ISDA Isle of Man J Jersey Jurisdictional risks J.P Morgan Junk bonds K K1 Group Key person clause Key person insurance Keynes, John Maynard See Keynesian economics Keynesian economics Kiener, Helmut KKR Klomp, Danny L Lamfalussy procedure Lascaux Cave Legal and compliance risks Legal counsel Legal documentation review See Legal due diligence Legal due diligence Lesson, Nick Leveraged buyout (LBO) LBO funds RJR Nabisco takeover Levine, Dennis Liability releases Liechtenstein Limited liability company Limited Partner Defined Distinction in valuation approaches Serving on Advisory boards Information flow with General Partner Fund of funds due diligence considerations Litigation support Lockup Luxembourg M Madoff Effect Madoff, Bernard Malfeasance Malta Manager See Investment adviser Markets in Financial Instruments Directive (“MiFID”) Material nonpublic information Mezzanine financing funds Minimum operational risk regime (MORR) MIT Modular framework Moral fraud See Fraud Mortgage fraud Müntefering, Franz N Nadel, Arthur National Commission on Fraudulent Financial Reporting Negative operational due diligence See On-site visits Netscape No-fault divorce provision Nondisclosure agreement (NDA) Noninvestment risk See Operational risk O Offering memorandum (OM) See Private placement memorandum Offshore block corporation Offshore jurisdictions Onshore versus offshore considerations in legal document analysis Private equity fund managers choice of Service providers location in Tax policy Ongoing monitoring On-site visits Documentation for litigation support Interview techniques and question design Negative operational due diligence Private equity fund manager considerations Underlying private equity portfolio companies Onyx Capital Advisors Operational Benchmarking Operational Drag Operational due diligence Arguments in favor of performing on private equity Below-core process Compared to operational risk Contrasted with an insurance policy Core process Defined Distinguished from operational management Document collection Expanded process Filtering stages Five-stage process Frameworks Lack of universal definition Private equity program design Process goals Process timing Resource allocation Time versus resource allocation Trends in Understanding time allocation to Universal definition Versus operational risk Operational due diligence consulting firm See Corgentum Consulting Operational fringe Operational Lift Operational Lift-to-Drag ratio Operational risk Common private equity operational risk categories Compared to operational due diligence Defined Operational risk plane Risk commonalities between private equity and real estate Risk differences between private equity and real estate Operational risk consulting firm See Corgentum Consulting Operational risk management (ORM) See Operational risk Operations risk See Operational risk Opinion letter See Financial statements Ops dd See Operational due diligence Orecchio, John Organizational risk See Operational risk P Palminvest Pang, Danny Paper Trail See Litigation support Pari Passu Pay-for-play See Pay-to-play Pay-to-play PEMGroup Fraud Performance vesting See Compensation structures Personnel and employee turnover Petco Petters Group Worldwide Petters, Tom Philips Pension fund fraud Picasso, Pablo Piñata problem PIPE transactions Ponzi scheme Ponzimonium Portfolio companies Positive fraud See Fraud Private Equity Private equity fund of funds Private placement memorandum (PPM) Process homogeneity Public Company Accounting Reform and Investor Protection Act of 2002 See Sarbanes-Oxley Act Q Quaker Oats R R Allen Stanford Rajaratnam, Raj Real estate Distinguished from private equity Feasibility study Fund fees Property management Risk commonalities with private equity Risk differences with private equity Sample process Technical due diligence Third-party developers Valuation Rebate See Sales charge Regional risk See Industry specific risks Regulatory risks Reputational risk See Firm and employee reputation Resource dilution RICS Valuation Standards Risk control model Rogue trader events Royal Brunei Airlines Sdn Bhd v Tan Royal Institution of Chartered Surveyors Rule 206(4)-2 See Custody Rule S Sales charge San Diego v Amaranth Sarbanes-Oxley Act (SOX) Savings and loans (S&Ls) Schedule of investments See Financial statements Scoop Management Securities and Exchange Commission (SEC) Service level agreement (SLA) Service providers SFAS 157 See FAS 157 Shared framework Side letters Signaling effect Silicon Valley Snapple Beverages Snowball Effect Standard Chartered Stanford Financial Group Statement of Assets and Liabilities See Financial statements Statement of Cash Flows See Financial statements Statement of Changes See Financial statements Statement of Financial Accounting Standards 157 See FAS 157 Statement of Operations See Financial statements Statement on Auditing Standards (SAS) No 70 Straw-man borrower T Tax haven Tax practices Technology and systems Third-party marketer Timber investment management organization (TIMO) Time vesting See Compensation structures Trade flow analysis Trade life cycle See Trade flow analysis Transcontinental Railroad in the United States Transparency and fund reporting Treadway Commission Tyco International U U.S GAAP See GAAP U.S Generally Accepted Auditing Standards (GAAS) See Generally Accepted Auditing Standards (GAAS) Ultra vires Uninterruptible power source (UPS) Unrelated business taxable income (UBTI) V Vaisey, Harry Sir Valuation Considerations for newly formed funds Consultants Distinction between fund and portfolio company level Fair value GIPS Statement of Private on Private Equity Real estate Review of in core process Third-party consultants Venture capital funds Vesting See Compensation structures Villalobos, Alfred Vintage fund Financial statement due diligence on Valuation considerations Side letter negotiation concerns Viscount of the Royal Court of Jersey v Shelton Voortman, Remco W Wagoner Doctrine Walker Guidelines Weather-related risks Willful default Willful fraud See Fraud Worldcom Y Yahoo! ... CHAPTER 1: Introduction to Private Equity Operational Risk INTRODUCTION TO OPERATIONAL RISK OPERATIONAL RISK COMPARED TO OPERATIONAL DUE DILIGENCE WHAT IS OPERATIONAL DUE DILIGENCE? OPERATIONAL DUE DILIGENCE IN THE FIELD OF... Library of Congress Cataloging-in-Publication Data: Scharfman, Jason A., 1978– Private equity operational due diligence : tools to evaluate liquidity, valuation, and documentation / Jason A Scharfman pages cm – (The Wiley finance series ; 731)... will refer to the management company of a private equity organization A private equity firm will typically manage several private equity funds Private equity fund The term private equity fund refers to a private equity investment