Contents

Cover

Series

TitlePage

Copyright

Dedication

Preface

CHAPTER1:IntroductiontoPrivateEquityOperationalRisk

INTRODUCTIONTOOPERATIONALRISKOPERATIONALRISKCOMPAREDTOOPERATIONALDUEDILIGENCEWHATISOPERATIONALDUEDILIGENCE?OPERATIONALDUEDILIGENCEINTHEFIELDOFPRIVATEEQUITYOPERATIONALDUEDILIGENCEASDISTINGUISHEDFROMOPERATIONALMANAGEMENTOFPORTFOLIOCOMPANIESTIMINGOFOPERATIONALDUEDILIGENCEINTHEINVESTINGPROCESSOPERATIONALDUEDILIGENCEPROCESSHISTORICALPERSPECTIVESOFPRIVATEEQUITY

OPERATIONALRISKITEMSTYPICALLYCOVEREDDURINGTHEOPERATIONALDUEDILIGENCEPROCESSCOREVERSUSEXPANDEDOPERATIONALDUEDILIGENCEREVIEWSSHAREDCOMMONALITIESBETWEENPRIVATEEQUITYANDREALESTATEOPERATIONSRISKDIFFERENCESINOPERATIONALRISKFACTORSBETWEENPRIVATEEQUITYANDREALESTATECOUNTRY-ANDINDUSTRY-SPECIFICRISKCONSIDERATIONSINVESTMENTANDOPERATIONALDUEDILIGENCE:NEXUSORBLURREDLINES?DIFFERENCESANDSIMILARITIESWITHHEDGEFUNDOPERATIONALDUEDILIGENCE

CHAPTER2:ImportanceofOperationalDueDiligenceforPrivateEquityFunds

UNDERSTANDINGTHEGOALSOFTHEOPERATIONALDUEDILIGENCEPROCESSCOMMONARGUMENTSAGAINSTOPERATIONALREVIEWSOFPRIVATEEQUITYFUNDSCOMMONARGUMENTSINFAVOROFPERFORMINGOPERATIONALREVIEWSOFPRIVATEEQUITYFUNDSCONCLUSION

CHAPTER3:BeginningtheOperationalDueDiligenceReview:CoreIssues

GOALSELF-ASSESSMENTDESIGNINGANOPERATIONALDUEDILIGENCEPROGRAMFORPRIVATEEQUITY

WHENDOESTHEOPERATIONALDUEDILIGENCEPROCESSBEGIN?SIGNALINGEFFECTSOFOPERATIONALFLAGSREQUESTINGANDCOLLECTINGDOCUMENTATIONNONDISCLOSUREANDCONFIDENTIALITYAGREEMENTSDOCUMENTCOLLECTION:WHATDOCUMENTSSHOULDINVESTORSREQUEST?DOCUMENTCOLLECTIONNEGOTIATIONTECHNIQUES:AVOIDINGAPASS-THE-BUCKENVIRONMENTDOCUMENTCOLLECTION:HARDCOPYORELECTRONIC?FUNDMANAGERON-SITEDUEDILIGENCECONSIDERATIONSKEYRISKCONSIDERATIONAREASTOCOVERCONCLUSION

CHAPTER4:AdditionalOperationalDueDiligenceConsiderations:AnExpandedAnalysis

COREISSUESVERSUSEXPANDEDANALYSISCOMPENSATIONSTRUCTURESINTRODUCTIONTOPRIVATEEQUITYFUNDFEESMANAGERINVESTMENTINFUNDSEVALUATINGSERVICEPROVIDERSADDITIONALON-SITEVISITCONSIDERATIONS:NEGATIVEOPERATIONALDUEDILIGENCEADDITIONALON-SITEVISITCONSIDERATIONS:INTERVIEWTECHNIQUESANDQUESTIONDESIGNASSETRAISINGANDTHEUSEOFPLACEMENTAGENTSANDTHIRD-PARTYMARKETERS

CASHMANAGEMENTANDCONTROLSBUSINESSCONTINUITYANDDISASTERRECOVERYUNDERSTANDINGTHETRADELIFECYCLEPROCESSLEGAL,COMPLIANCE,ANDREGULATORYRISKSINSURANCETECHNOLOGYANDSYSTEMSTAXPRACTICESDIAGNOSINGANDMITIGATINGREPUTATIONALRISKCONCLUSION

CHAPTER5:ValuationTechniques,Methodologies,andStandards

LIMITEDPARTNERDISTINCTIONBETWEENFUNDLEVELANDPORTFOLIOCOMPANYVALUATIONAPPROACHESVALUATIONCONSIDERATIONSFORNEWLYFORMEDFUNDSINTRODUCTIONTOVALUATIONGIPSSTATEMENTONPRIVATEEQUITYIPEVGUIDELINESFAS157USEOFTHIRD-PARTYVALUATIONCONSULTANTSVALUATIONOUTPUTPROCESSDOCUMENTATIONVALUATIONCOMMITTEEREVIEWSCOPEADDITIONALLIMITEDPARTNERVALUATIONCONSIDERATIONSCONCLUSION

CHAPTER6:LegalDueDiligenceOPERATIONALDUEDILIGENCESPECIALISTSVERSUSGENERALISTS

COMMONPRIVATEEQUITYFUNDSTRUCTURESUNDERSTANDINGTHEPRIVATEPLACEMENTMEMORANDUMCOMMONDOCUMENTRISKASSIGNMENTTERMSEXCULPATIONANDINDEMNITYTRENDSININDEMNIFICATIONANDEXCULPATIONCLAUSESOTHERLEGALDOCUMENTSCONSIDERATIONSCONCLUSION

CHAPTER7:FinancialStatementDueDiligenceAUDITSTANDARDSACCOUNTINGSTANDARDSOTHERFINANCIALSTATEMENTFORMATSCONSIDERATIONSTHATAREUNIQUETOPRIVATEEQUITYANDREALESTATEFINANCIALSTATEMENTSUNDERSTANDINGFINANCIALSTATEMENTSECTIONSOTHERFINANCIALSTATEMENTSECTIONSUNDERSTANDINGFAS157CONCLUSION

CHAPTER8:DistinguishingtheAssetsClass:RealEstate–SpecificConcerns

REALESTATETRADEFLOWPROCESSSAMPLEREALESTATEPROCESSREALESTATEVALUATIONMONITORINGCONFLICTSOFINTERESTFRAUDCONSIDERATIONS:MORTGAGEFRAUDANDSTRAW-MANBORROWERSUNDERSTANDINGREALESTATEFUNDFEESPROPERTYHOLDINGSLEGALCONSIDERATIONS

CONCLUSION

CHAPTER9:PuttingItAllTogether:AssetAllocationandOngoingMonitoring

INCORPORATINGTHERESULTSOFOPERATIONALDUEDILIGENCEINTOASSETALLOCATIONEVOLUTIONOFMINIMUMOPERATIONALRISKREGIME(MORR)OPERATIONALRISKCORRELATIONSTOPORTFOLIOTRANSACTIONFREQUENCYOPERATIONALLIFT-TO-DRAGRATIONEGOTIATINGPRIVATEEQUITYSIDELETTERSONGOINGMONITORING:OPERATIONALDUEDILIGENCEMONITORINGFORPRIVATEEQUITYFUNDSCONCLUSION

APPENDIX9A:MathematicalConceptsTHEDERIVATIVETHECHAINRULETHESECONDPARTIALDERIVATIVETEST

CHAPTER10:Boards,Committees,andActivismPRIVATEEQUITYFUNDADVISORYBOARDSDIFFERENTTYPESOFADVISORYBOARDS:LIMITEDPARTNERSVERSUSPUREADVISORSONGOINGOPERATIONALDUEDILIGENCEMONITORINGADVISORYBENEFITSBALANCINGTHEROLEOFINNERCIRCLEVERSUSBROADLYREPRESENTATIVEADVISORYBOARDSADVISORYBOARDCRITICISMS:CROWDINGOUT,

POWERAGGREGATION,ANDREDUNDANTBOARDLAYERSINFORMATIONFLOWCONSIDERATIONSFROMUNDERLYINGPORTFOLIOGENERALPARTNERTOLIMITEDPARTNERSLIMITEDPARTNERDUEDILIGENCECONSIDERATIONSFORAPRIVATEEQUITYFUNDOFFUNDSADDITIONALPRIVATEEQUITYADVISORYBOARDCONSIDERATIONSCONCLUSION

CHAPTER11:CaseStudiesandScenariosCASESTUDIESHYPOTHETICALSCENARIOS

CHAPTER12:TrendsandFutureDevelopmentsUSEOFTHIRD-PARTYADMINISTRATORSINCREASEDFOCUSONMATERIALNONPUBLICINFORMATIONINTHEUNITEDSTATESINCREASEDRELIANCEONAUDIT-TYPECERTIFICATIONSINCREASEDUSEOFOPERATIONALDUEDILIGENCECONSULTANTSPOOLINGOPERATIONALDUEDILIGENCERESOURCESAMONGMULTIPLELPSOPERATIONALBENCHMARKINGILPAGUIDELINESFROMSELF-REGULATIONTOMANDATORYREGISTRATIONIMPACTOFDODD-FRANKONOPERATIONALDUE

DILIGENCECONCLUSION

AbouttheAuthor

AbouttheWebsite

Index

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Preface

People tend tonot takeoperationalduediligence in the fieldofprivate equityvery seriously.The risk category that operational due diligence is supposed toevaluate—operationalrisk—isnotasnarrowlydefinedasotherrelatedtypesofrisks, such as credit risk, counterparty risk, currency risk, and so forth.Depending on the context, the implications of the term operational risk canchange. In part, the broadness of the field and subsequent confusion aboutexactly what is meant when discussing operational risk and operational duediligencearelikelycontributingfactorstothelackofattentionpaidtothisriskcategory.Whenaninvestorfirstdecidestotaketheplungeintoprivateequityinvesting,

itisoftenananticlimacticchoice.Insomecases,hundredsofmillionsofdollarsarecommittedbyinstitutionalLimitedPartners(LPs)toprivateequityfunds,butthe money may not generate returns for years. Yet, with such a long-termcommitment of capital into a traditionally illiquid and complex asset class, itwouldseemonly logical thatLPswouldseek toperformat leastas rigorousaduediligence analysis on aprivate equity fund as theyperformonother assetclasses, such as hedge funds. In investing arenas outside of private equity,operational duediligencehas slowlygained acceptanceover theyears.Withinthealternativeinvestmentarenaingeneralandhedgefundsinparticular,akeydriver of increased focus is the losses that have been caused by fraudulentactivity, which in turn was facilitated by weak operations. In recent memory,investors have seen a number of headlines and articles about the hundreds ofmillions in losses associated with names such as Bernard Madoff, R. AllenStanford, Jerome Kerviel, Tom Petters, and Samuel Israel III, which help toexplainthemeteoricriseininterestinoperationalduediligenceinthealternativespace. Even as this book is being written, alleged UBS rogue trader KewkuAdobolihasbeenchargedwith fraud that resulted ina lossofover$2billion.Because of a series of similar private equity frauds, LPs and, howeverbegrudgingly,GeneralPartners(GPs)havebeguntorespecttheneedforprivateequityoperationalduediligence.Butoperationalduediligenceinvolvesagreatdealmorethanfrauddetection.

Sometimes honest GPs and LPs simply do not have the requisite skills,resources, or foresight to avoid underperformance or losses due primarily to

operational concerns.Properoperational riskmanagementwithina fund isnotsimply a matter of throwing experience or money at the problem. Rather,operational risk evolves within a fund organization over time. To effectivelymanageitsowninternaloperationalriskexposure,afund'smanagementmustbeactively involved in all aspects of operations oversight.At different times andduring different types of market events, private equity funds may reactdifferentlyandtheensuingconsequencesmaynotbeuniformfor their internalfundoperations.Operationalduediligenceisanongoingdiagnosticprocess.Muchlikeprivate

equity investing itself, however, operational due diligence on private equityinvestmentsrequiresameasureddoseofpatience.Duediligencecanbemoreartthan science, and a thorough analysiswill allow investors to detect funds thatwillhaveanincreasedlikelihoodforunderperformanceorforfailureintheeventofunexpectedstresses.This book seeks to accomplish several goals, but in particular the author

wishes to convince LPs of the benefits of designing, performing, andmaintainingarobustoperationalduediligenceprogramforprivateequityfunds.Tosupportthiscause,Ihaveoutlinedabriefhistoryofoperationalriskcoupledwithanintroductiontotheuniqueaspectsofoperationalduediligenceonprivateequityfunds.The second aim of this book is to provide LPs with the tools necessary to

execute detailed comprehensive operational due diligence reviews of privateequity funds. To accomplish this, I have outlined the elements of core andexpanded operational due diligence reviews. I have provided comprehensivechapters dedicated to analyzing approaches to valuation, legal, and financialstatementrisks.InChaptersandyouwillseearedflagicon(liketheonesetnexttothisparagraph)thatindicateskeyoperationalriskareasinwhichdeficiencieshavehistoricallytendedtosignallargerproblems.

Ialsoofferasummaryofhistoricalprivateequityfraudsandhypotheticalcasestudies to familiarize LPs with the scenarios they may encounter whenperformingoperationalduediligence.ThisdiscussionalsoincludesareviewofthekeyconsiderationsLPsshouldtakeintoaccountwhenreviewingrealestatefunds.Additionally, this book seeks to broaden the discussion surrounding

operationalriskassessmentinprivateequityfundsbeyondthenotionsof“pass”or “fail.”To accomplish this, I haveprovided an introduction to incorporatingtheresultsofoperationalduediligencereviewsintotheassetallocationprocess.This book also includes discussions regarding ongoing operationalmonitoringtechniquesandtheroleofadvisoryboardsinduediligence.Finally, one of the other goals of this book is to foster an increased

understandingamonginvestorsintheprivateequitycommunityabouttherightsof LPs to perform comprehensive operational due diligence reviews and thewaysinwhichGPsapproachoperationalriskmanagement.Itislikelythattherewill be readers who disagree with some of the opinions and conclusionspresented in this book. Debates are welcomed, and I encourage all thoseinterested in private equity to throw their hats into the arena, to join in anddiscusstheissuesandenhancethelargercommunity'sunderstandingandfocusinthefieldofoperationalrisk.A detailed, comprehensive operational due diligence program for private

equityfundsrequirestime,resources,andskilltodevelopandrefineovertime.The benefits of implementing such a programwith discipline, uniformity, andcautionarethatitwillallowLimitedPartnerstoweedoutmanagerswithweakeroperations, make investment decisions with stronger convictions, facilitateongoingmonitoring,andavoidlossesassociatedwithoperationalrisks.ItismyhopethatthetechniquesandadviceinthisbookaretakenupbyLPsandmorerisk-consciousGPs.PerhapsBenFranklin'ssayingbestsumsuptheimportanceofoperationalduediligence in the illiquid,complex,andoftenopaquefieldofprivateequityinvesting:“Anounceofpreventionisworthapoundofcure.”

JASONSCHARFMANMarch2012

CHAPTER1

IntroductiontoPrivateEquityOperationalRisk

Private equity investing is a unique asset class that can offer a number ofattractivebenefitstoinvestors.Comparedtomoretraditionalinvestments,someofthebenefitsassociatedwithprivateequityinvestingcanincludetheabilitytofocus on long-term capital growth with higher uncorrelated returns. Despitethesebenefits,asisthecasewithanyassetclass,privateequityinvestingisalsofraught with a number of unique risk sets and challenges that investors mustconsider. These risks can include traditional investment-related risks such asstyledrift,excessiverisktaking,andoverallpoorperformance.Wheninvestinginprivateequity,investorsarealsoexposedtoaseriesofwhatmaybethoughtofas risks thatarenotpurely related to investments.These riskshavebecomecommonly grouped together under themoniker of operational risks. Butwhatexactlyisthismysteriousriskcategoryknownasoperationalrisk?

INTRODUCTIONTOOPERATIONALRISK

Noninvestment-relatedriskscanbeoftengroupedintodifferentcategoriesduetocertain shared similarities. These noninvestment risks also go bymany namesdepending on with whom you are speaking. Some may refer to thesenoninvestmentrelatedrisksasfat-tailrisks.Thetermfat-tailrisksisusedduetothe severe effects that these risk may have, coupled with the perceivedinfrequencywithwhich theyactuallycausedamage.Othersmayuse the termsbusinessriskororganizationalrisk.Thetermthatmostindividualswhofocusonanalyzing and monitoring these risks have settled on in recent years isoperationalrisk.The concept of operational risk is not unique to theworld of private equity.

Indeed, it is not even unique to assetmanagement or the financial industry in

general. Concerns related to risk management falling under the heading ofoperational risk are present across a number of industries that have nothingwhatsoever todowiththebusinessof investingormanagingmoney.TheFAASystemSafetyHandbookforpilotshasasectiondedicatedtoOperationalRiskManagement (ORM) and defines the goals of ORM as “protecting people,equipment,andotherresources,whilemakingthemosteffectiveuseofthem.”1

In the medical field, surgeons have procedures in place to mitigate literaloperational risk, to prevent mistakes such as wrong-side surgery whenconductingactualoperationsonpatients.2

Withsuchawell-developedfieldspanningmultipledisciplines,whyinrecentyearshas therebeena flurryof interest ina subject that is supposedlysowellfleshedout?Afterall,withalargebodyofresearchonoperationalriskinotherfields not related to assetmanagement or private equity, could a discussionofoperational risk and due diligence in a private equity context actually yieldanything new? While the field of private equity investing has continued toincreaseincomplexityandspecialization,theissuesofoperationalriskandduediligence areas applicable to private equity as they are in other fields. Thisambivalentsituationcanperhapsbebestsummedupbyacomment thatPabloPicassoisrumoredtohavemadefollowingaviewingatLascauxCaveofsomeof the earliest prehistoric cave paintings ever discovered: “We have inventednothing.”Regardlessofthefieldorcontextinwhichoperationalriskisbeingdiscussed,

oftentimesitseemsbothpractitionersandacademicsalikehaveadifficulttimepinningdownanappropriatedefinitionofthisbroadtopic.Partofthisproblemperhaps stems from the typically broad number of topics and disciplines thatoperational risk generally encompasses. Within the financial and specificallyasset management world, defining operational risk is often a contentiousexerciseatbest.Indeed,asChapter2discussesinmoredepth,manyintheassetmanagementworldandprivateequitycommunities inparticular,maynotevenseearealneedtodevotematerialresourcestowardanalyzingoperationalriskinprivateequityfunds.Indeed,whybotherattemptingtodevelopadefinitionofsomethingifthereis

acommonlyheldbeliefthattheverythingattemptingtobedefinedisnotitselfofanyconsequence?Statedplainly,asthereadermaybeabletogatherfromthetitleof thisbook,operationalrisknotonlymattersbutshouldbeofparamountimportance to any investor evenconsidering investing inprivate equity.Asanaside, for those in the private equity community who may disagree with this

statement, I invite them to read this book, fully consider the benefits ofdevelopingaprivateequityoperationalriskassessmentprogramandultimatelythink aboutwhether or not theywould findmaking amore informeddecision(e.g.,adecisionbasedonanunderstandingofnotonlytheinvestmentrisksofaparticularprivateequityinvestment,buttheoperationalrisksaswell) tobethemostprudentcoursebywhichtoproceed.Ultimately,more informedinvestorstend to make better investment decisions and realize fewer losses due tooperationalrisks.Withintheprivateequityworld, thereareanynumberoffactorsthatcanfall

intothecategoryofoperationalrisks.CommonoperationalrisksareoutlinedinExhibit1.1.

EXHIBIT1.1CommonPrivateEquityOperationalRiskCategoriesRiskCategory

Cashcontrols

Tradelifecycleprocessing

Valuation

Transparencyandfundreporting

Liquiditymanagement

Technologyandsystems

Legalandcompliance

Counterpartyoversight

Qualityandrolesofserviceproviders

Businesscontinuityanddisasterrecovery

The list of common private equity operational risks in Exhibit 1.1 are thegeneralrisksthatcometomostindividuals’mindswhentheyfirsthearthetermoperationalrisk. As this chapter discusses inmore detail, the operational riskcategorylacksatrueuniversaldefinition.Withintheprivateequityworld,thereis no operational risk rule book. Furthermore, no private equity legislation,regulatoryguidance,orotherlawsdescribewhatfallsunderthetermoperationalriskanditisthereforeusuallydefinedbywhatiscoveredbytheoperationalduediligenceprocess.Assuch, inaprivateequitycontext,operationalrisk isverymuchatermwhosedefinitionisdrivenbythemarket.Investors,fundmanagers,andprivateequityserviceprovidersalikeareeffectivelylefttotheirowndevicesin some regards to come to termswith this concept.That being said there arecertainriskfactors,asdiscussedthroughoutthisbook,whichmostintheprivateequitycommunitywouldgroupintothecategoryofoperationalrisk.It isuponthisfoundationthatwewillbegintoplacethebuildingblocksofthediscussion

oftheoperationalduediligenceprocess.

OPERATIONALRISKCOMPAREDTOOPERATIONALDUEDILIGENCE

Nowthatwehaveintroducedabasicunderstandingofwhatiscommonlymeantby operational risk we can next focus on operational due diligence. The twoterms are occasionally used synonymously in practice; however, there is adistinction between the two. The term operational due diligence is correctlyutilized when employed to refer to the processes of gathering data about aparticularprivateequityfund.Thetypeofdatacollectedduringtheoperationalduediligenceprocessisoperationalriskdata.Afterthisdatahasbeencollectedduring the operational due diligence process, an investor then can perform ananalysisofthisdatatocometoadeterminationastotheamountofoperationalriskpresentataparticularprivateequityfund.Thisanalysisstage,ascomparedto the data collection stage, is also typically considered to be a part of theoperationalduediligenceprocess.Operationalduediligencecanbethoughtofastheprocessofperformingdue

diligence on these operational risks. But this definition does not really tell usmuch. So,what exactly do those in the private equity communitymeanwhentheyrefertooperationalriskandoperationalduediligence?

WHATISOPERATIONALDUEDILIGENCE?

Withthebasicunderstandingnowinplacewecannowbegintothinkaboutwhatexactlyoperationalduediligenceactuallyentailswithinaprivateequitycontext.Operational due diligence is a peculiar subject. Indeed the acronym that iscommonlyusedintheindustryis“ODD,”althoughthisbookwilluse“opsdd.”Many investors and fund managers may have a general idea about whatoperational due diligence encompasses. Some investors may even thinkoperationalduediligencetobelimitedtotheseeminglyeasy-to-diagnoseareassuchasposttradeanalysisandotherback-officeprocesses.Anysuchriskswouldcertainlybeobvioustodetectforanyonewhodevotedthetimetotakealook—they are hiding in plain sight. While these statements are certainly

overgeneralizations, they definitely contribute to the understanding of whatencompassesoperationalduediligence.What is lessobviousperhaps is thatwhileeach individual's exactnotionsof

whatismeantbyoperationalduediligencemayvary,therangeofvariationscanbe quite wide. This is one of the reasons why operational due diligence is amultifaceted and fairly deep field of due diligence and lacks one universaldefinitionthatwouldsumupalloftheseaspectsintooneuniquepackage.Thelack of a universal definition is brought evenmore into focus in the complexworkofalternativeinvestments.Underthebroadumbrellacategoryofalternativeinvestments,itisevenmore

difficult for investors and fund managers to explain how operational duediligence processes may vary among different types of investments such ashedgefundsandprivateequityinvesting.Itisthelattercategory,privateequity,uponwhich this bookwill focus.By introducing the various related concepts,duediligencetechniquesandapproaches,aswellastrendsinthisfield,thisbookattempts to provide guidance toward fostering amore complete understandingfor the parties involved in private equity investing, including investors, fundmanagers, and private equity service providers of what the field of a robustoperational due diligence program entails. Perhaps this will foster a moreuniversal definition of the term among members of the private equitycommunity.Butperhapswearegettingaheadofourselves.Asintimatedearlier,theworld

ofprivateequityisacategoryofalternativeinvestinguniqueuntoitself,repletewith its own series of challenges and opportunities. This uniqueness and thegeneralways inwhich investors and fundmanagersmayhave approached theconcept in the past have developed into a situation in which, among mostindividuals in the private equity community, operational due diligence in theprivateequityworldtendstobeanamorphousconcept.

FocusonFraudDetectionWhenmanyprivateequityinvestorsfirsthearthetermoperationalduediligence,they may immediately begin to focus on fraud detection. Indeed, when firstbeginning to think about the subject of items that may influence the ultimateinvestment decision other than purely investment-related concerns, there is astrong temptation for investors to focus on concerns related to fraud in themanagement of a private equity fund. Certainly, this is understandable for

severalreasons.Duetothefat-tailedrisksassociatedwithfrauditiscertainlyreasonable,and

from a pragmatic standpoint logically prudent, that due diligence surroundingpotentialissuesoffraudshouldbeofpenultimateconcernduringeverystageoftheentireduediligenceprocess.Privateequityinvestorslogicallywanttoavoidall losses,but lossesduetofraudcanleaveaparticularstingandanypotentialrecoveryfromsuchlossesisoftenastickybusiness.Whenanassetmanagementfraud occurs it can generally lead to total losseswith little hope for recovery.Indeedifrecoverybydefraudedinvestorsdoesoccuritisoftenonlyafteralongextended process steeped in legal costs. Moreover, any recovery processtypicallyonlyresultsinpartialrecoverybecausethecapital“pie”tobedivideddoesnotmeettheneedsofallinvestors.Ofcourse,therearerareexceptionsinwhichinvestorsrecouptheentireamountoftheirinitialinvestment.Additionally,inthewakeofaseriesoffrauds,Ponzischemes,andthelike,in

thealternativeinvestmentarenaconcernsrelatedtofraudarestillattherelativeforefront of the general investment collective consciousness. Furthermore,regardlessofwhetheraprivateequityfundmanagerhasa longtrackrecordofstellar performance, coupled with experienced well credentialed professionalsand a highly compelling investment thesis for a fund—if the entire thing is afraud—noneoftheotherduediligencethatmayhavebeenperformedregardingthe merits of the investment strategy (i.e., investment due diligence) and thequalityofthemanagers’reputation(i.e.,reputationalduediligence)mattersverymuch.In the context of fraud detection, the distinction matters little whether an

investor is performing investment due diligence, operational due diligence, oranyothersubcategoryofthetwo.Statedplainly,iftheduediligenceprocessfailstodetectfraud,ithasfailed.Nowof course there aredifferent levelsof fraud.There is the complete and

totalfraudoftenemployedunderthemodelofthePonzischeme(e.g.,Madoff)and then there are other types of fraud that may not be so apparent or socompletely ruinous toanorganization (e.g., aprivateequitymanagerclaimingthattheyhave80percentoftheportfolioindependentlyvaluedwheninactualityitismorelike70percent).Inthelatterexample,thefraudmaynotresultinanylossesatall,however,theprivateequityfundmanagerisstillcommittingafraudin thebroadestsenseof thewordbymisrepresenting the truthof the factsandcircumstances relevant to their particular organization. So if a due diligenceprocessfailstodetectthese“whitelie”lesserfrauds,hasitfailed?

Itwouldbeeasyperhapstogiveintothetemptationtostate,quitedirectly,yes.However, this seeks to impose black-letter bright-line pedagogy on amutablesubjectmatter.Infact,oneapproachtowardreachingananswertothisquestionrelates to issuesof theweightswithwhichaparticularareasof theunderlyingitems queried by the due diligence process both matter to an investor anddirectly relate to the potential severity with which overlooking such an itemcouldcreatelossesorfutureliabilities(i.e.,clawback)forinvestorsviafraud.So,forexample, theremaybelittlepotentialfor investor lossesduetofraud

solely related to the fact that a private equity firmmayclaim touse themorewell respected, and expensive, FundAccounting SystemAwhile in fact theyutilizethecheaperandlessrobustFundAccountingSystemB.Certainlythisisan important misrepresentation that would raise red flags, lead investors toconsiderwhatelseafundmanagermaybelyingabout,andultimatelyaffectaninvestor'sdeterminationwhetherornottoinvestwithaparticularprivateequitymanager.However,iftheprivateequitymanagerutilizestheaccountingsysteminonlya limitedcapacityandaccomplishesall thenecessaryaccounting taskswithFundAccountingSystemB,thenthepotentialfordirectinvestorlossesduetofraud(i.e.,perhapsthatthefund'saccountswerenotproperlymaintained)isminimal as related to the fund manager's misrepresentation of accountingsystemsutilized.Therefore, in theoverall schemeof things certain instancesof fraudmaybe

more or less deadly to a particular investor in terms of their ultimateconsequences to generate losses. However, the opportunity for fraud is stillprevalent throughoutmultipleareasofaprivateequityorganizationatboththemanagementcompanyandfundlevel.Assuch,investors’sometimesseeminglyzealous focus on fraud detection and prevention is certainly reasonable. Fraudconcerns however, should not overshadow other goals of the operational duediligenceprocess.Afterall,anorganizationcanberunwiththebestofintentionsinanonfraudulentmannerbut still be a completeoperationaldisaster. In suchcases, whether a private equity fund fails due to fraud or a weak operationalinfrastructure,regardlessofthepotentialrecoveryoptionswhenafraudoccurs,bothsituationshavethesameinitialdestructiveeffects.

UniversalDefinitionofOperationalDueDiligenceDependingonwhoyoutalktoandwhattheirgeneralroleis(e.g.,investor,fundmanager, fund operations personnel, service provider, etc.), you will likely

receiveamultitudeofanswerstoquestionsregardingthemeaningofoperationalduediligence.Fromtheinvestor'sperspective,theauthorhasheardtheheadofan alternative investment allocation platform describing the work of theiroperational due diligence team along the following lines, “Sure we docomprehensivework.Theseoperationalduediligenceguysgoinandmakesurethat the fundmanagerdoesn'thave twodifferentdriver's licensesorhasneverspenttimeinjail.”Ifyoutalktosomeonewithanaccountingbackgroundtheymayinterpretthe

termliterallytomeanduediligenceontheoperationalaspectsofafirm,suchastheback-officeaccountingwork.Theywouldbecorrect.Others,asourexampleillustrates,mayconsideroperationalduediligence toconsistoffrauddetectionand background investigations (e.g., making sure that their private equitymanagerisnotthenextBernardMadoff).They,too,wouldbecorrect.Otherswith a focus on controlsmight describe operational due diligence as

focusingontheflowofcashthroughoutanorganization.Still othersmight describeoperational duediligence asmaking sure that the

fundmanagerisproperlyvaluingsecuritiesandnotstealingfromthefirm.Stillothersmayconsideroperationalduediligencetobealloftheleftoversfromtherest of investmentduediligenceprocess (e.g., things that don't quite fit neatlyinto the parts of due diligence that are used to determine the merits of aparticular private equity fund andwhether it will be profitable or not). Theseopinionsare alsocorrect.Wecouldgoonwith this listbutbynow the readershouldhave the idea thatoperationalduediligence isviewedby some tobeacatch-allhodgepodgeofdifferentdisciplinesandsubjectscobbledtogetherintoadevelopingfieldwithitsownuniquemoniker.

CoreOperationalDueDiligenceProcessFunctionalityWithin this potpourri of concepts and terminology, as with all areas of duediligence, be they operational investment or otherwise, are a series of basicprocesses,techniques,andriskfactorsthatcanbefound.Itistheseareasthatarethecoreofoperationalduediligence,andshouldbethebedrockuponwhichalargerdueoperationaldiligenceprocessisfounded.AsoutlinedinExhibit1.2,by diagnosing, analyzing, and monitoring operational risk in private equityinvestments,investorscanfosteradeeperunderstandingofanyoperationalriskexposures,mitigate those exposures, and avoid taking unnecessary operationalriskswheninvestinginprivateequity.

EXHIBIT1.2FunctionsofaCoreOperationalDueDiligenceProcess

OPERATIONALDUEDILIGENCEINTHEFIELDOFPRIVATEEQUITY

Manyinvestorswillnotbedirectlymanagingtheirownprivateequityfundsbutinstead entrusting capital to a third party to manage on their behalf in acommingledinvestmentvehiclealsoknownasaprivateequityfund.Thereareseveralcategoriesofprivateequityfundstrategiesincluding:

Venturecapital(VC)fundsLeveragedbuyout(LBO)fundsMezzaninefinancingfundsDistresseddebtinvestingfundsCrossoverfundsPIPEtransactionsIntervalfundsRealestatefunds

In addition to these strategies there also exist private equity fund of funds,

whichareprivateequityfundsthat investwithotherprivateequityfunds.Thisbookwillprovideanoverviewofthegeneraluniversalelementsofoperationaldue diligence for private equity funds in general and will also pay particularattentiontocertainofthespecificrisksassociatedwithdifferentclassesoffundsjust referenced including real estate funds.With anunderstandingof thebasiclandscape of private equity fund strategies,we can begin to discuss in greaterdetailtheinvestor'sroleintheprivateequityprocess.Tobeginwith,despiteallof thebenefits thataninvestment inprivateequity

fundsmayoffer,theassetclassdoeshaveitsdetractors.Itisanassetclassthathas been referred to as having “lottery-like characteristics.”3 Private equitygroupshavebeencalled“amoralassetstrippers”and“casinocapitalists.”4FranzMüntefering,formervice-chancellorofGermany,referredtoprivateequityfirmsas“Heuschrecke,”orlocusts,andwentsofarastopublishaso-calledlocustlistthatincludedsuchfirmsasCarlyle,GoldmanSachs,KKR,andDeutscheBank.5Othershavereferredtoprivateequityinvestorsasvulturesorbuzzards.6Groupssuch as the Service Employees International Union have criticized the taxadvantagesenjoyedbymanyprivateequityfirmsascomparedtotheemployeesoftheportfoliocompaniesthattheymanage.7

Puttingtherhetoricaside,privateequitycanindeedbeclassifiedasoneofthealternative investment asset classes inwhichmanager selectionplays themostcrucial role in all asset classes.8 Therefore, one of the key considerations inassessingthepotentialbenefitsandrisksthatwillbefactoredintoaninvestor'sdecisionmakingprocesstoinvestinprivateequitywillnotonlyberelatedtothescopeoftheunderlyinginvestmentsand/orportfoliocompaniesthatwillbeheldin theprivateequity fund,butalso to thecompetency, skill, andqualityof theoperationalinfrastructureoftheprivateequityfundmanagerthemselves.

OPERATIONALDUEDILIGENCEASDISTINGUISHEDFROMOPERATIONAL

MANAGEMENTOFPORTFOLIOCOMPANIES

As is the case in many disciplines and particularly in finance, the terms andconceptsassociatedwithoperationalriskandoperationalduediligencecanhavemorethanoneinterpretation,particularlyinaprivateequitycontext.Assuchit

is important to clarify the specific context within private equity in which thetermisbeingusedhere.Forthepurposesofthisbook,operationalduediligencerefers to the due diligence on operational risks that investorswill perform onprivateequityfunds.This is to be distinguished from any operational planning or management

assessment that a private equity fund manager would perform on underlyingportfolio investment companies.Whilemany of the core operational conceptsand techniques thatwill bediscussed in thisbookare certainly relevant, thosetypes of operational reviews fall more into the context of investmentmanagement than theywould operational due diligence and are therefore bestleftforothertextsfocusedmoreexclusivelyonsuchsubject.Beforeweproceed,sothatallreadersareonthesamepageitisworthpausing

foramomenttodefinesomebasicterminologythatwillbeusedthroughoutthisbook:

Privateequityfirm.Forthepurposesofthistext,aprivateequityfirmwillrefertothemanagementcompanyofaprivateequityorganization.A private equity firm will typically manage several private equityfunds.Privateequityfund.The termprivateequity fund refers to aprivateequity investment vehicle that adheres to a particular strategy. Aparticularprivateequity fundmaybeoffered inavarietyofdifferentinvestmentvehicleformatssothatinvestorsfromdifferentjurisdictionscan invest in a particular investment strategy. Motivations for suchdifferent investment vehicles can include jurisdictional and taxconcerns.GeneralPartnerorGP.Thegeneralpartner,commonlyreferredtoasaGP, is themanagingpartnerofaprivateequitycompany.ToclarifytheGeneralPartnerisnottypicallyasingleindividualbutratheralegalentitythatisorganizedbytheprivateequityfirm'sprincipalstooverseethemanagementofaprivateequityfund.Theseentitiesarecommonlyorganizedasalimitedliabilitycompanies.ManagerorInvestmentAdviser.Inmanycases,aprivateequityfundwill have an intermediary level entity known as the Manager orInvestmentAdvisor between the general partner and investors,whichtechnically may serve as the manager of a particular private equityfund.

Limited Partners or LPs. Investors in a private equity fund arecommonly referred to as Limited Partners or LPs. This term comesfrom the fact thatmanyprivate equity funds areorganizedas limitedpartnershipsand,therefore,theinvestorsthatsubscribe(i.e.,invest)inthosefundsarelimitedpartners.

TIMINGOFOPERATIONALDUEDILIGENCEINTHEINVESTING

PROCESSDuringtheinitialprivateequityfundassessmentprocessinvestorsarefacedbyaseries of due diligence challenges. These challenges often broach the duediligence process first with investment considerations, which are thensubsequentlyfollowedbyvariousstagesofbothinvestmentandoperationalduediligence.Exhibit1.3providesanoutlineofatypicaldecision-treeprocessthatmay be followed by investors as they progress from first considering aninvestmentinprivateequitydownthroughtotheactualduediligenceprocessesthatsuchaninvestmentmayentail.

EXHIBIT1.3TypicalPrivateEquityDecision-MakingProcess

TheprocessshowninExhibit1.3isbynomeanssetinstone.Aninvestormaybegin the operational due diligence process in parallel with the investmentprocess. In certain cases, in much the same way that an investor may havecertainminimumcriteriaregardingtheinvestmentmeritsofaparticularprivateequitymanagerorfund,sotoomaysimilaroperationalrequirementsbeinplace.Inthesecases,inordertopreventaninvestorfromunnecessarilyexpendingthenecessarytimeandresourcesrequiredtoperformafulloperationalduediligenceprocessonaparticularmanager, an investormayattempt toperforman initialoperational screening,or smell test, as itmaysometimesbecalled, inorder toevaluatewhethertheprivateequityfundormanagershouldbediscardedoutofhand, based on a preliminary failure to adhere to an investor's minimumoperationalrequirements.

EXHIBIT1.4InvestmentandOperationalFilteringStagesinPrivateEquityDecision-MakingProcess

Anexampleofsucharequirementmightbethataninvestormay,aseitherafunction of their own internal policies or perhaps on a case-by-case basis asdetermined by the sector of the particular market a private equity fund isanticipatedtobeactivein,determinethatasaminimumoperationalrequirementtheinvestorwillnotallocatecapitaltoaprivateequityfundthatisnotassociatedwithafirmthathasmanagedcapitalbefore.Fornonprivateequityfirms,suchaminimumoperationalrequirementcouldbeperhapsequatedtothepresenceofaminimumtrackrecordthat ismaintainedforanumberofyears.Arequirementthatwouldbetypicalforahedgefund,forexample,isathree-yeartrackrecord.Returning toprivate equity, anotheroperational requirement couldbepreviousexperience in managing funds in a particular sector. To illustrate, an investormaycomeacrossaprivateequityfundthathastraditionallyinvestedinhealth-care(pharmaceutical)fundsandthenlaunchesafundfocusedoninfrastructureortechnology-basedsectors.Whilethetechnology-basedsectormayindeedberelatedtohealthcare,such

as a private equity fund that invests in medical device companies fueled bytechnologicalinnovations,theoriginalfundinourexampleinvestedprimarilyinpharmaceuticals and an investormay consider these two funds to be differentenough that the technology-based sector fund would not pass the minimumscreening requirements. As such, if these initial screens or filters are not

successfullymetby the funds then, regardlessof the results of the subsequentoperationalduediligenceprocessandanyoperationalrisksorstrengthsdetected,the fund has effectively been doomed to fail before the process even startedbecause it has been determined by the investor that such a fund will not besuitable.Exhibit1.4outlinesatypicalprocessemployingtheseinitialinvestmentand operational screens,whichmust be passed before proceeding through theremainingduediligenceprocessflow.

EXHIBIT1.5StagesofAnalysisinInvestorPrivateEquityDueDiligenceProcess

OPERATIONALDUEDILIGENCEPROCESS

Once an investor has moved through the initial fund screening and selectionprocesses,itistimetobegintheoperationalduediligenceprocess.Thisprocess,

towhich thebulkof this text isdevoted,will focusonperformingoperationalduediligenceonaparticularprivateequityfundanditsaffiliatedentities,suchasamanagementcompany.This is incontrast to themoregeneraloperationalduediligence screeningoutlined above,which facilitates theuniversedefiningstageoftheprocess.Tomarkourprogressalongthepathofaninvestor'sfund-focused operational due diligence review, it is at this stage that a number offundshavesuccessfullypassedtheoperationalminimumcriteria.Wewill limitour focus at this stage tooperationaluniversedefinition criteria asopposed toeithersolelyinvestmentuniversedefinitionsorbothinvestmentandoperationalminimumuniversecriteria.With the universe now defined by those funds that an investor has both a

sufficient amount of investment interest in, as well as those that possess therequired minimum operational qualities to merit further due diligence, aninvestor can nowproceed.At this point, an investorwill typically approach anewseriesof sequential stages focused lessonminimumcriteria requirementsandmore on assessingminimum operational practices andweaknesseswithineachparticularfundandfirm.Inmakingthesedeterminations,theseoperationalduediligenceprocessesoftenaremarkedbyanumberofbroadstages throughwhichaninvestorprogressesbeforecomingtoafinaloperationaldeterminationregarding the private equity fund.A common four-stage process is outlined inExhibit1.5.Asthefirmstageintheprocesssuggests,theoperationalduediligenceprocess

typicallybeginswithaninvestorbeingapproachedby,orapproaching,aprivateequity firm. The first stage of the operational due diligence process willthereforegenerallybeginwithaninvestordevelopingadialoguewiththeprivateequityfirm.Duringthisstageabasicunderstandingofthefirm'skeyplayers,thefundsmanaged,anditsorganizationwillcometolight.The next stage of the operational due diligence process typically involves

investorsfocusingtheireffortsmoreonaninvestmentstrategymanagedbythefirm.During the courseof this stage, investorswill likelybegin to focus theirduediligenceprocessonitemsspecificallyrelatedtoacertainfund.Generally,this process will entail investors familiarizing themselves with investmentpersonnel,suchasportfoliomanagerswhomaydevotethemajorityoftheirtimetoaparticularfund.Additionally, thisstageisoftenwheretherealmeatof theoperational due diligence process occurs and many fund specific operationalpolicies,procedures,andcontrolsarediscussed.The final stage in the broad four-stage process involves investors reaching

through the private equity fund itself and looking through to the investments,actual or proposed, inwhich the fund under consideration currently invests orintendstoinvest.Inmanyoftheprivateequitysituationsinvestorswillface,theprivate equity fund under consideration will be allocating capital to anunderlyingcompanyorseriesofcompanies.Insuchcases,theoperationalduediligenceprocessmayinvolvenotsomuch

an assessment of the investment merits of such investments (e.g., why is theprivate equity fund planning on investing in this particular sector, or why iscompanyAmoredeservingof funding from theprivate equity fund than fundB?) but rathermay pose questions regarding appropriate policies, procedures,controls,andtransparencyattheprivateequityfirm,andoversightandreportingoftheseinvestmentssuchthattheoperationalrisksassociatedwithfundingtheseunderlying companies is appropriately monitored and mitigated. Of course,contingentonthescopeandamountofotherduediligencebeingperformed,aninvestor may gauge the depth at which he looks through to such underlyingcompanies.Thepointof referencing thisstage in theoperationalduediligencecontextisthatjustbecauseaninvestorhasputontheiroperationalduediligencehatandhasundertakenareviewfocusedprimarilyonoperationaltyperisks,itisoften not advisable for investors to shut themselves off completely from aparticular area of review because it may border, however tangentially, oninvestment-relatedmatters.Based on this description, one may imply that the broad stages in the

operationalduediligenceprocessaresequential innature(i.e., firstoperationaldue diligence is performedon the fund, then the firm, and then, if applicable,portfoliocompanies).This isnotnecessarily thecase,andmanyinvestorsmayopttoadvancethrougheachofthesestagesoutoforder,orsimultaneously,orinanoverlappingfashion.The suggested sequence seems tobe themost logical andpractical route for

mostinvestorstofollow.Manyinvestorspreferthisapproachbecauseitallowsthem to start with a big picture view and then drill down into more focusedareas.Thereasonforconductingtheprocessinanincongruousfashionmaybeduetoconsiderationsoftheoperationalduediligenceprocessaligningwithanyinvestmentduediligence.Additionally,asisoftenthecaseinprivateequity,aninvestormayneed tofireonallcylinders inorder tomeetaparticularfundingdateuponwhichafundwillrealizeacloseandstopacceptingnewcapital.In the case where an investor is performing operational due diligence on a

privateequityfundoffunds,afifthstagecanbeaddedtotheprocess.Thisfive-

stageprocessissummarizedinExhibit1.6.

EXHIBIT1.6StagesofAnalysisinInvestorPrivateEquityDueDiligenceProcess

Underthisfive-stagecategoryoperationalduediligenceprocess,the“PrivateEquityFund”categoryiseffectivelytransformedinto“PEFundofFunds.”Thisswitchismadeinreferencetothefactthatthereisnowanadditionalplayerinthemix, the fundof funds, as not just an investormaking a direct investmentintoaprivateequityfund.Theprevious,“PrivateEquityFund”category,whichwasusedtoreferencethestageof theprocessatwhichaninvestorapproachesperformingoperationalduediligenceonadirectprivateequitymanagernowisslottedbeneaththe“PrivateEquityFundofFunds”stage.Ifyouthinkabout itfor amoment, this additionof thePrivateEquityFundofFunds category andsubsequentreorderingoftheprocessadherestothesamelogicalprocessutilized

inthefour-stageprocess.Aninvestorwilltypicallystartwithabig-pictureviewoftheprivateequityfirm,acategorythatisthestartingpointforbothfour-andfive-stageprocesses,andthenprogressesintosubsequentlevelsofmorerefineddetail.

HISTORICALPERSPECTIVESOFPRIVATEEQUITYOPERATIONALRISK

Nowthatwehaveestablishedabasicunderstandingofwhatisgenerallyimpliedbythetermoperationalduediligence,wecannextproceedtoadiscussionoftheroles of operational risk and operational due diligence in a private equitycontext. To facilitate this discussion, it is perhaps useful to first consider thecurrent state of the private equity operational due diligence world. In recentyears investors have begun to focus more on operational risk across allinvestmentclassesrangingfromtraditionallong-onlyinvestmentstoalternativeinvestments.Aswith theevolutionofmost areasof riskmanagement andduediligence,intheearlystagesofthisacceptancereviewsofoperationalrisksweretypicallycouchedintoprimarilyinvestment-relatedprocesses.Beforegoingany further, it is important tohighlight that thepurposeof this

discussion is toprovide the readerwithageneral senseof thedevelopmentofoperationalduediligenceinaprivateequitycontext.Duetothegeneralnatureofthis discussion, the goal is not to imply that there were organizations severalyears ago, for example, that did not have distinct dedicated operational duediligence functions. Rather, such organizations were generally more theexception rather than the norm. As there was an increased acceptance of theimportanceofoperationalriskmanagementinanassetmanagementcontext,thecarving out of distinct operational due diligence functions then became morecommon. In recent memory, perhaps the most obvious and notable point ofdemarcation fueling the development of operational due diligence was theuncoveringofMadoff'sPonzischeme.

Madoff'sPonziSchemeandOperationalDueDiligence

Somemay say, perhaps rightly so, that theMadoff scandalwas the exceptionrather than the norm. Others may say that Madoff was not a private equity

manager and, therefore, any increased awareness or lessons learned from theMadoffscandalaresimplynotapplicable.Manypractitionersinthehedgefundprofessionhad immediategut reactions thatMadoff's schemewasnot ahedgefundand,therefore, itshouldnotbeheldupasanexampletowhichtheentirehedgefundorevenbroaderalternativeinvestmentindustryshouldbecompared.Whilewell-intentioned,suchnotionsarepatently incorrect.Thishead-in-the-

sandattitudebordersonasset-classxenophobiaandcertainlydoesnotfosteranopen-minded approach toward learning from mistakes. By conducting suchoperational case studies of fraudulent activities both investors and fundmanagers, regardless of what asset classes they primarily participate in, cancertainlylearnagreatdealaboutnotonlywhatsteps theymaytaketopreventfraudulent activity, but also what concerns might be at the forefront of theircurrentorprospectiveinvestors’minds.CorgentumConsulting,anoperationalriskconsultancy(andalsoyourauthor's

employer) that works with investors to perform operational due diligencereviewsonassetmanagersplacesanemphasisonstudyinghistoricaloperationalduediligencecasestudies.Corgentumhasfoundthatcasestudiescannotonlyinformaninvestor'soperationalduediligenceprocessesinordertoavoidfraud,butcanoftenprovideaframeworkbywhichaninvestorcanexpandtheexistingscopeoftheiroperationalduediligencereviewstofocusonareaspreviouslynotvetted,inwhichtheopportunityforfraudmaybemoreapparentthanpreviouslythrough. In general, while the merits of modeling fraud to predict futurefraudulent activity with any certainty is limited by the nature of the nextunanticipatedfraud,suchresearchandanalysisofpriorfraudscertainlyyieldsamuchmorecomprehensiveoperationalduediligenceprocessandresultsinmoreinformedinvestors,ascomparedtonotanalyzingsuchfrauds.Returning toourdiscussionof thedevelopmentofoperationalduediligence,

thepre-Madoffandpost-Madoffworldsofoperationalduediligenceisperhapsbest thought of as the 23rd equatorial parallel above and below which lieinvestorswhoeitherhaveembracedoperationalduediligenceorthosewhohavenot.TheMadofffraudwasalsoimportantbecauseithadaresoundingeffectonthe way in which many investors approached the concept of operational duediligence. A Corgentum Consulting study found a so-calledMadoff Effect bywhich investors tend to tailor their operational due diligence around recentfraudswhileminimizingcertainotheroperationalrisks.9

The Madoff scheme has become one of the most-cited illustrations offraudulentactivitiesandPonzischemes.Itisusedinthiscontextbecauseofthe

preeminent initialandsubsequentattentionandmediacoverage from investorsandthepress.Manyotherfraudsinrecentyears,whichoccurredbothbeforeandafterMadoff'sPonzischemewererevealed,havefueledanincreasedawarenessof thedangersof ignoringoperational riskandnotperformingoperationalduediligence. Examples of these fraudsters include R. Allen Stanford (StanfordFinancialGroup),TomPetters(PettersGroupWorldwide),ArthurNadel(ScoopManagement),NicholasCosmo(AgapeWorld),andHelmutKiener(K1Group).EvenserviceprovidersgotinontheactwiththerevelationoffraudulentactivitybyprominentattorneyMarcDreierthatstolemillionsfromassetmanagerswiththefraudulentsaleofnonexistentsecurities.SuchwasthespateofPonzischemes,asopposedtootherfraudulentschemes,

inthemedia,thattheterm“Ponzimonium”cameintothepublicconsciousness.This increased awareness on the part of investors and fund managers of theimportance of understanding operational risk and performing operational duediligencehadalastingeffectamonginvestorsacrossallassetclasses,includingprivate equity. It is in this post-Madoffworld that the techniques described inthisbookarefocused.However, before discussing operational due diligence techniques and

approaches,itisfirsthelpfultoobtainanunderstandingofhowwearrivedatthecurrentenvironmentasitrelatestotheworldofprivateequityinvesting.Tothatpoint, before analyzing the current framework for operational risk analysis inprivate equity funds, it is useful to gain an initial understanding of the basichistory of private equity investing. This historical perspective will allowinvestors to better understand how we arrived at the present state of privateequityoperationalduediligence.

ABriefHistoryofPrivateEquityTheearliestprivateequityinvestmentswerenotreallyviamodernpooledfundstructures asweknow them today. Instead, the concept of individuals poolingtogether capital to fund private, and often risky, ventures has in its earliestbeginnings extending back hundreds, if not thousands, of years. For example,merchantsintheancientworldwouldpooltheirassetstogethertofinancetradeexpeditionswithothercountries.The first private equity deals of the modern era consisted of groups of

financiers and companies putting together private pools of capital to extendloans or fund various infrastructure projects. The focuswas on one project or

dealatatime.ExamplesofsuchearlyprivatedealsincludethefinancingoftheTranscontinentalRailroadintheUnitedStatesviatheconglomerationofCreditMobilierandCivilWarfinancierJayCookein themid-1800s.10These typesoftransactionswereeventually followedbymoresophisticateddeals, suchas thebuyoutoftheCarnegieSteelCompanybyJ.P.MorganfromAndrewCarnegiein1901.11 Even the roots of large companies such as International BusinessMachines (IBM) grew because of the combined efforts of groups of wealthyindividuals combining pools of capital with combinations of other less-successfulbusinessestoproducebettermanaged,moreefficient,andprofitablefirms.Forthenext40yearsorso,thesophisticationofprivateequitydealscontinued

to gradually increase; however, deal originations predominately remainedlimitedtoaselectgroupofwealthyindividuals.Themid-1940ssawtheriseofthefirstmodernprivateequityfirmsandfundstructures,withaparticularfocuson venture capital. During this period the appeal of private equity firms wasbroadenedandfirmsbegantosolicitcapital fromanumberofsourcesanddidnotlimitcapitalinflowssolelytowealthyfamilies.Thiswasespeciallytruewiththe growth of venture capital firms during this time, such as the AmericanResearchandDevelopmentCorporation(ARDC).ARDCwasfoundedbyGeneralGeorgesDoriotandCarlComptontoinvestin

developing firms that had technologies rooted in military applications fromWorldWarII.ARDCinvestedprimarilyincompanieswithtiestotheacademicjuggernautsofMITandHarvardand the firm's investments included theHighVoltage Engineering Corporation and the Digital Equipment Company.12 Thefocusing on continued investment in innovation in science and technologycontinuedtofuelthegrowthofventurecapitalintothe1950swiththegrowthofSiliconValleyfirmssuchasDraperGaitherandAndersen.13

Inthemoremodernera,privateequityhasgonethroughanumberofso-calledboomandbustcycles.Theseincludetheincreasedfocusonjunk-bond-financedleveragebuyoutsthroughouttheearly1980sthroughtheearly1990s.Thefirmof Drexel Burnham Lambert was a leader in this area until the firm waseffectivelyshutdownasaresultofaninsidertradingscandalinvolvingDennisLevineandIvanBoesky.Perhapsthemostfamousleveragedbuyout(LBO)dealduring this time was the record-setting $25 billion takeover of RJR Nabisco.Thisdealwasimmortalizedinabookandamovie,bothcalledBarbariansattheGate.14

Itwas during this period that themodern focus on regulation first began to

haveanotedimpactonprivateequityinvestmentactivities.Fueledinpartbyapolitical backlash against jumbo deals such as theRJRNabisco buyout, firmsthat underwrote junk bonds came under increased scrutiny, particularly inrelation to their beneficial tax treatment.After the failure ofDrexel BurnhamLambert,coupledwithsignificantincreasesindefaultsamongjunk-bond-issuingcompanies, theU.S.Congress took action. InAugust 1989, they implementedtheFinancialInstitutionsReform,RecoveryandEnforcementActof1989.ThisAct, driven by the savings and loans (S&Ls) crises of the 1980s, preventedS&Lsfrominvestinginjunkbonds.For thenext fewyears, post–RJRNabisco,private equity continued togrow

andshirkwiththeebbandflowofinvestors’demand.NotabledealsduringthistimeperiodincludethesaleofSnappleBeveragestoQuakerOats,andbuyoutsbyprivateequitygroupsofContinentalAirlines,Domino'sPizza,andPetco.The next stage of private equity was realized by the growth of the venture

capital investment in technology and Internet companies. Notable firms thatreceivedventurecapitalfundingduringthisdot-comperiodincludedNetscape,Yahoo!, and Amazon.com. The dot-com bubble eventually burst, turning intowhatmanyhavecalleda“dot-bomb”.Itwasaroundthistimethatadditionallegislationhadamaterialimpactonthe

activities of private equity.After the failure of such firmsdue to a number ofaccounting and management scandals that brought down companies such asEnron, Tyco International, and WorldCom, the Sarbanes-Oxley Act of 2002,commonly referred to as SOX, was enacted. SOX imposed a number ofincreasedreportingandtransparencyrequirementsforpubliclylistedcompanies.AfterthepassageofSOX,manyventurecapitalfirmscouldnolongeraffordtheincreased cost of compliance for initial public offering exit strategies, whichfurtherstagnatedthegrowthofsuchprivateequityinvestments.After this period of decline, and the eventual resurgence of private equity

during the 2000s, several private equity firms took a page from their ownplaybook and considered pursuing their own offerings via a combination ofprivateandpublicofferingstrategies.Oneof themostnotableofferingsduringthistimeperiodwastheinitialpublicofferingoftheBlackstoneGroupin2007.The credit crisis of 2008 sawmanyprivate equity firms transition to focusonpurchasing debt in existing LBOs or private investments in public equity,commonlyknownasPIPEs.Now thatwehavedeveloped abasic summaryunderstandingof themodern

roots of private equity investing, it is worth noting a few items. First of all,

privateequity,asitsnameimplies,haslargelysucceededinremainingjustthat,private.While some of the largemega-deals and tax benefits granted to assetmanagerssuchasprivateequityfirmshavegarneredattention,ingeneralfromaregulatory perspective private equity firms—as compared to banks, insurancecompanies, and even hedge funds,—have for the most part undergone lessscrutiny.Thesehistoricaldevelopmentshaveservedtodriveawedgebetweenboththe

effortsinvestorsallocatetowardperformingoperationalduediligenceonprivateequityfirmsaswellasagrowingdesireamonginvestors inotherassetclassesfor operational transparency. As such, if one looks at the development ofoperational risk standards in general, private equity investors have beenseemingly less focused on leveraging developments in the field of operationalrisk management and due diligence to push for increased operationaltransparencyandbestpractices.Thedevelopmentofoperationalriskinamoderncontextcanbetracedbackto

theworkofgroupssuchas theTreadwayCommissionandthedevelopmentoftheCommittee ofSponsoringOrganizations through to theBaselAccords andtheenactmentofSOX.15Exhibit1.7providesanoverviewofthemajorhighlightsinthedevelopmentofoperationalrisk.

EXHIBIT1.7MilestonesinRecentHistoryofOperationalRiskDevelopmentYear/TimePeriod

NotableDevelopmentinOperationalRisk

Mid-1980s U.S.HouseofRepresentatives’CommitteeonEnergyandCommerceinquiriesintoaccountingprofession

1985 i.NationalCommissiononFraudulentFinancialReporting/TreadwayCommission;ii.formationofCommitteeofSponsoringOrganizations(“COSO'')

1988 i.CreationoftheBaselCapitalAccordbytheBaselCommitteeonBankingSupervision;ii.PublicationoftheHampelreport

1990s Seriesofroguetraderevents

1991 FormationoftheCadburyCommission

1992 PublicationoftheCadburyCodeandtheCOSOreport,“InternalControl-IntegratedFramework”

1995 ReportoftheGreenburyCommittee

1996 FormationoftheHampelCommittee

2001 Mynersreportpublished

2002 EnactmentofPublicCompanyAccountingReformandInvestorProtectionActof2002(SOX)

2004 BaselIIimplemented

2007 i.MarketsinFinancialInstrumentsDirective(“MiFID”)enacted;ii.PublicationofGuidelinesforDisclosureandTransparencyinPrivateEquity(the“WalkerGuidelines”);

2010 i.EnactmentofDodd-FrankWallStreetReformandConsumerProtectionAct;

ii.PassageofAlternativeInvestmentFundManagersDirective(“AIFMD”)

As a result of the impact of these regulatory developments, throughout thecourseofthedevelopmentofoperationalrisk,investorsinotherclassesseemedto gain leverage from these developments and began to integrate them, withvarying degrees of success, into their own due diligence processes. Perhapsfacilitating their focus was the ease by which the targets of regulatorydevelopments could be equated to funds in which they invested. Anothercontributing factor toward integrationwas likely themarket eventsdriving theimplementation of subsequent regulations that promoted increased operationaltransparencyandquality.Forexample,itiseasytoimaginehowaninvestorreadingaboutrogue-trader-

typeeventsintheearly1990scarriedoutbyindividualssuchasNickLessonatBarings Bank, could begin to integrate questions regarding any controls orprocessesafirmmayhaveinplacetopreventroguetradersfromoperating.Asmore and more types of these questions were integrated into an investor'soperationalduediligenceprocessover time,coupledwith increased regulatoryaction, so too does the scope of an investor's operational due diligence focusbegintogrow.Private equity funds however, do not have many of the high-profile

characteristics associated with such frauds and subsequent losses. Continuingour trading example, private equity firms generally do not trade nearly asfrequently as more traditional funds or even some low-volume hedge fundstrategies.Assuch,aninvestorperformingduediligenceonprivateequityfundsduring the same time periodmay not have brought any such concerns to theforefrontoftheirduediligenceprocessbecauseoftheseeminglydifferentnatureof therisks.Furthermore,evenif theyhad,suchaninvestorwouldlikelyhavebeentheexceptionratherthanthenorm.ToborrowfromKeynesianeconomics,theinvisiblehandofthemarketwilldictatetheappropriatecourseofaction.Ifenoughinvestorsorregulatorsdonotplaceenoughpressureonaparticular

manager,industry,orassetclass,thenamanagermaybelieve,howeverfoolishly,that they have nothing to gain from either establishing high degrees ofoperational quality or being able to demonstrate operational transparency in adigestible,easy-to-followformatthathighlightstheiroperationalstrengths.Thishasineffectcreatedwhateconomistsrefertoasamultipliereffect.However,itseems in relation to operational risk concerns related to private equity (ascomparedtootherassetclasses)thattheeffecthasbeenvirtuallystagnantonanabsolutebasisandeffectivelynegativeascompared tobothotherassetclasses

andtheincreasingcomplexityofprivateequityoperationalinfrastructure.So is it fair to say that operational due diligence ismerely a poor victimof

circumstance,castbythewaysideasafieldoflesserimport,subservienttoothermorelegitimateareasofduediligence?Notnecessarily,asrecentdevelopmentshavesuggestedanincreasedinterestinthisarea.Consequently,whenexaminingthehistoryof thedevelopmentofoperationalduediligence inaprivateequitycontext from an investor's perspective it seems as if it is only in very recenttimes that the majority of investors have opened the door to entertainingdiscussionsof private equity in theoperational duediligenceprocess.Withoutthisincreasedinvestorattentionandpressurebroughttobearanenvironmentiscontinuallycreatedthatnotonlyacceptspooroperationalqualitybutfostersit.This trend of increased attention and resource allocation makes sense for a

numberofreasonsthatChapter2discussesinmoredetail.Fornow,oneofthemostnotablereasonsthatreadersshouldkeepinthebackof theirmindsis thefactthat,allelsegenerallybeingequally,thereisapositivecorrelationbetweenanoperationalqualityandpositiveinvestmentperformance.

ITEMSTYPICALLYCOVEREDDURINGTHEOPERATIONALDUEDILIGENCE

PROCESSEarlier in this chapter, we refer to something known as a “basic” or “coreoperationalduediligenceprocess.”Thetermcoreprocessisutilizedheretoreferto the basic building blocks of operational due diligence. A core processencompassesareviewof,ataminimum, thoseoperationalriskfactors thatarenecessary to allow an investor to reach an informed opinion, and ultimatelycometoanoperationaldetermination,regardingaparticularprivateequityfund.In an absolute bare-minimum core process, if one of these operational riskfactorsisnotexamineditishighlyunlikely,ifnotimpossible,toquestionifaninvestor has truly taken the operational due diligence process seriously. Thebare-bones minimum items in a private equity operational due diligence corereviewprocessareincludedinExhibit1.8.

EXHIBIT1.8SampleCoreOperationalRiskFactorsTradeflowanalysis Legaldocumentationreview

Cashoversight,managementandtransfercontrols Valuationpoliciesandprocesses

Complianceinfrastructure Qualityandappropriatenessoffundserviceproviders

Fundreporting Financialstatementreview

Humancapital Custodyproceduresandthird-parties

After reviewing this list, an investor may comment, “I think that businesscontinuityisaveryimportantriskfactor,particularlybecausetheprivateequityfund I am considering is located in Caribbean country X, which is prone tohurricanesandpoweroutages.SoIwouldconsideritveryimportanttolookattheseareasduringtheoperationalduediligenceprocessaswell.”Such a question certainly raises valid concerns andoften arises during early

discussionsconcerningcoreoperationalduediligenceprocessfactors.Itaffordsuswithanopportunitytoreiterateexactlywhatthegoalofacoreprocessoftenis.Itis,asthenameimplies,togettotheheartofwhatkeyoperationalrisksaretypicallyassociatedwithprivateequity.Indevelopingacoreprocess,aninvestormayconsidertheoperationalriskfactorsincludedinthecorelisttobethoughtofascontainingthelow-hangingfruitoftheoperationalriskspectrum.Cashoversight,management,andtransfercontrols,forexample,isoneofthe

operational areas that is fertile ground for the breakdown of operationalprocessesresultingineitheroutrightfraudandtheftoroperationalriskswithlessnefarious motivations such as improper transfers of cash due to a lack ofappropriate transfer controls. The opportunity for noticeable operationalweaknesses and subsequent actual losses due to the breakdown of operationalprocesses is prevalent in this area. As such, most investors would include areviewofthecashmanagementandtransferprocessinoneformoranother, intheircoreoperationalduediligenceprocess.Thiscanbecontrastedwithacategorysuchasbusinesscontinuityanddisaster

recovery. As our hypothetical investor questioned, depending on thecircumstance,businesscontinuitycanbeanimportantfactortoreviewaswell,isitnot?Theanswer,ofcourse,isyes.Butastherewordingoftheinvestor'squerymay have suggested, the answer to such a question is very circumstancedependent. Such is the case with most rules or maxims in life– there areexceptions.Asageneralrulehowever,inthefieldofoperationalduediligenceexceptions

to such rules tend to lean more toward conservatism in approach. Suchconservatismultimatelyresultsintheinclusionofmoreoperationalriskfactors,which necessarily broadens the scope of the operational due diligence review.Therefore,toclarify,twodifferentprivateequityfundsunderreviewcouldeachhavedifferent coreoperationalduediligenceprocesses thatwouldvaryby the

number of operational risk factors included in each review.What then is thepoint,youmayask,ofhavingacoreprocess?Theansweristhatacoreprocessgives investors a startingpoint fromwhich towork.Additional factors canbeadded to the process on a case-by-case basis for each fund as prudence andcommon sense dictates. So, returning to our hypothetical investor's originalexample, itwouldbeconsideredcertainlyadvisable toadd to thecoreprocessthe business continuity and disaster recovery category for a private equitymanager located in an area that experiences a great deal of weather-relatedeventssuchashurricanes.Thislistoffactors,aswithanyofthecorelistsincludedthroughoutthisbook,

arebynomeansall-inclusive.Rather,thepurposeofdiscussingacoreprocessisto provide investorswith a general idea of the baseline amount of operationalrisk factors they should consider analyzing before deciding to pursue anoperationalduediligenceprogram. Ifan investor isnotprepared todevote thenecessary resources, time, and energy intovetting eachof the typesof factorsincluded in a core process, then they may want to reassess their goals inperformingoperationalduediligencetobeginwith.Corgentum Consulting advises clients that as a firm we cannot give an

informedopinionregardingaprivateequitymanagerunless,ataminimum,thefirmhastheopportunitytoreviewcertaincoreoperationalriskfactors.Thinkofit this way: How can an investor form any sort of opinion regarding theoperationalstrengthoftheprivateequityfirmorfundiftheydonotunderstandthebasicsoftheoperations?Inordertogetthesebasicsdowntherearecertainkeyfunddocumentsandprocessesthatmustbereviewed.Thegoalofthecoreprocess is to draw a line in the sand, below which a risk opinion cannot beformed.ThisconceptissummarizedinExhibit1.9.

EXHIBIT1.9CoreProcessandInformedOperationalOpinionFormation

COREVERSUSEXPANDEDOPERATIONALDUEDILIGENCE

REVIEWSOnceacoreprocesshasbeendevelopedandthenamendedorenhanced,itisnolonger a core process. Rather, depending on your perspective, these additionshave effectively altered theDNAof a core process such that it has become adifferentspeciesofoperationalduediligencereviewentirely.Perhapswecouldrefertothisprocessasacorepluslevelofreview.Atsomepoint,dependingonthenumberofadditionaloperational risk factorsadded to thecoreprocess, aninvestor may be more comfortable with dropping the core association alltogether.Wecanrefertoamorebroadlyscopedprocessasanexpandedlevelofreview.Exhibit1.10outlinesanexampleoftheoperationalriskfactorsincludedinacoreascomparedtoanexpandedoperationalduediligencereviewprocess.

EXHIBIT1.10SampleCoreOperationalRiskFactorsOperationalRiskFactor OperationalRiskFactorType

Tradeflowanalysis Core

Cashoversight,managementandtransfercontrols Core

Complianceinfrastructure Core

Humancapital Core

Legaldocumentationreview Core

Valuationpoliciesandprocesses Core

Qualityandappropriatenessoffundserviceproviders Core

Custodyproceduresandthirdparties Core

Technologyandsystems Expanded

Reviewofregulatoryinteraction Expanded

Businesscontinuityanddisasterrecovery Expanded

Informationsecurity Expanded

Insurancecoverage Expanded

ISDAreviews Expanded

Boardofdirectors Expanded

Taxpractices Expanded

Duetothenumberofadditionaloperationalfactorsincludedintheexpandedoperationalduediligencereviews,theserequiremoreresourcestocomplete.Thesamecanbesaidwhencomparingabelow-corelevelofreviewtoacorelevelofreview,which necessarily containsmore operational risk factors. Exhibit 1.11provides a theoretical outline of the resource allocation percentages dispersedamong the components of the due diligence equation (e.g., investment duediligence andoperational duediligence) for eachof the three levels of reviewpreviouslydiscussed.

EXHIBIT1.11ResourceAllocationamongBelow-Core,Core,andExpandedOperationalDueDiligenceReviewProcesses

A few comments should be kept in mind when considering the theoreticalresource allocation guidelines outlined in Exhibit 1.11. First, a criticalassumption in reviewing the resourceguidelines is that thesumofeachof therespectiveprocessestotals100percent.Itisfurtherworthclarifyingthatthis100

percentsumofallduediligenceeffortsistobeappliedonacase-by-casebasis.This is in contrastwith an investor's total due diligence resources. It isworthnoting this distinction because an investormay have access tomore total duediligence resources than they are deploying to a particular fund review.Theseother nondeployed due diligence resources could simply be sitting on thesidelines or employed in other projects. This situation does not necessarilyrepresent an investor being spread too thin by performing too many duediligenceprojectsinanysingletimeperiod.Furthermore, an investor may deploy these due diligence resources toward

funds onwhich theymay be performing only preliminary due diligence. Thisinitialscreeningcouldthenfeedthemorecomprehensiveduediligencereviewsfurtherdownthe line.Assuch,oneseriesofduediligenceresourcesarebeingutilized to keep others busy. Regardless of the situation, this 100 percentassumesthatforeachparticularprojectaninvestorisallocating100percentofdesignatedduediligenceresourcestowardaparticularreview.Anexampleofascenario that would not apply to the theoretical allocation guidelines outlinedearlierwouldbewhenaninvestordecidestoreducethepercentageofresourcesdedicatedtoinvestmentduediligencebutdoesnotreallocatetheseresourcestooperational due diligence. This of course assumes that such investment andoperational due diligence resources are swappable and available,which in thereal world might not be the case, but in order to facilitate our discussion ofresourceallocationsuchtheoreticalguidelinesandassumptionsareemployed.Secondly, it is worth reiterating that the percentages in Exhibit 1.11 are

intended to represent resources allocated toward the respective areas of duediligenceandnotthetimeallocatedtosuchprocesses.Whilethereisgenerallyapositivecorrelationbetweentheextentofresourcesdedicatedtowardaparticularduediligencefunctionandthetimeittakestocompletesuchareview,therearea number of variables involved that can skew such notions that a directcorrelationispresent.Forexample,onemustfirstconsiderwhatismeantbytheterm time in this context. Is it the number of cumulative hours required tocomplete an initial due diligence review or perhaps the absolute time periodnecessaryforcompletionofaninitialduediligencereview?Thedifference in these twoslightlydifferent interpretations in theuseof the

timeprincipalisperhapsbestillustratedbythefollowingexample.Considertwodifferent investment organizations making an investment in the same privateequityfund.Thefirstsuch investmentorganization,Firm1,employsa totaloffive due diligence analysts. Four of these analysts focus on investment due

diligenceandoneonoperationalduediligence.Nextletusconsiderthesecondinvestment organization, Firm 2. This company employs three due diligenceanalysts.Firm2's duediligence analysts are primarily dedicated to investmentduediligencebutdonateaportionoftheirtimeasnecessarytowardoperationaldue diligence. Putting aside the requisite competencies and skill sets of eachanalyst,aswellasthelikelybenefitsinqualityandefficiencytoberealizedbyFirm 1 in having a dedicated operational due diligence analyst, we can nowexamineascenariobywhichthetimetocompletionofeachreviewisevaluated.Let us further assume that both Firm 1 and Firm 2 begin their due diligencereviews of our private equity fund onMonday, January 1, in the year 20XX.Further, let us assume that Firm 1 dedicates its one operational due diligenceanalyst to the review but only dedicates two out of its four investment duediligence analysts to the review of the fund (the other analysts are busyreviewingdifferentfunds).Contrast this with Firm 2, which dedicates all three of its due diligence

analysts to the job. As the due diligence work proceeds, Firm 2, having anoverall smallerduediligence teamascompared toFirm1,decides toburn themidnightoilanddedicatealloftheirwakinghourssolelyonthisreview.Firm2,however, has the disadvantage of not having a dedicated operational duediligence analyst.As such, the review process takes longer for Firm 2 than itwould have if it had regarded the analysts as being two individuals,with onededicated to investment due diligence and the other toward operational duediligence. (Chapter4discussesstrategicoperationalduediligenceallocation inmore detail). As a result of their stalwart dedication to the process, the duediligence process for Firm 2 subsequently takes two-and-a-half weeks(approximately300hours).Firm1'sduediligenceprocessfortheprivateequityfirminregardtototal timeiscompletedoveraspanoffourweeksbutintotaltakesonlyapproximately250hours.Thequestionnowbecomeswhichprocesstook longer, Firm 1's or Firm 2’s? The answer of course depends on theparticulardefinitionofprocesstimetocompletion.Mostinvestorswouldlikelyview the four-week timeperiod takenbyFirm1 tobe the longer timeperiod.Viewedfromtheperspectiveofan investorperformingan initialduediligencereviewofaprivateequityfundwithaneyetowardmeetingaparticularfundingdeadline,suchanabsoluteviewoftimewouldlikelybemorepractical.It is also worth noting that the percentages in Exhibit 1.11 are merely

guidelines. Certainly, as compared to the chart, an investor performingoperationalduediligenceatabelow-core standardcouldcertainly increase the

amount of resources dedicated to investment due diligence and dial down thepercentage increased towardoperationalduediligence.Whilesuchachange iscertainlynotadvisable,someoperationalduediligenceisbetterthannoneatall.Anextremeexampleofsuchachangeinallocationpercentageswith100percentofan investor'sduediligence resourcesbeingallocated toward investmentduediligenceandnoresourcesallocatedtowardoperationalduediligenceisshowninExhibit1.12.

EXHIBIT1.12ExtremeExampleofBelow-CoreProcessAllocationtoInvestmentDueDiligence

Furthermore, returning to our original theoretical resource allocationparadigms, the allocation separation points themselves are once again merelyguidelinesandnottobeviewedashardchecklistpointsofdemarcationamongthedifferentlevelsofreviewthataresetinstone.So,forexample,aninvestormay allocate only 65 percent of their total due diligence resources towardinvestmentduediligence.Doesthismeanthattheycannotclaimtohaveacoreprocess?No;rather,thisindicatestwopointstobeconsidered.First,becausetheyarededicatinglesstime(e.g.,65percentasopposedto70

percent)oftheirtotalduediligenceresourcestowardinvestmentduediligence,itis assumed that this 5 percent is being reallocated toward operational duediligencetoaccountfortheentire100percentofallocatedresources.Assuch,atrade-offfrominvestmentduediligenceresourcesthatincreasestheoperationaldue diligence resource allocation certainly can be viewed as pumping up aprocess thatmightnot,according to the theoreticalguidelines,beconsideredacoreprocessbecauseof theincreasedallocationtowardoperationalasopposed

toinvestmentduediligence.Second,thetermsbelow-core,core,andexpandedutilize operational due diligence as a frame of reference as opposed toinvestment due diligence. Therefore, as described earlier, by increasing theamount of resources dedicated to operational duediligence, an investorwouldtend to progress along the spectrum from below-core to expanded assummarizedinExhibit1.13.

SHAREDCOMMONALITIESBETWEENPRIVATEEQUITYANDREALESTATE

OPERATIONSRISKForthepurposesofthistext,wewillconsiderrealestatefundstobeasubsetofthe larger categoryof private equity funds.That being said, due to theuniquechallenges of the real estate asset class, and associated real estate funds, thisbook will outline several of the differences and similarities between privateequityandrealestatefunds.

EXHIBIT1.13OperationalDueDiligenceResourceAllocationasaDriveramongTransitionsfromBelow-Core,toCore,toExpandedReviewLevels

Ingeneral,regardlessoftheassetclasstherearecertainuniversalcategoriesofdue diligence considerations that are applicable. This maxim applies to bothinvestment due diligence and operational due diligence. From an investmentperspective, these similarities could include performing due diligence on a

manager'sresearchfunction,theabilityofafundmanagertogeneratealpha,anda manager's approach toward and execution of a risk management program.Regardlessofwhetheraninvestorisconsideringaninvestmentinamutualfund,separateaccountplatform,hedgefund,privateequity,orrealestatefund,generaluniversalcategoriesofinvestmentconsiderationswouldlikelybepresentinthedue diligence programs of prudent investors. This is not meant to imply thatcookie-cutter,one-size-fits-allduediligenceapproachesareemployedacrossallassetclasses.Onthecontrary,oncethesegeneralcategoriesareestablished,thedifference in theduediligenceprocessamong theassetclasses in termsof thediagnostic approach, as well as the types of risks being vetted, should benecessarilycustomizedtoeachspecificassetclass,subclass,andfundtype.Forexample,aninvestorwouldlikelyutilizeadifferentapproachtoanalyzetheriskmanagement function of a mutual fund than it would an event-driven hedgefund.Similarly, there are certain universal categories that generally arise from an

operationalperspectiveaswell.Someexamplesofthetypesofoperationalriskareas that prudent investors would incorporate into their operational duediligencefunctionregardlessoftheassetclassorfundtypeunderconsiderationcould include such axiomatic categories as valuation, business continuity anddisasterrecovery,andcashtransfercontrols.Similartothemanifestinvestmentconsiderations,eachoftheseoperationalriskareaswouldlikelybeincorporatedbyinvestorsintotheiroperationalduediligenceprocess,regardlessoftheassetclassorfundtype.Thislarger,universalgroupoffactors,bothinvestmentandoperational,canbe

furthernarroweddownwhenperformingduediligenceonsimilarassetclasses.Turning specifically to private equity and real estate, there is a subgroup ofuniversalfactorsthatarecertainlymoreapplicableamongthesetwoassettypesthan among two dissimilar types of investments. In other words, whenperforming operational due diligence on a private equity fund and real estatefund, many more similarities in approach will be employed than whenperformingoperationalduediligencereviewsofamutualfundandarealestatefund.Oneprevalentissueinanoperationalduediligenceanalysisofaprivateequity

and real estate fund is valuation. Both types of funds typically involveinvestmentsinhard-to-valueandilliquidcompaniesandpiecesofproperty.Longgone are the days when a statement from a private equity or real estate firmclaiming that everything isheldat costwas sufficient.An investorperforming

operational due diligence on both real estate and private equity funds shoulddevotesubstantialeffortstonotonlyunderstandingtheparticulartypeofilliquidassetsbeingheldbutalso thevaluationprocessesandapproachesemployed indeterminingsuchvaluations.SeeChapter5forfurtherdiscussionofvaluation.Asthisexampleillustrates,thereareanumberofsimilaritiesbetweenthetwo

operationalduediligenceprocessesforbothprivateequityandrealestatefundsduetosomeofthesharedsimilaritiesbetweenthetwotypesoffunds.Investorscan utilize these similarities to enhance the efficiency of their operational duediligencereviews.Thatbeingsaid,anumberofoperationaldifferencesalsoexistbetween the two types of funds, as discussed inmore detail in the followingsection.

DIFFERENCESINOPERATIONALRISKFACTORSBETWEENPRIVATEEQUITY

ANDREALESTATEInadditiontoanumberofsimilarities,privateequityandrealestatefundsalsohave differences that become apparent during the operational due diligenceprocess.Aspreviouslysuggested,realestatefundspresentanumberofuniqueconsiderations for investors. These considerations may be asset or industryspecific,butforeaseofreferenceandforthepurposesofthisdiscussionwecanconsider real estate tobe theodd-man-out andprivate equity thenorm.Underthisapproach,aninvestormorefamiliarwithcommonprivateequityoperationalrisks,whenapproachinganoperationalduediligencereviewofarealestatefundmay be unfamiliarwith some of the differences to be on the lookout for. Forexample, a private equity fund that invests in underlying companies may nothavetodealwithconsiderationsrelatedtoafundthatownspropertyormanagesandrentsstructuresonthatproperty.Socontinuingourexample,considerthedifferenceinassetsthatmaybeheld

byaprivateequityfundandarealestatefund.Letussayaprivateequityfund,PEFund1,ownsequityinacompanythatmakesapplicationsforsmartphones.Next consider a real estate fund, RE Fund 1, which owns a shopping malllocatedonMainStreet.Nowletusconsiderbothofthesefundswithregardstothe universal operational risk category of cash controls referenced above. AninvestorperformingoperationalduediligenceonPEFund1wouldlikelyfocus

on a number of different cash-related considerations, including the ways inwhich cash moves into and out of the fund, the cash transfer and approvalprocess, and the processing of any subscription and redemption.We can nowcontrast thistoaninvestorperformingoperationalduediligencewithregardtocashcontrolsonREFund1.Remember,thisisarealestatefundthatownsandmanagesashoppingmall.A

shoppingmallhastenants.Tenantspayrent.Rentpaymentsneedtobecollectedandprocessed.Thismeans that in addition to the cash considerations outlinedwithregardstoPEFund1,aninvestorperformingoperationalduediligenceonourrealestatefund,REFund1,alsoneedstoconsidertheseadditionallevelsoftenantscashflows.Theadditionalareasaninvestorwouldlikelyneedtodelveintoduringtheoperationalduediligenceprocessincludehowrentsareactuallycollected, towhichbankaccountsrentsaredeposited,andhowinterestonanyoverduerentsisaccruedandcollected.Thesearealladditionaloperationalriskconsiderationsthatwouldnototherwiseberelevantfortheinvestors’operationaldue diligence review of PE Fund 1, and are therefore specific to real estatefunds.As this example illustrates, there are a number of additional and unique

considerationsspecific torealestateandprivateequity.While therearecertainsimilaritiesamongprivateequityandrealestatefunds, therearealsoanumberofdifferencesbetweenthese twotypesoffunds. Investorscannotsimply lumpthetwogroupstogetherintoagenericoperationalduediligenceprocess.Amoredetailed discussion of operational due diligence approaches and the uniqueoperationalriskconsiderationrelatedtorealestateispresentedinChapter8.

COUNTRY-ANDINDUSTRY-SPECIFICRISKCONSIDERATIONS

Beforeproceedinganyfurther,itisperhapsadvisabletopauseforamomenttodiscuss country-and industry-specific concerns that arise in the context of anoperational due diligence review.While these concerns are applicable to bothprivateequityandrealestatefunds,incertaincaseseachtypeoffundmayhavetheirownuniqueconsiderations,aswell.

Country-SpecificConsiderations

First,we turn to country-specific considerations.Different countrieshave theirown laws, regulatory structures, tax codes, and approaches toward fundestablishment and operations. When performing operational due diligence ondifferent funds located in different countries, it is advisable for investors tofamiliarize themselves with any country-specific matters. Regionalconsiderationsoftencomeintoplay in thecontextofoperationalduediligencereviews. These regional considerations may be particularly prevalent in thecontext of operational reviews of real estate fundswhen themanager is oftenlocatedintheregionorcountryaroundwhichpropertyholdingsofaparticularfundmaybecentered.Toillustrate,aU.K.-basedfundmaybefocusedonpan-Europeanproperties.Bycontrast,aGerman-basedfundmightinvestinGermanproperties.Eachof thesecountriesmaypresenta regulatorybackdrop thatcanberifewithuniqueoperationalchallenges.These types of country-specific items can include unique laws, regulatory

requirements,andinvestorreportingorfinancialstatementpreparationformats.Oftentimes, investors performing operational due diligence outside of theirnaturecountrymaybeunfamiliarwiththelandscape,legalorotherwise,outsidetheirownprimary jurisdiction. In thesecases,many timesan investor runs therisk of relying too heavily on the local (i.e., outside the investor's primaryjurisdiction)privateequitymanagertoprovideguidanceoncertainissues.Nowof course, any sort of guidance contained in a private equity fund manager'sdocumentationwillusuallybesurroundedbysomanylegaldisclaimersthataninvestorwould virtually lack any recourse if theywere given bad advice, butnonetheless investors need a starting point bywhich to familiarize themselveswiththelayoftheland.However,aninvestorshouldnotsolelytaketheprivateequitymanager'sword

for it.Oftentimes lawsand regulations, regardlessofwhichcountry theywerecreated in, are open to interpretation. After all, arguments in favor or againstcertain interpretations of laws are what keep lawyers, judges, and politiciansemployed in the first place. Consequently, an investor may need to seek theadviceoflocallegalcounsel,taxadvisors,orotherstogetasenseofnotonlythelocalgeneralpractice(e.g.,inCountryXmostprivateequityfundsareorganizedasalimitedliabilitycompany),butalsoaninvestor'soptionswithinaparticularjurisdiction(e.g.,undertherulesofCountryXtheprivateequitymanagercouldhave decided to create a legal structure thatminimized taxes, but opted for adifferentlegalstructurebecauseitwouldbenefitthefirmitselfmoredirectly).Dependingonthejurisdictionoftheprivateequityfundstructure,asopposed

totherespectivejurisdictionofanyinvestors,aprivateequityfundmayhaveanumberofadvantagesregardingtaxregimes.Indeed,theselectionofaparticularjurisdictionforthecreationofafundmaybehighlyinfluencedbynotonlylegalconcerns,buttaxconsiderationsaswell.Inthehedgefundworldpreferentialtaxtreatmentsaretheprimarymotivatingfactorsforthegrowthoffundregistrationsin offshore jurisdictions throughout the Caribbean and Europe such as theCaymanIslands,Luxembourg,Liechtenstein, theIsleofMan,andtheChannelIslands–basedGeminitaxtreatytwins,JerseyandGuernsey.Thesameistrueintheprivateequityworld,withmanytraditionalhedgefundoffshorejurisdictionsbeing utilized for fund structures. Additionally, depending on where theinvestingactivityoftheprivateequityfundiscentered,eithertheprivateequityfirmand/orthemanagerorinvestmentadviserforthefundmayberegisteredinalocationthathasbeneficialtaxstatus,ascomparedtothenatureofunderlyinginvestments.This is trueeven in thesituationofaprivateequity fund-of-fundswhere the

underlyinginvestmentsarethemselvesinvestmentsinotherprivateequityfunds.Anexampleofonesuchstructurewouldbeaprivateequityfundoffundswithafocus on Indian private equity funds. Many such funds, via the previouslymentioned affiliations with a parent firm and investment advisers, are legallycenteredaroundanunexpectedlocation—Malta.Malta, one of theworld's smallest andmost densely populated countries, is

separatedfromIndiabytheArabianSeaandadistanceofapproximately4,000miles.YetMalta,likemanyothersmalloffshorejurisdictions,hadtheforesightto make enough political changes to effect a favorable tax environment andencouragemanycompanies,investors,andassetmanagerstoengageinbusinessrelations with a country they would not have otherwise considered. The tinyislandcountryofMaltahasover50taxtreatiesinplacewithcountriessuchasIndia, Switzerland, France, Germany, Sweden, and the United Kingdom. TheUnitedStatesandMaltahavealsorecentlyratifiedanewincometaxtreatythatbecameeffectiveonJanuary1,2011.Through Malta's numerous double taxation tax treaties, foreign (i.e., non-

Maltan)investorsreceivereliefintheformoftaxcreditsthatsignificantlylowerthetaxbillforforeignerswhoutilizeMaltaasaregistrationhub.However,thepoint of this discussion is not to inform investors about the intricacies ofstructuringMaltese tax efficient private equity structures. Rather, the point isthis:InvestorsseekingtoinvestinanIndia-focusedprivateequityfundoffundsmay,becauseofthefavorabletaxregimesoutlined,findthemselvesforcedtoat

leastobtainabasicfamiliaritywiththesometimestechnicallawsofacompletelydifferent country. In order to perform an informed operational due diligencereviewofafund,investorsneedfirsttounderstandwhattheyareanalyzing.SoifaninvestorissimplytoldthataparticularfundisbasedinMaltabecause

of tax treaties, and then has no understanding or experience with commonpracticesinaparticularcountry,theyareleftwithtwooptions.Optionnumber1involves effectively taking the private equity manager's word for it. Optionnumber2isforaninvestortoattempttomakeanindependentassessmentofthemanager's statements and opinions in this regard. Chapter 2 provides a moredetailed analysis of performing operational due diligence on private equityinvestments,whichwillnecessarilyinvolveinvestorsdevelopinganindependentunderstandingofanyinformationprovidedbyaprivateequitymanager.Sufficeittosaythatthesecondoptionisclearlysuperior.Indeed,mostprudentinvestorswouldcertainlyprefertoputthetimeandeffortintonotsimplytakingaprivateequity manager's word for it, but independently determining the facts andcomingtotheirownindividualassessmentofthesituation.Ataminimum,sucha process allows investors tomakemore informed allocation decisions,whichshouldafterallbeoneoftheprimarygoalsofduediligencetobeginwith.

Industry-SpecificConsiderationsAmong the larger subset of private equity funds there are a number of fund-specificfactorsthatcanariseduringthecourseoftheoperationalduediligenceprocess.Asoutlinedabove,theseitemscanrelateeithertotheuniquestructuringofthefund,jurisdictionalissues,ortheseoperationalriskscanalsobetheresultof risks inherent in the underlying portfolio companies or assets inwhich theprivateequityfunditself invests.Forthepurposesof this text,wewillrefer tosuch risks as industry-specificrisks, in contrastwith the previouslymentionedcountry-orregional-specificrisks.It is worth noting that investors should not run the risks of placing these

industry-andcountry-specificrisksintoindependentsilos.Inmuchthesamewaythatinvestmentriskandoperationalriskinteract,sotoomustinvestorsconsiderin parallel the interactions between country-specific and industry-specificoperational risks.Butwhat exactly are these industry-specific risks?After all,fromanoperationalperspective,aren'tthenutsandboltsofmostprivateequityandrealestatefundsthesame?For example, an investor may consider private equity funds that primarily

investintimberortimberland.Atfirstglance,duediligence,apparentlyfallinginto the category of investment due diligence,would focus on the benefits oftimber investing and any correlation timber may have to other assets. Whennarrowing down the universe to a specific private equity fund timber fund,investmentduediligencemaythenfocusonquestionssuchas:

Whatcompetitiveedgedoesthismanagerbringtothetable?Is the methodology utilized for biological tree growth in line withindustrystandards?Howdoesthismanagersustaintheirinvestmentedge?Whatfactorsareconsideredincomingtoadeterminationregardingtheappropriatetimingoftreeharvesting?What, if any, risk management oversight does the manager have inplaceforthisfund?Isthismanagermakingaccurateprojectionsaboutthefuturemarketforhardwoodsandsoftwoods?

Whentheoperationalduediligenceprocessbegins,ofteninconjunctionwiththe timing of the investment due diligence process, other asset-specificconsiderations may come to the forefront (some of which may be related toinvestment due diligence). For example, investing in a timber fund, which issometimesreferredtoasatimberinvestmentmanagementorganization(TIMO)is a unique exercise as compared to other typesof private equity investments.Timberinvestinginvolvesknowledgeaboutanumberofdistinctfieldsincludingforestry,botany,andcutting,milling,andprocessingtrees.Theskillsetsthatareinvolved in investing in private equity funds that invest in other real assetsbesides timber are completely different. Other types of real asset funds couldincludethosethatmakeinvestments,eitherdirectlyorindirectly,inoilandgas,gold and other precious metals, energy, infrastructure, and agriculture. Thesefundseachhavedifferentareasoffocus.The considerations of investing in agriculture are completely different from

those invested in fundswhose development of real assets such as oil and gasinvolvesdrillingorminingoperations.Dependingonthetypeofoperationandthe sourcematerial (e.g., oil, gas, coal, etc.) being sought, drilling andminingoperationssimilarlyinvolveuniqueskillsetssuchasknowledgeofgeology,thestorage of waste products from drilling and mining operations, and safetyconcerns and appropriate insurance amounts required for dangerous activities.Compared to timber, these knowledge bases are completely different.

Specifically, when investing in TIMO funds, some areas that should beunderstoodbyaninvestorperformingoperationalduediligenceinclude:

If new timberland is acquired, does themanager take steps to ensureexperiencedlumberjacksandforesterscontinuetoworkwiththesamelandasitchangeshandsfromownertoowner?Whatsystemsareinplacetomodeldiseaseratesinthetreesproducedtogrowtimber?Whatprecautionsaretakentoensurediseasedoesnotinfesttrees?Howdoesamanageraccountforincreasesinlandvalueonwhichtreesarelocated?

Aspotentialinvestorsinprivateequityfundsarereadingthisdiscussion,theymay comment, “Wait a minute. I understand these concerns and the uniqueconsiderations of different assets classes even among similar subsets of assetclasses such private equity funds that invest in real assets. But I thought thatthese were more investment-related concerns; why would I need to considersuchissuesinanoperationalduediligenceprocess?”Theanswerscanlieinseveralareas.Everyinvestmentduediligenceprocessis

different. Certain investment due diligence processes may pursue a broaderscopeofreviewthanothers.Asunfairasitmayseem,operationalduediligenceissometimesthedumpinggroundfortheleftoversthatwerenotcovered,eitherintentionally or inadvertently, during the investment due diligence process.Assuggested,thismaynotbeastheresultofanysinisterplanordesigntopunishoroverwhelmtheoperationalduediligenceprocess.Onthecontrary,duetoanumberoffactorsuniquetoeachindividualinvestor

or investment organization, considerations, including time and resourceconstraints, may be in place that influences this decision. For example, aninvestment organization that allocates to private equity couldmake a strategicchoice to have investment personnel focused on sticking to their knitting andfocusing more on the purely traditional investment-related merits in the duediligenceprocesswhereas,theoperationalduediligencefunctioncouldbeaskedto fill in theholes in theseareas.Therefore, theoperationalduediligence rolebecomesincreasinglyexpandedinsuchduediligenceframeworks.Returningtoouroriginalinvestorquery,operationalduediligenceisoneofthe

mostimportantfunctionsoftheentireduediligenceprocess.Yetoperationalriskcannot be viewed in a vacuum.The investment and operational processes canoften play off each other in a symbiotic relationship to produce due diligence

synergies that yield risk insights greater than the sum of their respectiveinvestmentandoperationalparts.AlawstudentintheUnitedStates,andmost likelyinothercountriesaround

theworldaswell,istaughtthatagoodlawyerisabletodefendbothsidesofanargument. After all, when the student graduates and eventually goes intopractice, there is no guarantee, regardless of which area of law they mayspecialize in, that they will become either solely a plaintiff's or a defendant'slawyer.As such, there is a joke about a lawyerwho is engagedby a client torepresenthimorher inaparticularmatter.Thedetailsof thecourtappearancearearrangedbytheclient'sassistantandthelawyershowsupatthecourthouseon the appointedday.Before the hearingbegins, the lawyer turns to the otherside'slegalcounselandasks,“WhichsideamIrepresenting?”andthenbeginstoargue accordingly. Clearly, no reasonable lawyer would undertake a courtappearancewithoutadequatepreparation;however,thisstoryisinsomecasesabit likeoperationalduediligence in certainorganizations, particularly in thosewithdedicatedoperationalduediligencefunctions.Anoperationalduediligenceprocess typically starts after that of investment

due diligence.When the handoff to the operational due diligence departmentoccurs, an investor is typically fairly far along in the process and progressingrapidlytowardmakinganinvestmentdecision.Typically,theinvestmentsideofthe due diligence process has already developed a number of opinions andconvictions regarding the strengths andweaknesses of the private equity fundandorganization.Thisprocesscanserveasaguideonwhichtheoperationalduediligencefunctioncanhangitshat,andcanutilizetobegintonavigatethroughtheoperationalduediligenceprocess.These types of risks might not have been the type that the operational due

diligenceprocessmayhavetraditionallyfocusedon.Oftentimes,suchissueswillbe driven, or certainly rooted in, investment-related considerations. As such,during the operational due diligence process an investor may likely read theinvestment related file andhave to argue a particular side onewayor anotherwith a manager in order to utilize as leverage to either obtain additionalinformationorultimatelynegotiatebettertermspriortoinvesting.AsChapter2discusses inmoredetail,knowingwheretopickyourbattles in theoperationalduediligenceprocesscanbeanimportantstrategicskillsetthatinvestorsmustmaster in order to maximize the benefits of the operational due diligenceprocess.

INVESTMENTANDOPERATIONALDUEDILIGENCE:NEXUSORBLURRED

LINES?The beneficial nexus between investment and operational due diligenceprocessesshouldnotbeconfusedwith theestablishmentofahomogenousduediligenceprocessthatperhapscompromisesefficiencyandsharedunderstandingwith a lack of independence and functional due diligence competencies. Theentireduediligenceequationisdisplayedasfollows:

Fromthisequationwecansee thatan investor'sentireduediligenceprocessconsistsofacombinationofbothinvestmentduediligenceaswellasoperationaldue diligence.With due diligence performed exclusively in one area, such asinvestment due diligence, the equation is unbalanced and incomplete. Bothcomponentsof this equation, investment andoperational duediligence, shouldnotoperate in isolation.This isparticularly trueof thefieldofoperationalduediligence. In order tomake a fully informed operational risk assessment of aprivateequityfund,aninvestormustbecognizantofseveralinvestment-relatedfacts specific to a private equity fund's basic investment strategy and tenants.Suchunderstandingsareusefulforanumberofreasons.Examplesofthiscanbefoundinsuchoperationalriskareasasvaluations.An investor performing operational due diligence cannot determine the

effectiveness of valuation policies and procedures if they do not have anunderstanding what the private equity fund is investing in. Without suchdiscussions,theoperationalduediligenceprocessrunsariskofbeingseparatedfromtheinvestmentprocess.Furthermore,suchcollaborativedialoguesbetweeninvestmentduediligenceandoperationalduediligencefunctionscanalsoyieldbothsidesofthetotalduediligenceequation,developingadeeperunderstandingofthetotalrisksinvolvedininvestinginaparticularprivateequitymanager.If such collaborations between the investment and operational due diligence

processesbecometooinvolved,then,ofcourse,thelinesbetweensuchprocessesmaybecomeblurredand investors run theriskofdissolving these twodistinctprocessesintoahomogenousprocess.Suchahomogenousprocessisdetrimentalto thebenefitsprovidedbyan investormaintainingan independentoperationalduediligenceprocess.Whensuchindependenceexists,theultimateoperational

determinationismuchlesslikelytobetaintedbyinvestmentconsiderations.Insummary, thebenefitsofcollaborationbetween the investmentandoperationalduediligenceprocessesmustbetemperedwiththemeasuredconcernofthelossofindependenceofeachdistinctprocess.

DIFFERENCESANDSIMILARITIESWITHHEDGEFUNDOPERATIONALDUE

DILIGENCE

SimilaritieswithHedgeFundOperationalDueDiligence

Due diligence processes across all asset classes, whether within the realm ofalternative investments ormore traditional investment strategies, share certaincharacteristics and goals. These similarities certainly apply to both traditionalnotions of investment and operational due diligence.As outlined earlier, thereareanumberofdifferencesandsimilaritiesevenamongsimilarassetclasstypessuch as private equity and real estate. Similarly, narrowing our focus toalternative investment operational due diligence, there are both a number ofsimilarities anddifferences betweenhedge fund andprivate equity operationalduediligence.Thesimilaritiesbetweensuchfundsmayhavebeenfirstdrivenbytheinvestmentside,withactivisthedgefundsbeingconsideredasalternativestoprivateequityfunds.16

Itshouldbenotedthatthepreviouslymentionedsimilaritiesarefundamentallyfound in the core operations of fund management and certain sharedcommonalities of operational risk.Also contributing to similarities among theoperationalduediligenceprocessesandactualoperationsmanagementofhedgefundsandprivateequityistheincreasinglyshrinkingoperationaldividebetweentraditionalnotionsofboth typesof fundsviaagrowingwaveofhybrid funds.The termhedge fund is an umbrella term that encompasses awide variety oftradingstrategies. Increasingly, these tradingstrategiesmayhavean increasingnumberofprivateequity-likefeatures.Thishasresultedinthegrowthinrecentyearsofso-calledhybridorcrossoverfunds.17Furtherblurringthelinebetweenhedge funds and private equity are rumors and concerns of collusion betweenhedgefundsandprivateequityfunds.18

In order to highlight some of the similarities between the operational duediligenceprocessesemployedforbothprivateequityfundsandhedgefunds,itisperhapsbesttoframethisdiscussionfirstinthecontextofthegoalsoftheduediligence process. The shared goals of investors performing operational duediligenceonbothprivateequity fundsandhedge funds include riskdiagnosis,mitigation,andmonitoring.Whilethespecificwaysinwhichsuchprocessesarecarriedoutdiffers,asdiscussedinmoredetailinthe“differences”sectionfurtheron, there are common goals to both approaches. Indeed, these goals may besharedamonginvestorsperformingoperationalduediligencenotonlyonhedgefundsandprivateequityfundsbutonothertypesoffundsaswell.Intermsoftheactualoperationalriskfactorsanalyzedduringtheoperational

due diligence process, many investors may incorporate the same basicoperational risk factors into their own core review process. These factorsimilarities, as with the other similarities outlined in this section, should notimply thathedge fundoperationalduediligenceandprivateequityoperationalduediligenceareinterchangeableprocesses,aswillbehighlightedinthesectionon differences. Returning to the core factor similarities, these sometimesoverlapping operational risk factors are not necessarily exact copies of eachotherineveryrespect.Onthecontrary,thesimilaritiesaremorelikelytobeamonggenericumbrella

operationalriskcategories.Differencesareoftenapparentas investorsbegintodig into themeat of these categories. This shouldmake sense, as certain coreoperational processes of hedge funds and private equity funds are similar inbasic function;however, such similaritiesonlyextendup toacertainpoint. Inpure private equity and hedge fundplays, each of these different asset classesinvolves a fund possessing markedly different portfolio of assets. Thesedifferencesareofcourseblurredbythepreviouslymentionedevolutioninrecentyears of private equity and hedge fund hybrids that may hold increasinglysimilarasset types,particularly in termsofan illiquidassetprofile.Thatbeingsaid, despite any asset type differences, similarities in large umbrella coreoperationalriskfactorcategoriesstillexist.Another way we can view the similarities in the investor operational due

diligencereviewsbetweenhedgefundsandprivateequityistoevaluatetheduediligenceexercisesintermsoftheactualduediligenceprocessesemployed.Ona high level from a process perspective, the basic waypoints along theoperationalduediligenceprocessforhedgefundsandprivateequityfundshavemanysimilarities.SuchaprocessisoutlinedinExhibit1.14.

EXHIBIT1.14GeneralOperationalDueDiligenceProcessforPrivateEquityandHedgeFundOperationalDueDiligence

Chapter3outlines theintricaciesofeachof thedifferentstepsregardingthisprocess inmoredetail.However, for thepurposes of our current discussion, anumber of similarities exist in terms of the core steps necessary to performoperationalduediligencereviewsofbothhedgefundsandprivateequityfunds.With the previouslymentioned similarities in the high-level operational due

diligence processes related to hedge funds and private equity, it is alsoworthconsidering the similarities between the operators of the processes. In certaincases,thiswillbeasingleinvestorperformingbothinvestmentandoperationalduediligenceontheirownbehalf.Inothercases,aninvestormayrepresentaninstitutionalentitysuchasanendowment,foundationorcorporatepensionoraprofessionallargerinvestmentallocatorsuchasafundoffunds.Regardlessoftheorganizationalaffiliationofaparticularinvestor,theroleof

aninvestormayfallintoanumberofdifferentrolesdependingonanumberof

factors including the size of their particular organizations as well as theirorganization's approach toward operational due diligence. That is to say, aninvestor may be solely dedicated toward investment due diligence relatedmatters, or solely dedicated toward operational due diligence, or, as is morelikelythecaseinthecurrentstateoftheprivateequitycommunity,dedicatedtoablended due diligence analysis consisting of a combination of investment andoperational rules. In the latter case, these blended roles typically slant moreheavilytowardtheinvestmentduediligencesideasopposedtotheoperationalside. However, a growing number of investment organizations are allocatingdedicated resources toward monitoring operational risk in private equityinvestments.Regardlessof the specificdesignated roleof the individual, therearecertain

skillsetsthatarerecommendedtoperformoperationalduediligence.Onacorelevel,manyhedgefundandprivateequityoperationalduediligencereviewswillhavesomedegreeofoverlapamongoperationalriskfactorscoveredonahighlevel.Logically, it thenfollowsthat therewillbeothersimilaritiesintheskillsand basic competencies required to perform these reviews. But exactly whatskillsarerequiredtoperformoperationalduediligenceinthisregard?While other texts provide amore complete overview in this regard, for the

purposesofourdiscussion,wecanbegindevelopingourunderstanding in thisregard by first acknowledging that operational due diligence is amultidisciplinary subject.19 Due to the multifaceted nature of this subject, anindividualperformingoperationalduediligencewillataminimumneedtohavesomedegreeofexperiencewithmanydifferentdisciplines.Someofthecommonrequisite basic skills can include knowledge of accounting, back-officeoperations,informationtechnology,thelaw,compliance,andvendorevaluation.Many times a single individual will not, even on a generic level, possess asufficientdegreeoffamiliaritywithallofthesedifferentareastobeaneffectiveoperationalduediligenceanalyst.Inthesesituations,oftenaninvestormayworkin a team environment consisting of operational due diligence analysts fromdifferentbackgroundsthatasagrouppossesssuchrequisiteskills.Alternatively,aninvestormayoptforthesometimesmoreefficientsolutionof

engagingtheservicesofa third-partyoperationalduediligenceconsultantwhospecializesinthisfield.Forreference,amoredetaileddescriptionofoperationalduediligenceconsultingarrangementsisofferedinChapter3.Fornow,thepointofthisdiscussionistohighlightthat,duetosomedegreeofsharedsimilaritiesinthe underlying core operational risk factors typically analyzed by investors

during the operational due diligence process on both hedge funds and privateequityfunds,similaritiesalsoexistintheskillssetsrequiredtoproperlyexecuteoperational due diligence on these funds. Similarities between Private EquityFundofFundsandHedgeFundofFundsIt should also be noted thatmanyof the similarities outlined above are also

applicable to funds that invest in private equity funds andhedge funds.Wheninvestorsareseekingtoinvestinfundofprivateequityfundsandfundofhedgefunds,itisadvisablethattheyperformoperationalduediligenceonthesetypesof investmentvehicles aswell.Whileperformingoperationalduediligenceonsuch funds is a bit of a different exercise than performing operational duediligenceonadirectprivate equity fundorhedge fund, there are anumberofsimilaritiesbetweensuchvehicles(e.g.,fundofprivateequityfundsandfundofhedgefunds)thatarecomparabletogoalandprocesssimilaritiesofdirectfundsoutlinedabove.

DifferenceswithHedgeFundOperationalDueDiligence

Based in part upon the different traditional investment approaches andoperationalinfrastructuressupportingtheseapproachesofbothhedgefundsandprivate equity funds a number of differences are apparent with regards tooperationalduediligenceonbothhedgefundsandprivateequityfunds.

LessTradingFrequencyOne notable difference between private equity and hedge funds relates to theanalysis of a factor that is generally a shared factor in the umbrella coreoperational risk category discussed in the similarities section. As suggestedabove,cracksbegintoemergeonceinvestorsstarttheprocessofdiggingintothedetails of the different umbrella categories between private equity and hedgefunds.Oneofthemostobviousfactorsinthisregardistradelifecycleanalysisandposttradeoperations.Hedgefundsasawholetendtoengageinmuchmorefrequenttradingactivityascomparedtoprivateequityfunds.Such generalizations are of course contingent upon the investment strategy

aroundwhichaparticularhedgefundorprivateequityfirmisbased.However,to utilize an extreme example, let us consider a venture capital fund asrepresentative of our private equity fund and a high-frequency commodity

trading advisory (CTA) to be representative of our hedge-fund strategy. CTAhedgefundsmayexecutetensofthousandsoftrades,ormore,onadailybasis.A venture capital fund, putting aside any consideration of trading aroundpositionsorcurrencyhedging,mayexecutea tradeonceamonthif it is lucky.These are two very different operational animals. As such, an investorperforming operational due diligence on these types of fundswill still inquireintothesubjectoftradeoperations,butthisiseffectivelywherethesimilaritiesend.Ahigh-frequencytradingoperationmusthavetheabilitytoexecutetradesin

real time.Onapostexecutionbasis thestaff, systems,policies,andproceduresmust be in place to confirm, allocate, and settle large volumes of trades in anefficient,ifnotautomated,manner.Withsuchhigh-frequencytradingoperations,evenwithdirect-exchangeFinancial InformationExchange (FIX)connectivity,tradebreaksbetweenthehedgefundandthetradingcounterpartiescanoccur.Insuch cases, the posttrade operations team's middle and back offices must becapableof investigatingand resolvingany suchbreaks inaneffectivemanner.Withoutsuchoperationalsystemsandknowledgeablestaff,thehedgefundwill,atbest,notbeabletofunctionefficiently,andatworstjustgrindtohalt.Contrastthiswithaventurecapitalfirm.Whenthedecisionismadetoallocate

newor additional capital to aparticularportfolio companyafter a capital call,this is generally a fairly straightforward repeatable process that occursinfrequentlyandwithagenerallylowtradevolume(certainlylow,comparedtomostCTAfunds).However,becausesuchtradingactivitiesarechunkierandlessfrequentinnaturedoesnotmeanthattherearenotjustasmanyoperationalrisksthat could result in significant losses as there are in a high-frequency tradingoperation. On the contrary, the deadly magnitude of such risks may be evengreaterinaprivateequityfundpreciselybecauseofthechunkynatureofthesetrades, which are often at much larger individual amounts, compared tothousands of very small high-frequency trades. The operational risks are stillthere,theyjustmaybeindifferentplaces.

MoreConcentratedPortfoliosSimilar to the notions of different trading frequencies outlined previously,privateequityfunds,ascomparedtohedgefunds,oftenhavemoreconcentratedportfoliosconsistingoffewertotalaggregatepositions.Suchgeneraltrendscanhave ramifications across a number of different operational risk areas, as

analyzedduringtheoperationalduediligenceprocessforbothhedgefundsandprivateequity.Anexampleofsuchanareaisvaluation.Toexplainthisinmoredetail, it is worth introducing the context in which valuations are commonlyevaluatedinthescopeofanoperationalduediligencereview.WhileChapter5offers a more detailed discussion of valuation, we can begin here with anintroductiontovaluation.Before discussing valuation, we must consider a few points regarding the

operationalduediligenceprocessitself.Anoperationalduediligencereviewisnot thesameasa traditionalaudit.First, anauditor is typicallyengagedbyaninvestment vehicle (e.g., a hedge fund or private equity fund) to perform anaudit.Inthiscase,aninvestoristypicallyperformingoperationalduediligenceon their own behalf and not at the behest of another individual. Second, anoperational due diligence analyst will most likely not have the level oftransparencythatanauditorwillhave.Thisislikelydueinparttothepointmentionedearlier.Manyhedgefundsand

privateequity fundsmayapproach theentireduediligenceprocess ingeneral,beyond the pleasantries of the initial marketing efforts, as an exercise ininformationcontrol.Furthermore,askilledhedgefundorprivateequityfirmcanoften conduct a sleight-of-hand, employing the age-old magician's aid ofdistraction, regarding the levels of transparency and types of information theyprovide to certain investors. Furthermore, based on their already preparedmaterials,suchasastockoff-the-shelfduediligencequestionnaireormarketingpresentation, they may be able to lead an investor down a primrose path ofoperationaldistractions,whichcancausean investor to focus theiroperationalduediligenceeffortsoncertainriskareas,whilecertainoperationalweaknessesare shielded from inquiry. Despite the cat-and-mouse elements of theseprocesses, a skilledoperationalduediligenceanalyst cannavigate thisprocesseffectivelyandcangenerallycollectall thenecessaryinformationtoperformadetailedoperationalassessmentofafund.With thesepoints inmindwecannowreturn to thesubjectofvaluation.An

operationalduediligenceanalystwilllikelyneverhavesufficientinformationtoconduct an independent valuation of an asset held in a portfolio of a privateequity fund. Furthermore, for a newly forming private equity fund, whenoperational due diligence is typically performed there is no fund yet likely inexistence,or if ithasbeen formed it is likely justa legal shellwithnocapitalfundingasyet,and,therefore,thereisnothingintheportfoliotovalue.Rather an investor performing operational due diligence at this stage must

evaluatewhatisavailabletothem.Thatisthepoliciesandproceduresregardingthe valuation process. It is from these pieces of operational information that adue diligence analyst can make a determination as to how conservative andconsistentafundwillbewiththeirvaluationprocess.Examplesoftheareasaninvestorcanlookat includethefrequencyatwhichsuchvaluationswilloccur;theprocesses,methodologies,andvaluationinputsthatareutilized;andwhetheranyindependentpartiessuchasthird-partyvaluationconsultants,willbeutilizedindeterminingvaluation.Valuations are typically aparamount concern amongmany investors performing operational due diligence on private equity fundsbecauseofthehighlyconcentratednatureofprivateequityportfolios.This can be contrasted with the issue of valuation in the hedge funds.

Dependingof course on the hedge fund strategy, the number of positions in ahedge fund, as compared to a private equity fund, is likely to bemuchmorediversifiedandlessconcentrated. Inmore liquidhedge-fundstrategies,suchasequity long-short, thebulkof theportfolio ispublicly listed,highly liquid,andcan be priced virtually in real time from a variety of third-party independentpricingsourcessuchasBloombergandReuters.Suchpositionsfromavaluationperspective are the complete antithesis of concentrated, illiquid private equityfund holdings. Consequently, an investor approaching the issue of valuationduring thecourseofanoperationalduediligencereviewofahedgefundmusttakeadifferentapproach tounderstandingvaluation.Yes, therearesimilaritieswithregardtotheevaluationofvaluationpoliciesandprocedures,astherewaswhen an operational due diligence review of private equity was performed.However, different considerations thatwere absent in aprivate equity context,such as which valuation sources are utilized by the manager and the way inwhich a larger number of valuation inputs are accounted for, must also beconsidered.

NoActivelyTradedPortfolioforNewFundsAnother key difference between the operational due diligence processes forhedge funds and private equity relates to the nature of new private equityvehicles that are undergoing initial capital raises. Many investors seeking toinvestinaprivateequityfundmaydosoduringtheinitialcapitalraisingperiodofaprivateequityfund.Itisatthisstageofthefundingprocess,dependingonthestructureofthefund,thatinvestorsmaybeaskedtoputupacertainamountofcapitaltogettheballrolling.Beyondthisinitialinvestment,investorsarealsoexpected to make capital commitments, which are called upon by the private

equityfund.Whenthecallcomes,investorscommittheirfunds,subjecttotheirpreviousagreements.Thisistobecontrastedwithmosthedgefundstrategies.Oftentimes,evenfora

newlyformedhedgefund,thefundisactivelytradinginsomeform.Thistradingcould be with the hedge fund principle's own proprietary capital, sometimesreferred to simply as prop capital, or via a combination of prop capital andexternal funds. Additionally, due to the ongoing rolling nature of hedge fundsubscriptionsandredemptions,puttinganyconsiderationsoflockupperiodsandgatesaside,moneyisactivelyflowingintoandsometimesoutofthefund,onanongoingbasis.Thepoint is that an investor approaching a fund is trading andtherefore,hastobeabletohandletherelatedpretradeandposttradeoperationalprocesses.Therefore,whenaninvestorisperformingoperationalduediligence,theythenhaveanopportunitytoanalyzeanactivefunctioningorganizationthatis likelyoperating, at least fromanoperational perspective, inmuch the samewayitwillbeafteraninvestorallocatescapital.Thisresultsinaninvestorbeinglikely to have a much better opportunity for operational data collection andanalysisinahedgefund,ascomparedtoaprivateequityfund.

DocumentCollectionDifferencesDue to the fact that a newly formed private equity fund has not yet been inoperationforasubstantialperiodoftime,anumberofdifferencescanbeseenintheoperationalduediligencedocumentcollectionprocess,ascomparedtohedgefunds.Ahedgefundthathasbeeninoperationforaperiodofoneyearhaslikelyproducedauditedfinancialstatements.Aninvestorcan thencollectandreviewsuch statements during theoperational duediligenceprocess.Anewly formedprivate equity funddoesnothave suchdocumentation available. Investors canutilize a number of techniques to broach this issue, including examiningstatements of any previous vintage fundsmanaged by the private equity firm.Despite such techniques, an investor familiarwith performing operational duediligenceonhedge fundswho isnowperformingoperationalduediligenceonprivateequityfundsshouldapproachthedocumentcollectionprocesswiththesedifferencesinmind.

MoreAsset-SpecificKnowledgeRequiredAnother difference between private equity fund and hedge funds from anoperational perspective is related to the more concentrated nature of private

equityportfolios.Hedgefunds,dependingonthestrategy,maygenerallytradeininstruments and securities for which exchanges or markets may exist. Thesemarkets may not necessarily the highly liquid markets that are present fromequitiesbut ingeneral there is somesortofexchangebywhichassetsmaybetraded,howeverthinly.Thisisnottoimplythathedgefundssolelyholdliquidpositions.Inparticular,since2008manyhedgefundsrealizedthatpositionsthattheybelievedtobequiteliquidwereinfactnot,andmanysuchpositionswereplaced and still remain in side-pockets. As we move along the spectrum ofliquidity from highly liquid to less liquidwe tend to bemore in the arena ofprivateequity.Withthisdroughtofliquiditycomesanumberofbothassettypeand individual asset-specific concerns that investors must consider during theoperationalduediligenceprocess.In a general sense, asset-type concerns for private equity funds can include

itemssuchasthegeneralcategoryofinvestmentsmadeintounderlyingportfoliocompanies.Certainlyadditionalgranularitycanbeaddedbyinquiringintowhata particular private equity fund may be exchanging capital for. Is a fundreceiving direct equity in an underlying portfolio company, a combination ofequityandstockoptions,orperhapsequityinaparticulardealalone?Regardlessof the typeofsecurityheld, there is likely lessofasecondarymarket forsuchassetsasopposedtomorehighlyliquidpositions,whicharecommonlyheldtosomedegreebyhedgefunds.Asset-type concerns can be further contrasted with individual asset-specific

concerns. Typically such concerns arise in relation to one-off unique assetscommonly seen in real estate.While it is true that certain similarities do existamong certain property types (i.e., there are common characteristics that areapplicableamongtwodifferentshoppingmallproperties),eachpropertyalsohasuniqueconsiderations.Oftentimesduring theoperationalduediligenceprocessfor such funds, an investorwill need to gain an understanding of these asset-specific considerations such that they can effectively analyze operational riskareas including valuation, as referenced previously. Such asset-type andindividual-asset specific concerns are often not as prevalent in hedge fundoperationalduereviewprocesses.

NOTES

1.FAASystemSafetyHandbook,Chapter15:“OperationalRisk

Management,”December30,2000.2.SeeDennisI.DicksteinandRobertH.Flast,NoExcuses:ABusinessApproachtoManagingOperationalRisk(Hoboken,NJ:JohnWiley&Sons,2009).3.LarryE.SwedrowandJaredKizer,TheOnlyGuidetoAlternativeInvestmentsYou'llEverNeed(BloombergPress,November12,2008),132.4.SeeChristineBuckley,“TUCCallsforActionon‘CasinoCapitalists,’”TheTimes,February21,2007(summarizingthecommentsofBrendanBarberfromtheUnitedKingdom'sTradesUnionCongress).5.SeeRalphAtkinsandPatrickJenkins,“GermanBusinessWelcomesthePrivateEquity‘Locusts’,”FinancialTimes,May5,2005.6.SeeRichardA.Booth,“TheBuzzardWasTheirFriend—HedgeFundsandtheProblemofOvervaluedEquity,”U.Pa.JournalofBusinessandEmploymentLaw10:3,Summer2008.7.SeeThomasHeath,“AmbushingPrivateEquity,”WashingtonPost,April18,2008.8.SeeCyrilDemaria,IntroductiontoPrivateEquity(Hoboken,NJ:JohnWiley&Sons,2010).9.SeeCorgentumConsulting,“TheMadoffEffect—AnAnalysisofOperationalDueDiligenceTrends,”June2010,www.Corgentum.com.10.SeeM.JohnLubetkin,JayCooke'sGamble:TheNorthernPacificRailroad,theSiouxandthePanicof1873(UniversityofOklahomaPress,2006).11.LesStandiford,MeetYouinHell:AndrewCarnegie,HenryClayandtheBitterPartnershipThatTransformedAmerica(Crown,2005).12.HansLandström,HandbookofResearchonVentureCapital(EdwardElgarPublishingLimited,UK,2007),11.13.SeeWilliamH.DraperIII,TheStartupGame(PalgraveMacMillion—adivisionofSt.Martin'sPressLLC,2011).14.SeeBryanBurroughandJohnHelyar,BarbariansattheGate:TheFallofRJRNabisco(HarperCollins,2009).15.SeeJasonScharfman,HedgeFundOperationalDueDiligence:UnderstandingtheRisks(Hoboken,NJ:JohnWiley&Sons,2008),Chapter1.16.SeeDouglasCumming,PrivateEquity:FundTypes,RisksandReturnsandRegulation(Hoboken,NJ:JohnWiley&Sons,2010),159.17.SeePierre-YvesMathonetandThomasMeyer,J-CurveExposure:

ManagingaPortfolioofVentureCapitalandPrivateEquity(WestSussex,England:JohnWiley&Sons,2007),34(discussingtheconvergenceofprivateequityandhedgefunds).18.SeeJamesMackintoshandMartinArnold,“FrenchProbeBuyout‘Collusion,’”FinancialTimes,June6,2007(outliningtheinquirybytheFrenchfinancialregulatoryauthority,AutoritédesMarchésFinanciers,intoallegationsthatactivisthedgefundsmayhavepressuredacompany'smanagementtoputcompaniesupforsalewithoutdisclosingagreementsinplacetosellthehedgefund'sstakesinthosecompaniestoprivateequityfirms).19.SeeJasonScharfman,HedgeFundOperationalDueDiligence:UnderstandingtheRisks(Hoboken,NJ:JohnWiley&Sons,2008),69.

CHAPTER2

ImportanceofOperationalDueDiligenceforPrivateEquityFunds

Inmostdisciplinesrelatedtotheconceptofinvesting,thereislittleargumentastoboththescopeof thefieldscoveredbytheparticulardisciplineandwhetherany particular field can be justified in the first place. Analyzed in astraightforward manner, the discipline of investment due diligence in privateequitywouldgenerallybeagreed tobebroadly related to selecting,analyzing,and funding private equity funds. Furthermore, in order to invest in privateequityitwouldcertainlyseemjustifiedthattherebeadisciplinededicatedtothisexercise. Another less obvious example would be the discipline of riskmanagement. Even outside the world of private equity, risk management is awell-established field in asset management that covers areas relating todiagnosing and mitigating risk or even facilitating calculated risk taking.Furthermore, it is likely that almost everyone both within and outside of theprivate equity communitywouldplainly acknowledge that riskmanagement isessential. Operational due diligence, however, is not as well understood andappearstobeoddmanout.Manyinvestorsseemunsureaboutwhetherornottheyshouldbeperforming

operationalduediligencereviewsonprivateequityfunds.Evenoperationalduediligence analysts who primarily focus on other asset classes such as hedgefunds often seemed confused, if not downright resistant, about performingoperationalduediligenceonprivateequityfunds.Thereareanumberofreasonsfor this confusion and resistance, many of which are primarily routed in thenatureofprivateequityfundsasawhole.Beforediscussingsuchobjections indetail, it is advisable to firstmake a brief detour and revisit our discussion inChapter 1 regarding the reasons an investor should consider performingoperationalduediligencetobeginwith.Agoodplacetostartthisdiscussioniswiththegoalsoftheoperationalduediligenceprocess.

UNDERSTANDINGTHEGOALSOFTHEOPERATIONALDUEDILIGENCE

PROCESSBefore undertaking a discussion of the merits, or lack thereof, in performingoperationalduediligenceonprivateequity funds it isbeneficial to takea stepbackandconsiderthepurposesorgoalsoftheoperationalduediligenceprocesstobeginwith.Afterall,withoutanunderstandingofthemotivationsbehindtheactionsofperformingduediligence,itisnotreallyafairevaluation.Sowhatisthegoalofoperationalduediligence?Aspreviouslyintimated,theprimarygoalsof many investors are driven not by lofty aspirations but are rather rooted inconcernsrelatedtooperationalrisk.Specifically,onesuchmajorconcernisthepossibility of fraud.Therefore, the corresponding goal is to avoid exposure tofraudulent activity. As we previously acknowledged, this is certainly areasonable and important goal.Exhibit2.1 presents a summary ofmany othercommonconcernsandcorrespondinggoals.

EXHIBIT2.1CommonOperationalDueDiligenceConcernsandGoals

OtherGoals:OperationalProcessLearningIn addition to diagnosing, analyzing, andmitigatingoperational risk, investorsmayalsohaveanumberofaffiliatedancillarygoalsthatareassociatedwiththeoperationalduediligenceprocess.Onesuchgoalcouldbetonotonlycometosomesortof conclusion regarding theoperational infrastructureof aparticularprivateequity fund,butalso toactually learn somethingduring theprocess.Acommonapproachwouldbeforaninvestortoperformoperationalduediligenceonaprivateequity fundwith thegoalofbeingable tounderstand the internaloperational processes of a particular private equity fund and also be able toexplainthemtoanotherinvestor.Typicallymanyinvestorswilleitherreadaseriesofdocumentscollectedfrom

amanager,orsit inameetingwithaprivateequitymanager'soperationsstaff.Duringtheprocess,manyinvestors,particularlywhenfacedwiththevolumeofinformation coming their way, feel overwhelmed. When this happens, manyinvestors, and rightfully so, default to a head nodding approach toward due

diligence.Forexample,duringanon-sitemeeting,aprivateequityfirm'schiefoperations officer (COO)will sitwith an investor andwalk them through theback-office processes. Within a few minutes, an investor who is not actuallytryingtounderstandaprocesswiththegoalofhavingtoexplainittosomeoneelse will end up simply trying to assess it. This typically results in investorsnodding in agreement with the COO's explanations.While this head-noddingmayindicatethattheCOOcancontinueexplainingsubsequentoperationalsteps,the investormayat best be logging this information intohis or her short-termmemory.If,ontheotherhand,aninvestorwasapproachingthisdiscussionwiththegoal

ofexplainingtheoperationalinfrastructureoftheprivateequityfundtoathirdperson,adifferentdialoguewouldlikelytakeplace.Atthispoint, it isperhapsworthwhile to discuss another ancillary goal of the operational due diligenceprocess:Howitisdocumented?

OtherGoals:OperationalDueDiligenceProcessDocumentation

Some investors perform operational due diligence with the goal of simplycomingtoanassessmentof theoperationalriskspresent inaparticularprivateequity fund. In these cases, investorsmaygive less consideration to how theydocument the data collected and the analysis process that led to this ultimateconclusion. It is common practice formany investors to seek to document, insomeway,shape,orform,theoperationalduediligenceprocess.Someinvestorsmayonlyproducedocumentationthatcontainsconclusionsof

the operational due diligence process. Others, such as CorgentumConsulting,produce extensive, detailed operational due diligence reports that outline notonlytheoperationalstrengthsandweaknessesofaparticularprivateequityfund,butalsothedetailsofeachoperationalprocess.Thereareanumberofbenefitsinproducingsuchadetaileddocument,perhapsthemostimportantofwhichisthatit facilitates an information-based approach toward reaching a conclusionregarding theoperational attributesof a particular fund.Compare this tootherapproachesthatmayofferonlysummaryconclusionsandeffectivelyaskreadersofthereporttotrustthereportwriterwithoutquestioningthedetails.Anotherbenefitofdocumentingtheoperationalduediligenceprocess,andthe

subsequentoperationalinfrastructuresofaparticularprivateequityfund,isthatit requires an investor to put things into writing. Many times investors may

believe that theyunderstandaparticularoperationalconcept indetail.Suchanunderstanding is facilitated when someone who is very knowledgeable aboutparticularoperationalpractices, suchas theCOOofaparticularprivateequityfund, explains them. Oftentimes investor preconceived notions of detailedunderstanding are deflated when they sit down to either explain the sameoperational processes to a third person in the same amount of detail or arerequiredtoconveytheinformationinwriting.This isnotmeant to imply that investorsarenotcapableofpayingattention

during the private equity operational due diligence process or are otherwiseincapable of following through with detailed descriptions of operationalprocesses.What thisdiscussion isattempting tohighlight is that investorswhodonot set thegoalandprepare to re-explaincertainprocesses,eitherorallyorviaadocumentedoperationalduediligencememorandum,oftenruntheriskoflettingdetailsfallbythewayside.

OtherGoals:BenchmarkingandOngoingMonitoringAnother goal that many investors may, or should, have when performingoperational due diligence is to facilitate the development of operationalbenchmarks.Thesebenchmarkscanbeutilizedtofacilitateongoingmonitoringof a particular fund under review. Furthermore, the development of suchoperational benchmarks can broaden an investor's operational knowledge baseandenhancethequalityoffutureinitialfundreviews.These goals relate directly to the previously referenced goals of operational

process learning and process documentation. By developing a measuredunderstanding of operational processes and documenting this understanding,investorscanthenbegintoconstructadatabaseofoperationalriskinformation.Corgentum Consulting has developed such a proprietary database to facilitateoperational benchmarking. This benchmark analysis allows investors andconsultants to compare a particular private equity fund's operationalcompetenciesandprocessestothepracticesofotherfunds.Thisbenchmarkanalysisnotonlyfacilitatessuchacomparisontoothermarket

practicesbutallowsforeffectiveexceptionreportingaswell.Anexampleofthisexception reportingwould be the use of third-party valuation consultants. Forexample, let's say that an investor has developed operational informationregardingadatabaseof100differentprivateequityfunds.Then,considerthataparticularprivateequityfundutilizesonethird-partyvaluationconsultant,called

ABC valuation consultants. If the other 99 funds in the database use othervaluationconsultants, thenanexceptionhasbeenproduced from thedatabase.While thismightnotbe representativeof a larger trendbecauseof the limitedsamplesizeoftheinvestor'sowndatabase,fromtheinvestor'sperspectivetheyare not likely to have any familiarity with or have performed any prior duediligence on ABC valuation consultants. Therefore, in our example, ABCvaluationconsultantsrepresentananomalythatshouldberesearched.Thisisnotmeant todisparage theworkofABC'svaluation consultants. Indeed, this firmmaybequitewell known in theprivate equity community, yet the firm is notknown to our investor. The investor may only be able to keep track of suchinformation via the previously mentioned operational due diligencedocumentationproceduresthatfacilitatesuchbenchmarking.Investors performing operational due diligence on private equity fundsmay

alsobeperformingthisexercisewiththegoaloffacilitatingongoingmonitoring.Ongoingmonitoringreferstoanyoperationalduediligenceprocessesthatoccurafter an initial operational evaluation is complete. This process is typicallyperformedafteraninvestorhasmadeanallocationtoafund.Regardlessofthearguments in favorofandagainstperformingsuchongoingmonitoring(whichwill be discussed in more detail in the next section), investors may wish tocollect operational data with the goal of facilitating this ongoing monitoring.Similar to the benefits of operational benchmarking processes, investors canlearnfromtheirowninternaloperationalduediligenceprocessdocumentation.Oftentimesmanyitemswillbeinprocessesorunderdevelopmentaloperationalchanges at the time of the initial operational review. By documenting suchprocesses,investorsthenhavearoadmapthatcanguidefuturemonitoringofaprivateequityfund'sprogress.Thisisofcoursemoreeasilyfacilitatedbyhavingadocumentedoperationalriskevaluation,comparedtowhensuchanoperationalduediligencememorandumorreportisnotproduced.

COMMONARGUMENTSAGAINSTOPERATIONALREVIEWSOFPRIVATE

EQUITYFUNDSNow that we have provided an introduction to some of the common goalsinvestorsmayhavewhenapproaching theoperationalduediligenceprocesses,

wecannextbegintoconsidersomeoftheargumentsforandagainstperformingoperationalduediligencereviewsofprivateequityfunds.Assuggestedabove,asabsurdasitmayseemtosome,othersarestilleither

notsureor totallyunconvincedabout themeritsofperformingoperationalduediligence on private equity funds. These objections are often raised despite aseriesofconvincingargumentstothecontrary,whichstronglyfavorperformingoperational due diligence on private equity funds. However, before delvingdeeper into such arguments, let us first focus on the questions raised andobjectionsinthisregard.

Doesn'tIncreasedGovernmentRegulationSufficientlyInsulateInvestorsfromOperational

Risk?In the context of the recent fervor with which financial regulatory regimesthroughout the world have sought to place restrictions on risk-taking andenhance transparency, fund disclosures, and the frequency of such oversights,manyinvestorsmayraisethequestion,“Whybotherperformingoperationalduediligenceonprivateequityfunds?”Afterall,isn'ttheincreasedpressurebythegovernmentgoingtocauseanypotentiallyseriousoperationalriskshiddeninaprivate equity fund to come to the surface and receive appropriate correctiveaction?Indeed, support for this line of thinking/questioning may be found in the

revivalofinterestinbothnewprivateequityfundestablishmentandfundraisingfrom jurisdictions with purportedly robust regulatory, anti-money-laundering,and tax information exchange regimes.1 The answer to such questions is asuccinct no, but rather than bluntly dismiss such considerations, it is perhapsworthconsideringtherecentpushtowardgovernmentregulationintheformofregulatory registration in the United States with the Securities and ExchangeCommission(SEC).In theUnited States, such registration requirements as they relate to private

equityfundsareperhapsmosteasilydiscussedbyexaminingtheriseandfallofthe so-called Hedge Fund Registration Rule. In 2006, one investor, PhilipGoldstein, challenged this registration requirement on a number of policy andlegalgrounds.Specifically,Mr.Goldstein'sobjectionsincludedthefactthattheSEC,byrequiringregistrationofhedgefundsas investmentadvisersunder the

Investment Advisers Act of 1940, was in effect exceeding its authority andincorrectlyconflatingthetermsclientandinvestor.2

The courts agreed with Mr. Goldstein and the rule was subsequentlyoverturned.Despitewhatcouldbearguablydeemedavictoryforthealternativeinvestment community, in thewakeof the 2008 financial industry bailout, thepolitical tide eventually turned toward an environment of increased regulatoryoversight.AttheforefrontofthisregulatorychargewereU.S.SenatorsGrassleyandLevinviatheintroductionoftheHedgeFundTransparencyAct.After thisinitial proposal a host of government personalities joined the bandwagon injockeyingfortheregulatoryreigns.ThemostvocalwereTreasury'sTimothyF.GeithnerandSECChairmanMaryL.Shapiro.Anumberofindustrygroupsbothin the hedge fund and private equity community also indicated that theysupportedregulationinoneformoranother.The SEC was eventually able to regain their standing in the regulatory

hierarchy under this retraction from an industry environment that once foughttooth and nail against regulation, to an almost resigned understanding thatincreased regulation was inevitable. Under Title IV of the relatively recentlyenacted Dodd-FrankWall Street Reform and Consumer Protection Act, mostprivatefundsthatincludehedgefundsandprivateequityfundswillberequiredtoregisterwiththeSEC.Whiletherearecertainexemptionsinplace,suchasforfunds that oversee less than$150million in assets undermanagement and forcertain venture capital funds, in general this new registration requirementrepresentsamajorchangetotheregulatoryenvironmentforprivateequityfundsintheUnitedStates.Manyinvestorswilllikelyviewthesenewregistrationsrequirementsasagood

thing. Regardless of whether an investor is for or against regulation, manyinvestorsalsoholdthebeliefthatsuchregulationenhancesthelevelofscrutinyto which a private equity fund will be subjected. Some investors extend thisargumentevenfurtherinordertoprovidethemselveswithanadditionallevelofcomfort with regard to fund operational oversight. Certainly, their logic goes,withthisincreasedregulationthegovernmentwillcatchanymaterialoperationalweaknesses as a result of an enhanced regulatory process. Such increasedscrutiny, these investors may reason, obviates the need for operational duediligence on private equity funds.Ultimately, increased regulation is likely anoverallpositivedevelopmentfor theprivateequity industry.However, takeninthecontextofduediligence,theseproposedregulationswilldolittletopromotea higher standard of operational due diligence. For example, theHedge Fund

Transparency Act requires hedge funds to disclose the name of a fund'saccountant and broker. If a hedge fundwill not disclose this information, anyresponsibleinvestorwouldneverallocatetothefund,regardlessofwhethersuchadisclosureisaregulatoryrequirementornot.In Europe, motivation toward increasing regulatory oversight of asset

managerswasperhapsmostnotablyrealizedinrecenthistoryintheearlystagesviatheenactmentoftheMarketsinFinancialInstrumentsDirective(MiFID)inNovember 2007 that replaced the previous Investment Services Directive.MiFIDwaspassedsoexpediently inpartbecauseof thefour-levelLamfalussyprocedure promulgated by the Committee of Wise Men (yes, that is its realname).ThisprocedurewassetupbytheEuropeanCounselin2000tomaketheEuropeanUnion(EU)securitiesregulationprocessmoretransparent.3

Several years later, following up on the MiFID initiative, the AlternativeInvestment FundManagersDirective (AIFMD)was adopted by the EuropeanParliament in November 2010. AIFMD has implications for hedge funds andprivate equity managers both inside and outside the European Union. In anattempttobalanceregulatoryoversightwithmarketconcerns,AIFMDpioneeredthe concept of a so-called EU passport that allows for non-EU alternativeinvestmentmanagers and alternative investment funds to eventuallyutilize thesameEuropeanpassportastheirEuropeanUnioncounterparts.Regardingprivate equity,AIFMDcontains requirements that directly impact

private equity operations. Some of the most notable changes include therequirementthataprivateequityfundappointanexternalvaluationfirmaswellasanindependentcustodian.Anothersomewhatcontentiousrequirementrelatesto the fact that private equity funds under AIFMD are required to disclosebusinessplansfortheportfoliocompanytothecompany,itsothershareholders,and its employees. Those who have argued against such enhanced disclosurerequirementsarguethatitwillplaceEuropeanUnionprivateequityfundsataninformationaldisadvantage.Furthermore, theyargue that such regulationsmaygotoofar.To support this argument, they may cite that enhanced disclosure-reporting

requirements overextend the private equity industry's already acknowledgedneed for transparency. They may refer to regulations such as the UnitedKingdom's2007GuidelinesforDisclosureandTransparencyinPrivateEquity,whicharereferredtoastheWalkerGuidelines.Theseguidelineswerepublishedin November 2007 and adopted by the British Venture Capital Association(BVCA).ApparentlyEUregulatorybodieshavesought togobeyondeven the

well-intentioned self-regulatory approaches (the BVCA and a group of majorprivateequityfirmscommissionedSirDavidWalkertowritetherulesthattheysubsequentlyadopted)andtoinsistonfurthertransparencyanddisclosures.4

Regardlessoftheactualnutsandboltsoftheenhancedregulatoryoversighttobe carried out, coupled with any additional enhanced reporting requirements,perhaps the biggest misconception concerning the enhanced regulatoryenvironment is the associated cache that often accompanies notions of privateequity fund registration. Such enhanced regulatory oversight and evenreregistration requirements run a very high risk of creating a false sense ofconfidence among many private equity investors. This is the very samemisplacedconfidenceinregulatorsthatledtotheongoingperpetrationofmanyoutright frauds such as Madoff's Ponzi scheme. Specifically, the proposedregulations are amissed opportunity to raise the standards of operational duediligenceontwoprimaryfronts,andserveasarebuttaltothemisplacedbeliefthattheneedforoperationalduediligenceissupplantedbyincreasedregulatoryoversight.

DisclosureRequirementsWillNotProvideSufficientOperationalTransparency

Theprivateequityregistrationregulations,whilemakingsomechangesdesignedtoenhanceddisclosuretransparencysuchasmodificationsinFormADVorthefairlyrecentrequirementsofFormPF,essentiallyturnbacktheclockonprivateequityoperationalinformationdisclosurerequirementstothepre-Goldsteinera,whenprivateequityfundswererequiredtoberegisteredwiththeSEC.Asnotedpreviously, few new disclosure bells and whistles are added; however, theoperationaldisclosurerequirementsthat theSECfinallysettledonhaveset theoperationalinformationdisclosurebarverylow.

AHigherStandardofDiligenceWillNotBeRequiredforFundofFundsofHedgeFundsandConsultants

Many hedge fund investorswho lostmoneywith fraudsters likeMadoffwereintroduced to these funds via “professional”moneymanagers such as fund ofhedge fundsor feeder funds.These entitieswere supposed tobeperformingacertainlevelofoperationalduediligence.Thenewproposedregulationswillnotplace increased responsibility or liability on these professionals to perform a

minimumlevelofoperationalriskreviews.In summary, private equity regulation is not a replacement for investor

operational due diligence. U.S.-based private equity funds will be required toproduceauniformminimumamountregulatorydocumentation.Thisbaselevelis far below the minimum amount of operational risk information that anyresponsible investor should require as part of the operational due diligenceprocess.Investorsshouldnotexpecttorelyontheregulatorstoproperlyvettheoperationalrisksassociatedwithprivateequity investing.As ithas in thepast,privateequity regulationwillonlycreateanartificialoperational informationalfloorthatsomeprivateequityfundsmaycontinuetoattempttohidebeneath.

Isn'tOperationalDueDiligenceSimplyOpeningaPandora'sBox?

This argument against operational due diligence is typically rooted in themultifacetednatureof thisdiscipline.Oftentimesoperationalduediligencecanbeequatedtotheconceptofperformingconstructioninanoldhouse.Letussaythatinordertoperformconstruction,sayinstallanewbathroom,youneedtocutaholeinawalltorunplumbingpipethrough.However,whenyoucutopenthisholeyoufindamultitudeofotherproblemsyoudidnotknowexisted.Ineffect,youhaveopenedaPandora'sboxoftroubles.Statedlessdramatically,youmustnow devote time, energy, and resources toward fixing these previouslyundiscoveredissues.Operational due diligence can be the same. Issues within a particular

organizationmaynotbeapparentatfirstglance.Onlyafteraninvestorstartstolearnmoreaboutaparticularprivateequityfund'soperationalinfrastructuremayproblems begin to become visible. Oftentimes operational risk issues areinterrelated,evenacrossmultiplefunctionsinafirm.Forexample,aweaknessin the trading systems utilizedmay have ramifications for valuation and fundaccounting.Once an investor starts to dig into these initial issues, a series ofmore troubling issuesmaybe skulkingunderneath.Some investorswho argueagainst performingoperational due diligence on private equity fundsmay say,whybotherwiththewholeprocessifyouwillpotentiallyuncoveraseeminglyendlessseriesofproblems?Furthermore, some investorsmay raise related objections to operational due

diligence being performed on private equity, with regard to the knowledgerequiredtodiagnosecertainlinkedPandora's-box-typerisks.Anexamplecould

be exogenous risks, which are those risks that come from outside the privateequityfunditself.PerhapsanicewaytoillustratesomeoftheargumentsagainstperformingoperationalduediligencethatarerelatedtoboththesePandorarisksaswellastoanti-exogenousconcernsisbyreturningtoanexamplethatChapter1discusses.Investors must include country-specific considerations when performing

operational due diligence. As an example of such considerations, Chapter 1discusses tax regimes in different countries. The tax program of a particularjurisdiction is an example of an exogenous type risk. The tax code for aparticularregionispromulgatedbythegovernmentandtaxingauthoritiesofthatparticularregionandnottheprivateequityfunditself.Anyrisksassociatedwithfuture taxcodechanges, forexample, asopposed to tax implicationsbasedonhowafundchoosestostructureitself,primarilycomefromoutsidethefund.InChapter 1 we also utilize the example of an investor who is performingoperationalduediligenceonanIndianprivateequityfundoffunds.ManysuchfundsaredomiciledinMaltaduetothedouble-taxationtreatybetweenIndiaandMalta.Basedonthelogicoftheargumentpresentedearlier,aninvestormaynotwant

to open the so-called Pandora's box of operational due diligence issues, andsimilarly theymaynotwant tobecome involved inunderstanding the specificbenefits and intricacies of the Malta tax code as related to their proposedinvestmentinanIndianprivateequityfundoffunds.When faced with such questions, an investor effectively has two options.

Optionnumberoneinvolvesaninvestoreffectivelyacknowledgingthattheyareinterested in investing in India and yet don't know anything aboutMalta's taxtreaties.Moreover,theydonotcaretoexpendthetime,resources,andeffortinresearchingsuchmattersand,aslongasitisnotillegalordetrimentaltothefundortheirinvestments,theyarecontenttotaketheprivateequitymanager'swordonthedetails.Investorsselectingthisoptiondonothavetheknowledgebecausetheyhavenotperformedanyindependentreviewsofcommonindustrypracticestodetermineifwhattheprivateequitymanagersaysisactuallyso.How does such an investor know whether the private equity manager had

madeastrategicchoicetoselectaparticularjurisdiction,offshoreorotherwise?Has the private equity manager taken measures that comport with commonpractices? Or has the fund made a shrewder choice that has other ancillarybenefits(suchasincreasedinsulationfromliabilities)thatmaybelessobvioustouninformedinvestors?Theanswer,plainly,isthataninvestorpursuingthefirst

option does not know, and this iswhere this argument falters.By not lookinginto such issues and performing operational due diligence, an investor is notmakinganinformedindependentassessmentoftheoperationalriskspresentinaparticularfund.The second, and better, option, is for an investor to incorporate an

understandingofsuchmattersintotheirlargeroperationalduediligenceprocess.But wait a minute, you may saying to yourself, this seems unfair! Thequestioningmaycontinueasfollows,“WhyshouldI,asaninvestor,beforcedtoexpendtime,energy,resources,andmyowncapitaltounderstandthis?Isitnotreasonable for an investor to rely on the experience of both the private equityfund manager and their lawyers and accountants to structure the fund in anappropriateandlegalmanner?”These are valid questions and they do raise genuine legitimate concerns

regardingwho should bear the onus of both responsibility and cost regardingoperationalduediligence.Suchquestionsareworthaskingifnotsolelyforthedidacticnatureofdiscussionstheyfoster.Afterall,perhapssuchlinesofinquiryregarding the second option of incorporating such seemingly nonprimaryjurisdictional concerns (e.g., by not focusing on understanding Malta's taxregimes and instead focusing solely on India) are legitimate. Furthermore,investing, particularly in a private equity context, is a time-sensitive process.When considering an investment in a newly formed private equity fund,investorsallocationdecisions,andsubsequentlytheirduediligencetimelinesaredrivenprimarilynotbythescopeoftheirownduediligenceprocessesbutratherby working toward meeting a particular fund closing deadline. Therefore, assuggested in thequestionsposited, perhaps amoreheuristic approach coupledwith reliance on the private equitymanager and their advisers is not so crazyafterall.Such an approach to investing, and certainly to operational due diligence, is

theantithesisoftheinformeddecisionmakinggoalofoperationalduediligence.While private equity fundmanagers and even some investors are comfortable,“taking someone else'sword for it” and blindly relying on others’ statements,most prudent investors would view such an approach as fostering ignoranceborderingonamiasmaofbarbarism.Sinceitisnotveryproductivetooutlineallofthecriticismsthatmaybeassociatedwiththefirstoption,letusinsteadfocusonthebenefitsofoptionnumbertwo.Byincorporatingabroaderscopeintothenatureofsuchmultijurisdictionalconsiderations,investorscanrealizeanumberofbenefits.First,regardlessoftheconclusionreached,investorswillbemaking

aninformedallocationdecision.Second,byperformingan independentreviewof even a small handful of key operational factors, they could be avoidingorganizationswithweakoperationalinfrastructures.

WhataboutOtherPressurefromInvestors?Assuming that the readerno longer relies solelyupongovernment regulations,then a second objection often raised to performing operational due diligencereviews on private equity funds has its grounding in economics. (Specifically,the “invisible hand of the market” theory of John Maynard Keynes.) With agroundingintheinvisiblehandorthodoxy,aninvestormayquestionthemeritsofperformingprivate equityoperationalduediligencebyasking something tothe effect of, “Won't other investors demand operational best practices?” Thisquestion then perhaps logically advances down the objection path to thefollowinglineofreasoning,“...andwon'ttheremovalofwhateverthemarketdetermines to be ‘unnecessary’ or ‘excessive’ operational risk result in thesurvivalofonlytheoperationallystrongfunds?”Thiseffectivelyisarguingthata Darwinian survival of the fittest occurs with regard to private equityoperational risk so that only the strongest operationalplayers remain standing.Survival, for the purposes of this discussion, can generally mean sufficientcapitaltostayinbusiness.Whenwetakeamomenttobreakdownthisargumentwecanseethatitrests

on fourbasicpremises.The first suchpremise is that information freely flowsamongprivateequityinvestors.Privateequity,justlikehedgefundinvesting,aswell as many other fields of asset management is a marketplace in whichinformation is exchanged. Investors who have particular operational concernsregarding a particular private equity fund do not necessarily call up otherinvestorstoletthemknowabouttheirconcerns.Wouldnotthefreeexchangeofideas foster amore transparent and ultimately safer investing environment forall?At first theremayappear tobebenefits in sharing information, but in thelongrunthereanumberofreasonswhytheencouragementofthispracticeisnotaneasysell.First,amongprofessionalinvestmentorganizationssuchasprivateequity fund–of-funds who are paid by investors to create a portfolio ofunderlyingprivateequityfunds,therearefewincentivestoencouragegroupstoshareinformation.Fromaneconomicperspective,ifoneprivateequityfundoffundshas significantoperational concerns regardingaparticularprivate equityfundthatithasperformedduediligenceon,anotherprivateequityfundoffunds

willnotbelikelypayforsuchinformation.Furthermore, another fund of funds may look suspiciously on information

suppliedbyadirectcompetitor.Additionally,fromthepointofviewofmarketcompetition itmayactuallyprofit theprivateequity fundof funds thathas theinformationnottopassitalong.Ifanotherprivateequityfundoffunds,investsinthequestionablemanager'sfund,thenitmayrealizesubstantiallossesorevengo out of business altogether.By not sharing its original operational concernswith its competitors, the first private equity fund of hedge funds allows for anatural thinningof thecompetitiveherd,whichmayultimatelybenefit itsownorganization.Asecondreasonwhyprivateequity investorsmaynotbroadcast information

concerninganyoperational concerns theymayhavewith aparticularmanagerrelatestoliabilityissues.Whenaninvestorbeginstheoperationalduediligenceprocess,someprivateequityfirmsmayaskaninvestortosignaconfidentialityagreement.Even if sucha confidentiality agreement isnot requested,manyofthe documents an investor collects and reviews will likely include legaldisclosures and statements that indicate that the material the investor isanalyzing is confidential. Regardless of the express or implied nature of theinvestor confidentiality relationship, investors who, based on a due diligenceprocess, then turn around and broadcast concerns they may have to otherinvestorsmaybebreachingthisconfidentiality.Puttingconfidentialityconcernsaside,assumethataninvestordoesshareoperationalconcernstheyhavebasedon the due diligence with other investors. Let us further assume that suchoperationalconcernshavenotbeenmanufacturedby the investor forwhateverreason,butthattheyareactuallytrue.Sonowwehaveascenarioinwhichaninvestorhasperformedoperationaldue

diligence on a private equity fund, come to a decision not to invest based ongenuine operational concerns that are grounded in fact, and shares hisoperationalconcernswithanotherinvestorconsideringthesamefund.Weliveina litigious society. This is particularly true in the United States. If a privateequityfundlearnsthataninvestorisbad-mouthingitsofferingsandpotentiallyscaringoffotherinvestors,theprivateequityfundmaywellsue.Thesuitmaybebasedon abreachof confidentialityorperhaps claimsofdefamation, libel, orslander.Peopleandorganizationssueforallkindsofreasons.Youdon'tneedtobe right to filea lawsuit;youneedonlyhaveagripe. Ifyouwerewrong,youwilleventuallylose.Theproblemisthatlitigationcanbequitecostlyfrombothan economic and reputation standpoint. Additionally, litigation is not a quick

solutionandcan takeyears, if notdecades.Most investorswould rather avoidthepossibilityofalawsuitandinsteadkeeptheirconcernstothemselves.Whatthis boils down to is that most investors effectively say, “I did my own duediligenceandprotectedmyownorganization.It'sthenextguy'sproblemtofindout what I found out.” Not exactly a neighborly sentiment, but no one saidinvestinginprivateequitywasacivilexercise.The second premise of the argument against performing operational due

diligence reviews of private equity funds is that investors are universallyinformedaboutandhold thesamegeneralstandardsregardingoperationalbestpractices.Nothingcouldbefurtherfromthe truth.Someinvestorsdonotevenbelievethatitisnecessarytoperformoperationalduediligenceonprivateequityfunds.With such an absolute dictum on avoiding the subject, certainly theseinvestorsareneitherinformedaboutoperationalriskinprivateequityfundsnorhave they formed any sort of meaningful opinions regarding operational bestpracticesinprivateequityfunds.Puttingtheseextremecasesofinvestorsaside,even if different investors are performing operational due diligence on privateequityfunds,thereiscertainlynotauniversalconsensusamongallinvestorsasto what constitutes a level of operational risk below which it is not worthinvesting. Each investment organization is unique and each investor has theirowninternalbenchmarksfortheminimumcoreprocesses(whichwediscussinChapter1).Ofcourse,99percentoftheprivateequitycommunitycouldbelievethatacertainoperationalpracticeisnotinvestibleandthatitwouldbeludicrousto even consider it, such as having no cash controls whatsoever in place.However, there is no way to say with any certainty that all private equityinvestorsfeelthesameway.Thereisjustnotenoughtransparencyamongprivateequityinvestorstocometoafinaldetermination.Third, the line of reasoning previously described assumes that all investors

apply the same level of standard toward operational due diligence to privateequity reviews. This reasoning is not practical because some investors may,foolishly, not be performing any sort of operational due diligence on privateequity funds. Setting aside these considerations, other investors who performoperational due diligence may allocate different amounts of resources to thisarea.Some investorsmay adhereonly towhat couldbe called a coreprocess,while other investorsmay pursue an expanded process or a process that fallssomewhere in between. Furthermore, some investorsmay employ experiencedoperationalduediligenceteamswhileotherinvestorsmayhaveoperationalduediligence analystswho are primarily experienced in investment due diligence.

With this diversity among resources and investor skill sets, it is difficult tosupport an argument that assumes that investors universally apply the samestandardsofoperationalduediligencetoprivateequity.Finally, the argument above implies that private equity funds with poor

operationalinfrastructureseitherfailorstayinbusiness.Viewingprivateequityinsuchblack-and-whitetermsdoesnotfitwithpracticalobservationsofprivateequityfunds.Inmuchthesamewaythataprivateequityfundisnotself-limitedtocategorizationsofbeingeitheranstronginvestmentorgoingoutofbusiness,so toodo similar notions apply toward a private equity fund's operational riskmanagement. A private equity fund can be operationally mediocre but stillremaininbusiness.It,ofcourse,willnotbeoperatingasefficientlyasitcould,butitmaynotgrindtoahaltanytimesoon.Furthermore,suchanoperationallymediocre private equity fund may also be unnecessarily exposed to highamounts of operational risk that could substantially increase the potential forfailurerelatedtoitsweakoperationalinfrastructure.However,untilsuchfailuresoccurthefundmaynotfaltertoanabsolutestandstill.

Illiquidity(theLockup)ArgumentPuttingexogenousfactorsaside, thatis, thoseelementsthatcomefromoutsidethe private equity fund itself, there may be other stalwart objections raisedagainst the operational due diligence process itself, due to factors that areinherentinprivateequityfundsthemselves.Thefirstofsuchargumentsmaycomedirectlyfromthegeneralcharacteristics

ofprivate equity investing.Generally, for anewprivate equity fund, an initialcapital raise occurs. During this time is when most due diligence (includinginvestmentduediligence) isperformed.After the fundraisingperiod, investorsareeffectively“lockedin”totheinvestmentforthetermofthefund.Theonlynecessaryorrequiredongoinginteractionbetweentheprivateequity

fundandinvestorsisthemailingoffinancialstatements,whichtypicallywillnotevencome from theprivateequity fundbut from the fund's administrator, andcalls for capital that are also referred to as drawdown requests.5 Therefore,because investors are “locked in,” the basic question becomes why botherperformingoperationalduediligence?The investorswon't be able to actupontheadviceby,forexample,submittingaredemptionrequestorevenaddingmorecapitaldependingontheparticularcircumstancesandresultsofanyoperationalduediligence.

Itisatthispointthatitisworthdistinguishingbetweenthetwobroadstagesintheinvestingprocessatwhichoperationalduediligencecanbeperformed.Thefirst period, before an investment is made, is termed initial operational duediligence. The second such period refers to operational due diligence after aninvestmenthasbeenmadeandistermedongoingoperationalduediligence.Manyof thepreviously referencedargumentsagainstperformingoperational

due diligence on private equity funds relate to the initial operational duediligence stage. The present argument relates more to an argument againstongoingoperationalduediligencethanitdoestoinitialongoingoperationalduediligence.Atfacevaluethe“actionability”oftheresultsoftheoperationalduediligenceprocess ismoreprevalentduring the initialoperationalduediligencestage(e.g.,aninvestorcandecidewhetherornottoinvestafterfactoringintheresultsof theoperationalduediligenceprocess).Oncean investmenthasbeenmade, the supposed “actionability” of the operational due diligence datagatherediseffectivelyuseless—aninvestorcannotredeemoraddmoretohisorhercapital.Before delving into the concept of actionability, it is ridiculous to hold the

opinionthatitisbetterforinvestorsnottoprovidethemselveswiththeoptiontolearn about particular operational risks simply because they feel theymaynothave the ability to do anything with the information. This is equivalent toobservingthesituationofanindividual,whomwecanrefertoasMr.IgNorant,whose house is on fire, and not caring that there is a fire hydrant outside hishouse because he doesn't have a hose to connect to it. Perhaps ifMr. Norantknew about the fire hydrant he could improvise a hose or seek help from aneighborwithahose.MaybeIgdoesnotevenneedahoseatall.PerhapsMr.Norant,whosehousehassinceburnedtotheground,couldhaveusedabuckettocollect water from the hydrant to put out the fire. Sadly, Ig is now warminghimself by the smoldering pile that used to be his house. Mr. Norant firmlybelievesthatignoranceisblissandoutofsightisoutofmind.Even if an investor believes that he or she cannot do anythingwith certain

piecesofinformationitisoftenmuchmoreadvisabletoobtainthisinformationand make a more informed decision about any action or inaction rather thanpreferring to keep their head in the sand. In fact, operational risk informationobtained during the ongoing operational due diligence process is indeedactionablefromanumberofdifferentperspectives.Consider, for example, that an investormay have a seat on a private equity

fund,withaseatonthefund'sboardoronanadvisoryboard.Inthesecases,an

investormay learn certain pieces of information butmay also perform furtheroperationalduediligence.Thisongoingoperationalduediligenceprocessmaybedrivenbyadesiretomonitoroperationalconcernsthatwereoriginallynotedduring the initial operational due diligence process or this may be part of aregularongoingprogramthatdoesnotfocusonanyspecificoperationalconcern.However,regardlessofthemotivationforperformingsuchongoingoperationaldue diligence, if an investor confirms additional operational concerns oruncovers new operational concerns theymay be able to take actions on suchconcernsbasedontheirroleontheboardofthefundortheadvisoryboard.An investormay not be fortunate enough, however, to sit on the board of a

fund or an advisory board. If based on an ongoing operational due diligencereview an investor develops or reconfirms operational due diligence concerns,thenaninvestorhasseveraloptions.First,theycancommunicatesuchconcernsto the fundmanager.Theprivateequity firmmaynotnecessarilywant to takeactionbasedonsuchconcerns,yettheyatleastwillbemadeawareofthem.Itisdifficult sometimes for a private equity firm to be conscious of a third party'sopinionof their own internal operations. In some cases, a firmmaynot knowthat a certain practice either deviates from current market practice or is ofconcerntoinvestors.Inthesecases, thefirmmaybewillingtomakeachangeonce an investor's concerns are communicated to them. If an investor had notperformedany sortofongoingoperationalduediligence, theywouldhavenotnecessarilyhaveanysuchconcernstocommunicatetothefundmanagerandnochangewouldbeeffected.Furthermore, by performing ongoing operational due diligence on a private

equityfund,regardlessofwhetherafundisamenabletomakinganyparticularchanges,an investor isstillaccomplishingsomethingvery important.Theyaresendingamessage to amanager that someone, even if it's one investor, isnotonly conscious of such issues but that they arewatching. Investing is often along-termrelationship.Privateequityfirmsareinthebusinessofraisingmoneyformanagingprivateequityfunds.Ifaninvestor,particularlyalargeone,raisesoperationalconcernsastheresultofongoingoperationalduediligenceandsuchissuesarecompletelyignoredorminimized,thiswillleaveaproverbialbadtastein the investor'smouth. Investors tend tobeabit likeelephants in this regard:Theydonotforget.SowhenthetimeinevitablyrollsaroundforPrivateEquityFund1, inwhich the investor raised their initialoperationalconcerns, tocloseandforanewfund,PrivateEquityFund2, toraisecapital, this investor isnotinterested. Andwhy should they be? So they can continue to be ignored. No

thankyou,thereareplentyoffishintheseaandaninvestormaychoosetodobusinesselsewhere.Manyprivateequityfundsarebeginningtorealizethefollyof this penny-wise, pound-foolish approach and are slowly minimizing theirpreviousresistancetoongoingoperationalduediligencereviewsfrominvestors.

EvenIfIPerformOperationalDueDiligence,MyPrivateEquityFundCouldStillFailforOperational

ReasonsInraisingobjectionstotheoperationalduediligenceprocessbeingperformedonprivateequity,someinvestorsmayraisethefollowingquestions:“Whyperformoperationalduediligenceonprivateequityfundsifmyfundcouldstill fail foroperational reasons? And what about fraud? After all, if my private equitymanager is a fraud and theywant to steal, theywill figure out away to do itregardlessofanyoperationalduediligencereviewIperform.”Whilethislineofreasoning may seem a bit drastic at first, it does raise a number of validargumentsthatshouldbeaddressed.In approaching these objections we must first highlight a key point about

operational due diligence. Posit the following objection to performingoperational due diligence reviews of private equity funds. Operational duediligenceisnotaninsurancepolicy.It isnotaguaranteeinanyway,shape,orform. Anyonewho tells you otherwise is lying. Anyone who attempts to selloperationalduediligenceasaninsurancepolicy,guarantee,sealofapproval,oranything else might also be trying to sell you a certain bridge in Brooklyn.Operational due diligence is a process via which an investor can diagnose,analyze,andmonitoroperationalrisk.Operationalduediligencecanbethoughtof as a hedge against operational risk.Byperforming a competent operationalriskreviewofaparticularfactor,aninvestoriseffectivelytakingthebulkoftherisksassociatedwiththatparticularfactoroffthetable.Tofacilitatethisdiscussion,wecanthinkofaprivateequityfundashavinga

certain fixed amount of operational risk.Whatever this amount of operationalriskisorhowweinterpretit,operationalrisk,regardlessofthegranularitywithwhich we delve into a certain area will approach some definite limit as weapproachinfinity.Ifweassumethispremise,thenwithinthatfiniteoperationallandscapeorplane,wecandemonstratethatbyutilizingaparticularprocessaninvestorcaneffectivelyshrinktheportionoftheoperationalriskplanethattheyhave not performed operational due diligence on.This necessarilywill reduce

theirexposuretooperationalriskfactorsthatareleftnotreviewedonthefiniteoperationalriskplane.ThisconceptissummarizedinExhibit2.2.

EXHIBIT2.2RepresentationofFixedOperationalPlanewithIndividualOperationalRiskFactorSelection

Wecanfurtherconsiderthefiniteoperationalplaneinthecontextofthecoreand expanded levels of operational due diligence review that we discuss inChapter1.Eachofthesetheoreticallevelsofreviewrelatestothescopeoftheoperationalriskfactorsencompassedbyeachprocess.Asthenameimplies,thetermcorereferstoaprocessthatencompassesareviewof,ataminimum,thoseoperational risk factors that are necessary to allow an investor to reach aninformed opinion, and ultimately come to an operational determination,regarding a particular private equity fund.An example of the core operationalduediligenceprocessplottedonthefiniteoperationalplaneisshowninExhibit2.3.

EXHIBIT2.3EntireFiniteOperationalRiskPlanewithCoreandExpandedRiskSegments

Moving down the spectrum from a core to expanded process increases thenumber of operational risk factors included in the operational due diligenceprocess.ThisrelationshipissummarizedinExhibit2.4.

EXHIBIT2.4ComparisonofOperationalRiskFactorInclusiontoOperationalDueDiligenceProcessScope

While the addition of each incremental factor does not necessarily implytransitionsamongthetheoreticallevelsofbelow-core,core,andexpandedthereis an increase in process scope with each additional operational risk factorincludedintheduediligenceprocess.Returning to our discussion in terms of the finite operational plane, an

expandedprocessbroadens the scopeof the coreprocess to includeadditionaloperational risk factors that generally result in an investor making a moreinformed operational determination. In this case, the broader the scope of aninvestor's operational due diligence review from core to an expanded process,thegreaterthenumberofoperationalriskfactorsthatareincluded.Consideredinthecontextofthefiniteoperationalplane,wecanseehowanexpandedlevelofreviewshrinksthesizeofthetotalunexaminedareaofoperationalplane.ThisconceptisoutlinedinExhibit2.5.

EXHIBIT2.5EntireFiniteOperationalRiskPlanewithCoreandExpandedRiskSegments

Now that we have developed an understanding of the concept of theoperationalplanecoupledwiththenotionsofexpandingprocessesscopebasedon risk factor inclusion that subsequently reduced the unexamined factors,wecan return to our analysis of the argument against performing operational duediligence based on the potential for losses or fraud due to unexaminedoperationalriskfactors.If investors had infinite resources, time, and an unending army of qualified

superb operational due diligence analysts, they could still not completelyeliminate the possibility for losses due to operational reasons. Fraud, forexample,cannotbemodeledbutonlyanalyzedandstudiedonahistoricalbasis.The next fraud could be carried out in a completely different manner from apreviousfraud.Therefore,anysuchbackward-lookingmodelutilizinghistoricalinputscouldnotaccuratelydetermineafuturefraudulentoccurrence.Thisisnotmeant to imply that it is not fruitful for investors performing operational due

diligencetobrainstormanddevelopmodelstotrytopredictsuchfraud.Indeed,their predictionsmayverywell be correct.Rather,what this discussion of thefraudmodelingismeanttoillustrateisthatanymodeloffraudinanoperationalriskcontextcannotbesaidtopredicttheoccurrenceofthemagnitudeandtypeoffraudwithcertainty.Furthermore, returning to our original discussion, investors do not have

limitlessresources.Additionally,privateequityfundsshouldnotbesubjectedtolimitlessscrutiny.AsChapter3discussesinmoredetail,aninvestorhasasmallwindow of opportunity during which operational due diligence may beconductedinregardtotheattentionandtimeaprivateequitymanageriswillingto commit. During this window of opportunity an investormay have only somany bites at the apple, so to speak, during which they can gauge particularoperational risk factors.Beyond a certain point, a private equitymanagerwilllikelynotentertainaninvestor'soperationalduediligenceinquiriesandwillaskthemtoeitheracceptthefundorleaveit.AnexampleofthedelicatebalanceoftherelationshipbetweenprivateequityinvestorsandfundmanagersisshowninExhibit2.6.

EXHIBIT2.6ModelRepresentationofBalancingofTimeandResourcesAllocatedtotheOperationalDueDiligenceProcessbyInvestorsandaPrivateEquityFirmunderReview

Withsuchaneventuallylimitedwindowofopportunity, it isunreasonabletolook toward theoperationalduediligenceprocess to serveasamagicpanaceaforallnon-purely-investment-relatedlosses.

The“InformationBarrier”ArgumentAnothercommonargumentthatisoftenraisedinthecontextofarguingagainstperformingoperationalduediligence reviewsofprivateequity funds relates tothe nature of information that is available to investors when approaching aprivateequityfund.Aspreviouslymentioned,whenaninvestorperformsinitialoperationalduediligenceonaprivateequityfundthathasnotyetfunded,thereisapaucityofdatapointsincertainoperationalriskareas,whichmayimpairaninvestor's ability to fully vet these areas. This dearth of information, to someinvestor'sminds,maybeareasonfornotperformingoperationalduediligence.

Thisillustratesaconceptknownastheinformationbarrier.Certain investorswhosupportnotperformingoperationalduediligenceonaprivateequity fundmayfeelthatifthereisnotwhattheyconsidertobe“enough”operationalriskinformation, thenwhybother?Fromthisperspective,operationalduediligencerequires a criticalmass of operational risk factors to bemeaningful.After all,isn't this a corollary to the concept of the core operational due diligenceprocessespreviouslydescribed?Theanswer isbothyesandno.From theaffirmativeperspective,yesasour

descriptionofthecoreprocessisstillvalid.Thetheoreticalconstructofthecoreprocess is that it ismeant todescribe theminimumamountofoperational riskfactors covered during an operational due diligence process upon which ameaningfuloperationaldeterminationmaybebased.Transitioningtoourbelow-corelevelofoperationalduediligencereview,itisherewhereweapproachtheconcept of the information barrier utilized to attack the merits of performingoperationalduediligenceonprivateequityfunds.Inthisregard,theseargumentsfalterinananalysisofthebelow-corelevelofreviewascomparedtoperformingnooperationalduediligenceatall.Put another way, if an investor is left with the option of performing zero

operational due diligence as compared to performing a below-core level ofreview,whichispreferable?Acomparisonofinformationbarriersascomparedto these hypothetical operational due diligence level thresholds is outlined inExhibit2.7,whichmayprovidesomeguidanceinthisregard.

EXHIBIT2.7ComparisonofInformationBarriersIncorporatedintoHypotheticalOperationalDueDiligenceLevelThresholds

Those in favor of utilizing the information barrier concept to support adefeatist concept (i.e., nothing is better than something) opt in favor ofperformingzerooperationalduediligence.Amoreprudentinvestorbelievesthe

contrary: someoperationalduediligence isbetter thannothing.Of course, theoperationalduediligencedoesnotneedtoremainatthisbelow-corelevel.Evenwith anewly formingoperationalduediligence fund there is certainly enoughoperationalriskdataavailabletosupportsatisfyingacorelevelprocess.The informationbarrier concept is also sometimes further extendedby those

who object to performing operational due diligence, into ongoing operationalduediligence.Thatisobjectingtoperformingoperationalduediligencenotonlywhen considering an initial private equity investment, but also once aninvestmenthasalreadybeenmade.Examplesof the linesof reasoningused tosupport such arguments with regard to the information barrier outline that asubsequent informationbarrier is effectively erected after the initial funding ismade.Thissecondinformationbarrier,whichwecanrefertoasIB′,representstheleveltowhichthisinformationbarrierreaches.TherelationshipbetweentheinitialinformationbarrierandIB′withregardtothehypotheticaloperationalduediligencethresholdsisshowninExhibit2.8.

EXHIBIT2.8ComparisonofPreinvestmentandPostinvestmentInformationBarriersIncorporatedintoHypotheticalOperationalDueDiligenceLevelThresholds

Asweprogress through the initialoperationalduediligenceprocess into thepostinvestment process, then the second information barrier comes to light. Inthisregard,theinformationbarrierthatthoseraisinganobjectiontoperformingoperationalduediligencereferstorelatestothegeneralnatureofprivateequityinvesting.Asnotedabove,privateequityfundsoftendonottradeasfrequentlyas compared to other alternative investment vehicles such as hedge funds.Continuing this trading frequency notion, hedge funds often frequently reportmore frequently to investors. With this increased trading activity also comesmore frequent changes in valuations. Additionally hedge funds have morefrequent changes in items such capital flowing into and out of the fund on a

morecontinualbasis.Private equity funds by contrast have limited open periods during which

capital is raised before closings are implemented. Similarly, capital calls aretypicallymoreregularlyscheduledascomparedtomonthlycapitalinflowsandoutflowsthatmaybepresentinafundsuchasahedgefund.Thepurposeofourcomparisonwithhedge fundshere is that there is oftenmore contact, activity,and subsequently more operational data points in regard to certain areas thateffectively destroy or severely limit any such concerns related to thepostinvestment ongoingmonitoring information barrier. Investors allocating toprivateequity,itmaybeargued,slamintothisinformationwallwithalmostthesameseveritythattheydointheinitialpreinvestmentoperationalduediligenceprocess. In rebuttal to such arguments, and in support of performing ongoingoperationalduediligencemonitoring,wecanrelyonmanyoftheargumentswepreviouslyoutlinedwithregardtoovercomingthefirstinformationbarrier.

COMMONARGUMENTSINFAVOROFPERFORMINGOPERATIONALREVIEWS

OFPRIVATEEQUITYFUNDS

SmallerWindowsofOpportunityOne argument that lends support to the reasons as to why an investor shouldperformoperationalduediligence relatesdirectly to thenatureofmostprivateequity investing in new funds. When a new private equity fund begins, ittypically raises a pool of capital up-front and then closes. This initial capitalclosemay be the only capital close that the fund undergoes. In other cases, aprivate equity fundmayundergomultiple closes dependent upon a number offactors, including the capital raising environment as well as the nature of theprivateequityfundinvestments.Whenan investorbeginsarelationshipwithaprivateequityfirmitiscommonthatheorshewilldepositacertainamountup-frontwith the fundandbecommitted to the rest.Theprivateequity thencallsdownthiscapitalfrominvestorsatregularintervalsand/orasneeded.Thetermof private equity funds generally extend for a number of years. Therefore,investor'scapitaliseffectivelylockedupduringthistimeperiod.Whilewehaveoutlined some of the concerns this raises with regards to performing ongoingoperationalduediligenceinthepostinvestmentstage,wecanfocusontheinitialpreinvestmentoperationalduediligencestageoftheprocessforthemoment.Investorswhoareconsideringaninvestmentinprivateequityareleftwiththe

prospectofhavingtheircapitallockedintoaparticularinvestmentprivateequityfundforquiteawhile.Thisisparticularlytruewhencomparedtohedgefunds,whichinrecentyearshavetendedtoeschewlongerlockupsandembracemorefrequent liquidity. Investors considering private equity should consider thisfuture illiquidity, when coming to a determination as to whether or not theyshouldperformoperationalduediligenceatall.Duetothefactthattheircapitalwill be effectively locked up for a number of years, it certainly suggests thatperforming due diligence would be prudent. This is particularly true if aninvestorhasmadehisorhermindup,howevermistakenly,thattheydonotneedto perform ongoing operational due diligence once an investment had beenmade. After an investor subscribes capital to a private equity fund, there isvirtually no going back. The private placement memoranda and subscriptionagreementsofmostfundswillcontainlegallanguagetothiseffectaswell.An investor who is considering whether to perform initial operational due

diligence on a private equity fund should consider what his or her respectivegoalsare.Onecommongoal,whichwehavepreviouslydiscussedinthisbook,relates to the notion of making more informed decisions. This is certainly a

prudent and reasonablegoal. In this case, an investor choosingnot toperformoperationalduediligenceonaprivateequityfundpriortoinvestingiseffectivelystating that theydonotwant tomake themost informed investmentallocationdecisionpossible.Wecanmakethisstatementbecause,evenifaninvestorperformsoperational

duediligenceonaparticularprivate equity fundand feels thatheor shehavelearnednothingthatwasnotalreadycoveredduringtheinvestmentprocess,theyhave in fact learnedsomething.Themost important take-awayan investorcanhavefromsuchaprocesswouldbetolearnthattherewasnothingelsethathefelthedidnotknow.Nostoneleftunturned,sotospeak.Of course, this example is offered to demonstrate a point. In practice, an

investorcan learnagreatdealofnew informationandgainadditional insightsduringtheoperationalduediligenceprocess.Itisthesepiecesofoperationalriskdata that allow investors to thenmakemore informed decisions.An informeddecision is not always the correct (i.e., profitable) one; however, the moreinformationaninvestorhas,thehighertheprobabilitythatshewillmakebetterdecisions. Furthermore, the more information they collect the more informedsuchadecisionwillbe.However, let's assume that despite the benefits of making more informed

decisions, an investor may still be unconvinced regarding performing initialoperationalduediligenceonaprivateequityfunds.Itisatthispointthatwecanrevisitaconceptoutlinedearlier.Investorsinprivateequitytypicallyonlygetalimitedwindowduringwhichinitialoperationalduediligencecanbeperformed.Thistimeperiodgenerallyrunsupuntilaspecificcapitalclosedate.Afterthisdate,becauseofthelongerlockupperioddiscussedearlier,aninvestor'scapitaliseffectivelystuckinthefund.Withthislimitedwindowandlongcapitallockupperiod,aninvestorisaskedtomakeafairlyquickdecisionthatcanhavelong-lastingconsequences.Undersuchascenarioitisadvisableforinvestorstoseizetheopportunitytolearnasmuchaspossibleaboutaprivateequityfirmandfundduringthisperiod.This“asmuchaspossible”notionrelatestoasecondpieceoftheoperational

due diligence.Once an investor hasmade the determination to perform initialoperational due diligence, theymust next consider the scope towhich such areview is performed. Such illiquidity and lockup considerations should alsofactorintoconsiderationsofwhatdegreeofoperationalduediligenceshouldbeperformed. Compared to other asset classes, such as hedge funds, the longerlockupsandsmalleroperationalduediligencewindowsuggest thatan investor

mustmaximizetheopportunityforinitialoperationalduediligenceup-frontandunder a tight time frame. Due to these reasons, it is advisable that investorsconductthemostdetailedandbroadlyscopedoperationalduediligencereviewsofprivateequitythattheirowninternalorganizationalresourcesallow.In order to conduct such expansive reviews, this means that investors will

likelyberequiredtodedicateaninordinateamountofduediligenceresourcesinthedirectionofprivateequitywhenconsideringanew investment inaprivateequity fund. Such large, focused resource allocations however, should notnecessarilybeasurprisetoinvestors.Performingduediligenceingeneralisabitof a chunky exercise. From aworkflowperspective, operational due diligenceitselfcanbequitelumpy.Bythiswemeantosaythattheworkflowisveryup-frontintensive.Whenconsideringmakingapotentialinvestmentinafund,beitamutualfund,hedgefund,orprivateequityfund,forexample,aninvestorwilllikely perform a certain degree of due diligence before investing. This duediligenceprocesstypicallybeginswithaninvestorperforminginitialinvestmentduediligence.Thiscanbeperformedinamultitudeofwaysincludingattendingindustry conferences, searching performance databases, speaking to industrycontacts,andworkingwithinvestmentconsultants.Afterthedecisionastowhetherinvestornotwithaparticularfundhasbeen

made,aninvestorwillthenmoveontothenextproject.Ifnonewinvestmentsarebeingconsidered,outsideofconsiderationsofongoingmonitoring,thentheduediligencefunctionmayberelativelystagnant.Whenthenextinvestmentisconsidered theduediligencemachine starts up in full gear again.The chunkynatureofthisworkasitisdrivenbyeachindividualinvestmentissummarizedinExhibit2.9.

EXHIBIT2.9ChunkyNatureofInitialOperationalDueDiligenceResourceAllocation

Once an investor has identified a prospective fund the operational duediligenceprocesstypicallybegins.Ofcourse,thereisnoformalpointatwhichtheoperationalduediligencedoes,orshould,start.Rather,itcanbeincorporatedintotheinitialduediligenceprocessesoutlinedearlierinanumberofways.Themost common method of such incorporation, as is likely similar with manyinvestmentcriteriautilizedtoweedoutpotentialfundsfromalargelist,isasafilter. So, for example, a potential investor, in addition to setting certainminimum primarily investment-related requirements for a potential privateequity fund,mayalso imposecertainoperational requirements includingassetsunder management size, number of personnel, presence of clean regulatoryhistory,andsoon.Afterthisinitialscreeningprocessiscompleteandafundhasbeenidentified

uponwhichapotentialinvestorwantstoconductmoreextensiveduediligence,typicallythisiswheretheheavyliftingintheoperationalduediligenceprocesscomesintoplay.Thebulkofoperationalduediligenceworktypicallyoccursatthisinitial(i.e.,preinvestment)stageforinvestorsbecausetheyaredealingwithanunknownentity.One of the purposes of operational due diligence is so that the investor can

educate themselvesaboutaprivateequity firmandfundoperations inorder tomake a more informed investment decision. As such, the slope of the initiallearning(andresourceallocation)curvesisgenerallysteepestinthebeginning.ThisrelationshipissummarizedinExhibit2.10.

EXHIBIT2.10ComparisonoftheLevelofInvestorCompetencytoOperationalDueDiligenceResourceExpenditure

In reviewing Exhibit 2.10, the reader should realize that the relationshipbetween the number of operational due diligence reviews performed, asindicatedbyresourceexpenditureinthechart,andaparticularinvestor'slevelofoperational competency is not necessarily linear. On the contrary during theearlydaysofanoperationalduediligenceprogramaninvestormaymakelargeincremental gains in the amount they know about operational risk. Such largegapsinknowledgeadvancestendtoplateauovertime;however,therelationshipmaynotalwaysbeassmoothasthegraphimplies.With an understanding of the nature of operational due diligence resource

allocationcoupledwiththecommonsmallerwindowsduringwhichoperationalduediligencemaybeperformedonprivateequityfunds,wecanseethelogicalreasons that support performing operational due diligence on such funds.Furthermore,duetoilliquidityconsiderationsoutlinedinmoredetailfurtheron,investorswilllikelybroadenthescopeofsuchoperationalduediligencereviewsascomparedtootherassetclasses.

LongerCapitalLockupsAs outlined earlier, due to the structure of private equity investing, after apotential investordecides toallocate toaprivateequity fund theyhave, forallintentsandpurposes,lockedtheircapitalupforthetermofthefund.Whilethetimeoverwhichafundrunsitscoursemayvaryamongfirmsandprivateequityinvestment strategy types, the average length is often much longer thancompared to other alternative investments such as hedge funds. For example,hedgefundsmayimposelockupsofcapitalforperhapsonetotwoyearswhereastheaveragelengthofanLBOfundisapproximatelysixyears.6

When there is thepotential that an investor'smoneywill be lockedup for alonger period of time, the investor must necessarily have a higher level ofconvictioninmakingsuchanallocationdecision.Inordertoobtaincomfortwiththislessliquidinvestment,manyinvestorswillrequiremoreduediligenceto,ata minimum, feel more comfortable with parting with their money for severalyears. This longer-term structure effectively reduces the opportunities forongoingmonitoring.Thismeansthatinvestorshavefewerbitesoftheappletoperform operational due diligence as referenced in the smaller window ofopportunitydiscussionsection.Therefore,itonlymakessensethataninvestorshouldnotonlyperforminitial

operationalduediligenceonaprivateequityfund,butthatthescopeofsuchduediligence should at leastmeet, if not exceed, that ofmore liquid asset classessuch as hedge funds. Furthermore, in comparison to other alternative assetclasses, this longer-term lockup structure suggests that investors havemore tolose by not dedicating increased amounts of resources to private equityoperationalduediligenceduringthepreinvestmentstage.

PerformingOperationalDueDiligenceFacilitatesProcessDocumentationandCreatesaPaperTrailfor

LitigationSupportTherearenumeroustopicsthatprivateequityfirmswouldgenerallyprefernottohave in-depth discussions with investors about during the operational duediligence process. These topics may understandably include fees (andsubsequent negotiations surrounding fees, including fee reductions), personnelturnover,poorperformanceofpastprivateequityfundsrunbythefirm,andso

on.Another overarching topic relates to the loss of money. This topic is

particularlyofnotewhenindividualsorgroupswhoadviseonormanagemoneyonbehalfofotherinvestors(e.g.,financialadvisors,brokers,privateequityfundof funds) losemoney for their clients via investments in private equity funds.Investors,ortheiradvisors,ultimatelyallocatetoaparticularprivateequityfundbecause they want to generate profits. Private equity firms want to generateprofits in their funds. If a private equity fund makes money it is a win-winsituationforbothinvestorsandtheprivateequityfirm.Ontheotherhand,wheninvestors lose money it is another story entirely, and certainly not one thatprivate equity firms would likely wish to discuss with investors during theoperationalduediligenceprocess.Ifaprivateequityfundmakesbadinvestmentsandenoughpeopleloseenough

money, then investors may sue to seek recovery. Note the use of the wordenough. In this case, it refers to losses sufficient to economically justify alawsuit. Investors may allege numerous types of awful conduct by a fundmanager when losses ensue, such as that the fund manager was reckless ininvestments or perpetrated fraud. Regardless, of whether the merits of suchinvestor's suits have a rational basis, when such a suit ensues several thingshappen.First, thisgeneratesnegativereputationalconsequencesfor thefirm.Second,

from a practical standpoint, if a lawsuit follows the normal progression,eventually it will come to a stage in the process known as discovery. Duringdiscovery a series of documents and pieces of information are requested andcollectedbythepartiessuingeachother.Duringthediscoveryprocessthetypesof due diligence documentation that may be required to be produced includethose from the private equity fund manager itself as well as from those whoadviseonormanagemoneyonbehalf of other investors.Let usunpack thesetwo types of due diligence documents inmore detail. The private equity fundmanagermayberequiredtoproducedocumentationrelatedtoanyduediligence,operationalorotherwise,thattheymayhaveperformedonunderlyingportfoliocompanies,forexample.Wecannextturntooursecondgroup,thosewhoadviseonormanagemoney

onbehalfofotherinvestors.Itisinthiscase,andtheonethatismostrelevanttoourpresentdiscussion,inwhichanadvisorormanagerofotherpeople'smoney,suchasabrokerorprivateequityfundoffunds,willberequiredtoproducewhatcouldeffectivelybereferredtoasaduediligencefile.Itshouldbenotedthatthe

termduediligencefileisnotalegallydefinedone;however,forourpurposeswecan define it simply enough as all documents related to the due diligenceprocess.Thesedocumentsinsuchafilecaninclude:

Copies of any communication (e.g., emails, document requests lists,log of phone calls, etc.) between the PE fund of funds and theunderlyingPEfundsDetailsofanyinternaldiscussionsregardingthedecisiontoinvest(ornotinvest)withaparticularPEfund(e.g.,meetingminutes,recordsofthevotesofanyinternalcommittees)CopiesofanydocumentscollectedfromtheunderlyingprivateequityfundDocumentation of any analysis performed on these documents (e.g.,reviewsoffinancialstatementsandlegaldocuments,etc.)Conclusions drawn based on reviewing documents (e.g., internalmemorandum)Detailsandagendasofanyon-sitevisitsDetailsofanyserviceproviderreviewsandanydocumentationreviewsfromserviceproviders

So if litigation proceeds and during the course of the discovery process if afinancialadvisororaprivateequityfundoffundscannotproduceadetailedduediligencefile,theyarelikelytobeofftoaverybadstart.Asnotedabove,thisduediligence file should includenot only copiesof documents collected fromthe underlying private equity fund in which capital was placed, but also anoutline,inwrittenform,ofthestepstakentoperformoperationalduediligence.While the stages of the due diligence process themselves are useful, a duediligence file should also demonstrate implementation of the operational duediligence program. If a financial advisor or private equity fund of funds canproducesuchadetailedfile,thenfromalitigationperspectivetheymayhavealegtostandon.By performing operational due diligence and developing a detailed due

diligence file, an investor will not only create a more uniform due diligenceprocess, butwill also be forced to document their operational conclusions.Asdiscussedpreviously,thisdocumentationprocessoftenforcesinvestorstoclarifytheirthinkingwithregardtotheoperationalriskspresentinaparticularprivateequity fund, and ultimately make more decisive operational determinations.

Furthermore,asoutlinedearlier,performingoperationalduediligenceonprivateequityfundslendsitselftowarddocumentingsuchaprocess.Whensuchaduediligence file is createdas a result, then in the eventof aworst-case scenario,where,forexample,aprivateequityfundoffundsendsuplosinginvestorfundsinbadprivateequity investmentsand litigationensues, theywillbe inamuchbetterposition todefend themselves,andperhapssave themselveshundredsofthousands of dollars in lawyer's fees and millions of dollars in investorcompensationtoboot.

CONCLUSIONInconclusion,performingoperationalduediligenceonprivateequityisagoodidea.Itprovidesinvestorswiththeopportunitytodiagnose,analyze,avoid,andpotentiallymitigateunnecessaryexposures tooperational risk.Operationalduediligence is also a process that lends itself to being documented. Thisdocumentationprocessallowsinvestorswhomanagemoneyonbehalfofotherstopotentiallyinsulatethemselvesfromliabilityintheeventtheyaresuedduetolosses related toduediligence,makepotentiallymore informeddecisions, andhavemoreconvictioninthesedecisions.

NOTES

1.SeePhilipMillwardandJulianAshworth,“Opinion:CautiousOptimisminCaymanforPrimaryPrivateEquityFundraising,”PrivateEquityWire,April4,2011.2.SeeFrançois-SergeLhabitant,HandbookofHedgeFunds(Hoboken,NJ:JohnWiley&Sons,2006),39.3.SeeWalburgaHemetsberger,EuropeanBankingandFinancialServicesLaw:ThirdEdition(Brussels:GroupeDeBoeckS.A.),2008,270.4.SeeSimonWalker,“BVCAResponsetoEUCommissioner'sCommentsonWalkerGuidelines,”www.bvca.co.uk/assets/features/show/BVCAresponsetoEUCommissionerscommentsonWalkerguide5.Thetimingofcapitalcallsandassociatedcashflowsmanagementcanbequitevolatile.Foradiscussionofthis,seeAndreFreiandMichaelStuder,“QuantitativePrivateEquityRiskManagement”inTheNewGenerationofRiskManagementforHedgeFundsandPrivateEquity,ed.LarsJaeger(InstitutionalInvestorBooks,2004).6.SeeKamalGhoshRay,“MergerandAcquisitions,”PHYLearningPrivateLimited,NewDelhi,2010,495.

CHAPTER3

BeginningtheOperationalDueDiligenceReview:CoreIssues

Chapters1and2provideanintroductiontothefieldofbothoperationalriskingeneral, as well as positioned operational due diligence considerations in aprivateequitycontext.Withthisbackgroundnowinplace,wecanproceedtoadiscussionofhowan investorcanactuallybegin theprocessofperforminganoperationalduediligencereviewonaprivateequityfund.

GOALSELF-ASSESSMENT

As we discuss in Chapter 2, before diving headfirst into the operational duediligence process, it is often critical for investors to determine what they arelookingtogetoutoftheprocess.Thereisnotalwaysauniversalanswerinthisregard. Some investors may have several goals when approaching theoperationalduediligenceprocess.Othersmaybemoresingle-mindedandseekto achieve one primary goal. Certain common goals that are often associatedwith operational due diligence include fraud detection and mitigation, moreinformedoperationaldecisionmaking,operationalprocesslearning,andprocessdocumentation. Regardless of the actual goals an investor may have, it is ahighly productive exercise for an investor to go through this self-assessmentprocess to determine not only what goals they may have in mind but whatoutputs,ifany,aretoresultfromthisprocess.Inthisway,investorscanbesurethatwhen they design a process there is an alignment of expectations and theproceduresthatarenecessarytoreachthesegoals.When performing fundmanager due diligence, there is a general consensus

thatchecklistsusedinevaluationsmaybeflawed,atbest.Achecklistisaself-limiting approach that can foster a due diligence process inwhich certain keyrisksarecompletelyavoided.Butwithoutachecklist,areinvestorsresortingtoanamorphous,free-formapproachtoduediligence,andiseachnewfundreview

auniquecase?Ofcoursenot—therearecertainkeyprocessesandcomponentsof theoperationalduediligenceprocess thatcanserveasagoodstartingpointfor virtually all reviews. In performing this goal self-assessment, onequestionfor investors to consider is whether their review approach is goal-driven orprocess-driven.Tofacilitate investorscompleting theirowngoalself-assessmentprocess,we

canfirstexaminewhatgoalsareinplacefortheirotheroperationalduediligenceprocedures. Additionally, investorsmaywant to consider viewing the processfrom a fresh perspective. The types of questions they may want to askthemselvesinclude:

Are there are process similarities we can leverage from otheroperationalduediligencereviews?Are there anykey risk areas towhichmyorganization isparticularlysensitive?How will this process differ from any existing operational duediligencereviewsweperformonnonprivateequitymanagers?What operational risk areas are of most concern to our organizationwithregardtoprivateequity?What output is required from my private equity operational duediligenceprocess?

Aninvestor'sgoalself-assessmentprocessisalsoimportantbecauseitallowsinvestors to consider the unique aspects of private equity operational duediligence.Many investors who are considering implementing a private equityoperational due diligence program may already be performing other types ofoperationalduediligencereviewstovaryingdegreesforotherassetclassesandnonprivateequitymanagerswithwhichtheyinvest.Ifthisisthecase,thereisahighdegreeoflikelihoodthataninvestormaysticktotheirknitting,sotospeak,andapplymanyelementsofthesameoperationalduediligenceprocesses.Afterall,thereisnoreasontorecreatethewheelifthereisafairlyrobustoperationalduediligenceprocessalreadyinplace.Thisassumptionisonlypartiallycorrect,however. Certainly, as Chapter 1 discusses, there are a number of similaritiesbetween operational due diligence processes across both all asset classes andmore specifically between fund managers such as hedge funds and privateequity. In this regard, the processes do indeed share attributes that may beleveraged. However, by applying the same cookie-cutter process to differenttypesofmanagers,sayhedgefundsandprivateequity,investorsruntheriskof

not incorporating the unique operational aspects of private equity into theirreviewprocess.

DESIGNINGANOPERATIONALDUEDILIGENCEPROGRAMFORPRIVATE

EQUITYOnce an investor has gone through the goal self-assessment process, they cannext approach the design of an operational due diligence program.During thegoal self-assessment process an investor has likelymade a number of choicesthathave implications for the scopeand scaleof theoperationalduediligenceprocess.Itisinthiswaythatoperationalduediligenceprogramdesigniscloselyrelated to process development design. Such choices will necessarily have animpactonprocessdesign.

OperationalDueDiligenceScopeConsiderationsOneexampleof the interactionbetween the resultsof thegoal self-assessmentprocess and operational due diligence process design, relates to resourceexpenditure. If an investor has very high expectations of the operational duediligenceprocessandwantsabroadnettobecastinanattempttouncoveranyand all operational risks, then this same investor must also be prepared toallocate the appropriate resources in this regard. Operational due diligenceresourceallocationcanbeabitofa trickybusiness.Asanyanalystwill likelytellyou,operationalduediligenceisoneofthoseareaswherethemoreworkaninvestordoes,themorethereseemstobetodo.Suchnotionscanrefertothefactthatwhenan investor reviewsaparticulardocument, suchasamanager'sowndue diligence questionnaire (DDQ), there may be an additional series ofquestionsthatcomeoutofthatprocess.Similarly, the more an investor expands the scope of the operational due

diligence process, the more operational risk factors are necessarily reviewed.This relationship is summarized in Exhibit 3.1, utilizing the previouslyintroducedbelow-core,core,andexpandedreviewlevelconcepts.

EXHIBIT3.1PositiveCorrelationbetweenIncreasingOperationalScopeReviewandOperationalRiskFactorsIncludedinReviewProcess

Returning to the phenomenon of increasing process scope toward factorreview,inthiscontext it isuseful tointroduceaconceptknownasoperationalfringes.Whenanoperationalduediligenceprocessof a certain finite scope isemployed,thisinturnimpliesthatotheroperationalduediligencefactorsareleftnotreviewed,oratleastnotreviewedcompletely,eveniftheymaybetouchedupontangentially.Inthiscase,afiniteduediligenceprocessoftenbordersontheedges,or fringes,ofcertain issues.Anexampleof this is illustrated inExhibit3.2, showing the operational fringe phenomenon in a comparison of core andexpandedprocessreviews.

EXHIBIT3.2OperationalFringesPresenceinComparisonbetweenCoreandExpandedScopeReviews

To better clarify the concept of operational fringes, consider an investoremployingacoreoperationalduediligenceprocessthathasasoneofitsgoals,developing an understanding of the trade life cycle process. As part of thisprocess,an investorwill typicallyexamine the tradingprocess fromthe timeadecision ismade to trade through to execution and settlement.As part of thisprocess, an investor will likely encounter a variety of trading systems andaccounting systems that may be used within and between different firms.Therefore, inorder to effectively evaluate the tradingprocess an investor nowneeds to be able to gauge the appropriateness and efficiency of these tradingsystems. Perhaps in this investor's core process a review of the informationtechnology framework of the private equity firm is not included. It is at thispoint that a decisionmust be reached.He or she can decide to either stop orproceedwith abasicunderstandingof the trading and accounting systems.Hecan expand his process to an expanded approach and include technology andsystems.Healsohastheoptionoflearning“justenough,”howeverhedefinesit,aboutthetechnologyandsystemsfunctionsofthefirmtobeabletoassessthetrading and accounting systems. The difference between the “just enough”approachand the full-blownexpandedapproaches is that the investorutilizingthe “just enough” approach isn't necessarily interested in evaluating the entireinformationtechnologyinfrastructureoftheprivateequityfirm.Onthecontrary,thisinvestorhasdecidedthattheywillneedtoknowjustenoughaboutthefirm'stechnology and systems to facilitate the primary operational risk review goalincludedintheircorereviewprocessofunderstandingthetradeprocess.

Areadermightbetemptedtocallthisinvestorlazy.Afterall,ifheisgoingtolook at the information technology function to beginwith,why not go all theway? However, this investor may not be lazy but rather have a number ofdifferent considerations that may not allow him to expand the process. Forexample,an investorcouldbe resource-constrainedandnothaveenough time,money,ormanpowertoperformanexpandedoperationalduediligencereview.Furthermore,suchan investormaynot feel thathehas the internaloperationalcompetencies to review a private equity firm's information technologyinfrastructure.Doesthismeanthatthisinvestorwouldbecompletelycorrecttoignore this subject entirely? Of course not. An investor faced with such asituation has a number of options, including hiring qualified personnel withtechnologybackgroundstoassistinsuchreviewsorworkingwithathird-partyoperationalduediligenceconsultant.Another reasonwhy an investormight not expand beyond their core review

process is because they areworking under time constraints. Certainly, cuttingback in theduediligencedepartment isnotadvisable,but some investorsmayfind themselves in this situation.Wewilldiscuss inmoredetail furtheron thedifferentapproaches that investorscan take towarddevelopingoperationalduediligence time lines, to avoid being in a crunch situation when managingmultiplereviews.Returning to our investor who has a choice to make, let's assume that he

decidestopursuethis“justenough”approach.Theinvestorincludesareviewofthetradelifecycleinhiscoreprocess,butdoesnotexpandtheprocessfullytoincludeinformationtechnology,andthereforeisnowconductingareviewalongaso-calledoperationalfringe.Statedinanotherway,thisinvestorisbroadeningthe scope of the core review process but only just enough to review thenecessary information inanoncorescope,without fullybroadening thereviewscope into that factor. An example of the operational fringe area utilizing thetradelifecycleandinformationtechnologyandsystemsoperationalriskfactorsisshowninExhibit3.3.

EXHIBIT3.3ExampleofanOperationalFringeAreabetweenTradeLifeCycleandInformationTechnologyandSystemsOperationalRiskFactors

OperationalDueDiligenceResourceAllocationAfteraninvestmenthasgonethroughaself-assessmentofgoalsandhasutilizedthatself-assessmenttofurthertheirunderstandingofthereviewlevelandscopeconsiderations,aninvestorcannextconsidertheresourcesthatwillbeallocatedtoward operational due diligence.One primary question an investormust firstconsider relates to what, if any, resources an investor is allocating towardoperationalduediligenceintherestoftheirorganization.Someinvestorsmaybenewto theconceptofoperationalduediligence.These investorsmaynothaveanyinternaldedicatedoperationalduediligenceresourcesatall.Otherinvestorsmayhave individualsperformingoperationalduediligence,whichare focusedonotherareassuchas investmentanalysis.Beforedetermining theappropriateamountofresourcestoallocatetowardprivateequityoperationalduediligencereviews, it isperhapsuseful toprovidean introductionofcommonoperationalduediligenceframeworksthataretypicallyemployed.

UnderstandingOperationalDueDiligenceFrameworksIn order to provide some guidance in this areawe can introduce the researchfindingsofCorgentumConsultinginthisregard.Corgentumconductedaseriesofstudiesrelated to trends inoperationalduediligenceframeworksutilizedbydifferent investment organizations. In order to facilitate this study, a series ofproprietary data sets were constructed. Data were culled from a variety ofdifferent sources including interviews and surveyswith employeesworking atinvestmentorganizationsthatperformoperationalduediligence.Otherdatawerecollectedfrompublicallyavailabledatabasesandregulatoryarchives,includingthosemaintainedbytheU.S.SecuritiesandExchangeCommission,theUnitedKingdom–based Financial Services Authority, the Hong Kong Securities andFuturesCommission,andtheCaymanIslandsMonetaryAuthority.For the purposes of these studies, Corgentum classified operational due

diligence frameworks into four style buckets:dedicated, shared,modular, andhybrid. Each of these operational due diligence style buckets refer to theframework implemented at an investment organization to perform operationalduediligencereviews.Thesestylebucketsdonotaddresswhichindividualsorgroups at an investment organization hold the authority to make the ultimateoperationalconclusionregardingaparticularmanager.Furthermore, thesestylebucketsdonotaddresswhichindividualsorgroups,

such as an investment committee, has the final authority to make the finalallocation decision to a manager. A definition of each of the style categoriesfollows:1.Dedicated.Anoperationalduediligenceframeworkwhereafundofhedgefunds has at least one employeewhose full-time responsibility is vetting theoperationalrisksathedgefundmanagers.2.Shared.An operational due diligence frameworkwhere the responsibilityfor reviewing the operational risk exposures at hedge funds is shared by thesameindividualswhohaveresponsibilityforinvestmentduediligence.Nofull-timededicatedoperationalduediligencestaffareemployed.3.Modular.Anoperationalduediligenceframeworkwherebytheoperationalduediligenceprocess isclassified into functionalcomponentsandparsedoutamongdifferentspecialistswithrelevantdomainspecificknowledge.4.Hybrid.Ahybridoperationalduediligenceframeworkreferstoanapproachthat encompasses some combination of the three previously described

approaches(dedicated,shared,andmodular).Inregardtothemodularframework,it isimportanttonotethatinamodular

operationalduediligenceframework,thesedomainexpertstypicallyhaveotherresponsibilities within the larger fund of hedge funds organization outside oftheiroperationalduediligenceresponsibilities.Examplesofthetitlesthatthesefunctional domain experts typically hold within the fund of hedge fundsorganization would be General Counsel, Chief Technology Officer, ChiefComplianceOfficer,andChiefFinancialOfficer.Underamodularapproach, theworkof thesedomainexperts isoftenpieced

together by an individual or group of individuals that we will refer to asoperational generalists. The operational generalist can be thought of as aninformation aggregator who pieces together the disparate functional reviewscompleted by the domain experts to facilitate the fund-of-hedge-fundsorganizationprogressingtowardanoperationalriskconclusion.Theoperationalduediligencedutiesoftheoperationalgeneralistcanbeverysimilartothoseofoperationalduediligenceanalystsunderadedicatedframeworkandcanincludesuchthingsason-sitemanagervisitsandoperationalriskreportgeneration.Underamodularframeworktheoperationalgeneralistorgroupofindividuals

performing the operational generalist function can be either a dedicatedoperational due diligence professional (i.e., fitting into the definition of thededicatedapproach)or theoperationalgeneralist(s) themselvescanserveotherfunctionswithintheorganizationandmayevenbedomainexpert(s)intheirownright.AnexampleofthiswouldbeanindividualwhosetitleisChiefOperatingOfficer and who has other responsibilities within the fund of hedge fundsorganization,yetwhoalsoservesas theoperationalgeneralistpiecing togethertheoperationalduediligenceworkofthefunctionaldomainexperts.Exhibit3.4summarizes the role of the operational generalist in a typical modularframework.

EXHIBIT3.4ExampleofModularOperationalDueDiligenceFramework

Returningtothehybridframework,anexampleofahybridframeworkwouldbeafund-of-hedge-fundsorganizationthatemploysafull-timeoperationalduediligence analyst (i.e., dedicated framework)while including in-house domainexpertsasneeded.Continuingthisexample,thesedomainexpertswouldnotbeapart of the standard operational due diligence review process followed by thefund-of-hedge-funds(e.g.,suchasamodularapproach)bututilizedonanad-hocbasis.Another example of an operational due diligence framework thatwouldfall under the hybrid classification would be a fund-of-hedge-funds thatoutsourcestheoperationalduediligencefunction,eitherinpartorentirely,toathird-partyoperationalriskconsultant.Therefore,withinthosemanagersthatfellintothehybridclassificationitisimportanttonotethatasignificantdiversityofsubapproachesexisted.

GeneralFrameworkTrendsThesummaryresultsoftheseCorgentumstudiesaresummarizedinExhibit3.5.

EXHIBIT3.5OperationalDueDiligenceFrameworksatFund-of-Hedge-FundsGlobally

Itshouldbenotedthatnamessuchas“hedgefunds(andnotprivateequity)”are notmeant to imply that an investment organization invests only in hedgefunds.On the contrary, this category title refers to an investment organizationthat may allocate to several different types of managers varying across assetclasses,suchaslong-onlymanagers.Tobeclear,“hedgefunds(andnotprivateequity)” indicates an investment organization that invests in hedge fundmanagers,andmayalsoinvestinotherassetclasses,butthatdoesnotinvestinprivate equity funds. Similarly, the “private equity (and not hedge funds)”categoryisnotmeanttoimplyaninvestmentorganizationthatinvestssolelyinprivateequityfunds,butratheridentifiesanorganizationthatinvestsinprivateequityfundsandnothedgefunds.Additionally, in this regard, dedicated does not refer to a firm that has an

operational due diligence function that is focused solely on private equityreviews. Instead dedicated falls into the definition of a dedicated frameworkoutlined earlier (i.e., individualswhose sole role is toperformoperational duediligencereviews,asopposedtootherreviews).ThefiguresoutlinedinExhibit3.5outlinesomeinterestingtrendsinrelation

to investors’ historical views toward performing operational due diligence inhedge funds and private equity. As compared to hedge funds, historicallyinvestorshaveseemedtoallocatefewerdedicatedresourcestowardoperationalduediligence.Thistrendseemstoreversewhenaninvestorperformsoperationaldue diligence on both hedge funds and private equity funds. Specifically, thestudy data suggests that investors who allocate to private equity, and not tohedge funds, allocate fewer dedicated resources toward operational duediligence. This can be compared to the marked difference, almost 9 percentgreater, of investment organizations that allocate dedicated resources toward

hedgefundoperationalduediligence.The argument could now be raised that perhaps in generalmore investment

organizations allocate more capital toward hedge funds than private equity;however,aswithmoststudiesthedataarenotmeanttoconclusivelyproveanycertaininvestorbehaviorbutrathertoimplywhatprevailingtrendsmightbeinpractice. Such amarked difference between the two suggests that historicallymore investors have allocated resources toward conducting hedge fundsoperationalduediligencereviewsasopposedtoprivateequity.Turning to the shared framework, the data suggests that only minimal

differencesexistbetweentheoperationalduediligenceframeworksofinvestorswhoallocate tohedge funds andprivate equity respectively.Thesedifferencesare somewhat magnified when we examine the operational due diligenceframeworksemployedbyinvestorswhoinvestinbothhedgefundsandprivateequity.Aslightdeclinecanbenoticedinthisregard,ofonly3or4percentforhedgefundsonlyandprivateequityonlyrespectively.Proceedingtothemodularframework,wecannoticeastarkdisparitybetween

thehedgefundandprivateequitygroupsofinvestors.Whileonly14percentofthose investment organizations that allocate resources to hedge funds and notprivate equity employed modular frameworks, double that amount utilizedmodularframeworksamongprivateequityandnothedgefundsinvestors.Thislargedisparity isdiminishedslightly to22percent forhedgefundsandprivateequity investors.Finally, turning to thehybrid framework,we can see a slightbias towardthehybridframeworkamonghedgefundinvestorsascomparedtoprivateequityonlyaswell as investors that allocated tobothhedge fundsandprivateequity.Sowhatcanwetakeawayfromthisstudy?Takeninthecontextofotherstudy

data, it seems as if private equity investors have historically shied away fromutilizing dedicated operational due diligence resources to perform operationalrisk reviews of private equity firms. Instead, the data suggests that theseinvestors,whenperformingsuchreviewsatall,havetendedtobenefitfromthesharedduediligenceresourcesoftheirorganizationoramodularframeworkofinternalspecialistscompetencies.Thedataalsoseemstoindicateaconvergenceof more evenly distributed operational due diligence framework utilizationacrossthefourcategorieslistedearlieramonginvestorswhoperformoperationalduediligenceonbothprivateequityandhedgefunds.Amongtheseinvestmentorganizations, there tends tobe a slightbias in favorofdedicated frameworkswithsharedframeworksfollowingasaclosesecond.

ProcessConstructionConcerns:ResourceDilutionandProcessHomogeneity

In processing the study conclusions in the context of an investor determiningwhich framework and howmany resources to allocate toward operational duediligenceonprivateequityfunds,itisalsoworthconsideringthecasealludedtoearlier, of an investment organization that already maintains an establishedoperational due diligence department. This dedicated department can beemployed to review, for example, hedge fund investments, or even multipletypes of investments such as hedge funds, fund-of-hedge-funds, and long-onlyfunds, then this investor has already effectively made a commitment towardoperational due diligence. In this regard, many such investment organizationswouldviewaddingreviewsofoperationalduediligenceofprivateequityfundsasiterativetotheexistingprocess.Thatis,itcouldeasilybeintegratedintotheexistingoperationalduediligencefunctionalreadyinplace.Suchorganizationsmayhowever run the risk of having both resourcedilution aswell asprocesshomogeneity.Wecanaddresseachoftheseconceptsindividually.An existing operational due diligence function with a fixed number of

employees represents a finite pool of due diligence resources from which aninvestment organization must execute its review, analysis, and monitoring ofoperationalrisksofallmanagersandgenerallyacrossallassetclasses.Thewordgenerally is used because of differences among firms; for example, oneinvestment organizationmay have a policy of not performing operational duediligenceonanyaffiliatedmanagersoronanylong-onlymanagers.Whenanewassetclasssuchasprivateequityisaddedtothepooloffundsthatremainunderthe purview of the operational due diligence function, this group now has aseriesofadditionalissuestoaddress.Puttingasideconsiderationsofanyuniqueor particular skills required to perform operational due diligence reviews onprivateequityfunds thatmaynotalreadybepresent, it isworthevaluating theworkflowaspect of these changes.Assuming that all other investment activityremainseffectivelystablethroughoutthefirm(e.g.,aninvestmentorganizationisnotinvestingsolelyinprivateequity)thenthefiniteresourcesofthepoolnowhave to be used for more operational due diligence reviews than previously.Particularlywhen considered in the context of balancing potential operationalduediligencereviewscopeexpansion,suchadditionalreviewrequirementscandilute this pool of finite resources and result in the resource dilutionphenomenon.

Asecondconsideration,processhomogeneity,alsorelatestoscopeexpansion.Ifanorganizationalreadymaintainsa finiteoperationalduediligence functionthatthenbeginsanexpansionintoprivateequityreviews,itisworthconsidering,asoutlinedearlier,howthisprocess isapproached.Manytimes, if theexistinginvestmentorganizationhaswhattheydeterminetobewell-definedoperationalduediligenceprocesses,acertainamountofinstitutionalentrenchmenttendstobepresent.When comparing operational due diligence methodologies across different

privateequityallocators,consistencyofapproachisoftenakeyconcern.Theseconcerns, however, must be counterbalanced with the notion that all privateequity funds are not created equal. In order to successfully vet the entirety ofoperational riskspresentat a fund,an investormust sometimesbeprepared toaddanelementofflexibilitytotheirapproach.Suchflexibilitycanoftenleadtocoveringareasnottraditionallyaddressedindetailduringthecourseofstandardmethodologyreviews.Suchflexibilityoftenshedsmorelightontheoperationalrisks already uncovered during standard methodology reviews. Similarly,flexibleapproachestendtoallowinvestorstouncoveraseriesofoperationalriskfactors that were previously not reviewed under standard methodologies.Inflexible operational due diligence approaches, which can result from thepreviously referenced institutional creep of existing operational due diligencemethodologies into subsequently added asset classes, can suffer fromacheck-the-boxmentality that can be detrimental to investors. Furthermore, inflexibleoperationalduediligenceapproachesaremore susceptible to fraudas theyareeasier to manipulate from the perspective of the private equity fraudster.Investorsshouldseek tohaveanelementof flexibility in theiroperationalduediligenceprocess todesign themostappropriate reviewspecifically tailored tomeet the needs of each unique fund manager, while at the same time notsacrificingthebenefitsaffordedbyhavingminimumuniformstandardsinplace.One example of the ways in which flexible and inflexible operational due

diligence standards candiffer relates to thenotion that different private equityinvestors may have different sensitivities and priorities in regard to theoperationalriskinessofahedgefund.Forexample,oneinvestormayplaceonlyminimal importance on a fund manager's business continuity and disasterrecovery plan, while this may be of high importance to another investor. Anoverly rigid operational due diligence methodology overlooks these differentinvestor sensitivities. Additionally, operational risk concerns may also varyamong different managers. Continuing our example, business continuity and

disasterrecoverymaybeofincreasedimportancetoamanagerthattradesmorefrequently than a fund that executes only a few trades a month. Inflexibleoperational due diligencemethodologies often ignore the nuances of differentinvestoroperationalriskthresholdsandthepotentialincreasedweightofcertainoperationalriskfactorsfordifferentmanagers.Another problemwith inflexible operational due diligencemethodologies is

thatentrenchedprocessescanoftenyieldoperationalduediligencereports thatcontainreamsofirrelevantinformationasaresultoftheirboilerplatecheck-the-box approaches to due diligence.Overloading investorswith volumes of suchinformationcanresultinimportantdetailsandriskconsiderationsbecominglost.This leaves investors with the problem of searching for an operational riskneedle in a haystack of immaterial information. A flexible approach tooperationalduediligencecanassistinmitigatingthisinformationoverload.Withtheseconsiderationsinmind, investorswithestablishedoperationaldue

diligenceprocessesalreadyinplacethatsimplyaddonprivateequityasthenextnew thing can run the risk of applying an inflexible generic operational riskprocess thatcandampensensitivitiesandproduceoperationalriskreviewsthatdo not consider the unique operational sensitivities present in private equityfunds.

DevelopinganOperationalDueDiligenceTimelineAn investor who performs operational due diligence does not undertake theprocess in a vacuum. Investors operate on timelines. When faced with thedecisionastowhethertoinvestinaparticularprivateequityfirm,thereisoftena finite hard deadline after which the fund will not accept additional capital.Certainlyaprivateequity fundmighthavemultipleperiodsduring thecapital-raising period when it accepts capital, a phenomenon often referred to asinstitutingasoftcloseandthenreopening.However,afteranysuchperiodsthereis a definite point after which an investor will no longer be able to invest,commonly referred toasahardclose.Therefore,an investordoesnothaveanunlimitedtimeperiodinwhichtoconsiderwhethertheywillallocatetoaprivateequity fund. Therefore, investors must strategize how best to plan theiroperationalduediligenceprocesswith this time line inmind.Returning toourdiscussionofthegoalsofoperationalduediligence,mostinvestorswouldlikelyagreewith the benefits ofmaking themost informed private equity allocationdecisionpossible.Therefore,investorsmustplantheirprivateequityoperational

duediligencetimelineforaparticularfundwith thegoalofaccumulatingandanalyzingalloftherelevantdatatofacilitatethisinformeddecisionmaking.Thequestionnowbecomeshowmuchleadtimeisenoughtoallowaninvestor

to appropriately review and come to a decision regarding the amount ofoperational risk present in a particular private equity fund.The answer to thisquestionisfirmlyrootedinnotionsofboththeinvestor'sownresourcesandthescope of the review being performed. All other things being equal, if twodifferent investors approach the challengeof having to performanoperationalduediligencereviewofaparticularfund,thenthetimeittakestoperformsuchreviewswillvarycontingentuponanumberofdifferentfactors.First, the most obvious way in which such processes may differ relates to

process scope. Assuming that two equally skilled operational due diligencefunctionsofequalsizearedeployedtoperformareviewofaparticularmanager,the investor seeking to cover more operational ground (i.e., review moreoperational risk factors) will necessarily take longer to complete the reviewcompared toan investor reviewing feweroperational risk factors.Ofcourse, asingle-skilledoperationalduediligenceanalystmaybeabletoconductreviewsmoreefficientlythantwoormoreunskilledorinexperiencedanalysts,whichcanservetomakeuptimedifferencesinreviewprocesses.Anotherconsideration,inadditiontoprocessscope,relatestohowmuchother

due diligencework has already been performed. If an investor has performedonlyminimalinvestmentduediligenceandislookingtowardtheoperationalduediligencefunctiontoperformmuchoftheheavyliftingintheduediligencearea,then theoperationalduediligenceprocesswill likely take longeraswell.Thiscanbeparticularly truewith regard toprocessdocumentationconcerns. If, forexample, the investment due diligence process produced a one-page summarymemorandum regarding a manager's particular investment merits, but theoperationalduediligencefunctionisexpectedtoproducea50-pluspagetomeonamanager'sweaknesses,thenobviouslyjustfromadocumentationperspective,itisamuchmoretime-intensiveexercise.Contrastthiswithaninvestmentduediligenceprocess thatproducesagreatdealofdetailed internaldocumentationthat already touches on a number of different issues, either tangentially ordirectly, that operational due diligencemay touch on aswell. Thiswill likelybothspeeduptheprocessfromanoperationalduediligenceperspectiveaswellas lessen the process documentation burden on the operational due diligencefunction.Suchreviewswilllikelybecompletedonamoreexpeditioustimeline.

OperationalSmellTestsAreaBadIdeaWhiledevelopinganoperationalduediligencetimeline,itisalsoworthnotingthat investorsmay uncover items during the operational due diligence processthatmeritfurtherreview.Operationalduediligenceisoneofthoseareaswhereitisoftendifficulttoperforma“smell-test”forafund.Thenotionofa“smell-test”willoftencomeaboutwhenaninvestmentanalystapproachesanoperationalduediligenceanalystwithinthesameorganization.Theinvestmentanalystwillasktheoperationalduediligenceanalysttotake“aquicklook”atthemanagerandlettheinvestmentanalystknowifthereareanyissues.Theinvestmentanalyst'smotivation can be directly influenced by when the operational due diligenceprocessbeginswithinanorganization.Some investment organizationsmay not begin the operational due diligence

processuntilafteracertainlevelofinvestmentconvictionforaparticularprivateequity manager is reached. Other investors may begin the operational duediligence in parallel with the investment due diligence process. In the formertypeoforganization, returning toourprevious example, an investment analystmaynotwanttowastethetimeandeffortrequiredtoreachaparticularlevelofinstitutional conviction with regard to a private equity manager, if soonafterwards the operational due diligence function will come along and eithervetothemanagerentirelyornoteaseriesofoperationalissues.Not to inflate the head of the operational due diligence analyst, however, in

suchcases,itisoftenadvisablefortheoperationalduediligenceanalyststotakea position similar to that of the Supreme Court of the United States. In thehistory of the United States there have been several occasions when thePresident has asked to theSupremeCourt for an advisoryopiniononmatters.ThatistherewasnotanactualcaseorcontroversybeforetheSupremeCourttodecide, but rather, the President was seeking legal advice in one regard oranother. A notable example of this was when President George Washingtonasked the Supreme Court for advice relating to his Neutrality Proclamationregarding the French Revolution.1 In this case, as with subsequent otherexamples, theSupremeCourtdeclined to render suchanopinionbecause theyare not the attorneys to the President. Rather their approach is, either let usconsidertheissueinitsentiretyornotatall.Operationalduediligenceisabitthesameway.Froman initial evaluationperspective, an investmentorganizationmayhave

certainminimumcriteriathatarerequiredinorderforaparticularprivateequity

manager to be considered eligible for investment. These criteria can includeminimumfactorssuchasaprevioustrackrecordofacertainlength(e.g.,threeyears or more) or certain firm-wide assets under management size (e.g., $1billionormore).Generally, any individualdoesnotneed tobea fully fledgedoperationalduediligenceanalystinordertomakesuchdeterminationsanditisoften fairly obvious whether a private equity manager complies with theseguidelines.Outsideofsuchconsiderations,however,operationalrisksmaybemuchmore

difficult to ascertain unless a complete operational due diligence process isconductedforaparticularmanager.Agoodexampleofthisrelatestothewayinwhichdifferentpiecesofinformationfromdifferentdocumentscollectedfromaprivateequitymanagerinteract.Oftenaninvestmentanalystmayhavecollectedcertain pieces of documentation during their preliminary investment duediligence process. The investment analyst will typically forward thesedocumentstotheoperationalduediligenceanalystforreviewwhenaskingthemtoperformtheso-calledsmelltest.Aswillbeoutlinedinmoredetailfurtheron,thereisaparticulararttodocumentcollectionthatthisinvestmentanalystmaynothavebeen awareof.As such, all of thedocumentation that anoperationaldue diligence analyst may require to perform a review may not present.Additionally, by being asked to conduct a cursory review of documents, anoperational due diligence analyst may not catch certain latent pieces ofinformation that may be inconsistent with other documents. Continuing ourexample,anoperationalduediligenceanalystinsmell-testmodemaynotcatchthenamesofcertainentitiesreferencedinthefund'sofferingmemorandumthatarenotaddressedelsewhereinotherdocuments.Itcouldpotentiallyturnoutthatthis entity could be related to significant operational issues (e.g., an affiliatedcustodian) that could either prevent an investor from moving forward with aparticularinvestmentduetooperationalconcerns,oralternativelyslowdowntheprocesssignificantly.Therefore,investorsarefacedwiththeproblemofnotknowingwhattheywill

finduntiltheyactuallyundertaketheworkofperformingareview.Sowhatisaninvestortodo?Onesolutionistobuildinanappropriatetimebufferorcushioninto the operational due diligence process to allow for the uncovering ofunexpectedoperationalriskfactorsthatrequirefurtherreviewalongtheway.

WHENDOESTHEOPERATIONALDUE

DILIGENCEPROCESSBEGIN?Nowthatan investorhasgone throughself-assessmentofgoalsandcometoageneral determination as to the scope and framework to be employed in theoperationalduediligenceprocessforprivateequityfunds,aninvestorcannextturn their attention toward beginning the process of reviewing a particularprivate equity fund. Before delving into the specifics, however, it is worthconsidering some of the major waypoints in the operational due diligenceprocess.Thisbroadfive-stageprocessisoutlinedinExhibit3.6.

EXHIBIT3.6TheOperationalDueDiligenceProcess

The first stage in the broad five-stage process is “Data collection andanalysis.”Thisstageinvolvestwodistinctprimaryparts.Thefirstsuchsectionrelates to data collection, which includes document collection. The documentcollection process is discussed in more detail further on. The data analysisportioninvolvesactuallyreviewingandanalyzingthedatacollectedduringthis

stage, including the operational risk data that has been culled from documentreview. The type of documents collected can include legal documents andfinancial statements. (Chapters 6 and 7 discuss techniques for analyzing thesedocumentsinmoredetail.)The next stage in the operational due review process requires an on-site

meeting.The on-sitemeeting stage refers to the process bywhich an investoractuallytravelstovisittheprivateequitymanagerathisorherownoffices.Theon-siteprocesshasanumberofbenefitsthatinvestorscanrealize.Thegreatestbenefit is that face-to-face communication between investors and a privateequityfirm'spersonneloftenyieldsenhancedqualityanddepthofinformation,as opposed to teleconferences, webinars or even video conferences. In caseswhereaninvestorfeelssuchavisitisprohibitivelyexpensive,theymaywanttopursuethesenon-face-to-faceoptions.However,suchapracticeisnotadvisable.Movingonfromtheon-sitevisit,wecannextapproachthethirdstageinthe

five-stageprocess.Thisstageinvolvesserviceproviderconfirmationandreview.It is important to note the positioning of this stage in the process. While aninvestormaywish toconduct individualstagesoutsideof theprescribedorder,orevensimultaneously,thereisamethodtotherelativeorder.Considering,forexample,thepositioningoftheserviceproviderreviewstageoftheprocess,aninvestormaypreferinsteadtoconfirmserviceproviderrelationshipsbeforetheon-sitevisitandthenperformamoredetailedreviewofserviceprovidersaftertheon-site visit.There is nothingwrongwith such a re-jiggeringof theorder.Investorseachmayhavedifferentconsiderationsmotivatingtheorderinwhichtheycarryoutsuchaprocess.However,akeyelementisthateachofthestepsreferencedintheprocessbecompleted.Returning to the service provider confirmation and review stage, during the

operationalduediligenceprocess it isadvisable thatan investor reachout toaprivate equity fund's service providers to confirm, at a minimum, that therelationshipactuallyexists.Aninvestorshouldthentakefurtherstepstoreviewthe nature of the relationship that a service providermay havewith a privateequity fund or firm respectively. Additionally, an investor should review thequality and appropriateness of the service provider in relation to the types ofservices being offered to the private equity firm or fund asmentioned earlier.(Chapter4offersamoredetaileddiscussionofserviceproviders.)Now that we have an understanding of the various components of the

operational due diligence process, we can next begin to focus on when theprocess actually starts. Before starting this discussion, however, it is perhaps

usefultopauseforamomenttoconsiderthefollowingoftenrepeatedstory:Anindividualwhoishavingagreatdealofemotionalproblemswalksintoapsychologist'soffice.Thepatientsitsdownandbeforethesessionbeginsshebeginstalkingaboutherproblemsandcrying.Thepsychologistpolitelypicksupsomepapersandstartstoreadthem.Hetheninterruptstheyoungwomanandsays,“Excuseme,wehaven'tbegunyet.”Uponhearinghisinstructionsthewomancalmsdown,stopscrying,drieshereyes,andsitstherepatientlywaitingforhimtofinishshufflingsomepapers.Thepsychologistthenpointsout to her that he has just been able to stop her from crying simply bydisruptingherbehaviorpattern.Operationalduediligenceissimilarinitseffects.Manyinvestors,andprivate

equity funds, may be under the perception that the operational due diligencereviewprocessonlybeginswheninterviewsstarttotakeplace(e.g.,viaon-sitevisitortelephonically).Thisshouldnotbethecaseatall.Operationalduediligenceinaprivateequity

contextisnotaformalisticengagement.Unlike,forexample,thepracticeoflawthereisnoGenevaConvention,norarethereCivilPracticeLawRules,FederalRules of Evidence, or any other formal rules that govern how to performoperational due diligence or, for the purposes of this discussion, when theprocess begins. This is not to say there are not standards, both legal andotherwise,thatdoandshouldapplytowardoperationalduediligenceapproachesand practices.However, in general terms, there is no one formal legal rule ordocument that outlines what an investor, or firm, must do when performingoperationalduediligence.The legal standards foroperationalduediligence, ifthere are any, are typically interpretations of the amount of due diligencerequiredtocomplywithcertainstandards(e.g.,“reasonableness”or“appropriatemeasurestoreducerisk”).Nowthatwehaveestablishedthattheoperationalduediligenceprocessdoes

not have a formal beginning, we now come to the general first step in theoperational due diligence process for investors. Generally, an investor's firstpoint of contact with regard to operational due diligence (after initialintroductionshavebeenmade)istorequestmaterials(e.g.,documents)relatedtoboththeprivateequityfirmandanyfundsunderconsideration.Wediscusstheactualdocumentrequestlistinmoredetailfurtheron;however,

onepointofconsideration(andanitemthatcanraisearedflag)wouldrelatetotheprivateequityfirm'sresponsetotheactualdocumentrequestprocess.

SIGNALINGEFFECTSOFOPERATIONALFLAGS

Atthispointitisbeneficialtointroduceaconceptthatwewillutilizethroughoutthisbook.Infinance,signalingtheoryrelatestotheconceptsofsymmetricandasymmetric information, by which the actions of certain groups, such ascompanies,may send signals to themarketby either acquiringor selling theirownstock.2 In the context of operational due diligence, a signaling effect canalso said to be present when certain key operational risks are present. Anexample of this would historically be a fund that held self-custody of assets.Withouttheoversightofathird-partycustodian,therearemoreopportunitiesforthisfundtoeitherperpetratefraud;sincetheyareholdingcustodyofassetsthereiseffectivelynoonestoppingthemfromtakingtheassetsandrunningaway,or,moreplausibly,thereisincreasedpotentialforoperationalissuesresultingfromthissituation,wherethereisalackofappropriatecontrols.In this case, a signaling effect often results from these key operational risk

areas,suchasalackofchecksandbalancesoralackofprocessindependence.Throughoutthebook,whensuchissuesarediscussed,aredflagsymbolwillbeplaced at the beginnings of these sections to highlight the signaling effect oftheseparticularoperationalriskfactorsassociatedwitheachrespectiveflaggedsection.Readersshouldbeconsciousthatthetermredflagisemployedhereinabroad context. The term red flag may have different meanings to differentpeople.Someinvestorsmayviewthepresenceofanyredflagitemsataprivateequity fund as being not investible. Othersmay opt to evaluate each red flagissueonacase-by-casebasis.Stillothersmayeschewabinarysystem—thatis,noflagorredflag—entirelyandpreferamultitieredflagcolorsystemconsistingofmid-leveloperationalriskareasthatwouldbemarkedwithyellowflags.Regardless of the gradations or the color scheme employed, certain key

operationalweaknessesorpractices canbe signalsofmuchbiggeroperationalproblemsorriskarea.Assuch,whenperformingoperationalduediligenceitisadvisableforinvestorstovettheseoperationalriskareasmoredeeplyandbeonthelookoutfortheseredflagitems.

REQUESTINGANDCOLLECTING

DOCUMENTATION

As previously noted, the process of beginning an operational due diligencereview on a private equity fund often begins with a documentation request.Documentcollectionandreviewisthelifebloodoftheoperationalduediligenceprocess. By not collecting and reviewing documentation, an investor iseffectivelygoingintotherestoftheduediligenceprocessblind—andatamajordisadvantage.Eventhedocumentrequestsandcollectionprocessitselfcanofferinsightintohowtheresultoftheoperationalduediligenceprocesswillproceedandmayalertinvestorstoanyredflagsthatmaybeonthehorizon.Whentheoperationalduediligenceprocessbegins,afterintroductionsareout

of theway, an investor generally has two options: submit a document requestthemselvesoraskthefundtoprovidethemwithduediligencedocuments.Thedistinctionbetweenthesetwooptionsisinwhodrivestheprocess—theinvestororthefund.Each option has its pros and cons and, as withmany things in the field of

operationalduediligence, there isnoonerightanswerashowtobestproceed.Eachinvestormayhaveadifferentpreferenceandtheselectionofhowtobeginthe document collection process may indeed be driven by the way in whichoperational due diligence interactswith other parts of the larger due diligenceprocess.For example, for an investment organization that begins the operational due

diligence process only after substantial investment due diligence has beenconducted,manyoftheneededdocumentsmayalreadyhavebeencollected.Ifthis is the case, an investor may find it more efficient to request only theadditionaldocumentsthatfillinanyholesthatremainfromtheinitialdocumentcollectionprocess.On the other hand, an investor who performs operational due diligence in

parallelwiththelargerduediligenceprocess,eitherasadistinctoperationalduediligenceprocessoraspartofthecompleteduediligenceprocess,mayseektohavethefundprovidethemwithdocumentstokickthingsoff,andthengobacktothefundwithmorespecificdocumentrequestsifnecessary.Regardless of which approach is taken, when an investor first makes the

document request to the private equity firm, not all firms will automaticallycomply.Inmanycases,thefundmanagermayimmediatelycomplywithcertaindocumentrequests.Inothercases,amanagermayeventuallycomplywithother

document requests after a delay, perhaps because the manager does not havethesedocumentsreadilyavailable.Amanagermayalsostatesuchplatitudesthatthefirmdoesnotdistributesuchdocumentationbut the investor iswelcometoreviewsuchdocumentsduringanon-sitevisit to themanager'soffices. In stillother cases, a manager may state flat-out that a firm does not share suchdocuments. In situationswhere themanagerdoesnot immediatelycomply, thedocument collection process can turn into an exercise in negotiation. Beforediscussingthenegotiationaspectofthisprocess,itisworthconsideringanoftenoverlooked consideration that is present in not only the document collectionprocess,butalsointheduediligenceprocessasawhole—confidentiality.

NONDISCLOSUREANDCONFIDENTIALITYAGREEMENTS

When an investor first begins the document request process, an investor canlearn a thing or two about the private equity firm themselves based on theirresponse. This is a type of metacommunication, or details embedded in theresponse to the document request itself. Certain private equity firms mayrespondtothesedatarequestsdifferently.Whenfacedwithadocumentrequest,a private equity firm may ask an investor to sign a nondisclosure agreement(oftenreferredtoasan“NDA”)oraconfidentialityagreement(oftenreferredtoasa“confi”).NDAs could be referred to as a subset of confidentiality agreements. In

general, some confidentiality agreements can be broader and cover a largerscope than a traditional nondisclosure agreement. From a more practicalperspective, itcouldalsobearguedthat itdoesnoteffectivelymatterwhat theagreementistechnicallylabeled(e.g.,eitherNDAorconfi).Thenamesareusedfor the same agreement and relate to the same subject matter—protectingconfidential information. Agreements of such types become important inbusinessoperationswhenonepartyorbothareprovidingcertaininformationofaconfidentialnature to theotherandwish toprotect their rights insofaras itrelates to the information being disclosed andwhat happens in the event of anonpermitted disclosure. In general, when presented with such documents,investorsaregenerallymoreconcernedwiththecontentsofthedocumentsthanwith the subtle differences perhaps implied by the names “NDA” or“confidentialityagreement.”

However, before diving headfirst into reviewing the NDA, or having anattorneydoso,itisworthpausingforamomenttoconsidertheimplicationsofthe request from theprivate equity firm itselfon theoperationalduediligenceprocess.Inthisperspective,forthepurposesofthisstageintheoperationalduediligenceprocess, the focus isnotnecessarilyon thecontentof thedocument,but ratheron thequestionofwhether aprivateequity firmasksan investor tosignaconfioranNDA..Whenaprivateequityfirmispresentedwithaninitialduediligenceinquiryfromaninvestor,theymaynotlikelyasksuchaninvestorto complete a confidentiality agreement. This is understandable from aninvestor's perspective because theminute legal documents are introduced intotheinitialgetting-to-know-youstage,itcanbringtheconversationtoagrindinghalt.Oncetheduediligenceprocessesprogressesalittlefurther,forexample,tothe

document request stage, the private equity firmmay certainly very reasonablyask an investor to enter into a confidentiality agreementwith the firm.Beforediscussingwhyit isgenerallyapositivesignwhenaprivateequityfirmunderconsiderationasksaninvestortosignsuchaform,weshouldconsidersomeoftheargumentsfor,andagainst,suchagreements.Tostartwith,someontheprivateequitysidemaybeagainstbringingupthe

issue of confidentiality at all at this stage in the due diligence process. Forexample,theymayfeel,andperhapsrightlyso,thatrequestingthataninvestorenter intosuchanagreementwill forestall theprocessbeforeitgetsunderway.Mostinvestorsarenotlikelytosimplysignsuchagreements,buttheyarelikelytoconsultwithlegalcounselandattempttonegotiatethetermsofthisdocument.Anotherobjection thatmaytypicallyberaisedbyprivateequitypersonnel is

thatsuchNDAsorconfisarenotrequired.Theseindividualsbelievethatthereisan implied confidentiality in place. After all, most of the materials that aninvestorwillreceiveaspartofboththeirinitialduediligenceprocessaswellasinreplytoanyspecificdocumentrequestsatthisstagemayevenhavelanguageindicating that such documentation is to bemaintained in confidence.That is,thereisasortofgentleman'sagreementamongallprivateequityparticipantsthatsuchinformationwouldnotbesharedoutsideoftheconfidencesoftheprivateequity firm and an investor. In reply to such objections, your author humblyquotesSirHarryVaisey,whowasaseniorjudgeintheChanceryDivisionoftheHigh Court of Justice in England andWales and who defined a gentleman'sagreementas“anagreementthatisnotanagreement,madebetweentwopersonsneitherofwhom is agentleman,wherebyeachexpects theother tobe strictly

boundwithouthimselfbeingboundatall.”3

As abhorrent as it may be to those with a legal background, some privateequity personnel overseeing an investor's operational due diligence inquiries,suchasrepresentativesofinvestorrelationsorevensenioroperationspersonnelthemselves,may seek to reinforce these notions of gentlemanly civility in theprivateequitycommunity.This involvessituationswhereaprivateequity fundwillseektomanufactureitsownsortofadhocconfidentialityacknowledgment.One such example, which your author has seen on more than one occasion,states,“Inregardstoyourduediligencerequest,pleasebeawarethatweregardthematerialswewillbesendingyouasconfidential.Werequest thatyou treatthem as such and that you please do not share with anyone outside yourorganization.Pleaseindicatethatyouagreetothisprovisioninareplye-mail.”Before discussing such generally well-intentioned attempts to replace the

formalities of a legal document with a quick e-mail, it is worth remindinginvestors of the types of firms they are investing in. Private equity firms aremultimillion-dollar complex investment organizations. In certain cases, asunbelievableasitmayseem,thesewell-fundedprivateequityorganizationswithexistingandongoingrelationshipswithlikelyamultitudeoflawfirms,maynothave a standard confidentiality agreement on hand. Furthermore, as we havediscussed,someprivateequityfirmsmaynotevenaskaninvestortosignsuchconfidentialityagreementsaltogether.Now let us return to our good-hearted private equity employee asking an

investor to confirm by e-mail that they will behave and not share any of thematerials that they are sent. First, assuming that an operational due diligenceanalystsrepliesyes,fromalegalperspectiveitmaybedebatablewhetherhehasthe authority tobindhis entire firm to confidentiality.Second, sucha replyofconfidentialitymaybealteredorchangedentirelybythebarrageofothersmallprintdisclaimersinthefooterofmoste-mailsthesedays.Third,ifaninvestor,oranoperationalduediligenceanalystataninvestmentorganization,indeedagreesto maintain the “materials” sent in confidence, then such confidentialityconcerns do not necessarily automatically apply to all other communications,electronicorotherwise,betweentheprivateequityfirmandtheinvestor.Soforexample, just because an investor has supposedly consented via e-mail toconfidentialityofmaterialssenttoaninvestor,thesameconfidentialitydoesnotnecessarilyapplytomaterialshanded,andnotsent,toaninvestorduringanon-site due diligence meeting. Furthermore, such confidentiality does not likelyapply in perpetuity to other materials that may be sent past a certain time

interval.Yet another argument thatprivate equitypersonnelmay raise inobjection to

introducing a confidentiality agreement at this stage of the game relates toinvestors’motivation.Whatbenefit,theymayask,willitserveinvestorstoshareinformationtheyobtainduringtheduediligenceprocesswithothers?Thislineofthinkingfranklymissesthepoint.Investorsarenotgenerallycollectingsuchinformationwithagoalofbarteringitforprofitamongothers.Onthecontrary,mostinvestorsarecollectingsuchdatatofacilitatetheirowndecisionmakingastowhethertoallocatetoaparticularprivateequityfund.During the course of this decision-making process, for example, it is not

outside the realm of possibility that, in the hypothetical collegial gentleman'scommunity of the private equity world, one gentleperson could inquire uponanotherastotheiropinionofaparticularfirm.Thisinquirycouldbemadeofanindividualwhohasalreadymadethedeterminationastowhethertoinvestinaparticularprivateequityfund,andsuchinformationwouldperhapsbecommonknowledgeamongtheprivateequityelite,eitherbecausehespreadthewordorothersdid.For thepurposesofourexample,wewill refer to the investorwhoinitiallyperformedduediligenceandultimatelydidnot investwith theprivateequity fund under consideration due to operational concerns, to be the firstinvestor. The second investor in our example will be the investor who iscurrently performing due diligence on the private equity fund and is seekingcounselfromthefirstinvestor.In this case, the lack of a confidentiality agreement in place with the first

investor has now caused difficulties for the private equity firm when dealingwiththesecondinvestor.Thisisparticularlytrueifthefirstinvestorfoundthingsthat theybelieved to beunfavorable and advisedothers not to invest.Withoutsuchaconfidentialityagreement inplace initially, theprivateequity fundmayhave little basis for seeking recourse against the first investor. This can beparticularlyfrustratingforaprivateequityfirmifthefirstinvestorwasperhapsmistakenregardingcertainoperationalconclusionstheyhavemade.Perhapsthefirstinvestorwasnotveryadeptatoperationalduediligenceandnotsuccessfulinpiecingtheoftendisparateoperationalfactstogetherattheparticularprivateequity firm tomake a completely informed operational decision. Furthermore,what if this investor, who ultimatelymade the decision not to allocate to theprivate equity fund, performed his due diligence some time ago and is now,when asked, recommending that others do not invest as well. Under such ascenario, an investor may not only be advising others with incomplete

information,butalsobasedonstaleoperationaldata.Perhapsbasedondecisionsofindividualssuchasourfirstinvestornottoinvest,theprivateequityfirmhassince made marked operational improvements that would now result in adifferentinvestingoutcome.From the perspective of the private equity firm, the argumentmay concede

that each of thesemay be well-founded issues that a firmmust contendwithduring the due diligence process. However, from a practical perspective theymay, playing devil's advocate, raise the question of “So what?” After all, aprivate equity firm is not likely to be privy to the private discussions of suchinvestors. Furthermore, if a particular investor, the second investor in ourexample,decidesnot to investwithaparticularmanagerorputs thebreaksontheduediligenceprocessas a resultof theadviceofhis investingcompatriot,thenheisnotverylikelytopointtheblameatthebearerofthisadvice.Assuch,even if a confidentiality agreementwas in place,what recourse if any does aprivateequityfirmhave?Theanswerplainlyisstilllittle,ifany.However,letussaythattheinvestorwhodecidednottoinvesttellsnotjustoneindividualoftheintricacies of a particular firm, but broadcasts such opinions to severalindividuals.Furthermore,letussaythatthisindividualsharestheiropinioninapublicforumsuchasontheInternetorduringaTVinterview.Doestheanswerchange? Many private equity funds do not stay in business by suing theirprospective investors. However, without such a confidentiality agreement inplace, the investorwould likelyhaveamuchstronger shield inplace thananysort of litigation-type sword a private equity firmmay try to brandish in theirdefense.Returning to the second investor, this individual may not be, as discussed

previously, seeking to sell the informationobtainedduring theoperationalduediligenceprocesstootherinvestors.Onthecontrarythisindividualmaysimplybeseekingperspective.Assuch,inapproachingthefirstinvestor,oranyinvestorforthatmatter,hemayinquireastohowcommoncertainpracticesemployedbythe private equity fund under consideration are in practice. In doing so thissecond investor may directly, or inadvertently, reveal certain pieces ofinformation.Onceagaintheinvestor'sintentionsmaybewellandgood,butheisrevealing information obtained from the private equity firm during the duediligenceprocess—information that, if construednegatively, theprivate equityfirmwouldratherlikelynothavedisclosed,particularlywhenitcannotrespondtosuchpotentialconcerns.Now,ofcourse,itmaybenaiveatbesttobelievethatpeoplewhoenterintoconfidentialityagreementsalwaysupholdthem.However,

fromtheperspectiveof theprivateequityfirm, ifan investor isgoing tosharethe informationobtainedduring theduediligenceprocessonewayoranother,thenhavingtheoptionsaffordedtothembyaconfidentialityagreementcertainlyare preferable. Reverting back to our practicality objection, if an investor hassuchaconfidentialityagreementinplace,theymaybelesslikelytosharesuchinformation with others. The fact that they are bound by confidentiality will,hopefully,beinthebackoftheirmindsbeforetheybegintospreadthewordonewayoranother.Reviewing the issue of confidentiality from an investor's perspective, many

investors may welcome with open arms the prospect of not having to sign aconfidentialityagreement.Thisprospectmayseemattractiveonmultiplefronts.Afterall,aninvestorisnotbindinghimselforherselftoanysortofobligationtoprotectinformationorkeeptheirmouthsshut.Furthermore,whenaninvestorisnot asked to sign any sort of nondisclosure agreement, thismeans there is nosuchdocumentforthemtoreview.Aninvestordoesnothavetoexpendthetimeand resources necessary to have such a document reviewed, and most likelynegotiated among their own lawyers and the private equity fund's lawyer.Nothavingtosignsuchanagreementseemslikeagooddealforinvestors.Yet, what such a viewpointmight overlook is the reciprocal nature of such

agreements. In nondisclosure agreements, not only is a private equity firmtypically seeking to protect their information from being spread about byinvestors, but it is also offering protection of any investor informationcommunicatedtotheprivateequityfirmaswell.So,forexample,letusassumethatduringtheduediligenceprocessaprivateequityfirmlearnscertainfactsorpreferences that a particular investormay have. An example of this could bemundane investor restrictions such as the need to maintain full portfoliotransparency. Or, perhaps, during the course of the due diligence process, aninvestorhappens tomention thatheor shehavehadagreatdealofpersonnelturnover at their investment organizations, or that recent asset flows into theinvestmentorganizationfromthirdpartiesmaynothavebeenparticularlystronglately.Similartotheexamplesoutlinedearlier,thepresenceofaconfidentialityagreement will not necessarily prevent a private equity fund from discussingsuchinformationwithothers,buthavingoneinplacecertainlycouldn'thurtaninvestor'schancesofkeepingsuchinformationconfidential.Other situations in which an investor may want to have their information

protected relate to the maintenance of confidentiality in the postinvestmentperiod.Occasionallyinprivateequity,asinmostindustries,mistakeseventually

happen, particularlywhen thepotential for humanerror ismoreprevalent.Anexampleofthisrelatestowhenaprivateequityfirmrespondstocertaininvestordocumentation requests. In this example, we will consider two differentinvestors.InvestorAisacurrentinvestorinaprivateequityfundthathasgonethroughitsfirstsoftclose.InvestorBisaninvestorwhostartedtheduediligenceprocessontheprivateequityfundafterInvestorAandmissedthefirstsoftclose.InvestorBisnowinthefinalstagesoftheoperationalduediligenceprocessandis in document collection and review stages with a goal of coming to anoperationaldetermination,andsubsequentallocationdecision,beforetheprivateequityfund'shard-closedate.Forourexample,wewillassumethattheprivateequityfunddoesnotrequireinvestorstosignconfidentialityagreementsduringthe due diligence process. One commonly requested document may be anoffering memorandum for a private equity fund under consideration. Let usassumethatInvestorBhasincludedtheofferingmemoranduminhisdocumentrequestlist.Theprivateequityfirm'sinvestorrelationsmanager,MollyDowell,ishappytocomplywithInvestorB'srequest.Relyingontheknowledgethataninvestoris,fromtheperspectiveoftheprivateequityfirminthiscase,implicitlypurportedtopossessregardingimpliedconfidentiality,Ms.Dowellexpeditiouslysendsalong theofferingmemorandumtoInvestorB.Unfortunately,Mollyhasmadeanerror. Insteadofsendingalong thesampleofferingmemorandumthatthe firm had scrubbed to be in generic format, she sent an actual offeringmemorandumthathadbeenissuedtoapreviousclient:InvestorA,tobeexact.InvestorBhasnotonly receivedanofferingmemorandum,buthealsoknowsthe identity of Investor A and that this same investor has at a minimumperformedduediligenceontheprivateequityfund.Assloppyassuchapracticemayseem,thesekindsofmistakesunfortunatelyhappenallthetime,particularlyduring the often frenzied capital raising period of a private equity fundapproachingaclose.Butwedigress,returningtoourexample,whataboutpoorInvestorA?NotonlydoeshenotlikelyknowthathispersonaldetailshavebeentransmittedtoInvestorB,evenifhedidhelikelyhaslittlerecourse.Remembertherewasnoconfidentialityagreementinplacetoprotectboththeconfidentialinformationoftheprivateequityfirmandtheinvestor.Now the readermay be saying to themselves, “Wait aminute!Why arewe

talkingaboutrecourse?Whatdamagehasbeendone to InvestorA?”Well,wedon't know exactly. As with most things, however, you don't generally seekrecourseuntilafterthedamageisdone.PerhapsunbeknownsttoMs.Dowellorher employer, theprivate equity firm InvestorsAandBhad separatebusiness

dealings that are now negatively impacted by the knowledge mistakenlyimparted to Investor B. There are any number of scenarios in which suchsensitive information getting into the wrong hands can cause problems. Thepoint of this entire discussion regarding confidentiality agreements, and asapplicable to our current example, is that most private equity firms whenspeakingtoinvestorsduringtheduediligenceprocess,operationalorotherwise,keep theireyeson theprize—raisingmoney.Asa result, subtle issuessuchasthe benefits of confidentiality agreements may be intentionally, or evenconsciously,ignoredbysuchfirmsattheirownperil.Furthermore,investors,forthe reasonsdiscussedearlier,mayconsider itaplus in termsofexpediting theprocess.Nottohavesuchagreementsperhapsremovesaroadblockonthepathtoward reaching an allocation decision. However, for all of the reasons justnoted, confidentiality agreements can be a good thing for both private equityfirmsandinvestors.Furthermore, when a private equity firm does not ask an investor to sign a

confidentiality agreement, it has a strong signaling effect. The private equityfirmisinessenceindicatedthattheyhavemadeadecision,eitherproactivelyorby silence, regarding the ways in which they approach issues of informationconfidentiality.Somemayarguethatsuchsilenceonthematterisnotnecessarilyan affirmation of a disregard for the importance of maintaining informationconfidentialitybut insteada lackofdesire topress the issue.Orperhaps,evenworse,relyingontheweakargumentthatarguablythisisnotanissuetheyhaveactively considered. After all, the obstreperous may continue, if the privateequity firm's counsel did not advise them that such confidentiality agreementswere required, then what harm, legal or otherwise, is the firm doing by notimplementing a required procedure of requiring investors to sign suchagreements?Regardless ofwhether such silence on the issuewith investors isrooted in misplaced blame on legal counsel or well-intentioned, albeitabsentminded,oversight,theappearanceofaprivateequityfirm'slackofdesiretoconsidertheissueofinformationconfidentialityinameasuredwayduringthedocument collection stage is reminiscent of the famousLatinmaximqui tacetconsentirevidetur,which is loosely translatedas,“Hewho is silentappears toconsent.”4

DOCUMENTCOLLECTION:WHAT

DOCUMENTSSHOULDINVESTORSREQUEST?

Withafirmunderstandingofthegoalsoftheoperationalduediligenceprocess,andresourceframeworkallocationconsiderations,aswellasthemeta-signalingeffectsembeddedinthereplytotheinitialdocumentrequestsubmission,wecanproceedtothemeatofthedocumentcollectionprocess—whatdocumentsshouldaninvestorrequest?Unfortunately,thereisnosecretlistofdocumentsinvestorsshouldrequest.Indeed, the document request process should not be driven by specific

documentnamesatall.Rather,thedocumentrequestlistshouldbetopic-driven.So for example, an investor will likely have better results in designing adocument request list that seeks to cover certain topics such as legal andcompliance, and then utilizing these general topics to drive the specificdocumentstoberequested,suchasaprivateequityfund'sofferingmemorandumor aprivate equity firm's compliancemanual.This is an area in thedocumentcollectionprocesswhereacombinationoftheartandscienceofoperationalduediligencecometogether.Asnotedearlier,dependingatwhichstageoftheoverallduediligenceprocess

operationalduediligencebegins,thetypesofdocumentscollectedthatrelatetooperational due diligence may be collected in part during a predecessorinvestmentduediligencestageoftheprocessoroperationalduediligencemaybebrought in tostart fresh. Inorder tofacilitateourdiscussionof the typesofdocuments, an investor should collect during the operational due diligenceprocess, we will assume the latter option, that an investor is approaching theoperationalduediligenceprocessofaparticularprivateequityfundfromafreshperspective.Thisisnottosuggestthataninvestorshouldeschewanyknowledgeor insights garnered fromanyprevious investment-related due diligence.Suchanassumptionwillallowusinsteadtoestablishamodelparadigmfromwhichinvestorscaneithersubtractoraddasapplicabletotheirrespectiveduediligenceprocesses.Furthermore, as discuss earlier in this chapter, the operational due diligence

process can be driven by either the investor or the private equity fund. In theformer case, an investor submits the document request list to the fund. In thelattercase,aninvestorperformingoperationalduediligencewillrequestthatthefund provide them with due diligence documents. For the purposes of the

followingdiscussion,wewillalsoassumethataninvestorisproceedingwiththedocument requestsprocess.Dependingon the typeof reviewbeingperformed,aswellasbalancedagainstthepreviouslydiscusseddifferingapproachestowardthe positioning of the operational due diligence process in the larger duediligence scheme, such a fund-driven process may be appropriate at differentstages.However, in order to facilitate our discussion,wewill assume that theinvestorisdirectingtheprocess.Thedocumentrequestlistitselfisnotmeanttobeall-inclusive.Furthermore,

ifaparticularprivateequityfirmorfund,asapplicable,doesnotpossessanyofthesedocuments, itdoesnotmean that theoperationalduediligenceprocessesshouldgrindtoahaltandthefundshouldbecastaside.Rather,thislistismeanttooutlineaseriesofgenerallyagreed-upondocuments,eachofwhichfocusontheprimaryoperationalcompetenciesofaprivateequitymanagementcompanyand fund, respectively. In reviewing the list, a cautionary word is necessary.First, the names or titles given to a particular document in this list are notnecessarilytheexactsamenamethateveryprivateequityfirmintheworldwillutilize. Further complicating the issue is that two different private equitymanagers may call certain documents that are similar in substance, by twodifferentnames.Anotherwrinkle thatmayappear is that aprivate equity firmmaydecidetogroupanalogousproceduresandpoliciesintoasingledocument,while another firm may split each of these policies into several differentdocuments.Inthisway,theinitialdocumentrequestandcollectioncanbeabitlike playing one side of Battleship, the famous board game in which playersattempt to sink each other's navy by guessing at the positions of shipsrepresentedbydifferentsquaresonagrid,assummarizedinExhibit3.7.

EXHIBIT3.7LocatingtheAppropriateDocumentMaySometimesBecomeaGuessingGameforInvestors

In much the same way, investors may guess at the appropriate name of aparticulardocument,asusedinthecontextofeachprivateequityorganization,inordertounlockaccesstothedocumentitself.Nowwiththeappropriatebackgroundinplace,thefollowingisanoutlineofa

suggestedbaselinedocumentrequestlist.ForthePrivateEquityManagementCompanyI.CoreCompliance/RegulatoryDocumentation:1.ComplianceManual2.Ifnotincludedincompliancemanual:a.Employeepersonaltradingproceduresb.Electroniccommunicationpolicyc.Antimoneylaunderingpoliciesandprocedures

3.FormADV(ifU.S.SECregistered)II.Othermanagementcompanycoredocumentation:4.Organizationalcharts

5.Businesscontinuityanddisasterrecoveryplan6.Valuationpolicyandprocedures7.Certificateofincorporation8.Certificateofgoodstanding(ifapplicable)

ForthePrivateEquityFund(s)underConsiderationIII.Corefundlegaldocumentation:9.Offeringmemoranda10.Subscriptiondocuments11.Articlesofassociation(ifapplicable)12.Limitedpartnershipagreement(ifapplicable)

IV.Othercorefunddocumentation:13.Previoussimilarfund'sauditedfinancials(ifavailable)14. Letters to investors (e.g., monthly or quarterly) for previous funds (ifavailable)15.Performancetrackrecordforsimilarfund's(ifapplicable)16.Samplesofrecentmarketingmaterials(pitchbook,etc.)17.PrivateequityfundmanagerprovidedDDQ18.Certificateofformation19.Detailsofinsurancecoverage(includingcopiesofinsurancecertificates)Asindicatedpreviously,thedocumentrequestlistoutlinedismerelymeantto

beabaselinefromwhich investorscanbegin theoperationaldocument reviewprocess. When reviewing this list, investors should be careful not to shootthemselves in the footbefore theprocess starts.Onewaymany investorsmaybecometrippedupbysuchabaselinedocumentlististhattheygettrappedintoaself-limiting requestmode.Anexampleof theway inwhichsuchascenarioplays itself out, is when a single private equity strategy is being offered viamultiple types of investment vehicles. Typically, each of these vehicles istypicallycreatedtocatertocertaintypesofinvestorsbasedontaxstatusand/orjurisdiction.Generally,eachof these investmentvehicles isgenerallymanagedinsubstantiallythesamemanner,whichissometimesreferredtoasaparipassuformat. While private equity funds, unlike hedge funds, are less likely to beoffered in common master-feeder structures, these different private equityinvestment vehiclesmay contain different terms.Whilewe delve into amoredetaileddiscussionoflegaldocumentanalysisinChapter6,fornowsufficeittosaythataninvestor,atthisstageofthegame,woulddowelltocollectthelegaldocuments of these pari passu investment vehicles.An investormay raise the

followingquestioninthisregard,“WhyshouldIbeinterestedinothervehiclesinwhichIamnotinvested?”Thereareanumberofresponsestothis,includingto make sure that the funds do not have the ability to engage in affiliatedtransactions and to inquire as to whether one fund may contain significantlydifferentterms.Additionally,theofferingmemorandumoftheparipassuvehiclecould contain reference to other entities or affiliated parties that may not bereferencedintheofferingmemorandumoftheprimaryinvestmentvehiclethatisbeingconsidered for investment.However, aswithmost items in theworldofoperational due diligence, you simply do not know if there is anythingworthconsidering in these other documents if you do not collect and review them.Therefore, investors must be cautious not to self-limit themselves by beingoverlystuckinthemudwithregardtobaselinedocumentrequestlists.Inreviewingthepreviouslist,itisalsoworthnotingauniqueaspectofprivate

equity investing that directly influences the documents to be collected. Theprivateequityfundunderconsiderationmayhavealreadybeenformedasalegalentity and as such there are generally legal documents for the fund available.However, the fund may not have commenced operations. Without actuallyhaving been funded yet by investors or having participated in any deals, theprivateequityfundonwhichaninvestorisperformingoperationalduediligenceis effectively not much more than a legal shell. As a legal shell, the fundtherefore has not yet been active for the length of a fiscal year and cannotproduceauditedfinancialstatements,aswellasahostofotherdocuments.Thisisuniquechallengeforinvestorsseekingtoperformoperationalduediligenceona newly formed private equity fund, but one that is surmountable and not anabsolute roadblock.WhileChapters 6 and7offer discussionsof theparticularaspectsofreviewinglegalandfinancialdocuments,onecommontechniquethatinvestors can employ when faced with the unique challenge of performingoperational due diligence on an as-yet uncreatedprivate equity fund relates tocollecting documentation of any previously managed funds. While such ananalysisisnotaperfectreplacementforperformingareviewofdocumentationthathadbeengeneratedspecificallyfor thenewfundunderconsideration, it isoften an acceptable, and perhaps the only, substitute. At a minimum, such areviewgivesaninvestoraflavorforthedocumentationformatthatthenewfundunderconsiderationmayutilize.Furthermore,areviewofsuchdocumentationofapreviouslymanaged fundwill alsoprovide anopportunity for an investor togaugeanyspecificchoicesaprivateequityfirmmayhavemadewithrespecttocertainitemssuchasaccountingconventionsorlegaldocumentationchoices.

DOCUMENTCOLLECTIONNEGOTIATIONTECHNIQUES:AVOIDINGAPASS-THE-BUCK

ENVIRONMENTInmuchthesamewaythatthereisnosecretlistofdocumentsinvestorsshouldrequestfromaprivatefirm,therearenomagicwordsofenfeoffmentinvestorsmayreciteinordertoconvinceaprivateequityfirmtoprovidesuchdocuments.Typicallyaninvestorwillsubmitthedocumentrequestlistelectronicallyviae-mail, although such detailsmay verywell be communicated via telephone oreveninperson.In certain cases, a private equity firm may respond only partially to an

investor'srequestlist.Why?youmayask.Aretheytryingtopullsomethingoverontheinvestor?Givingtheprivateequityfirmthebenefitofthedoubt,thereareamultitudeofreasons.Providingcertaindocumentswhilecompletely ignoringotherdocumentsisanegotiationtechniquethatwerefertoastsunamitactics.For those who may be unfamiliar with the term, a tsunami is a very large

wave. When an investor first requests documentation from a fund, and theprivateequityfirmbeginstoreplywithsuchdocumentation,investorscanfindthemselvesvirtuallydrowning in a seaofveryvoluminousandoften complexdocumentation.Inthesecases,theburdenhasnowbeenshiftedtowardinvestorsto weed through such documentation and figure out exactly what is missing.Thisinvestoronusisoftenmultipliedwhenaprivateequityfirmmaybeinclinedtostatethatcertainoftherequesteddocumentsareeffectivelycoveredinanotherdocument. Inmany cases, the referenced documentmay only contain scant ifanydetailson thesubject that theoriginally requesteddocumentwasmeant tocontain. In these cases, the investor must then review the document and beequipped with enough ammunition to go back to the firm and continue thedocumentnegotiationprocess.The success of these tsunami tactics is further fueled by an investor-driven

phenomenon known as the piñata problem. This refers to an investor'sperspective when presented with a flood of manager documentation. For theinvestor,beginninganoperational reviewisabit likebustingopenapiñata inthat an investor does not exactly know what is falling out, but it all looksenticing.Thisexcitementcancauseinvestor'seyestoglazeoveranditemscan

getlostinthedetails,particularlywhenaninvestorperformingoperationalduediligenceisoperatingunderatightdeadline.Inothercases, inorder to limit theburdenonaprivateequity firm, thefirm

may indicate to investors that theymust obtain certain documentation directlyfromthird-partyserviceprovidersofthefirmorpreviousfunds.Anexampleofthismightrelatetoauditedfinancialstatementsfrompreviouslymanagedfunds,whichan investormightfinduseful tocollectandreview.Someprivateequityfirms may want such audits or other statements related to the previouslymanagedfundstocomedirectlyfromtheadministratororauditorasopposedtodirectly from the private equity firm. Perhaps they aremotivated bymistakennotionsofpotential liability ifsuchdocumentswere tocomedirectly fromtheprivateequityfirmasopposedtofromtheserviceproviders.Regardless, to equatewhat the private equity firm is saying to a nonprivate

equitycontext,thisistheequivalentofacustomergoingintoarestaurant,askingthewaiterforaglassofwater,andthewaiterhandsthecustomerabucketandamap to the nearest well. Not very user-friendly, to say the least. In certaininstances,investorsmaywanttocollectcertainitemsofdocumentationdirectlyfrom a third-party service provider of a private equity firm. However, a keydistinction here is that the choice should be the investor's. The private equityfirmshouldnotbeallowed toskatebywithsuchdiversionary tactics.Aswithmostthingsintheduediligenceprocess,whenaninvestorisfacedwithsucharesponse they should look skyward for a big bright signal flare. The privateequity firm is being just plain lazy at best. Atworst, they are betting that aninvestorwillnot followthroughandfollowuponactuallycontacting thefirm,potentiallysigningoffonaserviceproviderprovidedconfidentialityagreement,likely waiting for the private equity firm to sign off on the service providersharing the documentation with the investor, and then the investor actuallyreceivingthedocumentation.Whatiftheinvestorshoulddaretohaveaquestionregarding such documentation that they would like to inquire about with theservice provider?Well, the process could be extended even longer. The likelysignal, in this case, is that the firm is seeking to make the operational duediligence process difficult. Some private equity firms may even flat-out tellinvestorswhoutilizethird-partyconsultantstoperformoperationalduediligencethattheydonotliketheprocess.Investorsshouldconsiderthistobeasignaltorampuptheduediligenceprocess.Thereisanoldadage,“Youcancatchmoreflieswithhoneythanyoucanwith

vinegar.”Yourauthorhasfoundthatintermsofdocumentcollection,thisadage

iscorrect.Thereisnoneedtobegintheprocessasifitwereanadversarialone.However,whena fundstarts toputuproadblockssuchas thosediscussedandbecomesinvolvedingamesmanshipoftheprocess,thenperhapstheadage“Niceguys finish last” ismore appropriate. In certain cases, investors should not beafraidtoputtheirfootdownandcallprivateequityfundsonthecarpet.Oftenafewcorrectly chosenwordsor demonstrations that an investorwill not put upwith shenanigans is enough to showaprivate equity firm that you are seriousabouttheoperationalduediligenceprocessandthattheyshouldtaketheprocessseriouslyaswell.

DOCUMENTCOLLECTION:HARDCOPYORELECTRONIC?

Another point worth noting in regard to the document collection and requestprocessrelatestotheactualformatinwhichdocumentationistransmittedfromthe private equity firm under review. In general, the document request list istransmitted to the fund electronically via e-mail. This is common with mostmoderncommunication,asopposedtoalong-form,hard-copyletter.Ofcourse,thissamerequestcouldbesubmittedinpersonoroverthephone;

however, electronic document request submissions are generally preferred forseveralreasons.First,asaninvestoryouhaveawrittendetailedwrittenrecordofexactlywhatdocumentsyoumayhaverequested.Second,assuggestedearlier,itismoredifficultforthefundtofaketheirwaythroughthislistbysubmittingapartially complete response. However, putting the document request formataside,wecanreturntotheformatinwhichtheprivateequityfundresponds,thatis,theformatormannerinwhichtherequesteddocumentsaredelivered.Putting the previously discussed considerations of confidentiality and

nondisclosure agreements aside, when faced with a document request list aprivate equity firm typically has four primary responses for each documentrequested.Thefirmcan:1.Providethedocumentinthesameformrequested(e.g.,ifane-mailwassentrequestingthedocument,thefundcanprovidethedocumentelectronically).2.Advisetheinvestorthatthefirmadherestoapolicyofnotdistributingthatparticular document but the investormay review the document in the firm'sofficesduringanon-sitemeeting.3.Refusetoprovidethedocument.

4.Providethedocumentinoneofthemoredifficult-to-manageformats(e.g.,hardcopy).The reader's eyes are not deceiving themwith regard to the last option. As

unbelievableas itmightseeminthetwenty-firstcentury,certainprivateequityfirms still believe it is appropriate to distribute documentation in hard copyformat. Likely a chief motivation for submitting hard-copy document, asopposedtoanelectronicone,isconfidentiality.Perhapsprivateequityfundsarealsoconcerned that if information is submitted toan investorelectronicallyaninvestor may be inclined, with a few clicks of the mouse, to forward thedocumenttootherparties.While the intention behind both of these concerns is certainly grounded in

laudable notions from an operational risk perspective (e.g., protectingconfidential information), unfortunately, technologyhas evolvedpast thepointofmakinghardcopytransmissionofmaterialsanysortofhurdletowardsharingsuch documentation and protecting confidentiality. The best way to perhapsillustratethispointisbyexample.Intheearlydaysofthemodernprivateequityera,investorsmayhavebeenforcedtoreviewalldocumentsinhardcopy.Thenalongcameaninventioncalledthemimeographmachine.Thisallowedcopiesofdocumentstobemade.Therefore,aninvestordidnotneedtoreviewanoriginaldocumentfromthefundbutcouldratherreviewareplica.Similarly,aninvestorcouldmaketheirownmimeograph(e.g.,photocopy)and

send it along to a friend unbeknownst to the private equity firm. Of course,modern photocopy technology still allows for copies to be made—strike oneagainst theso-calledsecurityofhardcopies.Thereadermayask,“Whataboutwatermarkeddocuments?”Wewillgettothisinamoment.Butassumeforthesakeofargumentthatdocumentsarenotencodedwithanywatermarksorothersecuritytechnologythatwould,forinstance,preventphotocopying.Fastforwardtomoderntimesandconsideraprivateequityfirmthat,despite

aninvestor'sbesteffortstoconvinceaprivateequityfundotherwise,adherestoapolicyofprovidingcertaindocumentssolely inhardcopy.The investor thenpatiently waits by the mailbox, and one day finally receives the requesteddocument in hard copy. Then, perhaps for the ease of electronic storage,potentiallyenhancedsearchabilityoncethedocumentisinelectronicform,andahostofotherbenefits,aninvestorthenrunsthedocumentthroughascanner.Yes,themodern scanner is a widely available and cost-effective tool that has justcircumventedthefund'shalf-heartedattemptatprotectinginformation.Thereareanumberofbettermethodsthefundcouldhaveusedtoprotectthisinformation

without the inconvenience and delays of the hard-copy document distributionprocess.Inorder toput inplace increaseddocument security,while at the same time

streamlining theprocess for investorsandnot involving thirdparties,aprivateequityfundcouldeasilysenddocumentselectronicallywithahostofidentifyingand security measures. Common document security measures can includewatermarking the electronic documentwith the investor's contact information,definingatimeafterwhichthedocumentisnolongeraccessible,andpassword-protectingthedocument.Therearealsoanumberofotherbenefitsthataprivateequity firm can realize by implementing these types of document securitycontrols, including increased tracking ofwhere investors’ documents are sent,which is often an added benefit, and in some jurisdictions a requirement, forcompliancepurposes.However,theimplementationofsuchproceduresrequiresthefundtobeupto

speed with modern technology, which some private equity firms are not.Additionally,suchelectronicdocumentsecuritymeasuresalsorequirealittlebitofefforttoactuallyimplement,beyondsimplybuyingthetechnology,toinstallthesesecuritymeasures,whichsomeprivateequityfundsdonotwanttoexert.Thenexttimeaprivateequityfirminsistsonprovidingcertaindocumentation

only inhardcopy to an investor, the investormaydowell tohavea reasoneddiscussionwiththefirm.Ifthefirmcannotprovideathoroughexplanation,thenperhapsthisisasignalofalackofadaptabilityinotheroperationalareasaswell.

DueDiligenceQuestionnaires:UsesandConsiderations

In reviewing the previously referenced document request list, the reader maynotice the inclusion of “Private equity fund manager provided due diligencequestionnaire.” Indeed, if the private equity firm does not automaticallyvolunteersuchadocument.Oneofthemostinitiallyusefuldocumentsinvestorswilllikelyreceivewhenperformingduediligenceonaprivateequityfundistheduediligencequestionnaire,which isalsoknownasaDDQ.TheDDQwearediscussinginthiscaseisonethathastheprivateequitymanagerhaspreparedontheir own accord and not at the request of any specific investor. Such duediligence questionnaires are created with the intention of making a genericquestionnaire thatcanbedistributed toevery investor.Often, suchDDQsmayattempt to addressmany of themost common topics covered during both the

investment and operational due diligence processes. DDQs are essentially thehighlightsof the firm'smost frequentlyaskedquestions—or, that is to say, theonestheprivateequityfundwantstoanswer.ManyinvestorsmayfailtorealizethatDDQs,justlikepitchbooks,aremarketingdocuments.AcompetentprivateequitymanagerwillmostlikelyattempttopresenttheinformationintheDDQinthemostpositivelightpossible.ThisDDQ provided by a private equity fundmanager should be contrasted

withaDDQthataninvestorwillprovidetoaprivateequityfundandaskthemto complete. When considering these options, many investors often raise thequestionofwhethertheyshouldrequireaprivateequityfundtocompletetheirown DDQ, sometimes called a request for proposal (RFP), or whether it issufficient to rely on themanager-provided DDQ. In regard to the operationalaspect of due diligence, there has been a growing trend in recent years not torequireaprivateequitymanagertocompleteacustomoperationalDDQ.Despitesome shortcomings, these manager-provided DDQs are often good startingpointsfortheprocess.BeforeaskingahedgefundmanagertocompleteaDDQorRFP,investorsshouldbearinmindthefollowingissues:

WhatisthegoalinhavingthemanagercompleteyourparticularDDQorRFP?HowwillyoufollowupwithamanagerwhorespondsvaguelyortoadifferentquestionthantheonepresentedintheDDQ?Willyourequirenewresponsesinwriting?Will you accept a previously prepared DDQ in lieu of your specificformat? How will you determine when a manager-provided DDQmeetsthisstandard?How will you incorporate the information from the DDQ into yourlargerduediligenceprocess?HowoftendoyouanticipatehavingthemanagerupdatetheDDQ?

Inadditiontothesequestions,thereareanumberofotherconsiderationsthatinvestorsshouldtakeintoaccount,withregardtothequestionofwhethertoaskafundtocompleteabespokeDDQ:

Anoff-the-shelfinvestorquestionnaireoftenresultsinsimilarlygenericresponses.When investors require custom DDQ completion, the element ofsurpriseduringtheduediligenceprocessisoftenlost,asinvestorsareeffectivelyshowingtheirhandbyrevealingquestionsinadvance.

Many investors have a tendency to use the DDQ as a crutch and inplaceofextensiveoperationalduediligence.The opportunity for the give-and-take of an in-depth operational duediligence process is often lost when due diligence is conductedprimarilyviaDDQsorRFPs.

AfinalwordregardingDDQs:OftenwhenaninvestorasksafundmanagertocompleteacustomizedDDQontheirbehalf,investorsruntheveryrealriskoffalling into a so-called copy and paste mentality. This occurs when a privateequity fund manager, perhaps by copying and pasting information from theirownDDQintoaninvestor'sDDQ,completesacustomizedDDQonbehalfofaparticular investor.Theinvestorreviewingthisquestionnairemaythenbeverytemptedtoeithertakethis informationatfacevaluewithnofurtherinquiry,orsimply cut and paste the relevant pieces of this information into their owndocumentationoftheduediligenceprocess.Thisisanexampleofagarbagein,garbageoutprocessthatsimplyresultsintheinvestor'sduediligenceprocessesbeing reduced to an exercise in language manipulation as opposed to duediligence. Investors who are aware of such pitfalls can navigate the processaccordingly to devote the bulk of their efforts toward developing anunderstanding of and inquiring about operational procedures, as opposed tosimply regurgitating a private equity fund manager's own descriptions abouttheirownprocesses.

BeginningtheDocumentReviewProcess:DocumentErrors

Some readers may have experienced, from their university or parochial days,instructors who took a relatively hard line toward grading papers. Theseprofessors adhered to a strict policy of reading a student's paper up until thepointwhere theyencounteredabasicerror ingrammarorspelling.Oneof theunderlying premises is that if a student could not take the basic precautionarymeasures and check their paper for basic spelling and grammar, then theprofessor should not extend the student the courtesy of continuing to read thepaper.Theprofessormayeitherfail thestudententirelyorawardcreditforthestudent'spaperuponlyuntilthepointwheretheerrorwasdetected.Now,whatdoesanyofthishavetodowithoperationalduediligence?Ifsuch

a standard were applied to operational due diligence it is likely that manyinvestor due diligence reviews of a private equity fund's materials would be

stalledbeforetheystarted.Private equity firms and funds, just like investors, are not infallible.While

both groups are indeed error-prone, in the context of the document reviewportion of the operational due diligence process, the focus is on anydocumentation errors made by the private equity firm in preparing thosedocuments. From the private equity firm's perspective, such errors may beunderstandable.After all, it isoftendifficult forone tocheck theirownwork,andaprivateequityfirmmaybetooclosetoitsowndocumentationtorealizecertain errors that are apparent from an outsider's, such as an investor's,perspective.Whileunderstandable,itcertainlydoesnotmeanthatallsucherrorsareexcusable.Documentationerrorscanbegroupedintotwobasicclassifications.Thefirst

such type of documentation error is the previously mentioned rudimentarygrammarandspellingerrors.Thereisnotmuchtosayaboutsucherrors,otherthanthefactthatthepresenceoftoomanymistakessuggestsalackofoversightindocumentpreparationandagenerallysloppyattitude.Ifaprivateequityfirmcannot evenprepareanerror-freedocument,howcanan investorbe sure theywillnotmakemistakesinbasicoperationalprocesses?The second type of error relates to factually incorrect or stale information.

Instancesoftheseerrorsoccurwhenadocumentprovidedbytheprivateequityfirmisaninaccuratedescriptionofactualpracticesinplace.Anexampleofthiswould be a manager-provided DDQ that describes a firm that requires twosignatoryapprovalsforallcashtransfersbutwhich,duringtheoperationalduediligenceprocess,isrevealedtorequireonlyonesignatory.ThestatementintheDDQisfactuallyincorrect.Anothertypeofrelatederrorasreferencedearlierisstale information. Stale information can come about in a number of differentways.Themostcommoniswhenaprivateequityfirmdoesnotupdatecertainmaterials frequently enough to reflect changes within an organization. Oneexamplecouldbewhenafirmnolongerutilizesacertainserviceproviderandhasswitchedtoanewone—suchasexternallegalcounsel—buthasnotreflectedthis information in documents such as their fund-offering memorandum ormanager-providedDDQ.Anothercommontypeofdocumenterrorthattypicallyresults fromstale informationariseswhenemployeeshavedeparteda firmbutthey are still referenced in certain documentation. This error may frequentlyarise in documents that a private equitymanager updateswith less frequency,such as a business continuity and disaster recovery plan. Such plans typicallycontainchainsofcommandorcall-treeliststhatreferenceindividualsbyname.

Upon the departure of an individual from the firm, a private equity firm'spersonnelmayhavetakencaretoremovethisindividual'snamefromdocumentsthatmaybedeemedtobemoreinvestor-facingsuchasDDQs,butmaybelesslikely to revise documents such as a business continuity anddisaster recoveryplan.Itisworthnotingthatthepurposeofthisdiscussionisnottosuggestthatthe

vast majority of private equity firms do not put thought into preparing theirdocumentsor takereasonableprecautionsinensuringthesedocumentsarefreeof errors. However, the point of this discussion is to provide investors withinsightintothefactthattheymustbevigilantinreviewingdocumentsforsucherrors.Afterall,isn'tthatpartofthepointoftheentireoperationalduediligenceprocess? If investors couldbe assured that all documentswere error-free, thenpartofthefunctionofthenecessityofduediligenceprocesswouldbeobviated.Sowhat is an investor supposed to dowhen they come across some errors?

Well,agoodfirststepisnottosimplyignorethem.Aninvestorshouldmakeanongoing list of such documentation errors.A process that investors frequentlyfollow in coming to an operational determination as to the overall levels ofoperationalriskpresentataprivateequitymanager,thesumtotaloftheseerrorsshouldbeevaluatedcumulatively.Inisolationanyoneoftheseerrorsmaynotbedammingbutviewedtogether,perhapsthesheernumbersofsucherrorsor thetypeofsucherrorsmaybeenoughtoshiftaninvestor'sconvictiononewayoranother.

FUNDMANAGERON-SITEDUEDILIGENCECONSIDERATIONS

In the broad five-stage operational process, after document collection andanalysiscomestheon-sitemeeting.On-sitevisitsareofparamountimportanceintheoperationalduediligenceprocess.Investorsseekingtocutcorners,duetocostor resourceconstraintswouldbe ill-advised tocutback in theareaof theon-sitevisit.First, even in thisworldof free Internet-based satellitemaps, themostobviousreasonis toconfirmthat thefundmanageractuallymaintainsanoffice.Anon-sitevisitalsoprovidesaninvestorwiththeopportunitytoconfirmthe size and scale of the fund manager's internal office space—an area thatsatellitephotosmaybeof littlehelp inviewing. Insights thatcanbegained inthisareacanfacilitateansweringanumberofquestionsincluding:

Is the fund manager's space shared or subleased to any entities thatwereconvenientlynotreferencedinanyofthefund'sdocumentation?Doesthefirmclaimtohave50employeesbutshowonly20desks?Iseveryoneconvenientlyouttolunchoronvacationduringthedayoftheon-sitevisit?Issecureaccessmaintainedtothefirm'soffices?Issecureaccessmaintainedtocertainareassuchasserverrooms?

Another benefit of the on-site visit is the additional information that can begarneredviaface-to-facecommunication.Operationalduediligenceisoneoftheareas thatcansuffergreatly fromanattempt to replaceon-sitevisitswithwebconferences, videoconferencing,or teleconferencing. In certain instances suchconferencingoptionsmaysupporton-sitemeetingfollow-up.However,investorsshould not try to use technology to replace the benefits of face-to-facecommunication.Duringanon-sitevisitinvestorscangaugepeople'sreactions—facialandbodylanguageandothersignals—tocertainquestions.Additionally, on a conference call, these types of conversations often take

place among several individuals at once. In such largegroups, the candor andfranknessofaprivateequityfirm'soperationalemployeemaybetemperedastonot express any negative or controversial opinions that he might otherwiseexpressinaone-on-one,in-personsetting.Additionally,intherealworldthereisnopauseormutebuttonavailable.Amoregenuinereactionisobtainedviain-personcommunications.Furthermore,aninvestor'spresenceinanofficeaffordsthe opportunity for any operational systems to be observed by the investor ortheiroperationalduediligencerepresentative.Whileitispossibletodemonstratesystems and technology that may be employed in a private equity firm'soperationsduringwebconferencing,suchdemonstrationscanberehearsedandmanufactured. The prepackaged nature of such web presentations is a poorsubstituteforanactualon-siteobservation.Nowthatweprovidedanoverviewofthebenefitsofinvestor'sperformingon-

sitevisits toaprivateequitymanagerduring thecourseof theoperationalduediligence process, we can next discuss certain considerations that investorsshouldhaveinmindwhenapproachingschedulingoftheon-sitevisit.Similartothe document collection process, discussions between investors and privateequitymanagers can often provide signaling insights into amanager's attitudetowardtheoperationalduediligenceprocess.When scheduling an on-site visit dedicated to operational due diligence in

particular,aprivateequityfirm,dependingontheirapproach,mayhearthewordoperationalandimmediatelyassumethataninvestorneedonlymeetwithpeoplewithsomeversionoftheword“operational”intheirtitle.Sucharesponseis,ofcourse, ridiculous, but one that your author has observed, in one shape oranother,onmultipleoccasions.Anothercommonresponseisthosewhomaybemorecomfortablediscussing themeritsofaprivateequityfund'sportfolioandlesscomfortableabouttraditionaloperationalareasandmayscatterassoonasaninvestorapproaches toperformoperationalduediligence.Thismaysometimesbeseenamonginvestorrelationspersonnel.Perhapsmotivatedbyfearthattheyarebeyondtheirprimarydomainofexpertise,theymaythinkitbesttodefertomoretraditionaloperationspersonnel,suchasachiefoperatingofficerorchieffinancial officer. While they may be well-intentioned, as investor relationspersonnelmostcertainlyare, theyoftenmissthepoint that theycanbehelpfulduringtheoperationalduediligenceprocess.Thevalueofinvestorrelationsandclient service personnel can come both in the form of the information theypossessaswellastheabilitytheymayhavetoassistinvestorsinnavigatingtheon-sitemeetingprocessingeneral.When scheduling the on-sitemeeting, another common inquiry that investor

relations may ask is “How long is this going to take?” Once again, such aquestionmayseemharmlessandwell-intentioned.Thisisparticularlyinlightofsomeinvestors’beliefthattheamountoftimespenton-siteduringanoperationalduediligencevisitdirectlycorrelatestothequalityofthereview.Suchinvestorbeliefs aremisplaced, and this commonly heldmisconception is illustrated inExhibit3.8.

EXHIBIT3.8MisconceptionThatThereIsaPositiveCorrelationbetweenIncreasedOn-SiteMeetingLengthandtheEffectivenessofanOn-SiteOperationalDueDiligenceReview

Rather, there is a point beyond which such on-site meetings can result indiminishing returnsor even indamaging theongoing relationshipbetween theinvestorandtheprivateequityfirm,whichisrequiredtocompletethepost-on-site operational due diligence review process. There is no magic number ofhoursforhowlonganon-siteoperationalduediligencevisitshouldormusttake.The length of time required is often contingent in part on several factors,including the transparencyof theprivateequity firm in sharingdocumentationpriortotheon-sitemeeting,andtheamountoftimetheinvestorspentpreparingfor the on-site meeting. An unprepared investor will likely spend more timecovering basic operational issues, as compared to one who has devoted asignificantamountof time topreparing for themeetingwhocan instead focusmore on why strategic operational decisions were made as opposed to theoperational basics that may be covered relatively quickly by an informedinvestor. Similarly, an investor could be willing to put the time in to prepareprior to the on-site meeting; however, if the private equity firm has minimaldocumentationor if theyattempt to stonewall the investorby sharingvirtuallynothinginadvance,thentheon-sitemeetingwillnecessarilytakelongerbecausetheinvestorhadlittletoworkwithpriortotheon-sitemeeting.Returningtoour“Howlongisthisgoingtotake?”question,dependingonthe

contextinwhichitisaskedaswellasthetone,sucharesponsecanonceagainhaveadirectsignalingeffect.Thesignalthatcanbesentisthataprivateequityfirm is not really interested in seizing a particular opportunity to demonstratetheiroperationalstrengthstoaparticularinvestorandinstillthestrongsenseofconfidencethatafundmayhaveinitsoperations,butratherjustgoingthrough

themotionswiththehopesthatthey“passthetest”andsecureanallocation.

KEYRISKCONSIDERATIONAREASTOCOVER

Thebaselinedocumentrequestlistwasdesignedaroundthecommonareasthatinvestorsarelikelytocover.Thisprocessisintendedtobemoregoal-drivenasopposed to focusing on any particular document or operational concern. Tofacilitateourunderstandingofhoweachofthesekeyoperationalriskareasmaybecoveredduringanon-siteprivateequity fundmanagervisit, it is todiscussthetypesofquestionsthatmaybeasked.Thefollowinglistofquestionsisbynomeansall-inclusive.Rather,questions

have been included that should provide an introductory overview of each keyrisk area. Generic questions such as “What are your firm's advantages ascomparedtopeers?”havebeenomittedfromthelist.Suchopen-endedquestionsdefinitely can add value during the operational due diligence process, but foreaseofanalysistheyhavebeenomitted.FirmwideIssues

Haveanypartnersorfoundersofthefirmsincedepartedthefirm?Provideadetailofanyaffiliatedentities.Areanymembersofthefirmrelated?Doesthefirmmaintainapolicyon relatives working together? If so, how does it prevent potentialconflictsofinterest?What is thealignmentof interestsbetweenthefirmandits investors?Amount of principal and employee capital invested? Deferredcompensationstructure,andsoforth?Sideletters:Dootherinvestorshavethem?Whataretheirterms?Istheprivateequityfirmlockedintoanylong-termcontracts,suchasofficespaceleases,technologyservicecontracts,andsoon?

AssetsUnderManagementWhatare thecurrentassetsundermanagementfor thefirm?Foreachfund?Whatwere theassetsundermanagementayearagofor thefirm?Foreachfund?What has been the peak of assets under management?When was it

reached?Whatisthebreakoutofinvestorsbyinvestortypeinthefirm?Ineachfund?Whatisthegeographicalbreakoutofthefirm'sinvestorbase?Whatistheanticipatedinvestorpipelineforthecurrentprivateequityfundunderreview?Whenisthefirstanticipatedclosingdateforthefund?Isitahardcloseorasoftclose?What percentage of assets under management do the followingrepresent (as a percentage of both firm and fund assets undermanagement):

LargestinvestorThreelargestinvestors

PersonnelandEmployeeTurnoverProvide details of historical employee turnover (additions anddepartures).Doesthefirmhaveanyadditionalplannedhires?If the firm indicates that someone has left on good terms, can youcontactthisformeremployeeasareference?What does the firm do to ensure retention of key employees? Arenoncompeteagreementsutilized?

LegalandComplianceWhatisthestructureofthefirm'scomplianceorganization?Areemployeesdedicatedsolelytocomplianceordotheyhavesharedresponsibilities?Doesthefirmworkwithanythird-partycomplianceconsultants?Ifregisteredwithanyregulatoryentities,doesthefirmworkwithanythird-partycomplianceconsultants?Isanycompliancetrainingperformed?Ifyes,whattopicsarecoveredbycompliancetraining?Doyouperformanyelectroniccommunicationmonitoring?What are the general policies regarding employee personal accountdealing?

Isarestrictedlistmaintained?Areminimumholdingperiodsinplace?

Ispretradeapprovalrequired?Whatsortofposttradereviewsareconducted?

Has there been any previous litigation against the firm, fund, or anyemployees?Is there any pending litigation against the firm, fund, or anyemployee(s)?Arethird-partyresearchnetworksutilized?Ifso,whatmeasureshasthefirmtakenwithregardstomaterialnonpublicinformation?

Isarestrictedlistmaintained?InsuranceCoverage

Whattypesofinsurancecoveragedoesthefirmmaintain?Whatarethetermsofthiscoverage?Whichcarriersprovidethiscoverage?Whatare theamountsofsuchcoverage?Howdid thefirmdeterminetheseamounts?Does the private equity fund self-insure for anything (as opposed toobtainingthird-partycoverage)?Hasthefirmeverissuedaclaimonanyofitsinsurancepolicies?

FirmandEmployeeReputationWhatistheemploymenthistoryofthefirm'sseniormanagement?Didthey leave their previous firms on good terms? Can they providereferences?Isthereanythinginseniormanagements’pastthatisnoteworthyfromareputational risk perspective (e.g., criminal convictions, sanctions byregulators,etc.)?Isseniormanagementinvolvedinanycurrentlitigationordisputesthatmay be distracting (e.g., a messy divorce, dissolution of formerbusinesspartnerships,etc.)?Does seniormanagement have any outside business interests? If yes,what is the nature of these interests? How much of seniormanagement'stimedotheytake?

CounterpartyOversightDoes the firm have any existing relationships with tradingcounterparties?What counterparty relationships are anticipated for the new private

equityfundunderconsideration?What is thereviewandapprovalprocessfornewcounterparties tobeaddedtothefirm?Wherearenewcounterpartiessourcedfrom?Does the firm have an existing counterparty review process? If yes,howfrequentlyareexistingcounterparties reviewed?Whoat thefirmisresponsibleforconductingexistingcounterpartyreviews?

TransparencyandFundReportingWhat types of reporting does the firm anticipate distributing toinvestorsinthenewprivateequityfund?Whatisthetimingwithwhichsuchreportswillbedistributed?Whatis themethodofdeliveryofsuchstatements(e.g.,viae-mailorviaacentralizedinvestorrelationswebsite)?Does the firm adhere to a practice of distributing performanceestimatesforfunds?Whenhaveauditedfinancialstatementshistoricallybeenavailable?Havetherebeenanyhistoricalfundperformancerestatements?Ifyes,whathappened?

TechnologyandSystemsWhatthird-partyandproprietarysystemsarecurrentlyinplace?What types of hardware are utilized (e.g., desktop PCs and servers)systemsareutilized?Haveanysystemsbeencustomizedorupgradedbythefirm?Arethereanyplanstodoso?Whatareexamplesof the typesofproblems thatarisewith thefirm'scurrentsystems?

InformationSecurityWhatarethefirm'sinformationsecuritydefenses?Whatkindsoffirewallsareinplace?Does the firm, either itself or via a third-party provider, performpenetrationtesting?Doesthefirm,eitheritselforviaathird-partyprovider,performsocialnetworktypepenetrationtesting?Doesthefirmlogemployeenetworkactivity?Has the firm taken any steps to monitor employee usage profiles to

monitorforunusualcomputerusageordirectoraccess?Istheuseofremotestoragedevicessuchaszipdrivespermitted?Howoftenareemployeesrequiredtochangetheirnetworkpasswords?

PersonnelandEmployeeTurnoverProvide details of historical employee turnover (additions anddepartures).Doesthefirmhaveanyadditionalplannedhires?If the firm indicates that someone has left on good terms, can youcontactthisformeremployeeasareference?What does the firm do to ensure retention of key employees? Arenoncompeteagreementsutilized?

BusinessContinuityPlanningandDisasterRecovery(BCP/DR)DoesthefirmmaintainwrittenBCP/DRprocedures?Istheplantested?Ifso,howoften?Whenwasthemostrecenttest?AreBCP/DRplanstestedfromatechnologyperspectivesolelyorarepersonneltestsemployedaswell?Whoisinchargeofupdatingtheplans?Whatarethefirm'sdatabackupcapabilities?Doesthefirmhavebackuppower-generationfacilities?Doestheprivateequityfirmhaveadisruptiongatheringlocation?Has the private equity firm ever had to activate itsBCP/DRplan? Ifyes,whathappened?If the private equity firm hasmultiple offices, how are these officessupposed to coordinate with each other in the event of a businessdisruptionineitherlocation?

QualityRolesofServiceProvidersWhat service providers do you anticipate utilizing for the currentprivateequityfundforwhichyouareraisingcapital?Howlonghaveyouworkedwithyourcurrentserviceproviders?Whatservicesdoyoureceivefromeachofyourserviceproviders?Howlonghaveyouworkedwithyourcurrentserviceproviders?Are you happy with your service providers or are you thinking ofswitching?Whatarethetermsandlengthofcontractwithyourserviceproviders?Haveyouexperiencedanyturnoverofpersonnelattheserviceprovider

thathasimpactedthelevelofservicethefundreceives?

CONCLUSION

Thischapterprovidesanintroductiontosomeoftheprimaryissuesaninvestorshouldconsiderwhenbeginningtheoperationalduediligencereviewprocessforprivateequityfunds.Theprocessshouldbeginwithgoalself-assessmentsothatinvestors ensure that they design an operational due diligence process thatcomportswith their notionof theprocess.With thesegoals inmind, investorsshouldnextconsidertheanticipatedprocessscopeandthenproceedtoconsideroperational due diligence resource allocation. As part of this frameworkselection design process, investors should consider framework design andselectionconsiderations.Withafirmgroundingingoalsandprocess,aninvestorcan next begin the document-collection process. As part of this process, thischaptercoveredcommondocumentrequestitemsaswellasthewaysinwhichsignaling effects can provide insights as to potential operational issues.Additionally, this chapter outlines some of the document collectionconsiderations surrounding confidentiality agreements, as well as the role ofnegotiationinthedocumentcollectionprocess.Finally,thischapterprovidesanoverview of on-site visit considerations, as well as an introduction to thebaseline typesof issues that investors should coverduring theoperational duediligenceprocess.Withsuchameasuredapproach,investorswillbeabletobuildastrongfoundationforathoroughoperationalduediligenceprocessforprivateequityfunds.

NOTES

1.SeeDavidSloss,TheU.S.SupremeCourtandInternationalLaw:ContinuityorChange(CambridgeUniversityPress,2011),26.2.SeeScottBesley,EssentialsofManagerialFinance(ThomsonSouth-Western,2008),516.3.SeeBryanA.Garner,ADictionaryofModernLegalUsage2ndEdition(OxfordUniversityPress,2001),384.4.SeeGeorgeFrederickWharton,LegalMaxims,withObservationsandCases(Baker,Voorhis&Co.,1878),279.

CHAPTER4

AdditionalOperationalDueDiligenceConsiderations:AnExpandedAnalysis

This goal of this chapter is to introduce some additional operational duediligencetechniquesthatareavailablewheninvestorsareseekingtoincreasethescope and depth of their operational due diligence reviews. In Chapter 3, weprovide anoverviewof someof the basic considerations thatmaybe in placewith regard tobeginning theoperationalduediligenceprocess.Aspartof thisintroductionwecoveredsomebasicdocumentsaninvestormightseektocollectduring theoperationalduediligenceprocess.Wealso introduced several basictopic-focusedquestionsinvestorsmayseektocoverduringtheinitialstagesoftheoperationalduediligencereview.Buildinguponthisfoundation,wecannowmove toward discussing the process expansion into a more comprehensiveframework.

COREISSUESVERSUSEXPANDEDANALYSIS

Earlierinthisbook,weconsiderthenotionsofabelow-core,core,andexpandedoperational risk theoretical resource allocation paradigms. With a firmintroductionto thecoreprocessalreadyestablished,wecannextproceedtoanoutline of the expanded review. The expanded review process seeks to buildupon an investor's core process, such as by broadening the scope of theoperational due diligence in a number ofways.An example of expanded riskanalysisiscomparedtoacoreprocessinExhibit4.1.

EXHIBIT4.1ComparisonofCoreandExpandedProcessesRiskCategory Core Expanded

Generalfirmoverview

Assetsundermanagementreview

Tradeflowanalysis

Cashoversight,managementandtransfercontrols

Complianceinfrastructure

Valuationpoliciesandprocesses

Legal/Compliance

Regulatory

Qualityandappropriatenessoffundserviceproviders

Reporting

Technologyandsystems ×

Informationsecurity ×

Humancapital ×

Businesscontinuityanddisasterrecovery ×

Operationsconnectivity ×

Taxpractices ×

Insurance ×

Counterpartymanagement ×

Humancapital ×

Administration/administrationagreement ×

Fundreporting ×

ItisworthnotingafewpointsregardingExhibit4.1.Aninvestormayobjectto the classification of certain operational risk categories. That is to say,investors may consider certain operational risk categories to be moreappropriately placed in the expanded column than in the core column or viceversa. Consider for example the operational risk category for technology andsystems. Some investors may feel that a private equity firm's informationtechnologyfunctionissocruciallyimportantthatthiscategoryshouldbeplacedin the core process review camp as opposed to the expanded review. Thisinvestormaybeperfectlycorrect.Thepointofcomparingthecoreandexpandedcategoriesisnottosaythatoneshouldbefocusedononeattheexpenseoftheother.Rather,thisisintendedtosuggestastartingpointfromwhichaninvestormay develop his or her own operational due diligence process. In certaininstances,aninvestormaybejustifiedinaddingtechnologyandsystemstothecorecategory.Another way inwhich an investormay transition from a core review to an

expanded process is to increase the depth of the review across existing coreoperational risk categories. Of course, the ability to conduct such increasingdepthcoreexpandedreviewsmaybe limited inscopeby theparticularsof thefund itself.For example, an investormaywant to fullyvet certainoperational

riskareas,suchascustody,butmaybelimitedbytheoperationalpracticesofthefund itself.An investorduringacore reviewprocessmayhave inquiredaboutwhetherthefundheldself-custodyofanyassets.Iftheinvestorwaspursuingamoreexpandedreviewprocess,theymaywanttodigdeeperbyinquiringaboutthedetailsofthecustodialrelationship,suchasattemptingtoconfirmaprivateequityfirm'sbalanceswithacustodian,gainanunderstandingoffeescharged,haveadiscussionoron-sitevisitwiththecustodiantounderstandtheirprocessesandprocedures,discussthewaysinwhichassetsareoverseen,andevencollectand review a copy of the service level agreement (SLA) between the privateequityfundandthecustodian.Anythingbeyondthislevelofreviewisreallyafunction of the operational particulars of each unique private equity firm. Assuch, there isonlysofaraninvestorcandig intoaparticularoperational issuefrom a generic perspective, beyondwhich the operational risk factormust beviewed in the context of the fund under review itself. An example of such atransition from a core process to a more expanded process in a particularoperationalriskcategory,thecustodycategoryinthiscase,isoutlinedinExhibit4.2.

EXHIBIT4.2ExampleofCoretoExpandedProcessTransitionthroughIncreasingDepthintheParticularOperationalRiskCategoryofCustody

Additionally,aninvestormaystillalsowanttotransitiontoblendbycastinga

larger net as compared to a core process (e.g., increasing scope) but limit theincrease inscope tosuchadegree that increaseddepthacrosseachof thenewtotalsetofexaminedoperationalriskfactorsisnowcovered,ascomparedtothepreviouslymoreshallowcoverageacrosseachoperationalriskfactorinthecorereview.

COMPENSATIONSTRUCTURES

Akeyareathatistypicallyincludedinmostinvestor'soperationalduediligencereviewsofaprivateequityfirmrelatestoemployeecompensation.Thequestionofcompensation,fromtheinvestor'sperspective,effectivelyboilsdowntothreeprimaryquestions.The first question relates to theways inwhich the existingfundemployeesarecompensated.Thisisofparticularimportanceforaninvestorapproachingaprivateequityfirmduringtheduediligenceprocessforanewlyformingprivateequityfund.Thequestionofcompensationisfocusedonthealignmentofinterestbetween

aprivateequityemployeeandthefundinwhichtheywillbeinvolved.Suchanalignment of interest is often paramount for investors. Investors generallybelievethataprivateequityemployeewhosecompensationisdirectlytiedtotheperformanceofaparticularfundwillworkharderonthatfundthantheywouldafund whose performance may only tangentially affect their compensation.Furthermore, many investors generally hold the belief that private equityemployeeswillbemore incentivized toact in thebest interestsof thefund,asopposed to their own best interests, if their compensation is directly linked tofundperformance.Thesecondof the threeprimaryquestions related tocompensation is,“Does

thefirmoffercompensationpackagesthatarecompetitiveenoughtoattracttoptalent?”Iftheanswertothisquestionisno,thenaninvestormustquestionhowthe private equity firm is going to continue to grow to attract either seasonedanalystsfromotherfirmswhomaybeausefuladditiontothecurrentfirm,andperhapsmoreeffectivelyparticipate inportfoliooversightandhelp togenerateincreasedfundreturns.The third and final compensation question is whether an employee's

compensationwill vest over a specifiedperiodof time.Vesting is a techniquewherebycompensationdoesnotbecomeimmediatelyavailabletoanemployeeunlesscertaingoalsaremet.Thisisatypeofdeferredcompensationschemethat

seekstorewardemployeesthroughoutthelifeofaparticularprivateequityfund.Bydeferringcompensationoveralongperiodoftime,andmorecloselyaligninglong-term compensation with fund performance, vesting can also seek topromoteemployees’focusonsustainedprofitabilitythroughoutthelifetimeofafund.There are a number of different approaches to vesting private equity firms,

suchastimevestingandperformancevesting.1Timevesting refers toaconceptwhereby compensation will continue to vest as long as an employee remainswith the firm. If the employee departs, the vesting period ceases. In certaincases, depending on the termination devices employed, the employee mayreceiveonlytheirproratedportionof thefullamount to thedegreewithwhichvesting occurred. Another option may be cliff vesting, whereby an employeewhoisnotfullyvested(i.e.,departsbeforethefullvestingperiodiscomplete)receivesnothing.Performancevesting refers toaconceptwherebyvestingwilloccurbasedontheachievementofcertainperformance-relatedtargets.Commonperformance vesting targets can include yearly performance targets for theprivate equity fund itself. Another type of performance target for the privateequity fund itself is so-called catch-up performance vesting wherebyperformancetargetsareaggregatedovertheentirevestingperiodtoallowforafund to potentially catch up for early poor performance. In addition toperformancevestingtargetsrelatedtotheperformanceofaprivateequityfunditself,sotoomayperformancemetricsbelinkedtotheunderlyingperformanceof portfolio companies of a particular private equity fund itself. Examples ofsuchaperformancemetricmaybetiedtonotionalenterprisevalueorvariationsofEBITDA.Employee compensation is a rich and sometimes complex subject that

investors should take care to analyze during the operational due diligenceprocess. In addition to the three questions outlined, there are a host of otherrelated compensation issues andways inwhich a private equity firmmay addadditionalbellsandwhistlestothecompensationprocess.Assuggestedearlier,one of the core issues that investors should focus on in evaluating thesecompensationissuesshouldbetoevaluatewhether there isa truealignmentofinterests between employees and the private equity funds that they may beworkingon.

INTRODUCTIONTOPRIVATEEQUITY

FUNDFEESAnother area that investors should focus on in the operational due diligenceprocessrelatestofees.Dependingonthestructureoftheprivateequityfundthataninvestorisanalyzing,anumberofdifferentfeesmaybeassessedtoinvestors.There are some common issues related to most fees that investors shouldconsider. The first of these relates to the actual number of fees charged. Forexample,aninvestormaybewillingtotolerateahighermanagementfeeifitisonlyoneofthefeescharged.Somefundsmaytrytonickel-and-dimeinvestorsviaahostof smaller fees that, inorof themselves,mayseemsmaller, at leastsmallerthanthemanagementfee(continuingourexample),butinaggregatearelargerinmagnitude.Examplesoftheseotherfeesthatcansometimesreartheirheads in real estate funds in particular can include asset management fees,incomeperformancefees,forwardcommitmentperformancefees,andpropertymanagementfees.Another general consideration regarding fees is the timing of fee collection.

Thetwobasicoptionsarewhetherthefeesarecollectedinadvanceorinarrears.Collection inadvancemeans that the fundsarecollectedat thebeginningofaperiod.Collection inarrears refers toaconceptwherefeesarecollectedat theendoftheperiod.Iffeesarecollectedinadvance,itisgenerallyconsideredlessbeneficialforinvestorsprimarilybecauseofthetimevalueofmoney.Investorsarerequiredtopartwiththemoneyallocatedtothefeesoonerthantheywouldhavehadtoifthefeeswerecollectedinarrears.Another consideration relates to the potential for the linking of any fees to

benchmarks or subject to high-water marks or hurdle rates. The latter twoconsiderationsareparticularlyapplicabletocarriedinterestfeecalculations.

MANAGERINVESTMENTINFUNDS

Earlierinthischapter,weprovideabasicoverviewofcompensationstructuresrelated to private equity funds. In particular, one area of focus that is oftenhighlightedduringtheoperationalduediligenceprocessrelatestothealignmentofinterestbetweenprivateequityemployeesandtheperformanceofaparticularprivate equity fund. A related issue, which is often paramount in investor'sminds, is how much capital the private equity employees themselves haveinvested in the firm's funds. Such concerns in this area are generally focused

around the senior management of the private equity firm including the fundmanagers themselves. The point of this inquiry, from a due diligenceperspective,istoonceagaingaugethealignmentofinterestsbetweentheprivateequityfirmemployeeandthefund'sinterests.Whiletheprivateequitymanagermayindeedhaveaduty—fiduciary,legal,or

otherwise—to act in the best interest of investors, many consider such analignment of interests to be crucial. The theory behind this is such that anemployeewhosecompensationistiedtothefundhasso-calledskininthegame,whichcanmotivatethemnotonlytoperhapsactinthebestinterestsofthefundbut togeneratestellarperformanceaswell. It isworthnoting that in regard toprivateequityfunds,asaparticularfundmaybeintheprocessofbeingfunded,aninvestormayalsocommonlylookathowmuchcapitalaprivateequityfirm'semployeesandprincipalsareanticipatedtoallocatetoaparticularfund.Assuming that thispremise isvalid,weshouldnextconsider thequestionof

howmuch isenough.Certain investmentorganizationsmayhavehardrules inplaceregardingthesecapitalrequirements.Theserulesmaycomeintheformofactual dollar requirements. Other investors may approach such requirementswithapercentage-basedanalysis.Forexample,aprivateequityfirm'sprincipalsand employeesmust consist of at least 5 percent of the newly formed fund'sassetsundermanagementduringthetimeofthefirstfundingclose;otherwiseaninvestor may not invest. There is no single magic answer to the question of,“Howmuchskininthegameisenough?”Differentinvestorsmaydeveloptheirappropriateinternalguidelinestosuchquestions.Agoodopportunitytoestablishsuchguidelinesisduringthecreationofaninvestor'soperationalduediligenceprogram.Itisatthisstagewheninvestorsarelesslikelytobeledintograyareasthatmayblurtheiroriginaloperationalduediligenceprogramguidelines.Returning to the subject of due diligence upon the amount of principal and

employee capital invested in the firm's funds, whether dollar or percentageguidelines are imposed, it is worth considering the ways in which a privateequity fund may respond to inquiries on this issue. As Chapter 3 outlines,operational due diligence is a process that can involve give-and-take betweeninvestorsandprivateequityfirms.Incertaincases,theprivateequityfirmmayattempttoerectinformationalroadblocksthatcanimpedetheeffectivenessofaninvestor's operational due diligence work. A common roadblock is raised byprivate equity funds when posed with the question of how much capital aparticularfundmanagermayhaveinvestedand/orisanticipatedtoinvestinthenewly formed private equity fund. Often an investor may be faced with a

responsesuchas“Ourportfoliomanagershaveinvestedasignificantportionoftheirliquidnetworthinthefirm'sfunds.”While perhaps well-intentioned, such a response is effectively useless to

investorsseeking toevaluate inanyrealway thealignmentof interestsamongthe portfolio managers and the firm's funds. When presented with such aninformational roadblock, investors can perhaps better gauge the financialcommitment of the portfolio managers by looking for more of a quantitativemetric in response to the question “What percentage of fund capital isrepresentedbyprincipalsandemployees?”Thecombinationoftheinterplayofsuch two questions is an example of technique that we will refer to asbackdooringandwhichwediscussinmoredetailinthequestiondesignsectionofthischapter.

EVALUATINGSERVICEPROVIDERSIn order to evaluate the quality of service providers, investors must firstunderstandexactlywhat serviceproviders theyaregoing toanalyze.The termservice provider may have different meaning and scope depending on aninvestor's perspective. Most investors would likely include a third-party firmsuchasaprivateequity fund'sauditor.Tobroaden thescopeabit, an investorcouldalsoincludelegalcounselamongthelistofaprivateequityfund'sserviceprovidersthatsheanalyzesaspartoftheduediligenceprocess.However,whatabout a third-party administrator?Does this fallwithin a core reviewprocess?Manyinvestorswouldlikelysayyes.Whenwebroadenthescopeevenfurther,it tends to get into a grayer area. Consider, for example, a third-party serviceprovider such as an information-technology consultant utilized by a privateequitymanager.Wouldthisfallintothescopeofacorereview?Someinvestorsmay not think so. Instead, others would say it is important to review such aserviceprovider.Toplaydevil'sadvocate,someinvestorsmaygosofarastoask,whocares?

After all, if a private equity fund utilizes a subpar information technologyconsultantthereisn'tanysortofpotentialforfundlosses.Isthere?Wecantablethisquestionfornow(theanswerisyes,bytheway),but,forthepurposesofourdiscussion,wewill insteadfocusonwhichserviceproviderswouldpotentiallybe included in an investor's operational due diligence review. Broadening thescopeevenfurther,wecanlookatserviceproviderssuchasinsurancecarriers.

Nowaninvestormaybeasking,“Waitaminute,aninsurancecarrier—that'snota real serviceprovider.”Certainly insurancecarriersare real serviceproviders,but more important for the purposes of this discussion some investors couldlikelybroadenthescope,perhapsinanexpandedreview,toaprivateequityfirmand fund's insurance carriers. The question comes down to how broadly aninvestorwill define such service providers.An example of such a broadeningprocessisoutlinedinExhibit4.3.

EXHIBIT4.3ExampleofBroadeningScopeofServiceProviderDefinitions

Regardlessofthescopeofthereviewemployed,beforeanalyzinganyserviceproviders,itisusefulforinvestorstoensurethattheyhaveanunderstandingofthebasicfunctionsofserviceproviders.Beforeprogressingwithadiscussionofservice providers, however, it is also important to consider any specificrelationships a private equity fund under consideration by a potential investormayhave.This is apointworthhighlighting—aprivate equity firmmayhavecertain service provider relationships that are not directly applicable to theprivateequity fundunderconsiderationandviceversa.Now, this isnot tosaythatitisnotappropriate(andnotadvisable)toevaluatetheserelationships,butthat thenatureof the relationship (as tobetween the fundand firm) shouldbedistinguishable. An administrator is a good example of this. An administratorhasarelationshipwithafund,notafirm.Investorswillnotordinarilyinvestinaprivate equity firm; they will invest in a fund. This is not to imply that aninvestor should not inquire into service providers on both the fund and firmlevels.However,itisimportantforinvestorstounderstandthesefirmandfund

distinctions, particularly when delving into the scope of service providerrelationships.With thiscaveatoutof theway,wecannowbeginourdiscussionofprivate

equity fund service providers. Common service providers utilized by privateequity firms and funds include the auditor, administrator, legal counsel,custodian,informationtechnologyproviders,complianceconsultants,andcash-management firms. We discuss the respective roles of each of these serviceprovidersinthesectionsthatfollow.

AuditorFromatraditionalperspective,privateequityfundauditorshavebeenprimarilyresponsible for overseeing the maintenance of a private equity fund's officialbooksandrecords.Auditorsarealsoresponsibleforthepreparationofafund'sauditedfinancialstatements.Overtimetheroleofauditorshasevolvedtoofferagreater degree of services including assistance with fund regulatory matters,assistance with management of the internal accounting function, such asproviding software for this function, tax planning, and compliance with taxreportingrequirements.Chapter7providesamoredetaileddiscussionoftheroleoftheauditor.

AdministratorAttheirmostbasiclevel,fundprivateequityfundadministratorstypicallyoffertwo primary types of services: fund accounting, which includes independentpricingoftheportfolio,andshareholderservicing.Within the fund accounting function, the types of services traditionally

providedinclude:TradecaptureValuationsCalculationofprofitandlossonadaily,weekly,andmonthlybasisCalculationoffeesandaccrualsCalculationofnetassetvalueandpreparationoffinancialstatementsInvestmentaccountingFeecalculationsPartnershipaccountingFinancialaccounting/generalledgermaintenance

DailyprofitandlossandnetassetvaluereportingPerformancemeasurementTaxpreparationReportingforinvestmentmanagersandtheirinvestorsPreparationofweekly/monthlyfinancialstatements

Theprimaryservicesprovidedbytheshareholderservicesfunctiongenerallyinclude:

Overseeing the subscription and redemption processing, that includesreceivingandprocessingalltherelevantdocumentationandcomplyingwith hedge fund-specific criteria such as required redemption noticeperiods,lockups,andpotentialredemptionpenaltiesEnsuring compliance with the anti-money-laundering and know-yourclientrequirementsineachjurisdictionTaxreportingforinvestors

Similar to the audit industry, administrators have been eager to meet thegrowingdemandsof theirhedge fundclients in recentyearsbybothenlargingthe suite of services offered and increasing the integration of their traditionaladministrationserviceswithotherhedgefundserviceproviders.Othertypesofservicesofferedbyadministratorsinrecentyearsinclude:

CorporateServicesMaintainingminutebooksandthestatutoryrecordsConveningmeetings,providingcompanysecretaries,andpreparingallnecessaryfilingsManagingregulatoryrequirementsandliaisingwithcompanyregistrarsCalculatingnetassetvalueandpreparingfinancialstatements

OtherTypesofServicesAssistancewithfundcreationandsetupMaintenanceoffinancialrecordsCorporatesecretarialservicesCoordinationoftheauditprocessandstockexchangereportingPrimebrokerreconciliationStructuringofalternativeinvestmentinstrumentsandproducts

Withthegrowthoftheprivateequityadministrationindustry,manythird-partyadministratorshavedevelopedintoeitherlargestandalonefirmsthathavebeenintheadministrationbusinessorarecompaniesaffiliatedwithlargeinvestment

banks that typically have large prime-brokerage operations as well.Administratorsoftenhaveofficesacrossmultipletimezones,inordertoprovide24-hourrollingcoverage,andincertainoffshorehedgefundhavensaroundtheworldsuchastheCaymanIslandsandBermuda.There has also been a tendency in recent years for certain private equity

managers who do not have the expertise or resources to manage an internalaccountingfunction tooutsource this function to thefund'sadministrator.Asaresult, severalhedge fundadministratorshavedeveloped technologyplatformsin recent years that provide straight-through processing and connectivitybetweenahedgefundandathird-partyadministrator'sfront,middle,andback-officefunctions.AsChapter12discusses,whiletheuseofthird-partyadministratorshasgained

tractioninrecentyears,somelargeprivateequityandrealestatefundsstillself-administer.Fundself-administrationcanpresentanumberofconflictsofinterestin regard to process independence and is generally considered to be anoperationalstrikeagainstafirm.

LegalCounselAprivate equity firm's external legal counsel provides advice and services onlaw-related matters. Depending on the jurisdictional location of both theinvestmentmanagerandtheunderlyinghedgefundvehicles,manyhedgefundshave both domestic (also referred to asonshore) and international (commonlycalledoffshore)legalcounsel.Thetypicaltypesofbasicservicesofferedbylawfirmstohedgefundsinclude:

InitialfundcreationdocumentationOngoinglegaladviceAssistancewithmaintenanceofcontinuallegalfilingrequirementsChangesinfunddocumentation

Certainlawfirmsalsoprovidehigherlevelsofservice,including:ComplianceconsultingMockregulatoryauditsEmployee training on both investment-and noninvestment-relatedissues

Custodian

At themostbasic level,aprivateequity firmutilizesacustodian tophysicallyholdafund'sassets.Acustodianactsforafundinmuchthesamewaythatanindividual's personal bank acts as a custodian of checking and/or savingsaccounts.Ofcourse,thisbasicconceptbecomesblurredbybook-entrysecuritiessettlement,contractoragreement-basedsecurities,andevenfurthercomplicatedwhen considering that physical custody is only one way in which a privateequity firm may have custody of a client's assets. The idea of “constructivecustody”ortheabilityofaprivateequityfirmadviseroritsaffiliatetoaccessormove assets or cash out of an account further complicates the custodiallandscape for investors and advisers alike. Potentially further complicatingcustodyissuesareuncertificated,sometimescallednoncertificated,securities.Recentlytherulesregardingcustodyrequirementsweresignificantlychanged.

Prompting such changes were a series of enforcement actions brought by theSecurities and Exchange Commission (SEC) that alleged misuse,misappropriation, and theft of client monies. While the Madoff and Stanfordscandals made big headlines, a number of smaller Ponzi schemes and assetmisuseenforcementactionsandprivatelitigationbroughtagainstadvisoryfirmsand their principals, and even technology personnel, emphasized gaps in thepreviouscustodialregulatoryenvironment.ToclosetheseloopholestheUnitedStates Securities and ExchangeCommission adopted amendments to theRule206(4)-2thatwasknownastheCustodyRule.TheseamendmentstotheCustodyRule have placed a number of increased requirements on both U.S. SECregisteredinvestmentadvisersaswellascustodians,suchas:

Investment advisersmusthave a reasonablebasis for their belief thataccountstatementsdistributedbyqualifiedcustodians,whichmuchbesentatleastquarterly.Investmentadvisersthatholdself-custodymayberequiredtoreceiveaso-calledwritteninternalcontrolreportatleastannually.Subject to certain exceptions for private fund advisors, investmentadviserswillberequiredtoundergoanannualsurpriseexaminationofclientassetsforwhichtheadviserhascustody.

Anotherkeypointof inquiry foranyhedge fund investorwhenevaluatingaprivateequityfirm'srelationshipswithacustodianiswhetherassetsheldatthecustodianareinthenameofthecustodianorthehedgefund.Assetsthatarenotheldinthenameofthehedgefundcouldpotentiallyexposethoseassetstoothercapital commitments of the custodian. If, for example, the custodian were tobecomeinsolvent,thiscouldputahedgefund'sinvestorsatgreaterriskoflosing

theircapitalthentheywouldbeiftheassetswereheldinthenameoftheprivateequityfirm.Investorsshouldalsobeonthelookoutforsituationsinwhichaprivateequity

firmdoesnotutilizeathird-partycustodian.Incertaininstances,aprivateequityfirmmaycreateanaffiliatedentitytoserveasacustodian,perhapstogivetheappearance thatan independentcustodial relationship is inplace.Thepotentialconflicts of interest surrounding affiliated custodial relationships are largelyconsidered by many investors to be too great. In summary, many investorsperforming operational due diligence reviews on private equity funds withregard to affiliated custodial relationships frankly agree with the adage, “Thejuiceisnotworththesqueeze.”Inotherwords,anybenefitsassociatedwithself-custodyofassetsarenotworththeoperationalrisksassociatedwiththepotentialconflictsofinterestthatarelikelytobepresent.

InformationTechnologyProvidersPrivate equity firms often address their information technology needs via acombinationof internal and external efforts. Information technology firms canprovide support across a number of different areas at a private equity firm,including basic initial firm systems installation and ongoing support.Increasingly, information technology consultants oversee the installation andmaintenance of trading systems and platforms, Internet systems, enterprisesystems, customer relationship management (CRM) systems, and softwaredevelopment. IT firms also oversee the development of integrated network,computer,voice,andsecuritysolutions,includingcommunicationsroomdesign,electroniccommunicationsolutions,andsecureremoteconnectivity.Informationtechnology firms can also assist in planning for technology-related businesscontinuityanddisaster-recoveryconcerns.Duringtheoperationalduediligenceprocess, investors shouldbeconsciousof the scopeand scaleof servicebeingprovidedbythird-partyinformationtechnologyconsultants.

ADDITIONALON-SITEVISITCONSIDERATIONS:NEGATIVE

OPERATIONALDUEDILIGENCE

While the focus ofmost investor's on-site operational due diligence processesmaybesquarelycenteredontheoperationalpolicies,procedures,andprocessesinplaceat theprivateequityfund,thereisanotheraspectofduediligencethatmanyinvestorsmayoverlook.Thisrelatestoaconceptwhichforthepurposesofthisbookwillwerefertoanegativeduediligence.This concept relates to the understanding that the investor due diligence

processisareciprocalone.Ifprivateequityfirmsandinvestorsarehonestabouttheoperationalduediligenceprocess, it isone inwhicheachpartyhascertainwantsandneeds.Aninvestorwants,ataminimum,toavoidexposuretofraudand weak operations and, at best, select private equity firms with strongoperationalinfrastructures.Toaccomplishthis,aninvestorneedsthecooperationoftheprivateequityfirmtocollectcertainpiecesofinformationandtoconductcertain steps, such as an on-site visit, to complete this process.Turning to theprivate equity firm, it too has wants and needs in this process. It wants toultimatelyobtaininvestmentallocationsfrominvestorstobeplacedinthefundsthatitmanages.Inordertoaccomplishthisfromanoperationalperspective,theprivateequityfirmneedstodemonstrate,oratleastconvince,investorsthatitisnot a fraud and that strong operations are in place. Because of sometimesconflictingwantsandneeds,theprivateequityoperationalduediligenceprocesscanhaveanadversarialaspect.Whengoingupagainstanadversary,evenonethat you are not looking to defeat but rather enter into a business relationshipwith,itisusefultolearnasmuchaboutyouradversaryaspossible.Thisbookisprimarily about methodology, tools, and techniques that investors can use todiagnose, monitor, and analyze their adversary in this process—the privateequityfirm.Ontheothersideof the tablewehavetheprivateequityfirm.This iswhere

theconceptofnegativeduediligencecomesintoplay.Negativeduediligence,orreverse due diligence, refers to the process that the target of a due diligenceanalysis itselfperformsupon the investor that is investigating it.This isnot toimply that the private equity firmhas any right to begin submitting documentrequests lists to investors or seeking an on-site visitwith them.Private equityfirmsshouldnotbeperformingthesametypeofduediligenceoninvestorsthatthe investorsareperformingon them.This isnot the typeofduediligencewearereferringto in thiscase; instead,wearereferringtoadifferent typeofduediligence.Itcouldalmostbethoughtofasduediligencelight.Therelationshipbetween traditionalduediligenceandnegativeduediligence is summarized inExhibit4.4.

EXHIBIT4.4ComparisonofTraditionalandNegativeDueDiligenceProcesses

Putting aside any anti-money-laundering safeguards, under the negative duediligenceconceptaprivateequity firmshould takebasic steps togather initialbackgroundinformationabouttheinvestor.Generally,aprivateequityfirmwillhave a basic understanding of an investor's investment organization, but theymay not have taken the time tomaintain an understanding ofwho is actuallyperforming operational due diligence. This can be particularly true when aninvestor may engage a third-party consultant to assist in the operational duediligenceprocess.Inthesecases,fromtheperspectiveoftheprivateequityfirm,thislackofduediligencecanputthematasignificantdisadvantageduringtheoperational due diligence process. What types of information are we talkingabout?Asindicatedearlier,operationalduediligencedoesnotneedtobeadversarial

in nature, but it can certainly evolve into an adversarial process. If such anadversarialdevelopmentisthecase,itiscertainlyreasonableforafundtoknowtheiradversary.Forexample,has the investorpublishedanyarticles thatcouldprovide insights intoparticularoperationalviews that the investorholds?Doestheinvestorhaveacertainbackground,eitherprofessionallyorfromhisorhereducational discipline, that could provide guidance as to any areas theymightfocusonintheoperationalduediligenceprocess?Consider if the individual performing operational due diligence has a

background working at a former financial regulator. For the purposes of ourexample, we can refer to him as Joe Regulator. While your author is not agamblingman,wecouldlikelywagedollars-to-doughnutsthatduringthecourseof his operational due diligence review process Joe is likely to focus more

heavily, or at least have the ability to dig deeper, on certain regulatory-andcompliance-relatedmatters,comparedtoanaverageinvestor.Contrastthiswithanother investor performing operational due diligence who used to work asChiefTechnologyOfficer at ahedge fund.For thepurposesofour continuingexample,wecanrefertothisinvestorasMr.MicroChip.AscomparedtoJoe,Microwould likely, at aminimum,want to poke around the server roomof aprivate equity firm. If he sees somethinghedoesn't like,Micro is likelymoreequippedthanJoetodivedeepintoinformationtechnology-relatedissues.Thepointofthisexampleistodemonstratethatifaprivateequityfirmisarmedwithsuchknowledge, theycanprepareaccordingly.Unfortunately formanyprivateequity firms, and perhaps fortunately formany investors, remember that, afterall, in the context of our present discussion operational due diligence is asomewhat adversarial exercise; many private equity firms do not devote thenecessarytimeorresources to takeafewmoments to learnabout investors’oroperationalduediligenceanalysts’backgrounds.Suchalackofeffortinthenegativeduediligenceprocesscertainlycouldhave

asignalingeffecttoinvestors.Aninvestormaywellpositthat,ifafundhasnottaken the time to learn some basic details about the investor performingoperational due diligence beyond when they are planning to invest and howmuch,thismaybearedflagrepresentativeoflargeroperationalproblems,suchasalackofthoroughness.Forexample,isthefundequallylaxwhenexaminingany trading counterparties or similar firms with which it might have balancesheetexposure?

ADDITIONALON-SITEVISITCONSIDERATIONS:INTERVIEW

TECHNIQUESANDQUESTIONDESIGNAnotherkeyarea thatcanbeconsidered in relation to theon-sitevisitprocessrelates to the nature of the interview process itself.While one of the primaryfunctionsoftheoperationalduediligenceprocessmaybetofocusonoperationalinformationcollectionandevaluatingthatinformation,thereisalsoagreatdealofinformationthatcanbegatheredfromtheon-siteprocessitself.Thistypeofmeta informationcanprovide investorswithduediligence insights thatcanbejustasinformativeastheactualoperationalduediligenceprocess.Aswithmost

aspectsoftheoperationalduediligenceprocess,suchpiecesofinformationmayonly be accessible to investors if they utilize appropriate techniques to collectsuchinformation.

InterviewTechniquesThese techniques relate to the concept of interview techniques. One suchtechnique may be in the way in which an investor approaches the entireoperational due diligence process. For example, consider the old adagepreviously alluded to in thisbook, “Youcancatchmore flieswithhoney thenyou can with vinegar.” If investors take a more aggressive or adversarialapproach toward the operational due diligence process, they will most likelyreceive a much different reaction from a private equity fund than if theyapproachtheprocessinamorefriendlyway.Thereisactuallyawholefieldofresearchdedicatedtointerviewtechniquesthatdrawsonelementsfrommultipledisciplinesincludingsociologyandpsychology.Beingniceorfriendly,perhapsvia the engagement of small talk, is a technique known as rapport building.Researchhasshownthatrapportbuildingcanproducemoreopenandproductiveinterviews.2Othertechniquescanincludeutilizingactivelistening,detachment,body language, and vocal tone, and how to respond to anger.Expanding suchtechniquesmayalsoincludeinterviewtechniquesthatfocusonliedetection,aswell.

QuestionDesignAnother often overlooked area of operational due diligence during the on-sitevisitrelatestotheconceptofquestiondesign.Arelatedfieldtothedisciplineofinterview techniques examines the ways in which investors ask certainquestions.Whilethegoalofaninvestorisultimatelytoobtaincertainpiecesofoperationalinformationtofacilitateananalysisofthisinformation,investorscanand should utilize the on-site visit to collect additional meta data by puttingthoughtintothewaycertainquestionsareasked.Thescienceofquestiondesigntechniquesbroadly includes theconceptsofclosedandopenquestions.Closedquestions,whicharesometimesreferredtoasclosed-endedquestions,attempttosolicitacurt“yes”or“no”answer.Openquestions,alsosometimesreferredtoasopen-endedquestions,areinsteadfocusedonlettingtheinterviewsubject,inthiscasetheprivateequityfirm,answeraquestionatlength.Withinthesubsetof open questions a variety of different question types can be employed by

investors performing operational due diligence including reflective questions,directive questions, pointed questions, indirect questions, self-appraisalquestions,diversionquestions,andleadingquestions.3

Theroleofsuch interview techniquesandquestiondesign in theoperationalduediligenceprocessisperhapsbestillustratedbywayofexample.Consideraninvestorwho isperformingoperationalduediligenceonaprivateequity fund.Forthepurposesofthisexample,wecanrefertothisinvestorasInvestA.Gator.AspartoftheoperationalduediligenceprocessMr.GatorseekstomeetwiththeChief ComplianceOfficer of the firm,Mr. Stick Ler, aswell as several otheroperationalprofessionals.WhenMr.Gatorarrivesat the firmhe ismetby theprivate equity firm's head of investor relations, Tom Fundmoney. Mr.Fundmoneysharesa fewpleasantrieswithMr.Gatorand then leaveshim inaconference room by himself. As the day progresses, Mr. Gator meets with aseriesofoperationspersonnel,eachofwhomprovidehimwithanoverviewofvarious issues regarding the private equity firm's operations.Mr. Fundmoney,whohasnotbeenpresentatanyofthesemeetingsbecausehewasonaseriesofconference callswith other investors, eventually comes by to check in onMr.Gator.Mr.GatorinformsMr.Fundmoneythatthereviewprocessisprogressingas planned and then requests tomeetwith theChief ComplianceOfficer.Mr.FundmoneygoesawayagainandthensendsintheChiefComplianceOfficerbyhimself,asthefirmhaddonewithalloftheotheroperationalprofessionals.TheChief Compliance Officer, Stick Ler, then enters the room and the interviewprocessbegins.As the interviewproceeds,Mr.Gator apologizes for having toaskwhatmightbesomeseeminglyobviousquestions,andheknowsthatStickisprobablyboredwithhaving tosit through“allof theseduediligencemeetingsinvestorsareperformingthesedays,”andthatMr.Gatorwilldohisbesttomovethingsalong.Mr.GatorisadeptatrapportbuildinginthiswayandSticktakesadeep breath, because he feels he can finally relaxwith an investorwhowon'tgrillhimduringtheduediligenceprocess.Unbeknownst to Stick,Mr.Gator is actually quite a shrewd operational due

diligence analyst. He has devoted a great deal of time preparing for theoperational due diligence process. Mr. Gator has even hired a third-partyinvestigation firm to conduct background investigations on several keyindividualsattheprivateequityfirmunderreview.Asaresultofthesereviews,Mr.Gatorhaslearnedthattwoindividualswhoworkatthefirmalsohappentoserveontheboardsofdifferentassociationsandprivatelyheldcompanies.WiththisinformationinhandandMr.Gator'sknowledgeofinterviewtechniquesand

question design, he has a variety ofways inwhich he can bring this issue upwithMr.Ler.One option would be to ask the question directly. This exchange might go

somethinglikethis:Mr.Gator:IsittruethatprivateequityemployeesAandBmaintainpositionsonboardsofassociationsandcompaniesoutsideofthisprivateequityfirm?StickLer:Um,ifthat'swhatyouhavefound,then,Ibelievesoyes.

This is a closed question that produces a singular response. Stick has eventried tobuildhimself somewiggle room in this regardwith the“Ibelieve so”language. In this exchange, the investor, Mr. Gator, has confirmed theinformationprovidedbyhisbackgroundinvestigationfirmbutlittleelse.Asecondoptionwouldbe to introduce thesubjectviaaseriesofclosedand

openquestionsandthenseehowStickresponds:Mr.Gator:CouldyoudescribetomeyourbasicdutiesasChiefComplianceOfficer?StickLer:Iconductanumberofdifferenttasksallofwhichrelatetocompliance.Monitoringofregulatoryfilings,ensuringthecompliancemanualisuptodate,employeetrading,etc.Mr.Gator:Thanks.Canyoutellmealittlemoreaboutthecompliancemanual?StickLer:Yes,it'sallfairlystandardpoliciesrelatingtoemployeetrading,giftspolicies,conflictsofinterest.Isthereanythingspecificyouwanttoknow?Mr.Gator:Whataboutoutsidebusinessactivities—doescompliancemonitorthose?StickLer:Yes,accordingtoourcompliancepoliciesandprocedures,employeesarerequiredtopreclearanyoutsidebusinessactivitieswiththecompliancedepartmentbeforeengaginginthem.Also,onanannualbasistheyhavetoletusknowifanyoutsideactivitieshavechanged.Mr.Gator:Thanks,that'sveryhelpful.Sodoyouaschiefcomplianceofficermaintainarecordofanysuchactivities?StickLer:Yes,thatpartofmyjob.Mr.Gator:Doesanyoneatthefirmcurrentlyhaveanysuchoutsideactivitiesorsitonanyboards?StickLer:No,theregisterisblank.

Okay,sonowwenotonlyhaveadifferentresponsebutwehaveaninterestingsituation. Ifan investorhas independentknowledgethatemployeesof thefirmsitontheboardsofcompaniesitcanmeanoneofthreethings:1.Thethird-partyinvestigationfirmmadeamistake.2.Stickislying.3.Stickisincompetent.Whilebackground investigation firmsdomakemistakes, for thepurposesof

ourexamplewewillassumeittobetruethattheemployeesoftheprivateequityfirmdo actually currently sit on theboardsof companies and associations.SowhydidSticknot reply in theaffirmative?PerhapsStickwasunsureas to theanswer. In that case, perhaps, the more honest response would have beensomething like,“I'mnotsure, I'llhave tocheckandgetback toyou.”PerhapsStickfelt theneed toagreewithMr.Gator.Afterall, itseemsStickwasn't toosureoftheanswerandheperhapsthoughtthebetteranswerwouldbetoshowthateveryoneatthefirmisfocusedontheirjobandemployeesdonotsitonanyoutsideboards.EitherwayitdoesnotbodewellforStickandtheprivateequityfirm. Additionally, our prospective investor, Mr. Gator, now has to getcomfortable that thiswasperhapsaminoroversightbyStickand that it isnotrepresentative of endemic operational problems throughout the firm. In eithercase,theoperationalduediligenceprocesswillcertainlybelengthenedandmaylikelyresultinadecisionnottoinvest.Readersmaybethinkingtothemselves,“Well,certainlyIdon'twanttoinvest

in a private equity fund with operations personnel who potentially lie or areincompetent,buthowcansuchasituationresultinlossestomeasaninvestorina particular fund?”Returning to our example, consider if Stick hadmade thismisstatementnottoapotentialinvestorbutperhapstoaregulatorconductinganon-siteexaminationofthefirm.Uh-oh.Misstatementstoregulatorscanresultinsanctions,fines,andeventhepotentialshutdownoftheentirefirm.Whilethisisonlyanexample,suchmetadataacquiredduringtheinterviewprocesscanhaveadefinitesignalingeffectregardingaprivateequityfund'soperationalstrengths.Thismetadataisgenerallyobservableifaninvestorisonthelookoutforitandemploys the appropriate interview and question design techniques to observesuchdata.Thisaimofthisbookisnottoprovidein-depthanalysisofinterviewtechniquesorquestiondesign,butinvestorsseekingtoenhancetheiroperationalduediligenceprocesses shouldat thevery leastbe aware that such techniquesexistandarepotentiallyavailable to themasanother tool toenhance theirduediligencearsenal.

CombiningInterviewTechniquesandQuestionDesignTactics:Backdooring

Earlierinthischapter,wealludedtoaconceptknownasbackdooring.Thetermcomes from theworld of computer science and can be defined as a hole in asecurity system thatwas intentionally leftbehindbya systemdesign.4We canalterthisconceptslightlytofitthecontextofoperationalduediligence.Whenaninvestorisinterestedinobtainingananswertoaparticularquestionorobtaininga certain piece of operational risk information, sometimes a fundwill complyand in other cases a fund may outright refuse to provide certain pieces ofinformation. In other cases, a private equity fund may attempt to distract aninvestorbyprovidingplatitudesmeant,inpart,tomaketheinvestorbelievethatthequestionhasbeenansweredwhenitactuallyhasnot.Whenfacedwithnoncompliance,aninvestorhastomakeachoiceastohow

to surmount this information barrier. When presented with an informationbarrier,aninvestormaybeabletogetaroundthebarrierratherthanattempttogostraightthroughit.Thisiswheretheconceptofbackdooringcomesintoplay.Consider a situation in which an investor is attempting to locate a list of thenamesofcertainsoftwareapplicationsutilizedataparticularfirm.Thereareanumberofreasonswhyaninvestormaybeinterestedinsuchinformation,suchastheneedtodeterminewhethertheprivateequityfirmisutilizingbestinclassor subpar systems. In response to such a request, the private equity firmmaysimplyattempttoplacatetheinvestorwithagenericreplytotheeffectof,“Weuseavarietyofthird-partyandproprietaryapplications.”Thisdoesn'treallygettheinvestorveryfartowardaccomplishingtheirgoalofobtainingthefirm'slistofsoftwareapplicationstothelevelofdetailrequired.Employingabackdooringtechniquemightyieldthisinformation.Consider,forexample,ifaninvestor,aftereffectivelybeingshutdownbythe

previous reply, could later in the due diligence process ask a question to theequivalent of, “Have there been any recent system upgrades to note?” Inproviding theanswer to thisquestion theprivateequity firmis likely to revealmoredetailsregardingparticularsystemsthantheywouldhavepreviously.Thismightbeparticularlytrueifthequestionsareposedtotwodifferentindividuals.So the investor relations employee at the private equity firm may be morepreparedwith canned prepackaged replies to the first question as opposed to,say,aninformationtechnologyemployeeansweringthesecondquestion.Thisisnottoimplythattheinvestorrelationsemployeeisinanywaysmarterormore

adept in dealing with due diligence requests as compared to the informationtechnology employee. Rather, the point is that the information technologyemployee at the private equity firmmay in fact bemore focused and open todiscussing technology-related issues, as compared to an investor relationsemployee.Continuing our example,what aboutwhen discussing the posttradeprocessaninvestorsheepishlyasksforthenameofthesystemwheretradesarebooked? This could then open a door by which an investor can gain furtherinsight into the names of systems utilized at the firm. When consideringemployee interview techniques and question design tactics, investors shouldconsider relatively straightforward techniques, such as backdooring, tocircumventinformationbarriersandkeeptheoperationalduediligenceprocessmovingforward.

VisitingPortfolioCompaniesandRealEstateProperties

Whilewe are on the subject of on-site visits by an investor to the office of aprivateequityfirm,itisalsoworthconsideringapotentialothertypeofon-sitevisit that an investor may consider. This relates to investors performing duediligenceontheunderlyingholdingsoftheprivateequityfundthemselves.If an investor is approaching a newly forming private equity fund that is

currently in its infancy and still effectively just a legal shell, these companiesmayhaveslottedacertainpipelineofinvestmentinwhichitisanticipatedthatsuchfunds,onceraised,willbeallocated.Incertaincases,particularlyfromaninvestment due diligence perspective, it may be worthwhile for a potentialinvestor in the fund to consider performing an on-site visit to the potentialportfolio company as well. Such visits may offer insight from an operationalperspectiveaswell.Forexample,someconsiderationscaninclude:

Howisitanticipatedthatthefundwillacceptcapitalfromtheprivateequityfirm?Whattypeofreportingcantheprivateequityfirmanticipatetoreceivefromtheportfoliocompany?What operational controls and procedures are in place at the privateequityfirmtopreventfraudulentactivities?

The lastquestion in this list raisesanoteworthypoint regarding instancesoffraud in private equity firms. In addition to concerns investors may haveregarding instancesof fraudat theprivateequity fundmanagement level,both

investorsandprivateequity fundsmustalsobeconsciousof fraudataprivateequityfund'sportfoliocompanies.Recentstudieshavesuggestedboththatsuchfraudulent activity occurs and that private equity managers remain concernedaboutsuchfraud.5

Inthecasethatataparticularstageoftheduediligenceprocessafirmpipelineof portfolio companies is not yet established, or an investor for one reason oranothermaynotwanttovisitportfoliocompaniesthatareonlyanticipatedtobeintheportfolio,orperhapsthemanagementofsuchfirmsisnotcompliantwithonlypotentialinvestorinquiries,aninvestorinsteadmaychoosetotakeapagefrom the document requests list methodology previously outlined and insteadconductanon-sitevisitofaportfolio-holdingcompanythatresidesinasimilarlymanagedbutalreadyexistingprivateequityfund,ifsuchafundismanagedbythefirm.Onceagain,aswiththedocumentrequestsmethodology,althoughsuchanexistingportfoliocompany inahistorical fund isnotanexactmatch to thefundunderdevelopment,suchanon-sitevisitcanstillprovidevaluableinsightsinto the private equity fund's operational connections and oversight of suchportfoliocompanies.Such anticipated portfolio holdings on-site visits can also be particularly of

interest with regard to real estate funds. In those cases, more so than simplyvisiting an office inwhich a particular anticipated portfolio company operatesoutof,aninvestorcangoactuallyvisitthebuildingand/orland.Furthermore,ifaninvestorreallydesirestodoso,theycouldevenattempttohireindependentexperts tosearch landrecords,performvaluationworkor landsurveys,andsoon. This type of spot-check audit may give a particular investor a great dealmore conviction than merely hearing a private equity manager describe aparticularpropertyorshowaninvestorapictureofit.Thisisnottoimplythatinvestors should perform full-blown audits of existing or potential portfolioholdingsofeveryprivateequityfundtheyinvestin.Rather,investorsshouldbeconscious of the fact that performing additional due diligence on portfolioholdings,eitheractualoranticipated, isanoption in theduediligenceprocess.Suchadditionalduediligencemayassuageanyconcernsofinvestorsincertainregards,orprovideadditionalinsights.

UnderstandingPrivateEquityJargon:KeepItSimple,Stupid

Whenitcomestodocumentrequestsoranythingelseduringtheoperationaldue

diligenceprocess,akeyphrasefromtheworldofsportscomestomind:KISS—keepitsimple,stupid!Realestate,insomeinstancesevenmoresothanprivateequity,isrepletewithitsownlexiconoflegaleseandesotericjargon.Thereisatendency among investors to get lost in this land of jargon. As with mostindustries, the specific terminology is steeped in history, has been developedover time,andforpracticalpurposesactuallycanaddrealvaluetodiscussionsamongthoseintheknow.For example, to the average non–Latin speaking average Joe on the street,

explaining that “the onshore vehicle is pari-passu to the offshore” might notmeanmuch.Thisshortsentenceconveysanumberofdifferentconcepts.First,itmeansthattherearetwofundvehiclesbeingofferedforaparticularinvestmentstrategy.Second,weknowthatoneof themisdomestic innature.“Domestic”typicallymeansfromthesamejurisdictionasthefundmanagementcompanyorinvestor. Third, we can further deduce that based on context, the domesticvehicle is in relation toour average Joe (e.g., thedomestic investmentvehiclewouldbe themost appropriate for Joe).Fourth,weknow that there is anotherinvestmentvehicleinadditiontothedomesticvehicle.Wefurtherknowthatthisvehicleisanoffshorevehicle.Anoffshorevehicleis

afundthatisgenerallymoreappropriateforinvestorswhoresideoutsideofthepreviously mentioned domestic jurisdiction. Finally, we know that both thedomesticandoffshorefundsor investment ismanaged inapari-passumanner.Pari-passumeans in substantially the samemanner andmost likely under theguidanceofthesameinvestmentpersonnel.Everythingwehavejustcoverediscertainly amouthful. Therefore, for practical reasons, the technical term pari-passuispreferredtothelongertranslationsofthefullterm.Investorscanthinkofthesetermsasbeingsimilartocourtroomstenography.Thesamemeaningisconveyed,onlyinshorthandform.Thepointofourdiscussion is to illustrate that investorsmayoftenbe faced

withsuchshorthandduringtheoperationalduediligenceprocess.Oftenafundmanagermaynotbetryingtohideanythingbyusingthisindustryjargon,rathertheyarejustusingthesegenerallyaccepted,commonlyusedtermsintheprivateequity industry to communicate in direct terms.When facedwith such terms,investors should not be afraid to take immediate action to stop an operationalduediligencereviewcoldinitstracks,raisetheirhands,andaskquestions.Thiscannotberepeatedoftenenough.Investors cannot begin to collect operational risk data and then analyze and

even monitor such data when they do not even speak the language. In other

words,withoutcompletelyunderstandingtheterminologybeingused,bothinagenericsenseaswellasinthecontextofanyparticularusagebeingconsidered,investorsareproceedingheadfirstintoablindingduediligencesnowstorm.Thefurther they proceed without a basic understanding of the terms, the worse itgets.Unfortunately,atthisstageinthegame,investorsmusttakeacloselookatnot

onlytheirowninternaloperationalduediligenceprocessesbutalsoattheirgoalsinperformingoperationalduediligence.Noonelikestoadmitthattheydonotunderstand something. It is at this pointworth taking amoment todistinguishbetweenthetermsignoranceanduninformed.Noonelikestoadmitthattheyareignorantofanything,andcertainlynotin

thecontextof sophisticatedprivateequityduediligenceactivities.An investorwhodoesnotunderstandsomething,albeitanobscureterm,anabbreviation,orevenanoperationalduediligenceprocessemployedatafirm,isnotignorant—theyaremerelyuninformed.An investorwho is ignorant isonewhodoesnotinquire about an issue that theymight not understand.Most investors are notignorant; they are uninformed.Uninformed investors should not be apologeticaboutbeinguninformed.Onthecontrary,aprivateequityfundisaskingfortheopportunity to manage their money and in the context of operational duediligenceprocessthereiscertainlynosuchthingasastupidquestion.Anyfundmanagerwho attempts tomake an investor feel foolish for asking a question,howeverbasicitmaybe,franklydoesnotdeservetheopportunitytomanagetheinvestor'smoney.

ASSETRAISINGANDTHEUSEOFPLACEMENTAGENTSANDTHIRD-

PARTYMARKETERSAnotherarea that investorsmightnotnecessarily think to include in theircorereviewprocess,butthatgenerallyfindsitswayintoexpandedreviewprocesses,is any relationships that a private equity firm may have with individuals orgroupsthatassistthefirminraisingfundcapital.Suchgroupsaretypicallyquitecommon in other areas of the alternative investment industry, such as hedgefunds.Privateequityfirmsmayalsoutilizesuchgroupsforavarietyofreasons.Nottosoundlikeacommercialfortheplacementagentindustry,however,some

firmsmay feel it is a better use of their time, energy, and resources to focusprimarily on what investors are paying them to do—manage the funds. Byutilizing third-partymarketing firms a private equitymanagermay be able tosticktotheirknitting,sotospeak,andhonetheirfocusonthetaskofmanagingmoneyratherthanraisingit.Inothercases,aprivateequityfirmmayhaveitsowninternalfund-raisingarm

via in-house investor relations or marketing teams. In such cases, the use ofplacementagentsmaybebeneficialtothefundtobothbroadenthereachofanyinternal efforts aswell as to provide access tomarkets that, for one reasonoranother,may otherwise not be easily accessible to the private equity firm.Anexample of this that investorsmay sometimes come across would be a U.S.–based private equity firm utilizing the services of a placement agent to raisecapital from sovereign wealth funds based in overseas regions such as theMiddleEast.There is nothing inherently wrong with such a relationship. Indeed, by

utilizing third-party marketing firms, private equity firms may be able tocapitalize on certain fund-raising opportunities that would otherwise not beavailabletothem.However,theplacementagentsarenotfacilitatingsuchfund-raisingeffortsoutof thekindnessof theirhearts.They,ofcourse,getpaid fortheirefforts.The payment to these third-party fund-raising entities can sometimes be

referredtoundertheeuphemismofafundrebateorasalescharge.Thistermistypicallythemorepolitewayofreferringtowhatothersmightcallakickback.Regardlessofwhataprivateequityfirmandtheirplacementagentscallsuchapractice, it is effectively a percentage of the fee that is paid to the placementagentbasedontheamountofcapitalthataprivateequityinvestorsubscribestosuchafund.For example, let's say that a capital-raisingorganizationhas aprivate equity

firm(TheJasonGroup)intheprocessofraisinganewfund.Thetargetamountof capital to be raised for the first close is $700million and the first close isanticipated to occur in three months. Despite their best efforts, The JasonGroup's team of internal marketers has had difficulty gaining access to theBlackacre state pension fund. The Jason Group feels their new fund, aninfrastructure fund, would be a good fit for the Blackacre state pension fundmandatetoreinvestintheeconomyandinfrastructureofAmerica.Atacocktailparty, The Jason Group's Chief Investment Officer (Mr. Alpha Beta) isintroduced to J.M.Wellington III, head of distribution at a placement agency

knownasCapitalIntroAssociates.J.M.informsMr.Betathathecouldperhapsbe of assistance in making an introduction because they have just hired therecently retired former controller of the state pension fund, Dom Telonge, toserveasanadvisertoCapitalIntroAssociates.Anagreementisstruckthenextdayand,loandbehold,afterseveralmeetingstheBlackacrestatepensionfundagreestoinvest$100millioninTheJason'sGroupinfrastructurefund.Similartothe way that many accident lawyers who frequently advertise on TV are notcompensatedunless theyare successful,Capital IntroAssociates alsodoesnotearn itskeepunless they raisemoney. In this case, theywere successful.Let'ssay that the rebate (aka, sales charge) that they are paid is 0.50 percent. Thatmeans that for their efforts J.M. Wellington III and his firm are entitled to$500,000.One question that investors should ask themselves is, “Who ends up paying

this$500,000?”Theanswerisgenerallythatitdepends.Itmayseemlogicalthatthe private equity firm should bear the cost of raising this capital. However,dependingon the language in theofferingmemorandumfor thefund, thefundforwhichthecapitalisraisedmayhavetobearaportionorallofthisexpense.This isanexampleofanarea that investorsmustdig into,withregard tosuchplacementagencyrelationships.Anotherpointworthhighlightingfromtheexamplerelatestothewayinwhich

certain introductions or relationships are made. In the example, Capital IntroAssociates, theplacementagent,hasrecentlyhiredtheformercontrollerofthestate pension fund,DomTelonge.While not to imply any sort of impropriety,another area that investors should investigate is so-called paying a fee orprovidingfavors inexchangeforsecuringcapitalcommitmentsfrominvestors.These practices,which for themost part are illegal, are calledpay-to-play, orsometimes referred to aspay-for-play, practices. In the example,Capital IntroAssociates hiring Dom Telonge would not likely be viewed as a pay-to-playviolation sinceMr.Delonghas since retired from theBlackacre pension fund.However, ifMr. Telonge had indeed still been employed at the state pensionfundandwasgiven,say,$20,0000oraboxseatattheSuperbowl,andthentheBlackacrestatepensionfundjusthappenedtoallocatetoTheJasonGroupfund,thiswouldtriggerpay-to-playconcerns.Inresponsetoaseriesofscandalssurroundingpay-to-playviolations,thelegal

and regulatory landscape for fund-raising, particularly from public pensionplans, has becoming increasingly difficult for both fund managers and third-partymarketerstonavigate.SomestatesintheUnitedStateshavetakenaction

inthisregard.AnexampleofsuchalawisknownasAssemblyBill1743.Thisbill was passed in 2010 in California and directly affects the ability of hedgefunds and private equity firms to raise capital in the state.The law came intoeffect on January1, 2011.This lawdirectly affects the activitiesofplacementagents by who solicit funds from California's two largest pension funds—theCaliforniaPublicEmployees’RetirementSystem(CalPERS)andtheCaliforniaState Teachers’ Retirement System (CalSTRS). Specifically, placement agentsmust both register as lobbyists and may no longer receive incentive fees forsecuring commitments from the pension funds. This law also has potentialramifications for the directmarketing efforts at private equity firmswho dealdirectlywiththepensionfundsaswell.Theimpetusbehindthislegislationisanattempttocurbthepaytoplayeffortsthathavereceivedincreasedattentionasoflate.NewYorkhasentirelybannedplacementagentsfromattemptingtoplacefunds at the state's CommonRetirement Fund. Illinois andNewMexico havealsorecentlyinstitutedsimilarrules.TheNewYorkTimes had reported that themove atCalPERS came about in

partafterscandalsoccurred,whenAlfredVillalobos,aformeremployeeturnedplacement agent, was accused of lavishing gifts on pension officials to steerpublic dollars to favored money managers.6 Registering as a lobbyist placesrestrictions on placement agents’ activities, including the inability to makecampaign donations. Additionally, as lobbyists, placement agentswill have tolimit and disclose gifts, report certain expenses annually, and take an ethicscourseeverytwoyears.Fund-raisingfrompublicplanshasbecomeevenmorecomplexandburdensome forbothplacement agents aswell as fundmanagersbecausecertainambiguitysurroundsthosewhohavetoregisteraslobbyists,andthereareconfidentialityconcernssurroundingenhanceddisclosurerequirements.At the federal level, the U.S. Securities and Exchange Commission, in an

attempt to broaden the scope of regulation surrounding potential pay-to-playviolations,haseveninstitutedrulesundertheInvestmentAdvisersActof1940that prohibit investment advisers from providing advisory services forcompensation to a government client for two years after the adviser oremployeesmakeacontributiontoelectedofficialsorcandidates.7Thisrulealsoprohibits advisors, which can include private equity firms, from agreeing toprovidepayment toa thirdparty,suchasaplacementagent, forsolicitationofadvisory business from any government entity unless the solicitation agentsthemselves are registeredbroker-dealersor registered investment adviserswhoarethemselvessubjecttopay-to-playrestrictions.

Furthermore, a private equity firm must also take care to ensure that themarketingeffortsofplacementagentsnotonlycomplywithrestrictionssuchasincreasing pay-to-play regulations, but alsowith a host of other state, federal,and international regulations.One example is the antibriberyprovisionsof theForeignCorruptPracticesAct.TherecentactionsinthisareaperhapssignalanindicationthattheU.S.SecuritiesExchangeCommissionandtheDepartmentofJusticewillincreaseenforcementactionwithregardtoprivateequityfunds.8

While the relationships of private equity funds with all of their third-partyservice providers should be an important focus during the operational duediligence process, the recent increase in the rigorousness of regulationsurroundingfund-raisingeffortsshouldcauseinvestorsperformingduediligenceto focus more intently on this topic going forward. Investors may want toconsider what additional legal and compliance resources a fund manager isplanningtodevoteinordertocomplywiththesenewrules.Inordertopreventbeing invested in a fund that ends up on the front pages due to pay-to-playscandals,investorsmayalsowanttotakestockofallofaprivateequityfund'sexisting and legacy third-partymarketing andplacement agent relationships inordertodetermineanypotentialwaysinwhichahedgefundmaybeexposedtoregulatorynoncomplianceeitherbythefunditselforviaassociationwiththeseserviceprovidersbeforeanypotentialregulatoryfinesmaybeimposed.

CASHMANAGEMENTANDCONTROLS

Someinvestorsconsidercashtobeoneofthecrucialareastobefocusedoninanoperationalduediligencereview.Thethinkinggoesthatcashflowingthroughaprivateequityfirmiseffectivelythelifebloodoftheorganization.Withoutcashto call from investors, invest, or pay bills, there is little concern, the thinkinggoes,fortherestoftheoperationalinfrastructureofafirm.Certainoperationalduediligence reviewsmayeven takea follow the cash approach,whereby theflowofcashfrominvestorsubscriptionsthroughtoredemptionsaretracked.Over the past several years, a trend had emerged of alternative investment

firmsseekingtooutsourcethecashmanagementfunctioninsomeregard.Partofthe reasoning behind this trend is similar to our discussion of the use ofplacementagents:Analternativeinvestmentmanagermayfeeltheyarecapableof placing unencumbered cash into a checking account or in amoneymarket

fund; however, some funds may not have the skills, time, or resources to befocusedongeneratingincreasedreturnfromthiscash.Ineffect,thesefirmsmaybeleavingmoneyonthetableasaresultofexcesscashsittingaroundearninglowerratesofreturn.In addition to generating increased return, cashmanagementmay also be of

concern for a private equity fund with multiple fund vehicles in differentcurrency denominations. In these cases, cash may be managed to reduce orhedgeagainstcertaincurrencyexposures.Manyprivateequityfirmsmaynotbefocused on the macroeconomic aspects of different developments in currencymarketsonadailybasisandmayrelyonthird-partycashmanagerstoassistinthisarea.Furthermore,dependingonthestrategyoftheprivateequitystrategy,third-partycashmanagersmayalsoprovideassistanceintheareasofcollateralandmarginmanagement.Despite these advantages however, with the recent turmoil in the markets

many private equity funds have focused on bringing the oversight of the cashfunction in-house. As part of the private equity operational due diligenceprocess,investorsshouldapproachthecashmanagementfunctionfrommultipleperspectives.Onesuchapproachistoconsidertheamountsofcashheldbythefund.Additionally,investorsshouldfocusonthewaysinwhichcashismanagedandcontrolledinternally.In regard to cash management at the private equity fund vehicle level,

questionsinvestorsshouldconsiderinclude:Howisunencumberedcash(alsocalledcashonhand)managed?Whereisunencumberedcashstored?What types of instruments are unencumbered cash held in (e.g.,treasuries,directcash,etc.)?Whatratesofreturnareearnedonunencumberedcash?Howmuchcashdothefundstypicallyhold?Howhavethesecashlevelsvariedovertime?Howmuchcashisheldbycounterparties(e.g.,primebrokers)?If a third-partycashmanagement firm isutilized,how is thisprocessmonitoredinternallybytheprivateequityfirm?If the fund utilizes a third-party administrator, is a separate cashreconciliationperformedbytheadministrator?Ifyes,howfrequentlyisthiscashreconciliationperformed?Howofteniscashreconciled?

Which individual or department at the private equity firm performscashreconciliations?Howarebillsofthefundpaid?If the private equity fund utilizes a third-party administrator, whatreviewsareperformedinternallybeforesigningoffonacashtransfer?If the fund utilizes a third-party administrator, does the administratorrequire the private equity firm to send copies of invoices from third-partyvendorswithanywiretransferrequests?Howaremarginrequirementsmanaged?Whatisthecash-reconciliationprocess?

Additionally,aspartoftheoperationalduediligenceprocess,investorswouldalso bewell-advised to be cognizant as to the policieswithin a private equityfund organization to control the movement of cash. Diagnosing not only thepoliciesandproceduresbuttheoverallnatureofthecontrolenvironmentcanbean important, and sometimes tricky, aspect of the cash oversight process togauge. In particular, during the operational due diligence process investorsshouldconsideraddressingthefollowingissues:

Howiscashmovedwithintheorganization?Whatwiretransfercontrolsareinplace?Howarebillsofthemanagementcompanypaid?Whohasauthoritytomovecashwithintheorganization?Aretheremultiplesignatoriesrequiredtomovecash?Are there situationswhere only one individual has authority to grantsignatoryapproval?Are there different levels of cash signatories (e.g., anA list and aBlist)?Dodifferentmovementsofdifferentamountsofcashrequiredifferentlevelsornumbersofcashsignatories?How are signature approvals granted? (i.e., electronically, via aphysicalform,etc.)Whoensuresthatthecorrectnumberofsignaturesisreceived?Is there an appropriate segregation of duties internally within theprivate equity fund as well as third-party oversight into the cashmovementprocess?Can approval signatures be granted remotely or can cash transferinstructions only be granted via certain computers (e.g., via a secure

keycarddevicereaderattachedtocomputers)?By taking the time to focus on such cashmanagement issues, investors can

gain a more detailed understanding of the seriousness with which a privateequityfirmapproachestheissueofcashmanagement.Areassuchasthenatureofthecontrolenvironmentofaprivateequityfirm'scashmanagementfunctioncan have a signaling effect as to howother, perhaps less perceived, importantoperationalissuesareaddressedthroughoutthefirm.

BUSINESSCONTINUITYANDDISASTERRECOVERY

In recentyears,due to increasedconcernsrelated to terrorism,aswellaswhatseem to be increasingly strong weather-related events such as hurricanes,earthquakes,flooding,andsnowstorms,businesscontinuityplanning(BCP)anddisaster recovery (DR) have increasingly come into the scope of investoroperationalduediligencereviews.TheoperationalrisksrelatedtoBCP/DRcancome fromwithin the private equity firm itself or theymay be exogenous innatureandtheresultofeventsfromoutsidetheprivateequityfirm.Itisworthpausingforamomenttoconsiderthetwotermsbusinesscontinuity

and disaster recovery. Such terms may be synonymous in the minds of bothprivate equity firm's and investors. This is logical in some sense because adisruption in the normal functions of a private equity firm's operations caninvolve activation of plans related to continuing operations (i.e., businesscontinuity)aswellasrestoringanylostdataorfunctionalityduetothebusinessdisruption(i.e.,disasterrecovery).Thesetermsarecertainlyrelatedbutdistinctconcepts.Business continuity refers to a private equity firm's ability to continue to

function in the event of a business disruption.Disaster recovery, on the otherhand,relatestoaprivateequityfirm'scapabilitiestorestoreitselfafteradisastereventtothepointwhereitwasbeforethedisasteroccurred.In themindsofcertain investorsandprivateequity firms,BCP/DRplanning

maynotbeconsidered tobeas important as inanother typeof fundmanager,perhaps a hedge fund,which tradesmore frequently. This is not necessarily acorrectbelief.Thethingaboutbusinessdisruptionsordisastertypeeventsisthattheydonotnecessarilyadvertisewhentheyaregoingtooccur.So,forexample,

let'ssaythatsomethinghappens,suchasanofficefire,thatpreventsaccesstoaprivate equity firm's office. If this fire happens to occur during a particularlybusy time operationally for the fund, say in themiddle of an annual audit orduring a capital call period, then the impact of such an event can be just assevere,ifnotmoresevere,thanafundthattradesveryfrequently.Disaster events need not be as large scale as a building fire; they can be as

limitedas awall electricaloutletbecomingoverloadedandcuttingpower to aserver.Ingeneral,asoutlinedearlier,investorscanclassifytheeventsthatleadto business disruptions as either exogenous, coming from outside the firm, orendogenous, internal to the firm. Examples of exogenous events includeterrorism,weather-related events (hurricanes, floods, etc.), and power failures.Typesofendogenousevents includehardwaremalfunctionandemployeeerror(e.g., an employee accidentally deleted essential files, leading to a businessdisruption).

EXHIBIT4.5ExampleBusinessContinuityandDisasterRecoveryGuidelinesandStandardsCountry/Region

Guideline/Standard

UnitedKingdom

BritishStandardsInstitution(BSI),BS25999

NorthAmerica

ASIS/BSIBCM.01:2010BusinessContinuityManagementSystems

Global InternationalOrganizationforStandardization(ISO)ISO/PAS22399:2007Guidelineforincidentpreparednessandoperationalcontinuitymanagement

NorthAmerica

NationalFireProtectionAssociationNFPA1600:StandardonDisaster/EmergencyManagementandBusinessContinuityPrograms

Australia StandardsAustraliaHB292-2006

Thedesignofaprivateequityfirm'sbusinesscontinuityanddisasterrecoveryplanseekingtoaddresstheseexogenousandendogenousriskscanbehandledbyamultitudeofdifferentgroupswithinaprivateequityorganization.Somefirmsmay have a single or multiple BCP/DR committees. One advantage of thesecommittees is that they are often staffed by employees from multipledepartmentsthroughoutthefirm.Thisisanimportantpointtonoteasbusinesscontinuity and disaster recovery planning spans all areas of the organization.SuccessfulimplementationofaBCP/DRplanrequiresthecoordinationofthesedifferent functions in order to keep the organization functioning as a whole.Other firmsmay hire third parties to design theirBCP/DRplans.Many fundsturn to their information technology departments to design and maintain the

BCP/DRplanforthem.Inordertoensurethattheirplanningeffortsareappropriate,somefirmshave

recently begun toworkwith specialized consultants to evaluate theirBCP/DRplans.ThebenefitofutilizingsuchBCP/DRconsultantsisthattheyaddadegreeof objectivity to the planning process and can avoid such things as thetechnology bias that may result from a third-party service provider utilizingtechnologies its staff is more familiar with rather than the best technologyavailable.Some private equity firms may also pursue certification of their BCP/DR

plans.ThereareanumberofBCP/DRcertificationprogramsthattypicallyvaryby region. These programs can be formal certifications ormerely adhere to aseriesofguidelinespublishedbyorganizations.ExamplesofsuchcertificationsaresummarizedinExhibit4.5.In evaluating the BCP/DR plans and functions of a private equity firm,

questionsinvestorsshouldconsiderinclude:DoesthefirmmaintainwrittenBCP/DRprocedures?Ifyes,whatisthescopeofsuchprocedures?Has the firmcustomized itsbusiness continuity anddisaster recoveryplansor isagenericplan inplace thatmaynotaddress theparticularoperationalaspectsofthefirm?AreanywrittenBCP/DRplansstructuredaroundindustrycertificationsorguidelines?DoBCP/DRplanscovermultiplescenariosincludinginaccessibilityofthefirm'soffices?Do BCP/DR plans provide for coverage of plans for outages oftelephonyandInternetloss?Whoisinchargeofupdatingtheplans?Areemployeesprovidedwithcontactinformationforeachemployerina manner that is not dependent on the firm's systems functioningproperly(e.g.,alaminatedcalling-treecard)?Databackupandrestoring:

Whatarethefirm'sdatabackupcapabilities?Is data backed up in multiple locations and via multiplemedia?Isdatastoredon-site,off-site,orboth?Isaseparatebackupfacilitymaintainedfordatastorage?

Hasthefirmperformedtestrestoresfromanybackups?Howlongwouldittakethefirmtoperformadatarestoreforsystemcriticalfunctionsintheeventofadisasterevent?

Backuppower:Are uninterruptible power supplies (also uninterruptiblepowersource[UPS]orbattery/flywheelbackup) inplace?Ifyes,areUPSsavailablefordesktopPCsandservers?HowlongdoUPSsprovidepowerfor?Does the firm have backup power–generation facilities? Ifyes, what type of generator (e.g., diesel, natural gas) isutilized?Whoisresponsibleformaintenanceofsuchdevices?Ifbackuppower-generationcapabilitiesareinplace,doesthefirmownsuchdevicesexclusivelyoraretheysharedamongotherfirms?

Doestheprivateequityfirmhaveagatheringlocationintheeventofabusinessdisruption?Does the private equity firmmaintain a separate facility fromwhichemployees may continue operations? If yes, how many seats are insuchlocations?Has the private equity firm ever had to activate itsBCP/DRplan? Ifyes,whathappened?Whoatthefirmisinchargeofplanactivation?Howisplanactivationcommunicatedtoemployees?If the private equity firm hasmultiple offices, how are these officessupposed to coordinate with each other in the event of a businessdisruptionineitherlocation?Testing:

Aretheplanstested?Ifso,howoften?Are BCP/DR plans tested solely from a technologyperspectiveorarepersonneltestsemployedaswell?Whenwasthemostrecenttest?Whatwere the results of the test?Were anymaterial issuesnoted?Howhavetheseissuesbeenaddressed?

BytakingcaretoincorporateanassessmentofBCP/DRfunctionalityintotheoperationalduediligenceprocess, investorscandevelopabetterunderstanding

ofhowafirmmaycontinuetofunctionintheeventofadisasterevent.Investorsshouldfocustheirattentioninparticularnotonlyonthedesignofsuchplansbutontestingaswell.Thebestbusinesscontinuityanddisasterrecoveryplansintheworld are effectivelyuseless if employees arenot awareofwhat steps to takewhensuchaneventoccurs.

UNDERSTANDINGTHETRADELIFECYCLEPROCESS

Despite the fact that private equity may trade less frequently as compared tootheralternative investmentstrategiessuchashedgefunds, thisdoesnotmeanthat investors should attempt to seek comfort in these relatively lower tradevolumes. Although trading volumes may be lower, each trade is likely moresignificant.Therefore,evenminorerrorsintradeprocessingforarelativelylowtradevolumecouldresultinlarge-scalelosses.Exhibit4.6showsasampletradeflowlifecyclechartfromideagenerationthroughtoreconciliation.

EXHIBIT4.6SampleTradeFlowLifeCycle

Additionally,foraprivateequityfundthathedgespositionsorcurrency,moreactivetradingmayoccurinthesesegmentsoftheportfolioaswell.Anexample

ofatypicaltradeprocessforpositionsandsecuritiesthatmaybeengagedinforthemorefrequenttradingactivitiesofaprivateequityfundisoutlinedinExhibit4.7.

EXHIBIT4.7SampleTradeFlowExecutionChart

Regardlessofthefrequencywithwhichtradesareexecuted,investorsshouldattempt to gain an understanding of the trade flow process. Such anunderstandingiscriticallyimportantsothataninvestorcanappropriateassessifthere is any room for error or manipulation in the process. Some key issuesinvestors should consider in analyzing the trade life cycle process for privateequityfirmsinclude:

What is the anticipated trade volume of the newly formed privateequityfundunderreview?Whattypesofinstrumentsaretraded?Whatistheaveragetradevolumeofthefirm'sfundshistorically?How

hasthisvolumechangedovertime?Whohasauthoritytoplacetrades?Dotradershaveresponsibilityformarkingthesetrades?Isthefirmadequatelystaffedtohandlesuchvolume?Whatisthetradedocumentationprocess?Ifablotterisused,whohasfinalauthoritytoreviewtheblotter?What oversight is there internally within the hedge fund overindividualswithtradingauthority?Howaretradesexecuted?Howaretradesallocatedamongdifferentfunds?Whodetermineswhatopportunitieswillbeallocatedamongthefirm'sfunds?Areallocationsbasedonanysortofpredeterminedallocationratio?Ifso,howfrequentlyisthisratioreset?What is the trade confirmation process? What percentage ofconfirmationsareelectronicversuspaperconfirmations?Do counterparties, for such instruments as swaps, provide dailypositionreporting?Depending on the instruments traded, are there dedicated individualswithinthefirmwhofocusoncertaintypesofreconciliationsthatmayrequirespecialexpertise(e.g.,bankdebt)?Whathappensintheeventofatradebreak?Howfrequentlyarepositionreconciliationsperformed?Howaretradebreaksinvestigated?Isthereaharddeadlinebywhichalltradesmustbereconciled?Does the third-partycustodianholdcustodyofall the fund'sassetsordoesthehedgefundholdcustodyofanyassets?Arereconciliationsperformedinternallybytheprivateequityfirmbyathird-partyadministrator,orboth?What trading systems are utilized?How are these systems integratedwithothersystemsatthefirm,suchasthefundaccountingsystem?

Wheninvestorstakecaretogainanunderstandingofthetradeflowlifecycle,theyaremorelikelytogainafullerunderstandingofafirm'sentireoperationalinfrastructure.This isbecausemanyofaprivateequity firm'sotheroperationsprocesses are centered around the trading processes. Therefore, investors can

accrue multiple benefits by incorporating a review of trading processes andproceduresintotheiroperationalduediligenceprocesses.

LEGAL,COMPLIANCE,ANDREGULATORYRISKS

InChapter3,weintroduceanumberofquestionsinvestorsmaywanttoaskwithregard to legal and compliance-relatedmatters.Due to new legislation in thisregard,thelegalandcomplianceareaisonethathasreceivedincreasedattentionfrom both regulators in recent years. As such, when discussing legal andcompliance-related risks, it is also beneficial to include a discussion ofregulatoryrelatedrisks:

Whatregulatorsaretheprivateequityfirmregisteredwith?Has the private equity firm filed for any exemptions with any ofregulatoryagencies?When was the last on-site audit of the private equity firm by anyregulator?Has the private equity firm received any inquiries from regulators orhadothercontactwiththem?Pleaseprovidethedetailofanyongoingregulatoryaction?Canyouprovideasummaryofallhistoricalregulatoryauditsandthefirm'sresponsetosuchaudits?

The legal and compliance function at a private equity firm is generallyoverseenbyachiefcomplianceofficer(CCO).InsomefirmstheCCOrolemayeitherbefilledbyan individualdedicated towardcomplianceorsharedamongother responsibilities. Many investors are under the misconception thatindividualswhowork in compliance-related roles are lawyers. This is not thecase.Compliance,whilerelatedtothelaw,isadistinctskillsetthatmayormaynotrequireknowledgeoflegalaspectstoperform.Workinginacompliancerolehowever,isnotnecessarilytheequivalentofpracticinglaw(e.g.,nolegallicenseis required). Inmany firms theGeneralCounsel of the private equity firm, orsomeone elsewith a legal background,may also be the individual responsiblefor the compliance function, but such a background is not a necessity. Asindicatedearlier,manyprivateequityfirmswillengagetheservicesofexternalcounselforavarietyofdifferentfunctions.Typically,dependingonthenatureof

thevehiclesoffered,mostfirmshaveonshoreandoffshorecounsel.Theroleofthecompliancefunctionhasevolvedovertime.Intheearlyyears

of the hedge fund industry, compliance personnel traditionally focused oninvestment-related compliance. That means ensuring that any requiredregulatoryfilingswerecompletedinatimelymannerandensuringthataprivateequity firm was not in violation of any particularly pertinent restrictionscontained in the offeringmemorandum, such as certain trading restrictions orrisk limits. In the modern private equity context, today the modern CCOmaintains a number of different functions including both investment andnoninvestment issues related toanumberofareas, includinghumanresources,anti-money-laundering compliance, electronic communication monitoring, andworkplaceethics.In recent years, due to increasing scrutiny by regulators and the increasing

complexity of financial industry legislation, many private equity funds, inaddition to external legal counsel, have also begun to employ the services ofthird-party compliance consultants. Depending on the expertise of thecompliance consultant as well as the scope of the engagements, complianceconsultants provide a variety of services, including establishing a firm's initialcompliance program, assisting with ongoing compliance training, and theconducting of mock audits, often modeled after an actual regulatoryexamination.Indeed,manycomplianceconsultantsusedtoworkforregulatoryagencies.Compliance consultants can also provide private equity firmswith continual

advice after an initial compliance program is established. Some private equityfirms may also hire compliance consulting firms to assist with ongoingcompliancetraining.Complianceconsultantscanbeavaluableresourcetomanyprivateequity firms.This isparticularly truewhensuch firmsmonitorandareinvolvedonaday-to-daybasiswithnewregulatorydevelopments.Inperforminga review of the use of such third-party compliance consultants during theoperational due diligence process, investors should take care to determine theextentoftheuseofsuchconsultants.Afirmmaybetemptedtoleantooheavilyonsuchfirms,whilesacrificingthebenefitsofcomplementingtheworkofthesefirmswith internaloversight.Acomplianceconsultantcannever substitute forinternal oversight.A compliance consultantwill not be at the firm on a dailybasisandhavethesamedegreeofinvolvementindailyfirmactivitiesasaCCOor other in-house employees will have. Investors should gauge how the firmfosters a culture of compliance through the development, enforcement, and

ongoingtrainingofcompliancepoliciesandprocedures.Wheninvestorsperformoperationalduediligenceonthelegalandcompliance

functions, they should attempt to gain an understanding of not only the firm'sinternal legal and compliance functions, but also the ways in which the firminteracts with regulators and third-party compliance consultants if applicable.Through this combined understanding a private equity firm will gain a moredetailedunderstandingofthewayinwhichthefirmapproachesandmaintainsacultureofcomplianceatthefirm.

INSURANCEAsweindicatedearlier,performingareviewofaprivateequityfirm'sinsurancecoveragecanalsoprovidevaluable insights into theoperational strengthof anorganization.Privateequity firms thatmaintainappropriate insurancecoverageare signaling that theynotonly takebusinessplanning seriously,butalsoplanforcontingenciesaswell.There is no standard list of required coverage necessary for private equity

fundstomaintain.Indeed,inmostinstances,insurancecoverageisnotrequiredby any laws or regulators but instead is driven by a combination of investordemandsandafirm'sowndesires.Indeed,inpractice,thereisnoconsensusthatinsuranceshouldbecarriedatall.Insurersthemselvesdisagreeabouttheneedtooffercoveragetoprivateequityfirms.Toclarify,insurersareinthebusinessofinsuringthingsandattherightpremiumstheywouldlikelyinsureagainstmostrisks.Thechallengeforprivateequityfirmsseekingtoobtainsuchcoverageiswhetherornotitisprohibitivelyexpensive.Ontheotherhand,insurersmaynotbe comfortable with the levels of risk, and potential magnitude of losses,associatedwithprivateequityfunds.Investorsshouldtakecaretoexaminenotonlythetypesofinsurancecoverage

maintained by a firm and fund, but also the amounts of such policies and theidentity of carriers. The standard types of insurance coverage maintained byprivate equity firms and funds and includes errors and omissions (E&O),directors’ and officers’ liability coverage (D&O), general partner liabilitycoverage,andemploymentpracticesliabilitycoverage.Investors performing operational due diligence should also takemeasures to

evaluatewhichpartiesarecoveredbythesepolicies.Thetypicalpartiescoveredbyinsurancepoliciesaretheunderlyinginvestmentvehicles, theprivateequity

firms themselves (e.g., portfolio manager), the general partners if there is alimited partnership vehicle, the investment manager and directors, officers,employees,andanyrelatedpartnersoftheabovementionedparties.Some private equity investment vehicles go beyond these basic levels of

coverage.Additional coverage types thatmay bemaintained typically includeso-called key person insurance. Investors performing such reviews of thiscoverageshouldtakecaretoevaluatetowhomthesepoliciesaremadepayableaswellaswhoispayingthepremiumsonthepolicies.In reviewing insurance coverage, investors must also take steps to be

conscious of any specific policy exclusions that may preclude coverage forcertainevents.Examplesofsomecommonlyusedexclusionsincludeclaimsbyregulators, claims arising from violation of anti-money-laundering rules, andbankruptcyofafirm.Investorsshouldbeonthelookoutforsubstantiallybroadexclusionlanguagethatwouldpreventaprivateequityfundfromfilingaclaim.Examples of such language could be “in the event of market volatility” or“failure to perform as expected,” which are often difficult to file claims for.Investors should also consider if a private equity firmhas opted to self-insureuntilpolicypremiumsbecomemorecosteffective.

TECHNOLOGYANDSYSTEMS

When performing an operational due diligence review, it is advisable that aninvestorgainanunderstandingofafirm'sinformationtechnologyinfrastructureduringtheoperationalduediligenceprocess.Inthemodernprivateequityfirm,technology is a critical component of many other core operational processes.Certain more technically inclined private equity trading strategies wouldeffectively not be able to function without technology. The primary softwareprograms utilized by private equity firms include those that facilitate thefollowingfunctions:

TradingsystemsandplatformsFundaccountingCustomerrelationshipmanagement(CRM)PortfolioandriskmanagementsystemsDataretentionElectroniccommunicationmonitoringsoftware

Thereshouldbeequal,ifnotmore,considerationpaidtoaprivateequityfirm'shardware platforms, including desktop PCs and servers. Investors should takemeasures to understand whether a firm has taken care to design its hardwareprograminawaythatitconsidersnotonlytheimmediateneedsofthefirm,butcansupportfuturefirmgrowthaswellandisscalable.Anissuerelatedtotechnologyandsystemsincludestheoperationalriskarea

of information security. Maintenance of the security of proprietary data is ofcrucial importance to private equity firms. While a private equity firm maymaintain certain compliance policies that prevent employees from sharingsensitive information outside the firm, private equity firms have often gone astepfurtherandtakenanumberoftechnologicalandphysicalsecuritymeasures.Froma softwareperspective,many fundshavebegun tomorecloselymonitoremployees’ Internet activities, e-mail, and personal trading activities viaelectronic surveillance systems. Specifically in regard to e-mail, firms tend tomonitore-mailcorrespondence forbothmessagecontentand the typesof filessent. Electronic communication surveillance can also extend to remote-accessdevicessuchasBlackBerriesandcellularphones.Manyprivateequityfirmsalsoban the use of external hardware devices, such as zip drives, so as to preventpeoplefromwalkingoutthedoorwithproprietaryinformationliterallyintheirpocket.In terms of information security, private equity firms also may maintain

employeeactivity logsand filedownloads.Through this increasedmonitoring,privateequityfirmshavetheabilitytodetectleaks,intheeventinformationorfiles go missing or end up in the hands of the competition. While suchproceduresmayborderonapproachinganOrwellianBigBrotherdystopia, forbetterorworsesuchinformationsecuritymeasuresarerealitiesofworkingandinvestinginthemoderndigitalworld.Thefollowingisasummaryofcertaininformationsecurityquestionsinvestors

shouldconsiderutilizingtobeginananalysisofaprivateequityfirm'sapproachtowardinformationsecurity:

Whatarethefirm'sinformationsecuritydefenses?Whatkindsoffirewallsareinplace?Does the firm, either itself or via a third-party provider, performpenetrationtesting?Doesthefirm,eitheritselforviaathird-partyprovider,performsocialnetwork–typepenetrationtesting?

Doesthefirmlogemployeenetworkactivity?Has the firm taken any steps to monitor employee usage profiles tomonitorforunusualcomputerusageordirectoraccess?Istheuseofremotestoragedevicessuchaszipdrivespermitted?Howoftenareemployeesrequiredtochangetheirnetworkpasswords?

TAXPRACTICES

The area of a private equity firm's tax practices may be one that is oftenobscured primarily by concerns of tax avoidance. Said another way, mostinvestorsmaynotfeeltheyneedtoevaluateaprivateequityfund'staxpracticesinmuchdetailaslongasthefunddoesnotgeneratenegativetaxconsequencesforthem.Furthermore,aninvestormaybelievethatsuchconcernsarebetterleftfortheirlawyersandaccountanttoadvisethemon,ratherthantointegratesuchconcerns into the operational due diligence process.While such concerns arepractical, there are a host of other tax-related issues that are operationallyrelevant to a private equity firm that investorsmust consider.One exampleofthis would be the host of employment-related taxes that a U.S.-based privateequityfirmisrequiredtopayasanemployer.TheseincludeMedicareandSocialSecuritytaxandfederalandstateunemploymenttaxes.Ifaprivateequityfirmisdeficientinpayingsuchtaxes,therecouldbematerialconsequencesforthefirm.Before proceeding with some common tax implications for investors it is

worth noting that this analysis is focused primarily on the tax implications asapplicable under U.S. accounting standards of generally accepted accountingprinciples, also known as U.S. GAAP. There are a host of other taxconsiderationsand implications for investors innon-U.S.-based firms thatmayoperate under differing tax regimes such as IFRS, which we discuss in moredetailinChapter7.Returning to the tax implicationsan investment inaprivateequity firmmay

haveforinvestors,oneareaofconcerniswhetheraprivateequityfundgeneratesunrelatedbusiness taxable income(UBTI).UBTImaybe thoughtofas the taxon income that federal income tax-exempt entities, such as charitableorganizations, are generally required to pay.Any such income that falls underUBTIisthatwhichisunrelatedtothebusinessdeemedastheprimarybusinessnormallycarriedoutbythetax-exemptorganization.Anexampleofthiswouldbe a pension fund, whose primary business ismanaging pension investments,

operating a construction company. That being said, UBTI does not typicallyinclude dividends, gains for the sale of capital assets, or interest. There are anumber of specific situations underwhich a private equity fundmay generateUBTI.Thisisgenerallyconsidereddisadvantageoustotax-exemptinvestorsdueto the additional tax implications. Private equity investors should inquirewhether aprivate equity fundhasevergeneratedUBTIandwhat stepsa fundhastakentoensureUBTIwillnotbegeneratedinthefuture.Another taxconcern forprivate equity investors relates to investmentsmade

by non-U.S. tax-exempt investors surrounding effectively connected income(ECI).Non-U.S. (i.e., foreign) investors arenotgenerally required to fileU.S.taxreturns.TheexceptiontothisruleiswheretheyhaveECIthatisbasedontheactiveconductofaU.S.-basedbusiness.Itisimportanttonotethattheconductmust be active. Passive investments do not generally give rise to ECI. Aninvestmentmadebyanon-U.S. investor inaprivateequity firm'svehicleofalimitedpartnershipnaturemaygenerateECI for a foreign investor.Topreventsuchnegativetaxconsequences,manyforeigninvestorselecttoinvestinprivateequity funds via offshore blocker corporations. Foreign tax-exempt investorsshouldbeconsciousofanydevelopments in tax law thatmayhavepotentiallynegativetaxconsequencesforthem.Duringtheoperationalduediligenceprocess, investorsshould takemeasures

to review tax-related issues toensure that aprivateequity fundhasproper taxplanningproceduresinplace.Suchreviewsshouldalsoencompassanytrendsofpotentialchanginglegislationindifferingtaxregimessothatinvestorswillnotincurunduetaxesasaresultofaninvestmentinaparticularprivateequityfund.

DIAGNOSINGANDMITIGATINGREPUTATIONALRISK

Beforeinvestinginaprivateequityfirm,aconcernprevalentinmostinvestor'sminds relates to the issues of reputation risk. This sometimes amorphousoperationalriskcategorycanbedifficulttodefine.Someinvestorsmayfocusonthis category solely from amore hard-line perspective of inquiringwhether aprivate equitymanagerhas everbeen arrested for financial crime.Othersmaybroaden the scope of such inquiries to determine if amanager has even beensuedorhasanynegativemediarelatingtothem.Inmanyinstancesinvestorswillengage third-party background investigation firms to perform such reviews.

Somekeyconsiderationsandquestionsinvestorsmaywanttoconsiderregardingbackgroundinvestigationsandreputationriskmanagementinclude:Toasktheprivateequitymanagerregardingreputationrisk:

Is the private equity firm willing to provide an investor with thenecessary release forms and permissions to conduct a backgroundinvestigation?If not, is this a threshold issue that in the investor's opinion wouldrenderthefirmnotinvestible?Howdoestheprivateequitymanagerrespondtoopen-endedinquiriessuch as, “Are there any reputational issues that we should be madeawareof?”

Questionstoconsiderwhenevaluatingabackgroundinvestigationfirm:Howdoesyourfeestructurework?Aredifferentfeeschargedforprivateequityasopposedtootherassetclasses?Ifso,why?Ifthebackgroundinvestigationfirmhasalreadyperformedworkonanindividualorprivateequityfirm,willitresellthiswork?Ifyes,issuchworkavailableatadiscount?Is all the background investigation work performed by the privateequityfirmitselforaresubcontractorsutilized?Whatisthefirm'sprocessfornon-U.S.investigations?How are searches that may require translation services (e.g., non-Englishlanguagesearches)performed?Howlongdonewinvestigationstypicallytake?What is the scope of background investigations performed?Do suchinvestigationsinclude:

PreviousemploymenthistoryverificationEducationbackgroundverificationAddresshistoryProfessionalcertificationsverificationLitigationsearches,civilandcriminalArbitrationanddisciplinaryactionarchivesofregulatorsReviewsofmediaandnewsarticlesStateandfederalregulatorysearchesUniform Commercial Code, bankruptcies, judgments and

liens,andresearchResearchintoaffiliatedentitiesReviewofhistoricalbusinessandregulatoryfilingsPropertyrecords

Anotherconsiderationwithregardtobackgroundinvestigationsrelatestotheissueofonwhombackgroundinvestigationsaretobeperformed.Allinvestorswould likelygenerallyagree that theGeneralPartnershouldbe investigatedaswellastheportfoliomanagerormanagersofthefunds.Beyondthatthereareanumberofdifferentapproachesthatcanbetaken.Thethreeprimarymodelsthataregenerallyutilizedinpracticeare:1.Equityownershipmodel.Aninvestigationshouldbeperformedonallthosewhohaveequityownershipinthemanagementcompanyoftheprivateequityfirm.2.Investmentdecision-making-authoritymodel.Backgroundinvestigationsareperformed on those individuals who have authority to make investmentdecisionsandact(i.e.,trade)onsuchdecisions.3. Risk-control model. Background investigations are performed on allindividuals, both investment and noninvestment focused, who control riskwithinanorganization.Thesecanbetheportfoliomanagersandheadtraders,aswell as the chief financialofficer (CFO), chief complianceofficer (CCO),chiefoperatingofficer(COO),andchiefexecutiveofficer(CEO).Investors must also consider the issue of when during the operational due

diligence process should such investigations be ordered. There is no singlecorrect answer to this question.Due to the expense involved in ordering suchinvestigations as well as the order of investor's different operational duediligence processes, timing may vary. Some investors may order theinvestigationearlyon in theprocess toprevent themfromexpendingeffortonfurther due diligence if an issue will be uncovered during the backgroundinvestigation that could be considered to be a deal killer.Other investorsmayview the background investigation process as the final hurdle that a privateequitymanagermustovercomeafterallotherduediligence,bothinvestmentandoperational,issubstantiallycomplete.

CONCLUSION

This chapter provides an overview of additional operational due diligencetechniques that can be employed to expand a basic operational due diligenceprocess.Thisdiscussionbeginswithprovidingacomparisonofthecoreversusan expanded analysis processes. This chapter next covers additionalconsiderations that can be incorporated into a more comprehensive expandedoperational due diligence process. Additional considerations includecompensationstructuresandthemanager'sinvestmentinthefunds.Thischapternext provides an overview of the benefits of incorporating interview andquestion design techniques into the operational due diligence process. Finally,thischapterprovidesanoverviewofcertainareaswherecommonredflagsmaybe present during the operational due diligence process, including serviceprovider reviews and cash management controls. Once an investor hasestablished a strong core operational due diligence program, expanding thereview process can increase not only the depth, but also the quality andeffectivenessofsuchduediligencereviews.

NOTES

1.SeeDavisPolkandWardwell,“ManagementEquityArrangementsinPrivateEquityTransactionsPartII:CompensatoryEquityAwards,”January26,2009.Availableat:http://www.davispolk.com/1485409/newsletters/privateequity/pe_20090122.htm2.SeeCharlesYeschke,TheArtofInvestigativeInterviewing:AHumanApproachtoTestimonialEvidence(Butterworth-Heinemann,2003),72.3.SeeNathanGordonandWilliamFleisher,EffectiveInterviewingandInterrogationTechniques,ThirdEdition(AcademicPress,2011).4.SeeJeffRutenbeck,TechTerms:WhatEveryTelecommunicationsandDigitalMediaPersonShouldKnow(FocalPress,2006).5.See“PrivateEquityInvestorsAreConcernedAboutFraud;ManyWouldPayaPremiumfor...,”September10,2008,www.reuters.com/article/2008/09/10/idUS136482+10-Sep-2008+BW20080910.6.AzamAhmed,“NewCaliforniaLobbyistLawUpsetsHedgeFunds,”New

YorkTimesDealbook,January14,2011.7.U.S.SecuritiesandExchangeCommission,“17CFRPart275,ReleaseNo.IA-3043;FileNo.S7-18-09,RIN3235-AK30,”www.sec.gov/rules/final/2010/ia-3043.pdf.8.SeeThomasFox,“PrivateEquityandtheFCPA,”January3,2011,www.lexisnexis.com/community/corpsec/blogs/corporateandsecuritieslawblog/archive/2011/01/03/privateequity-and-the-fcpa.aspx.

CHAPTER5

ValuationTechniques,Methodologies,andStandards

Valuation is one of the areas that Limited Partners (LPs) tend to focus theirefforts on during the operational due diligence process. Understanding anddiagnosingoperationalriskinthevaluationprocessiscertainlyanareathatmaybe fraught with considerable operational risks. Investors who take care toappropriately understand not only the valuationmethodologies employed by aparticularprivateequity fundbutalso theways inwhichsuch theoriesareputintopracticewillalsolikelygaininsightsintootherareasofafirm'soperationalrisk exposures. This further highlights the central area of private equity fundvaluation, asmany other operational functionsmay be affected in addition tofund marks such as reporting, information technology platforms to handlepricingfees,andthepotentialuseofserviceprovidersinthevaluationprocess.Thischapterprovidesanoverviewoftheprivateequityvaluationlandscapeandconsiderations that LPs must consider in approaching the private equity fundvaluationprocess.

LIMITEDPARTNERDISTINCTIONBETWEENFUNDLEVELAND

PORTFOLIOCOMPANYVALUATIONAPPROACHES

Investors performing operational due diligence on a private equity fund canapproach the subject of valuation from two different regards. The first suchconsiderationregardingvaluationisthewayinwhichtheprivateequityfirmwillcalculateavalue for theportfolio itself.Thisvaluation isutilized todeterminethe fund's overall performance and how an investor's return on investment iscalculated. The second consideration relates to the ways in which a private

equity firm will value the fund's holdings. It is this second valuationconsideration towhich themajorityof investorsdedicate their operationalduediligenceefforts.

VALUATIONCONSIDERATIONSFORNEWLYFORMEDFUNDS

Investors, performing operational due diligence on a newly formed privateequity fund that has yet to begin any investment activity, do not have anyhistoricalfundspecificvaluationevidencefromwhichtheycanassesswhetherappropriatevaluationmethodologiesarefollowed.Inthesecases, investorscanlook to the valuation procedures employed in vintage funds or similarlymanaged funds overseen by the private equity firm, if any such funds werehistoricallymanaged.Additionally, despite the fact that a fund has not been actively trading,

investorscanstill takemeasurestoevaluatetheanticipatedvaluationprocessesandprocedures thataprivateequity fundanticipatesemployingonce investingactivitybegins.Suchvaluationguidancewill likelybememorializedinseveraldocuments that a firmmaintains.Thesecan include theofferingmemorandumandduediligencequestionnaires.Additionally,manyprivate equity firmsmayalso maintain separate valuation policies and procedure documents that mayspelloutthewaysinwhichvaluationsarecalculatedonamoredetailedbasis.

INTRODUCTIONTOVALUATION

Theoperationalduediligenceprocesspresentsinvestorswithanopportunitytounderstand themethodology choices employed by private equity firms. SomeGeneral Partners (GPs) and even LPs may be inclined to imply that privateequityfundvaluationisastraightforwardprocess.Indeed,yourauthorhascomeacrosssomeGPswhoarguethatLPsshouldjusteffectivelywriteachecktotheGPswhen the fund is first formed and, at least froma valuations perspective,theyshouldnotbeoverlyconcernedwithvaluationsonanyannualbasis,nevermindaquarterlyone.Thismentality is supportedby the longer-termnatureofprivate equity funds as compared to more liquid investments, such as hedgefunds.A longer-term investmenthowever,doesnotmean that investorsshould

simplyputtheirhandsupandturnablindeyetooversightofthefunduntilthefund isapproaching theendof its term.This isparticularly true in theareaofvaluation.WhileaGPmayprefernottobebotheredwiththeso-calledinconvenienceof

ongoingvaluationwork,suchcontinualprocessreviewandongoingvaluationshave investment benefits for the actual management of the private equityportfolio and for investors, as well. Investors should be wary of any GP thatpushesbackonvaluationfrequencyandtransparencyinthisregard.Indeed,asthe discussion in this chapter outlines, many private equity industry self-promulgatedvaluation standards aswell asmore general accounting standardssuggest, or in some cases require, that a GP devote increased resources toproviding such additional oversight to investors in this regard. Additionally,privateequity firms that increasereportingfrequencyandrigorousnessof theirown fund valuation proceduresmay reduce the burden for the LP to performmore detailed due diligence at certain times on the fund's valuations.Additionally, this will likely reduce the time and resources that LPs may berequired to devote to providing transparency or justifications of their ownvaluationprocessesandprocedures.

GIPSSTATEMENTONPRIVATEEQUITYThe CFA Institute created and administers a series of fund calculation andreporting standards that are utilized throughout the assetmanagement industryacross multiple asset classes and fund types. These standards are collectivelyreferred to as Global Investment Performance Standards (GIPS).1 GIPS hasproduced a series of guidance statements on standards interpretations andguidance statements regarding different aspects of fund reporting andtransparency. Relevant to our present discussion, these guidance statementsinclude a Guidance Statement on Real Estate and Guidance Statement onPrivateEquity.TheGIPSstandardsaredesignedtoprovideafund'sprospectiveclientswith

the information needed to evaluate a fund's performance figures. The GIPSguidancewithregardtoprivateequityfundvaluationoutlinesthatthenotionsoffairvalue that areutilized in theGIPSprovisions as applicable towardprivateequity are similar to the concepts of fair value utilized in internationalaccountingstandards.

TheGIPSguidance in this regards also points out the difficulties in valuingprivateequityinvestmentshasresultedinanumberofdifferentattemptsatmoreglobalized valuation methodology harmonization through the work of privateequity industry groups such as the British Venture Capital Association, theEuropean Venture Capital Association, and the U.S. Private Equity IndustryGuidelinesGroup. It should be noted that theGIPSPrivate EquityValuationsprinciplesarenotmeanttoreplaceanyregionalvaluationguidelinesbutrathertosupportsuchmethodologiesviahigh-levelvaluationguidelines.2

The GIPS private equity guidelines provide guidance with regard tomethodologyandperformance-reportingstandardsthataprivateequityfundcanemploy. In this regard, the GIPS standards also outline formulas that can beutilizedtocalculateafund'sinternalrateofreturn,commonlyreferredtoasIRR.Examples of the formulas that the Guidance Statement on Private Equitystandards outline include the calculation of the annualized IRR, calculated asfollows:

whereVB=valueoftheinvestmentatthebeginningofthemeasurementperiodVE=valueoftheinvestmentattheendofthemeasurementperiodCFi=cashflowi(positivevaluesforinflowsandnegativevaluesforoutflows)i=numberofcashflows(1,2,…I)duringthemeasurementperiodrIRR=annualizedinternalrateofreturnti=numberofcalendardaysfromthedaywhenthecashflowioccurredtotheendofthemeasurementperiodTD=totalnumberofcalendardayswithinthemeasurementperiod

Additionally, the GIPS private equity guidance outlines that firmswith lessthanoneyearofperformancesinceinceptionmustpresentanonannualizedsinceinceptionIRRthatiscalculatedutilizedthefollowingformula:

whereRIRR=nonannualizedinternalrateofreturnrIRR=annualizedinternalrateofreturn

TD=totalnumberofcalendardayswithinthemeasurementperiodInvestors approaching a private equity fund's performance reporting and

valuationprocessescanutilizeguidelinessuchasGIPStoevaluatethevaluationmethodologies employed. By developing an understanding of such standards,limitedpartnerswillhavebenchmarkmethodologiesagainstwhich tocomparevaluation andperformance reporting approaches.Even if a private equity firmdoesnotadheretoGIPSreportingstandards,familiaritywithsuchstandardscanprovide useful guidance in evaluating a private equity firm's approach towardvaluationandperformancereportinginthisregard.

IPEVGUIDELINESThroughacollaborativeeffortofprivateequityindustryparticipants,theprivateequityindustryovertheyearshaspromulgateddifferentguidelineswithrespecttovaluationguidance.OnefairlyprevalentstandardistheInternationalPrivateEquityandVentureCapitalValuationGuidelines,whicharegenerallyreferredtoastheIPEVguidelines.Theseguidelinesprovideamethodologyframeworkthataprivateequityfundmayseektoutilizewhenevaluatingandreportingthevalueof its investments. Compared to the GIPS guidance, the IPEV guidelines arefocusedprimarilyonvaluationandnotonperformancereportingstandards.3

AconceptcentraltotheIPEVguidelinesisthenotionoffairvalue.TheIPEVstandardsdefine fairvalueas“thepriceatwhichanorderly transactionwouldtake place between market participants at the reporting date.” This can becontrastedwith the likely discounted amount that a private equity fundwouldrealize should it be forced to exit a position in a distressed sale situation or aforcedliquidation.The IPEV guidelines further outline that, regardless of the valuation

methodology employed, the so-called Enterprise Value utilized by a privateequity fund to value portfolio companies should follow several measuresincluding:4

AdjusttheenterprisevalueforsurplusassetsorexcessliabilitiesDeductfromtherevisedEnterpriseValueanyfinancialinstrumentsthatmay rank in priority ahead of the next highest ranking instrument offundintheeventofaliquidationAllocate the relevant enterprise value among the firm's relevantfinancialinstruments

The IPEV guidelines also outline guidance with regard to a number ofcommonlyutilizedvaluationmethodologies.Thesevaluationmethodologiesaresummarized in Exhibit 5.1 and are discussed in more detail in the followingsections.

EXHIBIT5.1OverviewofValuationMethodologiesasApplicabletoCommonCompanyTypesValuationMethodology CommonUse

Priceofrecentinvestment Start-up,seed,andearlystate

Multiples Establishedbusiness:identified,maintainableincomestream

Netassets Propertyholdingcompanies,investmentbusinesssuchasfundoffunds,whosefairvalueisderivedprimarilyfromtheassetsheldascomparedtonetearnings.

Discountedcashflowsorearnings(ofunderlyingbusiness)

Bothestablishedandearly-stageportfoliocompanies

Discountedcashflows(fromtheInvestment)

Underlyingprivateequityfundinvestmentsoontoberealizedorpendingfloatationofunderlyingportfoliocompany

Industryvaluationbenchmarks Limiteduses

PriceofRecentInvestmentThepriceofrecentinvestmentapproacheffectivelycanbeequatedtovaluingapositionatcost.TheIPEVguidelinesoutlinethatthismethodologyisgenerallymostfrequentlyemployedinstart-up,seed,andearly-statevaluationsituations.Overtimetheaccuracyofsuchvaluationstendstodecrease.Whilethepriceofrecent investment, or at-cost, valuationsmay be appropriate in the short termafterapositionisacquiredbyaprivateequityfund,theIPEVguidelinesoutlineanumberofreasonswhyovertimethecontinueduseofsuchvaluationsarenotanaccurate representationofaposition's fairvalue.These reasonscan includethefactthatthetransactionmaybepartofaforcedsaleandthatdifferentrightsininvestmentsmayattachtoportfolioinvestments.There is no fixed amount of time afterwhich the use of this price of recent

investment methodology is no longer effective, and substantial discretion isaffordedtotheGPor,perhaps,a third-partyvaluationconsultantasapplicable.In determiningwhether a change in the fair value of a position has occurred,oftentimestheGPorvaluationagentmayemployaso-calledmilestoneanalysisapproach, for early-stage investments.Often,when differentmilestones in thegrowthofaportfoliocompanyareachieved, itpresentsanopportunity for theprivate equity firm or valuer to determinewhether a new valuation should beperformed.TheIPEVguidelinesdescribeanumberofdifferentfactorsthatare

likely to be included under this milestone analysis approach in reaching adecision as to whether to revalue a position. Examples of typical valuationmilestonesareanalyzedinExhibit5.2.

EXHIBIT5.2IPEVGuidelinesCommonlyAcceptedMilestonesforEarlyDevelopmentStageCompaniesFinancialMeasures

Revenuegrowth Cashburnrate

Profitabilityexpectations Covenantcompliance

TechnicalMeasures

Phasesofdevelopment

Patenapprovals

Testingcycles

MarketingandSalesMeasures

Customersurveys Testingphases

Marketshare Marketintroduction

MultipleValuationThe multiple valuation methodology focuses on the earnings of a portfoliocompany. The IPEV guidelines outline that, in general, this method isappropriate for valuing established businesseswith identified income streams.This methodology may also be utilized for an early-stage firm's applyingrevenue multipliers to estimate position valuation. The IPEV guidelines alsooutline that themultiplevaluationapproachcanbeemployedwhencompaniespossessbothpositiveandnegativeearnings.Inthecaseofnegativeearnings,thenegative earnings cannot generally be sustained for extended periods of time.For short-termnegative earnings, the IPEVguidelines state that such negativeearningsarepermissibleaslongastheycanbenormalizedtoidentifyapositivelevel of maintainable earnings. The IPEV guidelines state that a number ofdifferent earnings multiples may be employed including a price/earningsmultiple(P/E),enterprisevalue/earningsbeforeinterestandtax(EV/EBIT),anddepreciationsandamortization(EV/EBITDA).

NetAssetsThenetassetsvaluationmethodologyconcentratesondeterminingthevalueofaportfolio companywith a focus on the value of the net assets of the portfoliocompany.TheIPEVguidelinesoutlinethatnetassetsvaluationmethodologyis

appropriate for businesses such aspropertyholding companies and investmentbusinesses, such as funds-of-funds,whose fair value isderivedprimarily fromtheassetsheldascomparedtonetearnings.Thenetassetsmethodologymaybemostappropriateforcompaniesthatareproducinglowprofitlevels,suchastheexampleincludedintheIPEVguidelinesofaloss-makingcompany.

DiscountedCashFlowsorEarnings(ofUnderlyingBusiness)

The discounted cash flows or earnings (of underlying business)methodologyfocuses on calculating valuations based on the expected value of future cashflows. This methodology is appropriate for both established and early-stageportfolio companies. Specifically, the IPEV guidelines outline that the presentvalue of expected futures cash flows or the present value of expected futureearnings can be utilized with this methodology. This methodology alsoincorporatesanassumptionastotheterminalvalueoftheunderlyingbusinessoftheportfoliocompany.This terminal value for the underlying business is compared to the terminal

value of the investment itself,which is not utilized under the discounted cashflowsorearnings(ofunderlyingbusiness)methodology.Anumberofdifferentinputs and methodologies may be utilized in calculating terminal values,includingOhlsonLogit regressionmodels.5 The guidelines further outline thatdue to the flexibility of the private equity firm or valuation agent in makingdetailedcashflowforecastsandtherequirementforaterminalvalueestimation,thismethodmayhavedrawbacksthatmayresultin“insufficientlyreliable”fairvalues.

DiscountedCashFlows(fromtheInvestment)The discounted cash flows (from the investment)methodology focuses aroundutilizing the discounted cash flow model to those cash flows that are to beexpectedfromtheinvestmentthattheprivateequityfunditselfmakes.TheIPEVguidelines outline that the use of this methodology may be appropriate insituations where an investment is soon to be realized or the flotation of anunderlyingbusiness isexpected.Similar to therisksofutilizingthediscountedcash flows or earnings (of underlying business) methodology, the discountedcashflows(fromtheinvestment)methodologyrequiresbothcashflowforecasts

and terminal value assumptions and estimations that may result in unreliablevaluations.

IndustryValuationBenchmarksThe industry valuation benchmarks methodology focuses on the utilization ofbenchmarks in the valuation process. Specifically the IPEV guidelines outlinethat thismethod employs the use of industry-specific benchmarks to assist invaluation.ExamplesprovidedbytheIPEVguidelinesincludebenchmarkssuchaspricepersubscriberforcableTVcompaniesorpriceperbedforcompaniesthat operate nursing homes. The IPEV guidelines caution that the benefits ofusing the industry valuation benchmarks methodology are limited to certaincircumstances and that the use of such benchmarks is likely to be morebeneficial to the private equity firm or third-party valuer as a common-sensecheck of values that are calculated via other previously referencedmethodologies.

OtherIPEVGuidanceIn addition to the previously referenced valuation methodologies, the IPEVguidelines also provide guidance with regard to the valuation of secondarytransactions and in calculating adjustments to a fund's net asset value. Theguidelinesalsopresent someconsiderations thatcanbeutilized indeterminingappropriate valuations to be employed in different insider funding rounds,distressedmarkettransactions,bridgefinancing,mezzanineloans,rolled-uploaninterest,andindicativeoffers.Finally,theIPEVguidelinesalsoprovideguidancewithregardtotheimpactthatthestructuringofaprivateequityinvestmentmayplayininfluencingvaluations.SomecommonclausesthattheIPEVguidelinesoutline have an influence on such valuations including antidilution clauses,ratchet clauses, convertible debt instruments, and commitments to follow-oninvestments.

FAS157Statement of Financial Accounting Standards 157: Fair Value Measurement,sometimesreferredtoasSFAS157orFAS157,isanaccountingpronouncementthat was issued by the Financial Accounting Standards Board (FASB) of theUnitedStates. Since taking effect onNovember 15, 2007, FAS157 has had a

major impacton thereportingofvaluationsofpositionsheldbyprivateequityfunds.FAS157wasenactedinanefforttoincreaseharmonizationoffairvaluereportingstandardsandmethodologies.Specifically,thefollowingexcerptfromthe Financial Accounting Standards Board's Summary of Statement No. 157outlinesthereasonsforissuingthisstatementonfairvaluemeasurements:Prior to this Statement, there were different definitions of fair value andlimited guidance for applying those definitions in GAAP. Moreover, thatguidance was dispersed among the many accounting pronouncements thatrequire fair value measurements. Differences in that guidance createdinconsistenciesthataddedtothecomplexityinapplyingGAAP.IndevelopingthisStatement, theBoardconsideredtheneedforincreasedconsistencyandcomparabilityinfairvaluemeasurementsandforexpandeddisclosuresaboutfairvaluemeasurements.6

Inparticular,FAS157hassoughttoaccomplishthreeprimarygoals:1.Createauniformdefinitionoffairvalue.2. Establish a fair value measurement framework under generally acceptedaccountingprinciples(GAAP).3.Broadenthedisclosurerequirementsforthosefairvalueobservations.FAS157paragraphfiveiscommonlyknownasFASBASC820.FASBASC

820definesfairvalueas“thepricethatwouldbereceivedtosellanassetorpaidtotransferaliabilityinanorderlytransactionbetweenmarketparticipantsatthemeasurementdate”(emphasisadded).7

Thissalepricecanbethoughtofastheexitpriceofaposition.Thisrepresentsasignificantdeparturefromthepreviousgeneralthinkingthatfairvaluewastheprice a private equity fund would pay to acquire an asset (e.g., cost or entryprice).Itisimportanttonotethisdistinctionbetweentheuseofsalepriceversuscost.

Different private equity funds may use different reference marks whendeterminingtheexitpriceofaposition.Additionally,certainfirmsmayfeelitisappropriatetoapplydiscountsbasedonfactorssuchasilliquidityofaparticularportfolio holding. Furthermore, contingent on a number of factors, includingtimingofthecalculationsandthetypesofassetsinvolved,entrypricesandexitpricescandiffersubstantially.FAS 157 provides a framework for fair valuemeasurement that categorizes

assetsintothreedistinctcategoriesthatarecommonlyreferredtoaslevels.Eachlevelcorrelatestotheeaseorcertaintywithwhichthevalueofanassetmaybe

obtained.Specifically,assetsthatfallintotheLevel1categoryarethosewhosepricesareeasilyavailableinthemarket.AnexampleofaLevel1assetwouldbeastocktradedontheNASDAQorNewYorkStockExchange.Level2assetsarethosewhosepricesarenotreadilyobservablebutwhosevaluationsarebasedonobservable inputs of similarly traded assets. An example of a Level 2 assetwouldbethecommonstockofapubliccompanyrestrictedfromsaleunderRule144. Level 3 assets are those whose values are not observable in themarket.Examples of Level 3 assets include certain mortgage-linked assets, privateequityinvestments,andcertainlong-datedoptions.FAS157requiresprivateequityfundmanagerstoprovidespecificadditional

disclosures regarding valuationmethodologies. As outlined earlier, for privateequity funds the bulk of a private equity fund's holdingswill be classified asLevel3assets.FAS157outlinesthatforLevel3assets,privateequityfundshadtomakemore disclosures thanwere previously required. Specifically, Level 3assets private equity funds are now required to disclose details such as adescriptionoftheinputusedtodeterminethemark,andtheinformationutilizedto develop this. An example of this disclosure would be, “For Level IIIinvestments,theFundsvaluetheinvestmentsprimarilyusingadiscountedcashflowmethodology.”For private equity funds, the biggest implicationhas not necessarily been in

regard to the requirements to classify assets into thedifferentFAS157 levels.Instead,arguablythebiggestimpactthatFAS157hashadontheprivateequityindustryhasbeenthatithasforcedprivateequityfundstofocusontheissueofvaluation on amore frequent basis. It is not that private equity funds did notnecessarilyhave tooutlineboth the cost and fair valueof positions in auditedannual financial statements,but rather thatFAS157has increased the scrutinypaidtothisissuebyLPsandfundauditorsalike.Withthisincreasedfocus,FAS157 has continued to promote an increased movement toward valuationtransparency anddisclosuresmadebyprivate equity funds.This has benefitedLPsduring theoperationalduediligenceprocessbecause theyhave additionalclarity and another series of data points that they can examine during theoperationalduediligenceprocess.Despite the benefits of FAS 157, many LPs still struggle to maintain the

appropriate level of information required to fully assess a GP's fair valuationprocess.8 These difficulties have caused frustration among LPs regarding theirownreportingandvaluationrequirements.Anexampleof thisrelates toFASBAccountingStandardsUpdateNo. 2009-12,which is commonly referred to as

ASU2009-12.ThisissomewhatironicbecausemeasuressuchasASU2009-12wereintendedtoexpeditefairvaluedeterminations.Othersintheprivateequityindustry have simply referred to FAS 157 as “stupid” and as a measure that“injectsatonoffalseprecisionandcosts”intotheprocess.9Investorsmustseekto balance the drawbacks of FAS 157 with the benefits of additionallytransparencyandoversightthatitprovides.

USEOFTHIRD-PARTYVALUATIONCONSULTANTS

Regardless of the required or self-driven valuation policies followed by aparticularprivateequityfund,theactualvaluationworkofaprivateequityfirmmaybeperformedcompletelyinternally,bythein-houseresourcesofthefund,orviaacombinationofexternalandinternalresources.Someprivate equity firmsmayargue in favorofperforming solely in-house

valuationsforanumberofdifferentreasons.Oneexamplethataproponentmayraise is that it is not cost-efficient to have a third-party valuation consultantinvolved.Third-party valuation consultants canbe retainedunder a numberofdifferent fee arrangements. Examples of such fee arrangements can includeretainingathird-partyvaluationconsultantonaproject-by-projectbasis,suchaswhen a new portfolio asset is first acquired or sold, or on a retainer basis toperformacertain fixednumberofvaluation reviewsona fixed timeschedule,suchasannually.Dependingonthescopeofthereviewservicesperformed,aswell as the size of the actual positions being valued in certain cases, theargument against utilizing a third-party valuation consultantmay gain supportwhenacomparisonofthetrade-offofthecosttotheprivateequityfundversusthe value of the actual position is taken into account. For example, if a third-partyvaluationfirmcharges$25,000inordertovalueaposition,buttheentirepositionwasacquiredbytheprivateequityfundatacostofonly$10,000,thenitdoes not make good economic sense for the fund to expend more on thevaluationofsuchaposition than thepositionmayactuallyhavebeenacquiredforormaybeworthuponexitoftheposition.Continuing our example, consider the same position with a $10,000

acquisition cost. Now assume that over time the value of the positionsignificantlyincreasedto$75,000.Thismaystillbeonlyasmallpercentageoftheoverallfund'sportfolio.Whatiftheassetwasworth$150,000or$250,000?

Woulda$25,000third-partyvaluationfeebeworththeexpense?Theanswertothis question is subjective. There is no single correct ratio or trade-off ofexpenses versus cost that a fund necessarily adheres to. To the contrary, thedecisionoftheprivateequityfundtoutilizethird-partyvaluationconsultantsisoftenasubjectiveonethatvariesonaposition-by-positionbasis.Theactualorperceived liquidityofsuchpositionsmayalsohaveastrong influenceonsuchdecisions.Whenapositionbecomesmoredifficulttovalueduetoilliquidity,aprivate equity fund may have less confidence in internal valuations. In thesecases, the decision of a GP to utilize a third-party consultant to assist invaluations may be more than a simple calculation of cost versus expense,becausethefirmmaynotbeoverlyconfidentofitsownvaluationworkormaysimplywanttoconfirmitsowninternalworkviaathird-partyopinion.Outsideof theseconsiderations,andbasedon theirownvaluationpolicies,a

privateequityfundmaynotprovide itselfwith theoptionofnotutilizingsuchconsultantsabovecertainfundassetsundermanagement(AUM)thresholds.Forexample, a private equity fundmay have a policy where any position that ismore than a fixed percentage of the overall portfolio at the time of purchaserequires a third-party valuation to be performed. Firms may also implementongoingvaluationrequirementsforpositionsthatcontinuetobeofacertainsizeatfixedintervals.Consider for example, a fund that makes an investment in an underlying

portfoliocompany.Atthetimeofpurchaseassumethatthepositionrepresents9percentoffundAUM.Letusfurtherassumethatthisfundmaintainsavaluationpolicythatrequiresathird-partyvaluationconsultanttoperformanindependentvaluationofpositions thatat the timeofacquisitionare10percentormoreoffundAUM. Therefore, this 9 percent position does notmeet the assets undermanagementthresholdandatthisstagewouldnotberequiredtoundergoathird-partyvaluation.ThisrelationshipissummarizedinExhibit5.3.

EXHIBIT5.3SampleAssetsunderManagementThresholdforaPrivateEquityFirmtoUseThird-PartyValuationConsultants

Continuing our example, let's also assume that the fund's valuation policiesoutline the position that an increase in size to over 10 percent of fundAUMrequires a third-party valuation. If the position subsequently increases in sizefrom9percent to11percent, thenaccording to thispolicy the fundmustnowutilize a third-party valuation consultant to perform a valuation. When suchpoliciesareinplaceanumberofquestionsareraisedastowhensuchvaluationsaretobeperformed.For example, itwouldnot likelymake sense for the fund to engage a third-

partyvaluationconsultanttoperformavaluationofapositionthatis11percentof the portfolio if the private equity fund anticipates perhaps that the positionmaydecreaseinsizeagaintobelowthe10percentthresholdinashortperiodoftime. It is alsoworthnoting thatmostprivateequity firmsprovide themselveswithenoughdiscretionincertainregardssothattheyhavetheflexibilitytomakesuch determinations. Furthermore, such valuation policies may provideflexibilityregardingthetimingofthevaluationofsuchpositions.Forexample,if the position due to a supposed increase in value rose from an anticipated 9percentto11percentofthefund'sassetsundermanagementatthebeginningofthefirstquarter, then theprivateequityfirm,whichforourexamplemayhavebeenusedtoperformingsemi-annualpositionvaluations,maynotbeinclinedtohave such a valuation performed off-cycle. As the earlier discussiondemonstrates, the presence of seemingly detailed valuation policies and

proceduresmayalsoprovidetheGPwithcertaindiscretioninthisregard.Wheninvestors perform operational due diligence on the valuation processes of aprivateequityfirmunderreview,theyshouldinquireastothescopeofservicesand the use of such consultants. Some questions that investors could poseinclude:

Doesthefundusevaluationconsultantsregularly?If not utilized for every position in the fund portfolio, with whatfrequency are such consultants utilized (e.g., asset threshold level orpositionsizelevels,etc.)?Areseveraldifferentthird-partyvaluationconsultantsutilized?Ifmultipleconsultantsareutilized,aretheyspecializedbyassettypeorgeneralists?What steps has the fund taken to ensure that cherry-picking ofvaluationconsultantsvaluationsisnotarisk?Areconsultantschangedwithanyfrequency?Whatisthescopeofvaluationworkperformedbytheseconsultants?Dothird-partyvaluationconsultantsperformon-sitevisits toportfoliocompaniestoassistinthevaluationprocess?Willthefundshareacopyofsuchvaluationworkwithinvestors?Is third-party valuation work shared with the fund's third-partyadministrator?Whatworkdoesthefund'sauditorsperforminreviewingorconfirmingthesethird-partyvaluations?Arethird-partyvaluationconsultantsprovidingactualvalues,rangesofvalues,positiveassuranceofvalues,ornegativeassurance?What are theplans to resolve a conflict, if theGPdisagreeswith themarkofthevaluationconsultant?

VALUATIONOUTPUTPROCESSDOCUMENTATION

Intermsofvaluation,oneconsiderationthatLPsshouldtakeintoaccountduringtheoperationalduediligenceprocess is thewayinwhichaprivateequityfirmdocuments the outputs of the valuation process. To clarify the documentationbeingreferenced in thisdiscussion isnot thevaluationpoliciesandprocedures

thatoutlinetheso-calledrulebywhichaprivateequityfirmintendstovalueitsportfolioholdings. Itshouldalsobenoted that theoutputdocumentationbeingreferencedisnotthatwhichisrequiredtobeproducedaspartofanyauditworkorregulatoryreviews.Rather,inthiscase,thedocumentationbeingreferencedisthatwhichaprivateequityfirm,adhering to thepreviouslyreferencedpoliciesandprocedures,mayproduceinconductingvaluationsinaccordancewiththesevaluationrules.Indeed,aprivateequityfirm'svaluationpoliciesandproceduresmay outline certain specific valuation output process requirements. In otherinstances, the valuation policies and proceduresmay not necessarily outline arequirement that a private equity fund produce any sort of valuation outputdocumentation,butratherleavethistothebroaddiscretionoftheGP.Due to this broad flexibility, investors may encounter a wide variety of

different methods by which a private equity firm attempts to document theresultsoftheirvaluationprocesses.Forexample,someprivateequityfirmsmayonlyproducedocumentation,suchasavaluationmemorandum,whenapositionis acquired. Other private equity funds may opt to produce a valuationmemorandumwhenaposition is exited.Still other firmsmay seek toproducesuchvaluationmemorandumwhenaneventoccursthattheyfeelwillmateriallyaffectthefairvalueofafundholding.Another option is for a private equity firm to producevaluationmemoranda

withacertainspecifiedfrequency(e.g.,quarterly)regardlessofwhetherornotanyvaluation-typeeventsoccur.Theseoptionsarenotexclusiveofeachother.Aprivateequityfirmmayopttoproducevaluationmemorandumatintervalsbasedon any of the previously referenced intervals or via some other alternativemethodology. Furthermore, a private equity may produce internal valuationdocumentation incoordinationwith theworkofany third-partyvaluations thatmayhavebeenperformed.Forexample,aprivateequityfirmmayhaveapolicyof employinga third-partyvaluationagent fornewpositionsbut the firmmayproduce its own internal valuation memoranda when valuation events occurthroughout the life of a held asset. When approaching an analysis of thevaluation process employed by a private equity fund, investors should inquireaboutthefrequencywithwhichanysuchvaluationmemorandaareprepared.Anotherconsideration regarding the frequencyof suchvaluationmemoranda

iswhatinformationiscontainedinsuchmemoranda.Forexample,foranewlyacquired position a private equity firmmay producemore extensive valuationmemorandathatmayleverageofftheGP'sowninitialduediligenceworkontheportfolio position, as compared to other valuation situations. There is no set

formatbywhichaprivateequityfirmmustdocument theoutputof its internalvaluationprocess.Indeed,asoutlinedearlier,outsideofanyauditorregulatoryrequirements, a private equity fund does not need to produce user-friendlydocumentationastohowvaluationswerecalculated.Assuch,duetothislackofuniformity, investors should inquire as to the format of any valuationdocumentation produced. For example, does a private equity fund's valuationmemorandum provide an overview of qualitative factors such as the marketenvironment as relevant to the asset and comparisons with other industrycompetitorsthatmayinfluenceanasset'sfundamentals?Incertaininstances,asoutlinedearlier,athird-partyvaluationagentmaybeutilized.Itislikelythattheworkof the third-partyvaluerwillbemoreextensive incertain regards thanaprivateequityfirm'sowninternalvaluations.Inthesesituations,investorsshouldinquireastohowprivateequityfirmscompensateforanysuchvaluationscopediscrepancieswhencalculatinganddocumentingvaluationsontheirownaccord.

VALUATIONCOMMITTEEREVIEWSCOPE

If a private equity fund does produce internal valuationmemoranda, investorsshould also inquire as to how such memoranda are utilized. Are they simplythrowninadrawerordoesthefirmemployactivediscussionsaroundthepointsraised? In certain cases, a private equity firm may also maintain a distinctinternalvaluationcommitteethatisresponsibleforreviewing,andinsomecasesapproving,anyvaluationmemoranda.Ifavaluationcommitteeismaintainedbyaprivateequityfirm,investorsshouldattempttogaugetherigorousnessofsuchvaluationcommitteereviews.Onewayinvestorscanbeginthisprocessisbyfirstreviewingthemakeupof

the valuation committee. If the committee consists solely of investmentpersonnel then there is a greater potential for a conflict of interest in thevaluationscommitteereviewsofanyvaluesstruckortheapprovalofvaluationmemorandabythevaluationcommittee.Rather,itisconsideredbestpracticefora private equity firm to have as members of the valuation committeerepresentativesofdifferentdepartmentsthroughoutthefirm.Examplesofdepartmentsthatmaybecommonlyrepresentedincludelegaland

compliance, fund operations, and riskmanagement.With an understanding ofthe makeup of the valuation, committee investors can next inquire as to the

frequency by which any review of valuations, or associated valuationmemoranda,occur.Thismaybean indicationofhowseriously the firmviewsthe role of such a committee. For example, if the valuation committee meetsonly once a year, this does not suggest vigorous valuation oversight, ascomparedwithone that convenesvaluation committeemeetingson amonthlybasis.

ADDITIONALLIMITEDPARTNERVALUATIONCONSIDERATIONS

Aprivateequityhedgefund'spoliciesandproceduresrelatedtovaluationshouldundergo careful scrutiny as part of the investor due diligence process.A LP'sproprietaryapproachtohedgefundoperationalduediligenceshouldencompassamultifaceted review of private equity valuation procedures. Investors shouldtake steps to ensure that their operational due diligenceprocess also evaluateswhat checks and balances, if any, are in place to ensure consistency andindependence in determining valuations. In addition to those considerationsoutlined as part of the evaluation process of a private equity fund's valuationprocedures,somekeyquestionsinvestorsshouldconsiderinclude:

What steps has the GP taken to ensure independence in the pricingprocess?Wheredothemajorityofpricinginputscomefrom?Howisanappropriatepricedeterminedifadiscrepancyexistsamongpricinginputs?Isanaveragetaken?Arethehighestand/orlowestpricediscarded?Whomakesthesedeterminations?Doesthefundmaintainaninternalpricingcommittee?Whatroledoestheadministratorplayinthepricingprocess?Is the administrator, independently of the private equity manager,corresponding with any trading counterparties? If so, what data issharedamongtheseorganizations?

CONCLUSIONThis chapter provides an introduction to valuation techniques, methodologies,and standards employed by private equity funds. It is advisable that LPs

approach the operational due diligence process armed with a familiarity withvaluationpoliciesandproceduresaswellastherelevantprivateequityindustryguidelines and any accounting or regulatory requirements regarding valuationprocesses or disclosures. Additionally, LPs should take care to review therelevant internalvaluationpolicies andprocedures thatmayhavebeencreatedby a particular private equity fund under review. These policies can oftenprovide useful insights during the operational due diligence process, as to aparticularprivateequityfirm'sapproachtowardvaluation.Despitetheirapparentdetail, suchpolicies often afford theGP significant discretion.Suchdiscretionmaybelimitedinpartbytheuseofthird-partyvaluationagents.However,LPsshouldtakecaretovetsuchrelationshipsanddeterminethescopeandextenttowhichsuchexternalvaluersareutilized.Valuationcanbeanopaquesubjectformany investors.Yet a comprehensive operational due diligence review shouldattempt to pull the curtain back and provide transparency of both process andactualvaluationpracticesemployedbyaprivateequityfirm.NOTES

1.GIPSisaregisteredtrademarkoftheCFAInstitute.2.CFAInstitute,GIPSGuidanceStatementonPrivateEquity,2010,www.gipsstandards.org/standards/guidance/develop/pdf/gs_private_equity_clean.pdf3.InternationalPrivateEquityandVentureCapitalValuationGuidelines,August2010Edition,www.privateequityvaluation.com/documents/International_PE_VC_Valuation_Guidelines_Sep_2009_Update_110130.pdf4.Ibid.5.SeeAliceLee,FinancialAnalysis,Planning,andForecasting:TheoryandApplication,SecondEdition(WorldScientificPublishingCo.Pte.Ltd.,2009).6.SummaryofStatementNo.157,www.fasb.org/st/summary/stsum157.shtml.7.FinancialAccountingStandardsBoard,“StatementofFinancialAccountingStandardsNo.157,FairValueMeasurements,”2008,www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820931833&blobheader=application%2Fpdf.8.NicholasDonato,“LPsStrugglewithFairValueAuditing,”PEManager,May3,2011,www.privateequitymanager.com/Article.aspx?article=60844&hashID=99B088427D9E0715489A2BDFC8FC6E546A548C90.9.JasonMendelson,“FAS157IsStupid,”VentureBeat,January15,2009.

CHAPTER6

LegalDueDiligence

Earlyoninthehistoryofprivateequity,investorsdidnotperformmuch,ifany,operationalduediligence. In recentyears, inpartdrivenby lossesdue topooroperations in funds and outright fraud in others, investors have begun torecognize the benefits of operational risk assessment in private equity funds.Thesemoments of enlightenment, whether driven by a true desire to actuallymakemoreinformedinvestmentdecisionsordrivenbyaoncebitten,twiceshyreactioncausedbybadexperienceswithpooroperational infrastructures in thepast, is a positive development for both private equity investors and fundmanagersalike.AsJusticeLouisBrandeisoncefamouslysaid,“Sunlightisthebestdisinfectant,”andwiththeincreasedtransparencythatisrequiredbyawell-developedandproperlyimplementedoperationalduediligenceprogram,privateequity investorswillhopefullymakebetter-informedoperationalchoiceswhenselectingaprivateequityfund.

OPERATIONALDUEDILIGENCESPECIALISTSVERSUSGENERALISTS

While increased acceptance of operational due diligence is commendable, itpresentsinvestorsandprivateequityallocators,suchasprivateequityfunds-of-fundsandconsultants,withaseriesofchallenges.Inadditiontocarryingouttheactual reviewandmonitoringworkentailed inaprivateequityoperationalduediligenceprogram,professionalallocators inparticularmustnowmakecertaindecisionsastothestructureandresourcestobeallocatedtowardoperationalduediligence.One decision that must be made in designing the structure of an investor's

operational due diligence function is the balance between specialization andgeneralization. Operational due diligence on private equity funds is amultidisciplinary exercise. This is a point worth repeating. To conduct athoroughassessmentoftheoperationalrisksofaprivateequityfund,aninvestor

needs to have the ability to employ analysis techniques from a myriad ofdifferent skill sets. These skill sets pull from a variety of different fields ofpracticeincludingthelaw,accounting,andinformationtechnology.Withineachof these broad categories of practice are a panoply of subcategories of relateddisciplines. Certainly, no single individual can be an expert in each of theseareas.This isparticularly truewhen it is taken into account that eachof theseareasisanevolvingfield.Thelawrelatedtoprivateequityfundsiscontinuallychanging, based on new court decisions and revisions to existing regulations.Similarly,newaccountingpronouncementsmayaffect theway inwhich fundsaccount for certain positions or the way information is presented in financialstatements.Informationtechnologyevolvesatwhatseemstobeanexponentiallyincreasing speed, particularly in the arena of alternative investments. Whendesigninganoperationalduediligenceprogram,aninvestormaythinkitbettertoplaninfavorofspecializationasopposedtoamoregeneralizedapproach.This intuitive response, however, may not be the best course that investors

couldtakeindesigninganoperationalduediligenceprogram.Let'sconsidertheexample of a specialist in the field of law.Of course, saying that a particularindividual is a specialist in a field as broad as the law is, in and of itself, ageneralization.Itisequivalenttosayingthatsomeoneisaspecialistinmedicine.Therearemyriadsubspecialtieswithinthefieldofmedicine.Ifyouhadabrokenleg you might not be inclined to go to a general internist but instead to aspecialistsuchasanorthopedist.Inthesameway,ifyouslippedandbrokeyourleginagrocerystoreyouwilllikelyneedacompletelydifferentattorneythanifyou are seeking assistance reviewing an offering memorandum of a privateequityfund.Assuch,selectinganappropriatespecialistwhoiscapabletoassistintheappropriatemannerisacrucialelementofanyspecializationprogram.While specialists may be a valuable asset in the operational due diligence

process,particularlyforinvestorswhomaynotpossessthecorecompetenciesina particular operational risk area, overspecialization can be detrimental to theoperational due diligence process. One reason for this is that when differentspecialistsareengaged,an informationsiloeffectmayresult. Informationsilosin the context of an operational due diligence review reflect a scenariowheredifferent specialists remain focused on their respective segments of theoperationalduediligencereview.Thedownsideoftheseinformationsilosisthatthere is typically a lack of communication among specialists. As such,information found in one operational risk segment that may be relevant toanother segmentmaynotbe sharedappropriatelyorbeconsidered inabroad-

enough context, making it difficult for an investor to connect all of theappropriateoperationaldotstofullyvetcertainlatentcross-sectionaloperationalriskfactors.Thischapterwill focusonkeyconsiderations investors shouldkeep inmind

whenevaluatingthelegalenvironmentinwhichaprivateequityfirmandfundoperates,aswellasreviewingcommonlegaldocuments.Thischapterwillalsoprovide an overview of trends in private equity fund legal documentation.Investorswhodonothavea legalbackgroundmayconsider leveragingoff thework of legal specialists, such as external legal counsel or operational duediligenceconsultantswhosestaffconsistsofindividualswithlegalbackgrounds,toassisttheminnavigatingthisfieldoftheoperationalduediligenceprocess.

COMMONPRIVATEEQUITYFUNDSTRUCTURES

Mostprivateequityfirmsareorganizedviaacombinationofpartnershipentities.AttheheadoftheseentitiesistypicallytheGeneralPartner(GP).TheGPisthemanagingpartnerofaprivateequitycompany.AsindicatedinChapter1,theGPisnot typicallyasingle individualbutrathera legalentity that isorganizedbytheprivateequityfirm'sprincipalstooverseethemanagementofaprivateequityfund.Sitting below the GP entity is the private equity fund itself. Private equity

funds are typically organized via a structure known as a Limited Partnership.Sittingbelowtheprivateequityentityitselfaretheportfoliocompaniesthatarethe investments held by the private equity fund. Feeding into a private equityfundareinvestorsinthefund.InvestorsinaprivateequityfundarecommonlyreferredtoasLimitedPartners(LPs).Thisnamecomesfromthefactthatmanyprivate equity funds are organized as limited partnerships and therefore theinvestorsthatsubscribe(i.e.,invest)inthosefundsareLPs.Exhibit6.1providesanoverviewofatypicalprivateequitylegalstructure.

EXHIBIT6.1DiagramofTypicalPrivateEquityLegalStructure

EXHIBIT6.2DiagramofTypicalPrivateEquityLegalStructurewithManager/InvestmentAdvisorLayer

Insomeinstances,aprivateequityfundwillhaveanintermediarylevelentityknownas theManageror InvestmentAdvisorbetween thegeneralpartnerandinvestors, which technically may serve as the manager of a particular privateequityfund.AnexampleofaprivateequitystructureincludingsuchanentityisoutlinedinExhibit6.2.

UNDERSTANDINGTHEPRIVATEPLACEMENTMEMORANDUM

Asprivate investmentvehicles,privateequitymaintainsaspecializedseriesofcommoncharterdocuments.Thesecharterdocumentsmayvary,contingentondifferentjurisdictionalregulatoryrequirements.Generally,thecharterdocumentsoutline a number of the material terms and risk factors associated with apotentialinvestmentintheprivateequity.Themostnotable,andgenerallymostdetailed,ofthesecharterdocumentsistheofferingmemorandum(OM).Thiscontrollingdocumentoutliningthemajorrisksandtermsofaparticular

fundisalsosometimesreferredtoastheprivateplacementmemorandum,whichis sometime referred to in abbreviated form as the PPMs. Regardless of themoniker employed, there are several key considerations that should be at theforefrontofanyinvestor'smindwhenapproachingareviewofthisdocument.Simplybecause theprivate equity fund is likely tobe themost information-

packedandlongestdocumentinvestorswilllikelyreviewduringtheoperationalduediligenceprocess, reviewing suchdocumentsdoesnot replace theneed toreadotherdocumentscollectedduringtheoperationalduediligenceprocess.Inbeginning to reviewtheprivateplacementmemorandum, investorsshould

beconsciousofwhatthekeyrolesofthisdocumentare.Forthepurposesofthistext we will refer to these key roles as the 3C's of private placementmemorandum:central,controlling,andcore.Eachoftheseconceptsisoutlinedinmoredetailinthesectionsthatfollow.

Central

PPMsAreDescribedbyManyOtherDueDiligenceDocumentsMany of the other documents that comprise the battery of documents thatinvestors should request, collect, and review during the private equityoperational due diligence process are descriptive documents. That is, theyattempttoboildownordigesttheoftencumbersomeanddisclaimer-riddenlegaljargonof thePPMintomoreinvestor-friendlynonlegalese.Agoodexampleofthis may be an already prepared descriptive due diligence questionnaireassembledbyaprivateequitymanager.Asiscommonplacetoday,manyoftheseduediligencequestionnaires(DDQs)willdetailthekeytermsofaprivateequityinvestment vehicle's offering. While the actual decisions about the setting oflevels for items such asmanagement fees resideswith the actualmanagementpersonnelofthefirmitself,suchdecisionsarefirstmemorializedinaparticularprivateofferinginvestmentvehiclesofferingmemorandum.

IncorporationbyReferenceAnother example of the central role played by the private placementmemorandumintheoperationalduediligenceprocessisthewayinwhichmanyother documents will not only describe the offering memorandum but alsoincorporatethedocumentbyreference.Toclarify,“incorporationbyreference”occurswhenthedocumentaninvestorisreadingataparticulartime,suchasanauditedfinancialstatement, refers toaseconddocument. Inanoperationalduediligence context, the onus is effectively on the investor reading the firstdocument (e.g., the audited financial statements) to pause midsentence andreviewtheotherreferenced(e.g.,second)document.As thisdescriptionof theprocessmayhave intimated, thiscanbesomewhat

cumbersome and confusing. This is particularly the case when an investor isperformingoperationalduediligenceonafirmorparticularprivateequityfundwithwhichtheyarejuststartingtogainfamiliarityduringtheinitialstagesofthedue diligence process. Further complicating the issues and adding additionalroadblockstotheprocessiswhen,continuingourexample,thedocumentbeingreferenced itself will reference yet another document. Even worse, from aninvestor's operational due diligence perspective, is the situation where thereferenceddocumentdoesnotevenattempt to incorporateotherdocumentsbyreferencebutsimplycontainsageneraldisclaimerorcouchinglanguagethat,asmay be the case for private placement memoranda, effectively states that thedocumentbeingreviewedisnotacompletestatementofallofthetermsoftheprivateplacementmemorandumandtheinvestorshouldconsulttheinvestmentmanagement firm. It may even contain a passing reference or halfheartedrecommendation that an investor should refer to yet other documents (and insomecasesmaynotevenprovideanenumeratedlistofthoseotherdocuments).This incorporation by reference approach, while it may possess strong legalfootingandasoundtheoreticalbackingandpotentiallypreventsthecombinationof all legal documentation into a single voluminous omnibus document, alsocreatesadifficultterrainthatinvestorsmustbeequippedtonavigatewhenfirstconsidering how to approach private placement memorandum analysis in thecontextofthebroaderoperationalduediligenceprocess.

ControllingIn the law, thereare tworelatedconcepts thatarerelevant toourdiscussionofprivate placement memorandum, particularly when considered from theperspective of an investor seeking to balance the operational due diligenceprocesswithaprivateequityfirm'sdesiretoraisecapitalviamarketingefforts.Thefirstsuchconceptisknownasparoleevidence.Paroleiscommonlyutilizedas an adjective interpreted to mean “oral.”1 The parole evidence rule is acommon law principle that outlines that a party is generally prohibited fromintroducingexternaloralevidencethatsupplementsorcontradictsacontract.Forthepurposesofthisdiscussion,thePPMcanbethoughtofasthelegalcontractenteredintobetweentheinvestorandtheprivateequityfund.Inthiscontext,thePPMcan be viewed as controlling because any other statements ormarketingpufferydonotgenerallycontrol. If adisputearises, theofferingmemorandumwill be the primary document thatmay be looked at by courts. This is not toimplythatotherdocumentsmaynotcomeintoplay;however,certainlythePPMofafundwillbecrucial.A second related concept is the so-called four corners rule. This states that

when ambiguity is present in a contract, or PPM for the purposes of ourdiscussion, the interpretation of such ambiguity should be determined only bylooking to the document itself.2 The term four corners refers to a nondigitaldocument(i.e.,arectangularpieceofpaper)thatcontainsfourcorners.Thepointof this rule, which sometimes may produce admittedly harsh results ininterpreting document ambiguity, is that the document itself is the controllingfactorandextrinsicevidenceshouldnotbeconsidered.

CoreFor the reasons justdescribed, theprivateplacementmemorandumisarguablyone of the most important documents that should be collected during theoperational due diligence process and is one of a core cadre of documentsaroundwhich the rest of the document collection and review should be built.Understandingtheimportanceofthecorenatureofthisdocumentiscrucialforinvestorstoacknowledgeduringtheoperationalduediligenceprocess.

OnshoreversusOffshoreConsiderationsThematerialtermsofmostcharterdocumentsforoffshoreandonshorevehiclesareoftentimesanalogous.Foronshorevehicles,theOMissometimesreferredtoas anoffering circular, and as aprivate placementmemorandum for offshorevehicles. Due to the structures of onshore and offshore entities, there will bedifferences with regard to the nature of disclosures between onshore andoffshoreOMs.Forexample,anoffshoreOMwilltypicallycontaininformationregarding the vehicle's board of directors,whichwould not be applicable, andthereforenotcontained,intheonshoreOM.

PrivatePlacementMemorandumReviewProcessAsnotedearlier,aprivateequityfund'sinterestsareofferedtolimitedinvestorssubjecttocertaintermsandconditions.ThePPMdescribesthesebasictermsandconditions.ItemsdescribedinthePPMincludeaprivateequityvehicle'stradingstrategies,andprovidesdescriptionsofthefund'smanagementteam.Inadditiontothebasicdescriptivefunctionsservedbythisdocument,theprimarypurposeof the OM is to detail a series of disclosures to potential investors. Thesedisclosures include the terms of the shares in the private equity vehicle, taxaspects, information about third-party service providers utilized by the privateequityvehicle,andsubscriptionandredemptionterms.

COMMONDOCUMENTRISKASSIGNMENTTERMS

Regardlessof the specificdomicileof eachprivate equityvehicle, such as thedistinctionbetweenonshoreoroffshore,privateequityOMsgenerallycontainaseries of standard risk assignment terms. Examples of these common riskassignment terms include which entities will be responsible for investmentmaking decision authority, which entities will be responsible for day-to-daymanagementofthefund,anykeypersonclauses,andtherolestobeplayedbyservice providers as opposed to the fund vehicle itself.3 It is important for thereader to understand the potential interaction of these other risk assignmentterms with these indemnity and exculpatory clauses. The interaction of suchclauses within the total framework of the investment and operational duediligence process can have marked impact on the total risk assessment of aprivateequitymanagerand,ataminimum,shouldbeconsideredaspartofanybest practice due diligence process.4 Two such common document riskassignmenttermsrelatetotheconceptsofexculpationandindemnity.

EXCULPATIONANDINDEMNITYEachriskassignmentterm,aswellasahostofotherintricaciescontainedinanoffering memorandum, is replete with its own unique considerations andintricacies.Investorsdonotnecessarilyneedtobefamiliarwiththefullscopeoflegal intricacies related to each term or risk assignment in the offeringmemorandum. However, when reviewing such terms investors would be welladvised to look below the surface. A full understanding of certain issues isnecessary in order to determine which items are relevant and which may beignored or given less importance. Oftentimes a specialized practitioner in aparticular field, such as accounting or the law, will possess more detailedknowledgeinthisregard.Asoutlinedearlier,suchspecializationcanaddvaluebut investors must not sacrifice overspecialization for a lack of continuity ofoperationalriskfactoridentificationthroughoutaparticularreview.Inordertointroducethereadertothelevelofdetailwithwhichcertainitems

may be considered, we will proceed with a detailed review of the terms ofexculpationand indemnity.While theseconceptsofexculpationand indemnityare just two of the common risk assignment terms contained in the offeringmemorandumof a private equity fund, this examplewill provide readerswiththe typeofdetailedunderstandinga specialistmaypossess.Furthermore, suchanunderstandingcanalsobeusefulforinvestorsseekingtorecoverfromlossesin the event of a fund failure. Finally,wewill provide an overview of trendsbasedontheresearchofCorgentumConsulting.

DefinitionsandHistoryofExculpationandIndemnification

The terms indemnity and exculpatory have a long history of uses in manycontexts outside of both private equity and securities law in general. Theconcepts of indemnity and exculpation have their roots in insurance law.5Examplesofearlyusesof thesetermsincludeadiverseseriesofareasrangingfrom the development of Saxon law to maritime law and twentieth-centuryconstruction contracts.6 Before beginning our analysis of exculpatory andindemnity clauses in a private equity context, it is useful to first develop anunderstandingoftheusesofsuchclausesinabroadercontext.Inaninvestmentcontext,theusesofindemnityandexculpatoryclausesinmodernprivateequity

OMsdrawmanysimilaritiestousesinmutualfundprospectuses,particularlyinoffshorejurisdictions.7

While concepts of indemnity and exculpation are both principally related totheassignmentofliability,differencesarepresentwithregardtothenatureandusesofsuchclauses.Black'sLawDictionarydefinesthetermexculpateas,“tofreefromblameoraccusation.”Anexculpatoryclause,initsmostgenericsense,is a contractual provision that relieves a party from liability resulting from anegligentorwrongfulact.8Exculpatoryclauseshavealonghistoryofuseintrustandestatelaw.While exculpatory clauses provide relief from liabilities, the core focus of

indemnity provisions is to provide compensation for damages.9 Black's LawDictionarydefinesindemnificationas“adutytomakegoodanyloss,damage,orliabilityincurredbyanother.”10Inordertoclarifythemeaningofindemnificationit is useful to analyze the nature of the “duty” described in the Black's Lawdefinition.The“duty”orobligationtoindemnifyisavoluntaryobligation.11Thefactthatthisobligationisvoluntarydiffersfromalegalobligationtocompensatethatmay arise. Somewhat clarifying the voluntary nature of this obligation isthatanindemnityclauseisfurtherdefinedas“acontractualprovisioninwhichonepartyagreestoanswerforanyspecifiedorunspecifiedliabilityorharmthattheotherpartymightincur.”12Areviewofthecaselaw,discussedinmoredetaillater, will demonstrate how knowledge and the voluntary nature of funddirector'sindemnityprovisions,playsakeyroleinliabilityapportionment.

UsesofIndemnityandExculpatoryClausesinPrivateEquityOfferingMemoranda

In private equity, OMs indemnity and exculpatory clauses may serve severalpurposes. First, these terms serve a risk assignment function by outlining thenatureandscopeatwhichthefundvehicleitselfwillbeindemnifiedandwillberesponsibleforexculpatoryrelief.Second,theriskassignmenttermsoftheOMoftenoutlinetheresponsibilityofnotonlythefunditselfbutalsorelatedentitiessuchastheGeneralPartnerortheInvestmentManager.Inadditiontoaffiliatedentities,theseclausescanalsoprovideguidanceregardinganyliabilitybetweenthefunditselfandserviceproviderssuchasthefund'sadministrator.Withregardto the fund administrator, it should be noted that indemnity and exculpatoryterms are typically first outlined in the services agreement signedbetween theprivateequityvehicleandtheadministrator.Afundadministratorisafirmthatis

typically responsible forprocessing investor's subscriptions and for calculatingthe value of the investor's holdings. A summary of the indemnity andexculpatory provisions of the fund administration agreement is then typicallyprovidedintheprivateequityOM.

ApproachestoIndemnityinPrivateEquityOfferingMemoranda

Private equity PPM's indemnity clauses can be classified into two primarycategories based on the entities involved. The first series of indemnificationprovisions focus on what can be described as “internal” indemnificationprovisions.Beforeanalyzing internal indemnityclauses,wemustoutlinesomeofthecommonentitiesdescribedin thePPM.ThethreemostcommonentitiesarethosepreviouslymentionedinthischapterandoutlinedinExhibit6.3.

EXHIBIT6.3CommonPrivateEquityPrivatePlacementMemorandumEntitiesEntityName

EntityExplanation Notes

Partnership ThePartnershipiscommonlyreferredtoastheonshorefund

Thisisgenerallyequivalenttothe“Fund”inoffshorevehicles

Generalpartner

Typicallyalimitedliabilitycompany(LLC)whichhasoverallresponsibilityforthemanagement,operationsandinvestmentdecisionsmadeonbehalfofthePartnership.

None

Managementcompany

Typicallyalimitedpartnership(LP)thatprovidesvariousmanagementservicestothePartnership.

Thissameentityalsocommonlyperformsthedutiesofanentitycommonlyknownasan“InvestmentManager”inoffshoredocuments.

These“internal”provisionsfocusonindemnificationamongvariousaffiliatedentitiesandindividualsassociated,eitherdirectlyor indirectly,withtheprivateequity fund. A typical internal private equity OM provision typically outlinesthat the Partnership will indemnify the General Partner, the ManagementCompany, their respective affiliates, and the respective members, partners,shareholders,officers,directors, employees, agents, and representatives thereofforliabilitiesincurredinconnectionwiththeaffairsofthePartnership.Thesecondseriesofindemnificationprovisionscanbedescribedas“external”

indemnification provisions. These external provisions focus primarily on therelationshipbetweenaprivateequityinvestmentvehicleandaserviceprovider,such as an administrator. In these external indemnification provisions, theadministration agreement typically outlines that the administrator will not beliabletothePartnershiporitsLPsandwillbeindemnifiedatacertainexemptionstandardoutlinedinmoredetaillater.

FocusofExculpationClausesinPrivateEquityOfferingMemoranda

Unlike indemnity clauses, exculpatory clauses in private equity OMs aregenerally completely internal in their focus. That is to say, exculpationprovisions tend to focus solely on the relationship between affiliated privateequityentitiesandpersonsratherthanbetweentheprivateequityandthird-partyservice providers. A typical exculpatory clause will generally provide thatneithertheGeneralPartnernoritsaffiliatesshallbeliableforcostsandexpensesfrommistakes of judgment or any action or inaction that a person reasonablybelieves to be in the best interest of the Partnership. These provisions alsotypicallygoontooutlinethattheGeneralPartnerwillnotbeliabletoanylossesdue to suchmistakes, action, or inaction aswell as costs, expenses, or lossesexceptforthoseabovecertainminimumexemptions.

ProhibitionsagainstBroad“HedgeClauses”Ahedgeclause isa typeofdisclaimer thatattempts toabsolve thewriter fromthe responsibility for any accuracy of information obtained from otherwisereliablesources.13Effectively,ahedgeclauseindicatesthatthewriterbelievestheinformation to be accurate and that reasonable care has been used to ensureaccuracy, but if it is not accurate thewritermade a reasonable effort so theyshould not be held accountable.14 These clauses are typically seen in marketletters, security research reports, or other printed matter having to do withevaluating investments. Such hedge clauses may also be contained in privateequityOMsor investmentadvisoryagreementswithclients.Theseclausescanbecombinedwithotherindemnityorexculpatoryprovisionsorstandalonehedgeclauses.IntheUnitedStates,wecanbeginouranalysisofhedgeclausesatthefederal

level.ThefocusofafederalreviewofhedgeclausesisguidedinlargepartbythetestoutlinedintheSecuritiesandExchangeCommissionReleaseNo.40-58,which states that, “the antifraud provisions of the Securities and ExchangeCommission statutes are violated by the employment of any legend, hedgeclause,orotherprovisionwhich is likely to leadan investor tobelieve thathehasinanywaywaivedanyrightofactionhemayhave…”15

From a federal regulatory perspective, supported by a series of repeatedholdingsseparatefromSECstatutes,ithasbeenshownthathedgeclauseshave

little, if any, legal effect as a protection from liability arising frommisstatements.16 This comports with similar notions from non-U.S. case law,whichoutlinesthatanyexculpatoryorindemnityclausewillbeineffectiveinthepresence of knowing dishonest or reckless disregard of duty where fraud ispresent.SomefurtherguidanceonthisissuecomesfromtheHeitmanSECNo-ActionLetter.17

At issue inHeitmanwaswhether theuseofhedgeclausesand relatedclientindemnificationdisclosure in investment advisoryagreementsconstitutes fraudunder Sections 206(1) and 206(2) of the Investment Advisers Act of 1940(AdvisersAct).18WhiletheSECdidnotoutlineabright-lineprohibitionagainsthedge clauses in its response to Heitman, the letter effectively stated that thedetermination as to whether a particular hedge clause was in violation of the1940 Act was contingent upon the specific facts and circumstances. TheHeitman letter further outlined several criteria that could be used to aid inmaking this determination, including the form and content of the particularhedge clause (e.g., its accuracy), any oral orwritten communications betweenthe investment adviser and the client about the hedge clause, and thesophisticationofeachclient.In the United States, in addition to registration with potential required

registrationwithfederalsecuritiesregulators,suchastheSEC,NationalFuturesAssociation, and the Commodity Futures Trading Commission, investmentadvisorsmayneedtoregisterwithinparticularstatesaswell.Dependingontheparticular laws of each state, certain states may have more or less rigorousrequirementsandrulesregardinginvestmentadvisors.Withregardtoalternativeinvestment advisors in different states, based potentially on a deeperunderstandingandfocusonalternativeinvestments,statesthathavebeenfoundto be particularly knowledgeable about private equity includeColorado,Utah,California,andWashington.19

Oneareaoffocusat thestate levelhasbeenrestrictionson theuseofhedgeclauses,particularlyregulatingthewaysinwhichprivateequitymanagershavesoughttolimittheliabilityofpartnersandmembers,particularlythoseorganizedas partnerships or limited liability companies. In Washington, for example,severallimitationsexistregardingtheuseofhedgeclauses.20

These restrictions include that a hedge clausemay not provide that a clientwaivescompliancewithstateorfederalsecurities laws,aswellasprohibitionsagainst overly broad hedge clauses.21 Furthermore, a broadly draftedindemnificationprovisionmaybedeemedtobeimpermissibleinWashington.22

Otherstatesmaintainsimilarprohibitionsagainsttheuseofoverlybroadhedgeclauses.Forexample,theConnecticutDepartmentofBankinghasoutlinedthatthe antifraud provisions of the Connecticut Uniform Securities Act may betriggeredbyoverlybroadhedgeclauses.23

ExceptionstoExculpatoryandIndemnityClausesExculpatory and indemnity clauses in private equity and OMs often containlanguage that serves to create exemptions to these clauses. In general, fivestandardexemptionstosuchtermsaretypicallyraisedasdefensesbyinvestmentmanagers,serviceproviders,andfunddirectorsonceafundfailureorsubstantiallossoccurs.Thesefivemostcommonlyraisedexceptionsareactualfraud,fraud,willfulfraud,willfuldefault,andgrossnegligence.24Wecanbeginouranalysisofthisexemptionbystartingwithagroupingoffraud-relatedexemptions.

ActualFraud,Fraud,WillfulFraud,andWillfulDefault

Black's Law Dictionary defines actual fraud as “A concealment of falserepresentationthroughastatementorconductthatinjuresanotherwhoreliesonit inacting.”25Other termsused to representactual fraud include fraud in fact,positive fraud, and moral fraud. Seeming to focus on the morality aspectassociated with actual fraud, other sources define actual fraud as involvingelementsofpersonaldishonestyandrecklessdisregardforduty.Most of the case law surrounding questions of actual fraud focuses on the

honesty and intentions of the parties. In the arena of investmentmanagement,issues of actual fraud and fraud have been primarily litigated in jurisdictionseitherdirectlybasedupon,orwithstrongrootsin,BritishLaw.Oneofthemostlitigated issues in this context surrounds the relationship between accessoryliability and both actual fraud and fraud. Regarding the question of theassignmentofliability,thepertinentseriesofcasesthatwillbefocusedonrelatetothecontextofeitheratrustorfiduciaryrelationship.Intheseseriesofcases,thegeneralfactpatterninvolvesseveralcommonelements:

Theperpetrationoffraudoractualfraud.Anassignmentofagencyorarequirementofoversightbyathird-party,suchasafunddirector,whoisnotthedirectperpetratorofthefraud.Agenuine lackofknowledge,or recklessdisregard,of the fraudulent

actionsoftheperpetrator.Alossoffundsasaresultofthefraud.

AccessoryLiabilityandDishonestyThe central question courts have been posed with based on the previouslydescribedgeneralfactpatternofoccurrencesistoopineastotheculpability,ifany, of these agents or third parties. One such leading case, Royal BruneiAirlinesSdn.Bhd.v.Tan,wasdecidedbythePrivyCouncilcourtoftheAsianState ofBruneiDarussalam.26 InRoyal Brunei the court addressed accompliceliability for third parties in relation to fraud. The court held that in a case ofactualfraud,dishonestyisrequiredforaccessoryliabilityinbreachoftrustforafiduciary.27Inthiscase,thecourtfurtheroutlinedthatthetestforhonestyshouldbeobjectiveratherthansubjective.Paraphrasingthecourt,RoyalBruneioutlinesanobjective testofhonesty thateffectivelyboilsdownaquestionof,knowingwhattheyknew,wouldanhonestpersonhavedonewhattheydid?Toutilizethistest,however,itfirstrequiresaworkingdefinitionofhonesty,whichinamoralframework may be inherently subjective. The Royal Brunei court offers thefollowingguidanceinthisregard:Inmostsituations,thereislittledifficultyinidentifyinghowanhonestpersonwould behave. Honest people do not intentionally deceive others to theirdetriment.Honestpeopledonotknowinglytakeothers’property.Unlessthereisaverygoodandcompellingreason,anhonestpersondoesnotparticipateinatransactionifheknowsitinvolvesamisapplicationoftrustassetstothedetriment of the beneficiary. Nor does an honest person in such a casedeliberatelyclosehiseyesandears,ordeliberatelynotaskquestions,lesthelearnsomethinghewouldrathernotknowandthenproceedregardless.FollowingtheRoyalBruneidecision,theuniformapplicationoftheobjective

testofhonestyhadbeencalledintoquestioninlieuofasubjectivehybridtest.28More recent interpretations suggest that the courts have reaffirmed theapplicationoftheobjectivetesttowarddishonesty.29

KnowledgeRequirementsTurningaway from tests that focused solelyon thehonesty requirement,othercaseshavefocusedonthedegreeandtypeofknowledgeheldbytheindividualinrelationtothefraud.AnexampleofonesuchleadingcaseisBadenv.SocieteGenerale.30Badenoutlinedfivecategoriesofknowledgeafunddirectororotheraffiliated individualmaypossess inrelation toafraud.Theyinclude(1)actualknowledge; (2) willfully shutting one's eyes to the obvious; (3) willfully andrecklesslyfailingtomakeinquiriesthatanhonestpersonwouldhavemade;(4)knowledge of circumstances that would indicate the facts to an honest andreasonableman;and (5)knowledgeofcircumstances thatwouldputanhonestandreasonablemanoninquiry.31 It isworthrecognizing,however, that thefivecategoriesofknowledgeoutlined inBaden incorporated the idea that apersonwouldbedeemedtohaveknowledgeiftheyfailedtomakeanyinquiriessubjecttoanhonestandreasonablepersonstandard.32

DirectorLiabilityandDishonestyExpanding on the inaction element of the knowledge requirement in Baden,courts have also focused on the relationship between honesty, knowledge, andproactivefunddirectoraction.33OneleadingcaseinthisareaisBarlowClowesInternationalLtd(InLiquidation)v.EurotrustInternationalLimited.34InBarlow,the fund directorswere found liable, despite indemnity provisions, because oftheir payments to the fund, even though the payments were made with notdishonestintentions.35ThecourtinBarlowfurtherheldthatitwasnotnecessaryfor the directors to know or understand the precise involvement of differentindividualsinthefraudulentactivity.36

GrossNegligenceShifting focus away fromhonesty andknowledge requirements of directors inrelationtofraud,othercaseshavefocusedontherolesofinvestorswhoinvestedin mismanaged investment programs, which subsequently ended up ininsolvency. One such recent leading case is San Diego v. Amaranth.37 In SanDiego the San Diego County Employee's Retirement Association (SDCERA)alleged that by mounting up fund losses in excess of $6 billion, the fundrecklessly ignored riskmanagementcontrolsand liedabout tradingstrategies.38SDCERAalsoassertedclaimsforgrossnegligence,breachoffiduciaryduty,andbreachofcontract.39Thecourt,inrulinginfavorofAmaranth,concludedthattheOM and subscription agreement provided to SDCERA outlined the risksassociatedwiththefundandthat,coupledwiththeindemnityprovisionsintheOM as well as the fact that SDCERAwas a sophisticated investor, insulatedAmaranth. This ruling illustrates an example where the negligence indemnityexemptions outlined in the OM provided a firm and directors with protectiondespite both alleged inaction (e.g., poormanagement oversight) and proactiveactions(e.g.,lyingabouttradingstrategies).

OtherExemptionsInaddition to the five standard indemnityandexculpatoryexemptions,privateequityOMsmaycontainanumberofotherexemptions.Theseexemptionswillbeoutlined inmoredetail in theempirical analysis section. It shouldbenotedthat these other exemptions may either be used in conjunction with the fivestandardexemptionsorindependently.SomeoftheothergeneralexemptionsaswellastheirdefinitionsareoutlinedinExhibit6.4.

EXHIBIT6.4OtherGeneralIndemnityandExculpatoryExemptionsOtherExemptionTerm

OtherVariationsandRelatedTerms

Definition

Malfeasance Willfulmalfeasance,misfeasance

Awrongfulorunlawfulact

Negligence Willfulnegligence Thefailuretoexercisethestandardofcarethatareasonablyprudentpersonwouldhaveexercisedinasimilarsituation

Badfaith N/A Dishonestofbelieforpurpose

Misconduct N/A Aderelictionofduty;unlawfulorimproperbehavior

ItshouldalsobenotedthatotherexemptiontermsnotincludedinExhibit6.4butalsofoundinprivateequityOMsincludedishonestyandmisfeasance.

LiabilityReleasesCourtsinmultiplejurisdictionshavereliedonprecedentrelatingtotheroleandliabilityoftraditionalcorporatedirectorlawstodecidecasesinwhichdirectorsserve on the boards of alternative investment management companies andfunds.40 There is a long history of case law from multiple jurisdictions thatdemonstrates that directors of a corporation may be exposed to liabilitiesresulting from corporate losses.41 Many jurisdictions historically provided forreleases from liability for investment fund directors. These liability releasesoften came in the formof indemnity and exculpatory clauses in fund offeringdocuments.Intheearly1900scourtsinmanyjurisdictionsupheldsuchdirectorreleasesofliability.42

In this context, one of the central questions that has arisen in regulatoryframeworks and litigation is whether directors maintain a responsibility toengage in proactive monitoring and supervision of the corporation.43 In theUnited Kingdom, for example, Section 205 of the Companies Act of 1948,whichhassincebeenrecodifiedinSection232oftheCompaniesLaw2006,hasimplicationsdesignedto,ataminimum,keepdirectorsontheir toesduetothethreatofprohibitionsagainsttotalreleasesfromliability.44IntheUnitedStates,aseriesof shareholderderivativeactions resulting fromconvictionsofcorporatewrongdoingprovidesguidanceinthisarea.Relevanttothisdiscussion,oneofthefirstsuchlandmarkcaseswasheardbytheDelawareSupremeCourtin1963.ThecasewasGrahamv.Allis-ChalmersMfg.Co.45InGraham,thecourtrejectedthe notion that directors maintained an obligation to implement a so-calledsystem of watchfulness to ferret out wrongdoing. The court clarified thatcorporate directors were affirmatively entitled to rely on the honesty andintegrityoftheirsubordinatesabsentanysuspicionstheymayhaveotherwise.46TheGraham court clarified that under such a situation liability would onlypotentially occur if a director had such a suspicion and took no action. Thispronouncementbythecourtcametobeknownasa“redflag”testunderwhichdirectorscouldassumethatallwaswellunlesstheycameacrossaredflag.In analyzing the liability assignment implications of indemnity and

exculpatory clauses, it is important to consider these clauses not in isolation,eitherindividuallyorasabundledgroup,butratherinthecontextofotherlegaldoctrines that address liability assignment. Such analysis is supported by thecaselawinthisarea,ascourtspresentedwithnumerousliabilityissueshavehad

toaddresstheminthecontextofmultiplelegaldoctrines.Inparticular,onesuchexample of this is the application of the ultra vires doctrine toward directorliability.Ultravires isdefinedasbeyond thescopeofpowerallowedorgrantedbya

corporate charter or law.47 A leading recent case in this area decided by theappealscourtofJerseyintheChannelIslandsisViscountoftheRoyalCourtofJersey v. Shelton. In Shelton, the court outlined that in the absence of ajurisdictional provision, which would render a particular indemnificationprovision void, such a clause in a company's articles of incorporation wouldallowadirectortoescapemostliabilityfromlosses,assumingthat thedirectordidnotactwithdishonesty.48Sheltonalsooutlinesasituationwhereanindemnityclause was present without an exculpatory clause. The court held that, via aprincipalofcircularityofaction,theindemnityclauseitselfwillhavetheeffectof an exculpatory clause because there is no cause of action against a partywhomapersonisliabletoindemnifyinrespectforthesamematter.

InPariDelictoandtheWagonerDoctrineinFraudDefenses

In cases involving instances of fraud, in which investors in private equitytypicallysufferlosses,thefraudisnotgenerallyuncovereduntilafterthelosseshaveoccurredtosomedegree.49Whenlitigationfollows,oftenquestionsariseastowhobearsresponsibilityforthefraud.Additionally,asthelossesmayexceedtheremainingassetsofthefirm,indemnityandexculpatoryprinciplesoftenarelitigatedinabankruptcycontext.Recentlysuchscenarioshavecometofruitionduring the global economic crisis of 2009 both in private equity and othercorporatecontexts.50

Theinparidelictodoctrinecanbedefinedastheprinciplethataplaintiffwhohas participated in wrongdoing may not recover damages resulting from thewrongdoing.51 In bankruptcy proceedings in caseswhere a fraud has occurred,the in pari delicto doctrine is often used as a defense to insulate serviceproviders,management,orfunddirectorsfromliabilitybyimputingliabilitytoboth the corporation and any individual actors.52 Some critics have raised theargumentthatthisimputationofequalfaultandsubsequentescapingofliabilityrelies on misapplication of the in pari delicto doctrine in conjunction withtraditionalagencyprincipals.53

The in pari delicto doctrine is often not utilized in isolation as a defense to

fraud imputation to service providers and directors.A common legal principlethat factors into a court's analysis and application of these fraud defensesincludes theWagoner doctrine.TheWagoner doctrineoriginates from the ruleoutlinedbytheSecondCircuitinShearsonLehmanHuttonInc.v.Wagonerthat“aclaimagainstathirdpartyfordefraudingacorporationwiththecooperationof management accrues to creditors, not the guilty corporation.”54 In certaininstances, the in pari delicto doctrine is referenced interchangeably with theWagonerdoctrine.However,othersourcesdrawdistinctionsbetween the two.55ThereisadivergenceofopinionamongdifferentUnitedStatescircuitcourtsastotheinterpretationofbothinparidelictoandtheWagonerdoctrines.ArecentrulingbytheUnitedStatesCourtofAppealsfortheEightCircuithascalledintoquestion certain aspects of the Second Circuit's original interpretation inWagoner.56 Such interpretations, however,may still give rise to in pari delictodefenses.Alsofactoringintotheuseofthesedoctrinesasdefenses,areanumberof exemptions including the “innocent insider” doctrine and the “adverseinterest”exemption.AsarecentNewYorkSupremeCourtdecisioninBullmorev.Ernst&Young

Cayman Islands, fund directors may not be able to rely on indemnity andexculpatory clauses to provide protection from claims arguing imputation offraud to them in bankruptcy contexts where in pari delicto and theWagonerdoctrinecomeintoplay.57AsBullmoredemonstratesindemnityandexculpatoryprovisionsmayrelynotonlyontheactiveorinactivenatureofafunddirector,but also on the nature of any communication between the fund's serviceprovidersandthedirectors.

TRENDSININDEMNIFICATIONANDEXCULPATIONCLAUSES

Nowthatwehaveestablishedanunderstandingof thebasicusesandstandardexceptionstotheexculpatoryandindemnityclausesinprivateequityandprivateequity offering memoranda, we can next review the results of a CorgentumConsulting study of a proprietary data set of these private equity offeringmemorandum. The purpose of this analysis is to facilitate a clearerunderstandingoftrendsinthedraftingofprivateequityofferingmemoranda.

PredataAnalysisHypothesesBeforeananalysisoftheCorgentumConsultingdatasetwasperformed,basedon professional experience performing operational due diligence reviews ofprivateequity,threedistincthypotheseswereinplace.First,itwaspredictedthata certain minimum level of standard risk inclusion and exception languagewouldbepresentamongtheOMsincludedin thedataset.Furthermore,abovethisminimumbaselinestandarditwaspredictedthatsignificantdiversitywouldemergeinregardto the typeandnatureofexceptions included.Second, itwaspredicted that a private equity vehicle's investment strategy would have nomaterialeffectondraftingtrendsinexceptionlanguageforbothindemnityandexculpatoryclauses.Finally,thethirdhypothesisthatwaspresentinthepredataanalysisstagewasthatexceptiondraftingtrendsforindemnityandexculpatoryclauseswouldbe influencedmoreby theprimary legalcounselutilizedby theprivate equity fund, andwhichmayhave drafted theOMas opposed to otherjurisdictionalconcernssuchasfunddomicile.

OverviewofDataSet

JurisdictionalConsiderationsofPrivateEquitiesIncludedinThisStudyNodomicileorjurisdictionalrestrictionswereinplaceforaprivateequityfundtobeincludedinthedataset.Agloballydiversecross-sectionofprivateequitywas included in this study as there were not any domiciles or jurisdictionalrestrictions.Thetwomostpopular jurisdictionsof incorporationfor theprivateequity vehicles included in this study were Delaware (United States), at 37percentforonshorevehicles,andtheCaymanIslands,at22percentforoffshorevehicles.Exhibit6.5showsasummaryof the jurisdictionsof incorporationfortheprivateequityvehiclesincludedinthisstudy.

EXHIBIT6.5DetailofPrivateEquityVehicleIncorporationJurisdictionsIncludedintheDataSetJurisdictionofIncorporation PercentofManagersIncludedintheDataSet

Delaware(UnitedStates) 37%

CaymanIslands 22%

Bahamas 19%

Guernsey 1%

IsleofMan 3%

Jersey 4%

BritishVirginIslands 14%

MultipleVersionsofOfferingMemorandaIn the course of the life cycle of private equity investment vehicles, multipleiterations of offeringmemorandum for the same vehicle at different points intime may be generated. Generally, subsequent iterations of a particularinvestmentvehicle'sofferingmemorandumaredrafted to reflectchanges inaninvestment vehicle's legal structure, offering terms, fees charged, or moregenerally to reflect global changes within an organization. Indeed, during thecourse of this study, 34 percent of the data set of offeringmemoranda had atleastoneinstanceofpriorissuanceataprevioustimeperiod.Insuchcases,themostcurrentversionofsuchofferingmemorandainthedatasetwasanalyzed.

PariPassuInvestmentVehiclesThe data set of private equity vehicle OMs utilized in this study containedapproximately 61 percentOMs thatweremanagedparipassu. To clarify, thiswouldbeapairofOMs,oneofwhichwasfor theonshoreOMprivateequityvehicleandonefortheoffshorevehicle.

LegalEntitiesandStructuresAsreferencedearlier, thesetofofferingmemorandautilized for thisempiricalanalysis included private equity vehicles organized under a wide variety ofcorporatestructuresincludinglimitedliabilitycorporations,limitedpartnerships,andunit trusts.Furthermore, theprivateequityvehicles that comprise thedatasetwerefurtherorganizedaseitherstandaloneindividualfundsoralternativelyunder a wide variety of multifund structures, including iterations of master-feederstructures.Exhibit6.6providesasummaryof the legalentities includedinthedataset.

EXHIBIT6.6DetailofLegalEntitiesofPrivateEquityVehiclesIncludedintheDataSetLegalEntityandStructureTypes PercentofManagersIncludedintheDataSet

LimitedLiabilityCorporation 48%

LimitedPartnership 38%

UnitTrust 11%

Others* 3%*Othersrefertoprivateequityvehiclesthatemployedlegalentityandstructuretypesthatwerestrategiesnotincludedintheabovecategories.Examplesofsuchstructureswouldbeso-calledexemptedcorporationsunderdifferentjurisdictionalregimes.

LanguageOmissionandMultipleDocumentRevisionsoverTimeDuring the course of the analysis of the offering memoranda of the fundsincludedinthisstudy,onetrendthatemergedwasthephenomenonoflanguageomissions. Language omission refers to instances where language in the OMconcerning one of the particular factors analyzed in this study was omittedentirely fromaprivate equity investmentvehicles’particularOM.Comportingwith notions of drafting consistency, among similarly managed private equityinvestment vehicles managed by the same private equity managementorganization, such language omissions were universally consistent amongdocuments drafted at or about the same time periodwhen comparing onshoreandoffshorevehicles.Approximately3percentoftheOMvehiclesincludedinthe data set represented some characteristics of language omission. Tocompensate for these, exogenous sources—outside of the offeringmemorandums themselves—were utilized to replace the omitted language. It

shouldbenotedthatinallcasesfortheOMsincludedinthedataset,indemnityandexculpatoryprovisionswereincluded.Dispersion in the consistencyof languageomission tended to increasewhen

the onshore and the offshore vehicle of a private equity investment vehicleoffering memoranda were drafted at different time periods. In these multipleversions cases, as outlined earlier, the most recent version of the OM wasselected.Surprisingly,suchdispersiontendedtooccurregardlessofwhetherthesame legal counsel that had drafted the original document also completed thesubsequentdocumentupdate,oranotherlegalcounselperformedtheupdate.Incertaininstances,theinclusionoflanguagetoaddressaparticulartopicthat

mayhavebeencompletelyunaddressedinapreviousOMforaparticularprivateequityinvestmentvehiclemayhavebeenmotivatedbyexogenousfactors.Thesefactorsmayhaveincludedachangeinthelawwithinaparticularjurisdiction,orevenmoreuniversally,ageneralchangeinthemarketperceptionofcertainriskfactors that bore more common inclusion in subsequent offering memorandadrafts, but patently did not merit similar inclusion across all private equityvehiclesatthetime.

OtherConsiderationsItshouldalsobenotedthataminimumrequirementofprivateequityvehiclestobe included in the data setwas that a private equity vehiclewould have beenmanaged for a period of not less than one year as of the date of the offeringmemorandum. Separatelymanaged or customized account structureswere notincluded in this study. There were no minimum firmwide assets undermanagement (AUM) requirements on either a firmwide strategy level orvehicles’levelbasistobeincludedinthisstudy.

DataPreparationThefirststepinpreparationofthisdatasetforanalysiswastogatherandreviewthe private equity vehicle OMs. In this state the OMs were reviewed with aspecific focus on compiling data on three primary categories: indemnity andexculpation provision exemptions investment strategy, jurisdiction ofincorporation,andlegalcounsel.Additionally,otherdatawerecompiledonthedescriptive categories (e.g., firmwide AUM, vehicle jurisdiction ofincorporation,etc.).Afteralltherelevantinformationwasloggedandcoded,thenextstepofthereviewinvolvedastatisticalandtrendanalysis.

TrendAnalysisandImplications

Standards/LevelsofIndemnificationAllof theprivateequityofferingmemoranda included in theCorgentumstudycontainedsomelanguagerelatedto indemnificationandexculpation.Typically,the languagespecifies that thefundhasagreed toexculpateand indemnify theinvestment manager, general partner, principals, affiliates and their partners,directors, officers, and employees against losses and liability in the event thattheir actions do not meet certain liability thresholds. More specifically, theseliability standards are typically categorized along more specific striationsincludingmalfeasanceandnegligence.Exhibit6.7summarizestheresultsofthisanalysis.

EXHIBIT6.7IndemnificationandExculpationStandardsinPrivateEquityOfferingMemoranda*Indemnification/ExculpationStandard PercentageofOfferingMemorandaIncludedinStudy

Willfulmalfeasance 41%

Malfeasance 12%

Grossnegligence 78%

Willfulnegligence 61%

Negligence 42%

Willfuldefault 24%

Badfaith 84%

Misconduct 34%

Fraud 81%

Actualfraud 24%

Willfulfraud 17%

Dishonesty 54%

Misfeasance 4%*Standards,andassociatedpercentages,includedarenotmutuallyexclusive.Alltheofferingmemorandaanalyzedinthisstudycontainedatleasttwoindemnificationandexculpationstandardsincludedinthetable.

Comparing the data inExhibit6.7 to the first hypothesis, it is apparent thatcertain indemnityandexculpatoryexemptionsweremoreconsistentlyutilized.Theseincludedbadfaith(84percent), fraud(81percent),grossnegligence(78percent),willfulnegligence(61percent),dishonesty(54percent),negligence(42percent),andwillfulmalfeasance(41percent).Wecannowcomparethistothefive standard exemptions referencedbymuchof the literature in this area and

outlined earlier in this chapter (e.g., actual fraud, fraud, willful fraud, willfuldefault, and gross negligence). This comparison demonstrates that portions ofthe five outlined standard exemptions comport with the data set, as grossnegligence and fraud are in the top of the standard exemptions. Furthermore,whilenegligenceisnotspecificallylistedinthefivestandardexemptionsforthepurposesofthisdiscussionwecangroupbothnegligenceandwillfulnegligenceunder the so-called umbrella category of gross negligence, as they are bothvariations of negligence. Turning to the remaining leading exemptions in thedataset, theanalysissuggeststhatperhaps,basedonthelimitedsampleofthisdata set, bad faith,dishonesty, andwillfulmalfeasance shouldbeadded to thelistofstandardexemptions.Returning to the first part original hypothesis, above theminimum baseline

levelofexemptions itwaspredicted thatsignificantdiversitywouldemerge inregardtothetypeandnatureofexceptionsincluded.Whenanalyzingthedata,itseems that indeed beyond the core exemptions previously discussed, littleclusteringorother termsexisted.Theclosestclusteroutsideof thelargestcoreexemptionsinthedatasetwasmisconduct(34percent)followedbyasignificantdrop-off of approximately 24 percent and 17 percent for incidences of fraud,actualfraud,andwillfulfraud,respectively.Additionally,23percentoftheprivateequityofferingmemorandareviewedin

thisstudycontainedaprovisionforindemnificationandexculpationintheeventthe above listed parties (including theGeneral Partners and/or the InvestmentManager)actedwith the reasonablebelief thatanact (oromission)was in thebestinterests—oratleastnotopposedtotheinterests—ofthefund.

ExemptionTrendswithinStrategiesandGeographicLocationNow that we have developed an understanding of trends of indemnity andexculpatoryexemptionswithinthedataset,wecancross-referencethesewithineach of the defined strategies to see if any trends are noticeable. Exhibit 6.8presentsasummaryof theexemptionandstrategydatawithineachdataset. Itshould be noted that inExhibit6.8 the sum total of each row equals the totalpercentage of each exemption outlined. For example, the sum of the“Malfeasance” row across each strategy is 12 percent, which equals theincidenceoftheMalfeasancerowinExhibit6.7.

EXHIBIT6.8IndemnityandExculpatoryExemptionsCrossReferencedby

PrivateEquityStrategy

In reviewing the cross-referenced data, several noticeable trends emerge.BeginningwiththeVentureCapitalstrategy,thiscategoryexhibitedthehighestpercentages in the willful malfeasance, willful default, and gross negligenceexemption category. Similarly, the LBO fund strategy exhibited the highestpercentages in the willful negligence exemption category, and tied with the“Mezzanine”fundcategorywithinthebadfaithexemptioncategory.Exhibit6.9presentsasummaryof theprivateequitystrategieswhich leadeachexemptioncategory.

EXHIBIT6.9PrivateEquityStrategyLeaderswithinEachIndemnityandExculpatoryExemptionsCategoryExemptions StrategyCategoryLeader

Willfulmalfeasance Venturecapital

Malfeasance Distresseddebt

Grossnegligence Venturecapital

Willfulnegligence LBOfund

Negligence LBOfund

Willfuldefault Venturecapital

Badfaith Tiebetweenventurecapitalandmezzaninefund

Misconduct Realestatefunds

Fraud Realestatefunds

Actualfraud Distresseddebt

Willfulfraud Mezzaninefund

Dishonesty Realestatefunds

Misfeasance Realestatefunds

Returning for a moment to the second predata analysis hypothesis it waspredicted that a private equity vehicle's investment strategy would have nomaterialeffectondraftingtrendsinexceptionlanguageforbothindemnityandexculpatory clauses. These data seem to contradict this hypothesis as certainstrategyexemptionsdidconsistently leadcertaincategories.Thatbeingsaid, itseemsmoreresearchmaybenecessarytotest thevalidityofcertainindemnityand exculpatory exemptions being closely associated with certain investmentstrategies.We can next perform a similar analysis to cross-reference strategyexemptions with jurisdictional information. This analysis is summarized inExhibit6.10.

EXHIBIT6.10IndemnityandExculpatoryExemptionsCrossReferencedbyJurisdiction

Similar to the methodology employed in the private equity strategy cross-referenceanalysis,itshouldbenotedthatinExhibit6.10thesumtotalofeachrow equals the total percentage of each exemption outlined. Reviewing thejurisdictional cross-referenced data, several trends are observable. Beginningwith the onshore jurisdiction of Delaware, this category exhibited the highestpercentages in the exemption categories of willful malfeasance, bad faith,misconduct,andfraud,andtiedwithGuernseyformisfeasance.Incomparison,thesecondmostpopularjurisdictionamongtheprivateequityvehiclesincluded

inthedataset,theCaymanIslands,exhibitedthehighestpercentageinonlyoneexemption category, dishonesty. Exhibit 6.11 presents a summary of thejurisdictions,whichledeachexemptioncategory.

EXHIBIT6.11JurisdictionLeaderswithinEachIndemnityandExculpatoryExemptionsCategoryExemptions JurisdictionCategoryLeader

Willfulmalfeasance Delaware

Malfeasance Guernsey

Grossnegligence Guernsey

Willfulnegligence IsleofMan

Negligence Bahamas

Willfuldefault Bahamas

Badfaith Delaware

Misconduct Delaware

Fraud Delaware

Actualfraud Jersey

Willfulfraud Jersey

Dishonesty Bahamas

Misfeasance TiebetweenDelawareandGuernsey

Furthermore,thisanalysissuggestsindemnityandexculpatorydraftingtrendsthatmayberepresentativeoftheperceivedrisksassociatedwithdifferentprivateequitystrategies.Thisanalysisstillleavesseveralunansweredquestions,whichrequirefurtherresearch.Forexample,whywouldaprivateequityfundadheringprimarilytoaventurecapitalstrategybemoreorlesssusceptibletoanactualorperceived risk from willful malfeasance, a category in which it exhibited thehighest incident percentage in the data set, as opposed to negligence?Furthermore, an investor could make the argument that if a private equitymanageradheringtoaparticularinvestmentstrategyfelttheneedtoincludetherelevantindemnityandexculpatoryexemptionwithineachcategorybasedonaperceived or actual risk of a higher incidence of this occurrence (e.g., willfulmalfeasance), why should the private equity manager benefit fromindemnification and exculpation at the investor's expense? Said another way,when drafting these exemptions, does the private equity manager or theirattorney know something the investor does not? In an attempt to answer thisquery, an analysis was performed to see if any indemnity and exculpatoryexemption trends developedwhen cross-referencedwith legal counsel used todrafttheOMs.

VariationsamongOfferingMemorandawhentheSameLegalCounselWasUtilizedThe private equity investment vehicles included in this study utilized a widevarietyofdifferentU.S.domesticandoffshorelegalcounseltodraftOMs.Theselaw firms ranged from small practitioners to large multinational firms.Surprisingly,analysisofthedataindicatedthatvariationsexistedamongcertainterms of the offeringmemoranda of different private equity organizations thatutilized the same legal counsel. Beyond basic indemnity and exculpatory andstrategyandfundspecificdifferences,thesevariationswerealsoinplaceamongtheofferingmemorandaanalysisfactorsnotincludedinthescopeofthisstudy,suchaskeypersonclauses.Thepresenceofsuchvariationswasmostapparentamongparipassufunds.When comparing this to the third predata analysis hypothesis, regarding the

possibility that exception-drafting trends to indemnity and exculpatory clauseswouldbeinfluencedmorebytheinterestsoftheprimarylegalcounselutilizedby the private equity rather than by geographical concerns, it seems that thisinitialhypothesiswasnotwhollycorrect.Asindicatedearlier,justbecausetwodifferent private equity vehicles have their OMs drafted by the same legalcounsel, itappears there is lessofa tendencyfor thesame lawfirms toutilizeboilerplate OMs in drafting indemnity and exculpatory exemption terms.Furthermore,itseemsthatwhencomparingthesedifferencestothejurisdictionalcross-referencedata, there isastronger linkamongcertainexemption terms todifferent jurisdictions than to any specific legal counsel. This perhapsmay betwodifferent regulatory regimes in eachonshore andoffshore jurisdiction thatwouldpotentiallyinfluencedraftingexemptionsor,asintimated,duemoretothebespokedraftingnatureoftheseOMstotheparticularitiesofeachprivateequitymanager.

IndemnificationandExculpationStudyConclusionsThe analysis in this paper confirmed two of the three original preanalysishypotheses.First, the data analysis confirmed that a certainminimum level ofstandard risk inclusion and exception language would be present among theOMsincludedinthedataset.Second,theanalysisconfirmedthepredictionthataprivateequityvehicle's investmentstrategywouldhavenomaterialeffectondrafting trends in exception language for both indemnity and exculpatoryclauses.The thirdpreanalysishypothesisdidnotprove tobewhollycorrectasOM indemnity and exculpatory drafting trends did not demonstrate a greaterinfluence from the legal counsel that was employed than from geographicalconcerns.Thedataanalysisalsosupportedthenotionthat,beyondacertaincoresetof

termsanddisclosures, theanalysisofOMs in thedata setdemonstrated that aprivateequityfundviaitslegalcounselhasagreatdealofdiscretioninnotonlycrafting the terms that dictate the economics of the particular investingrelationship (e.g., management and performance fees), but also regarding thetermsofindemnityandexculpatoryprovisions.Theconclusionsfurthersuggestthatperhaps,basedonthelimitedsampleof thisdataset,badfaithandwillfulmalfeasanceshouldbeaddedtothelistoffivestandardexemptions.By developing a further understanding of benchmark indemnity and

exculpatoryexemptions,investorsmaythenbeabletousethesedatainseveralways.First,investorscanincorporatethesedataasanaidintheirpreinvestmentduediligenceprocess.BycomparingtheindemnityandexculpatoryexemptionscontainedintheOMofaprivateequityvehicleunderconsiderationtothedatain this study, or perhaps based on a larger data set utilizing the analysisframeworkoutlinedinthisstudy,aninvestorcoulddevelopanexceptionreportto alert for anypossible due diligence red flags. Furthermore, once a decisionhasbeenmadetoallocatetoaparticularprivateequityvehicle,investorscoulduse this benchmark data to demonstrate to a private equity manager that thedrafting standards of a particular OM do not comport with drafting trends.Therefore,investorsmaybeabletoutilizethesedatatonegotiatesidelettersormorefavorableinvestmentterms.

OTHERLEGALDOCUMENTSCONSIDERATIONS

InadditiontothePPM,duringtheoperationalduediligenceaninvestorshouldrequest a number of different legal documents. These documentsmay includeitems such as subscription documents, articles of association, and the limitedpartnershipagreement. Inreviewingeachof these legaldocuments, inadditiontotermssuchas indemnificationandexculpation, investorsshouldtakecaretovetanumberofdifferentconsiderationsandterms.Thefollowingisasummaryofquestionsandissuesinvestorsshouldconsiderinevaluatingtheseissues:

KeyPersonClauseDoesthefundmaintainakeypersonclause?Ifso,whichindividualsarenamed?Ifmultipleindividualsarenamed,doesthekeypersonclauserequireatriggeringactivitytooccurtobothindividuals(i.e.,an“and”clause)ortoeitherindividual(i.e.,an“or”clause)?Doesthekeypersonclausecontainanotice-onlyprovision?What is the scopeofanykeypersonclauses? (e.g.,death, incapacity,etc.)Doesthekeypersonprovisionprovideforpenalty-feeredemptions?

CarriedInterestHowisthesubjectofcarriedinterestapproached?Arewaterfalldistributionorothersimilarschemesemployed?Doescarriedinterestfollowareturn-all-capital-firstapproach?Isadeal-by-dealapproachappliedtocarriedinterest?Areanyso-calledgross-upprovisionsincludedinthedocuments?Areanycarried-interestescrowstructuresemployed?

OtherConsiderationsIn reviewing the legal documents, does the investor have a goodunderstandingofadvisoryandtransactionalfees?Whatdisclosuresarecontainedregardingfees?What is the timing of fee and expense collection and recovery anddistributions?Whatisthetimingoffeecollectionandrecovery?Areanyfee-sharingarrangementsinplace?What are the general partner's potential liabilities for clawbackobligations?Is there any language that limits the ability of the GP to offer feediscounts?DoesthePPMcontainlanguagerelatedtomanagerreserves?WhattypesofconflictsofinterestarediscussedinthePPM?Arethereself-dealingoradvance-consentprovisions?Do the legal documents for the fund contain no-fault divorcetermination provisions aswell as allowing for termination for cause?Bysupermajority?Bysimplemajority?Dothelegaldocumentscontainanyjurisdictionspecificlanguagethatmay present unique risks or other implications that an investormustconsider?

CONCLUSIONIn conclusion, this chapter provides an introduction to some of theconsiderations that investors should take into account when approaching thelegal due diligence portion of an operational due diligence review. As thischapteroutlines,merelyreadingsuchdocumentsandtakingthematfacevalueisnot sufficient in a thorough operational due diligence review. Investors canutilize research in this field, such as theCorgentumConsulting study that thischapter mentions, as well as their own experience to develop perspectiveregarding legal documentation trends. Additionally, investors evaluating aprivate equity firm and fund's legal documentation may consider utilizing acombinationofspecialists,suchasexternallegalcounselaswellasoperationalduediligenceconsultants,tobolsterinternalefforts.

NOTES

1.SeeBryanGarner,ADictionaryofModernLegalUsage(OxfordUniversityPress,1987).2.SeeStevenEmanuel,EmanuelLawOutlines:Contracts(AspenPublishers,2010).3.VinhQuangTran,EvaluatingPrivateEquityPerformance(Hoboken,NJ:JohnWiley&Sons,2006),245.4.ThePrivateEquityJournal,ExcerptsfromtheGuidetoSoundPracticesforFundsofPrivateEquity'sManagers,2.1(AIMA,2009).5.“ExculpatoryClauses:TheHistoricalImpactofCommon-CarrierLawandtheModernRelevanceofInsurance,”TheUniversityofChicagoLawReview(vol.24:2,Winter1957,315,317.6.SeeHenryHallam,HistoryofEuropeDuringtheMiddleAges,vol.3(TheColonialPress,1899),210;seeDeutscherNautischerVerein,HistoryofIndemnificationofGermanPrivatePropertyatSeaoutoftheFrenchWarIndemnity(OxfordUniversity2006),119;seeJustinSweetandJonathanJ.Sweet,SweetonConstructionIndustryContracts:MajorAIADocuments(AspenPublishers,1999),630.7.HouseofCommonsTreasuryCommittee,TheRunontheRockFifthReportofSession2007–08,vol.II(ParliamentaryHouseofCommons,2008),257.8.Black'sLawDictionary,8thed.(2004),608.9.A.N.Yiannopoulosetal.,AdmiralityandMaritimeLaw(BeardBooks,2006),485.10.Black'sLawDictionary,8thed.(2004),783.11.JessieScott,Insurance—ACompleteGuide(Othello,2008),9.12.Black'sLawDictionary,8thed.(2004),783.13.JohnDownesandJordanElliotGoodman,Barron'sFinanceandInvestmentHandbook,6thed.(Barron'sEducationalSeries,2003),469.14.DavidLoganScott,WallStreetWords:AnAtoZGuidetoInvestmentTermsforToday'sInvestor,3rded.(HoughtonMifflinCompany,2003),17615.SECReleaseNo.40–58(April18,1951),Fed.Sec.L.Rep.(CCH)¶56,383–6.16.LouisLossetal.,FundamentalsofSecuritiesRegulation(AspenPublishers,2003),1026.

17.HeitmanCapitalManagement,LLC,SECNo-ActionLetter,2007SECNo-Act.LEXIS159(February12,2007).18.CillianM.Lynch,“SECIssuesNo-ActionLetterontheUseof“HedgeClauses”inInvestmentAdvisoryContracts,”StradleyRononFund/AdviserAlert,May2007.19.JohnR.HewittandJamesB.Carlson,“SecuritiesPracticeandElectronicTechnology,”LawJournalPress,2006,9–11.20.StateofWashingtonDepartmentofFinancialInstitutionsSecuritiesDivision,NoticetoPrivateEquityManagerRegardingtheUseofPartnershipandLLCAgreementstoSatisfytheWrittenInvestmentAdvisoryContractRequirements(September28,2006),2,www.dfi.wa.gov/sd/pdf/notice_hedge_fund_sept_28.pdf.21.WashingtonAdministrativeCode,460WAC§§24A-220(19)(2008).22.RevisedCodeofWashington,RCW25§§15.040(1)(a)(2001).23.ConnecticutDepartmentofBanking,InvestmentAdvisersCautionedonUseofHedgeClauses,(May1991),www.ct.gov/dob/cwp/view.asp?a=2252&q=299222.24.ChristopherRussell,“BriefingExculpationandIndemnityClauses,”OgierClientBriefing,June2008.25.Black'sLawDictionary,8thed.(2004),685.26.RoyalBruneiAirlinesSdn.Bhd.v.Tan[1995]2AC378.27.CharlesMitchell,“DishonestAssistanceinaBreachofTrust,”www.ucc.ie/law/odg/messages/051011h.htm.28.TwinsectravYardley[2002]2AC164(HL).29.DubaiAluminiumv.Salaam[2002]2AC164(HL).30.Badenv.SocieteGenerale(1983)[1993]1W.L.R.509.31.AlastairHudson,.“KnowingReceipt,”30,http://cw.routledge.com/textbooks/9780415497718/podcasts/podcast30.pdf,outliningthefivetypesofknowledgerequirementsdiscussedinBadenv.SocieteGenerale(1983)[1993]1W.L.R.509.32.AlastairHudson,“TheImpactofBarlowClowesv.EurotrustonDishonestAssistance,”availableatwww.alastairhudson.com/trustslaw/BarlowClowesNote.pdf.33.CompareTwinsectraLtd.v.Yardley(200)UKHL12,explainingthatalawyerwhoassistedalenderindefraudingabankwasnotliablebecausehehadnoknowledgeofthefraud;andGrupoTorresv.Al-Sabah(2001),outlining

thatalawyerwhowasadirectorofacompanywasfoundguiltyofblind-eyedishonesty;withBrinksLtd.v.Abn-Saled[1996]CLC133,describingthatanaccomplicedefendantmustactuallyhaveassistedinthefraudtobeliable;andAgip(Africa)Ltd.v.Jackson(1990)1Ch265,explainingthataccountantswereliableforknowingassistancebyparticipatinginfraud.34.GaryWatt,ToddandWatt'sCasesandMaterialsonEquityandTrusts(GaryWatt2007),531,explainingthatthecourtinBarlowClowesInternationalLtd.(InLiquidation)v.EurotrustInternationalLimited(2006)1AllER333,PrivyCouncil,focusedontherelationshipbetweenhonestyandproactiveknowledge.35.MohamedRamjohn,Text,CasesandMaterialsonEquityandTrusts,4thed.(CavendishPublishingLimited,1995),300.36.PhilipR.Wood,PrinciplesofInternationalInsolvency(Sweet&MaxwellLimited,2007),754.37.JennyStrasburg,“AmaranthAsksCourttoDismissSanDiegoFundLawsuit”(update3),Bloomberg,June7,2007.38.JennyStrasburg,“AmaranthSuedbySanDiego,WarnsofRefundDelays”(update3),Bloomberg,March30,2007.39.WinstonandStrawnLLP,SanDiegoCountyEmployeesRetirementAssociationv.NicholasMaounis,CharlesWinkler,RobertJones,BrianHunter,andAmaranthAdvisors(2010),www.winston.com/index.cfm?contentID=154&itemID=2793.40.MichaelGreeneandDavidDobbynetal.,“Ireland,”inDirectors’Liability:AWorldwideReview,eds.AlexanderLoosetal.(2006),293,294.41.See,forexample,CharitableCorporationv.SirRobertSutton[1742]EngR115;(1742)2Atk400;26ER642,explainingthatdirectorscanbefoundliableforinactivity.42.SeeReBrazilianRubberPlantationsandEstatesLtd.[1911]1Ch.425.43.MarkJ.Loewenstein,“TheCorporateDirector'sDutyofOversight,”TheColoradoLawyer33,May1998,27.44.SeamusAndrew&NiallGoodsir-Cullen,AccountabilityofCaymanIslandsDirectors,RECOVERY,Autumn2007,at36(explainingtheprogressionofdirectorliabilityreleaseregulationfromSection205,CompaniesLaw1948whichisthepredecessorsectiontoSection.45.188A.2d125(Del.1963).46.EdwardP.Welchetal.,FolkontheDelawareGeneralCorporationLaw:

Fundamentals(AspenPublishers,2009),259.47.Black'sLawDictionary,8thed.(2004),1559.48.IanM.Ramsay,“LiabilityofDirectorsforBreachofDutyandtheScopeofIndemnificationandInsurance,”CompanyandSecuritiesLawJournal5:3(1987).49.JerryW.Markham,AFinancialHistoryofModernU.S.CorporateScandals:FromEnrontoReform(M.E.Sharpe,2006),441.50.RobertBernsteinandJeffreyGross,“CircuitExplores‘Wagoner’RuleonCorporateManagementFraud,”NewYorkLawJournal,March5,2009.51.Black'sLawDictionary,8thed.(2004),807.52.SteveJakubowski,“InPariDelictoandaJurisprudentialHouseofCards,”TheBankruptcyLitigationBlog,January14,2010.53.CatherineE.Vance,“InPariDelicto,Reconsidered,”AmericanBankruptcyInstituteJournalXXVII:9,November2009.54.SeeShearsonLehmanHutton,Inc.v.Wagoner,944F.2d114(2dCir.1991).55.RobertA.Schwinger,“Lawvs.Equity:SecondandThirdCircuitsDivergeon‘InPariDelicto,’”NewYorkLawJournal,July2010.56.“DefenseofInPariDelictoDoesNotAffectTrusteeStanding,”BankruptcyCaseBlog,http://stjohns.abiworld.org/node/26#_ftn4(March19,2009),explainingthattheEightCircuit'sdecisioninMoratzkav.Morris(InreSeniorCottagesofAmerica),482F.3d997(8thCir.2007)delineatedtheissueofstandinganddefensesthatbolstersthestandingofatrusteetopursuefraudclaims.57.AlejandraKim,“JudgeBarsSuitAllegingNegligencebyPrivateEquityAccountants,”NewYorkLawJournal,July10,2008,explainingthatthedecisioninBullmorev.Ernst&YoungCaymanIslands,20Misc.3d667,861N.Y.S.2d578,582-83(N.Y.Sup.Ct.2008)foundthatdirectorswerenotinnocentbecausetheyhadcededcontroltothefundanditwouldhavebeenimpossibleforthemtotakeactionifErnst&Younghadalertedthemoffraudulentactivity.

CHAPTER7

FinancialStatementDueDiligence

Investors are becoming increasingly aware of the importance of documentreviewsduringtheprivateequityoperationalduediligenceprocess.Oneofthemost important sets of documents that investors should collect, analyze, andmonitor are a private equity fund's audited financial statements. Auditedfinancial statements provide a historical snapshot into the financial life of aprivateequityfundandcanserveasavaluablesourceofinformationduringtheduediligenceprocess.Before investingwith anyprivate equity fundmanager,investorsshouldtakestepstoanalyzeandunderstandtheinformationcontainedin these documents. To fully capitalize on the information learned during areview of a private equity fund's audited financials, these reviews should beincorporatedintothelargeroperationalduediligenceprocess.Financial statement analysis is a useful tool that investors have in their

operationalduediligencearsenaltodetectandevaluateavarietyofoperationalriskfactorsthatmaybepresentataprivateequityfirmandfund.Beforedelvingintoadiscussionofthesetechniques,itisfirstusefultogainanunderstandingofwhat is contained in a fund's audited financial statements.Wewill begin thisdiscussion by considering the role of the group preparing them—the auditors.Auditorsorauditfirmsareengagedbythemanagementofaprivateequityfundtoprovideanaccountingof the fund.Auditorsconduct theirworksubject toanumberofdifferentauditstandardsasoutlinedinthefollowingsections.

AUDITSTANDARDSAuditstandardsareeffectivelyasetofbenchmarkrulesorguidelinesbywhichan auditor should perform their audit. Generally accepted auditing standards(GAAS)areprinciplesmeanttobeutilizedbyauditorssothattheycanproducefinancialstatementsthatallowthemtoprepareauditsinamannerthatcomportswiththeprofessionalstandardsoftheaccountingindustry.There are two general types of audit standards that are employed in private

equityauditedfinancialstatements.Sittingontopofalloftheseconsiderationsarenotionsofanyrelevantjurisdictionalchoicesandgoverningcountryorstatelawsthatmaybeapplicableaswell.

U.S.GAASThefirststandardhasitsoriginintheUnitedStatesandiscalledU.S.GenerallyAccepted Auditing Standards (U.S. GAAS, or simply GAAS). Under theguidance of the American Institute of Certified Public Accountants (AICPA)standards,U.S.GAASisdividedinto10standards,whicharefurthersubdividedintothreegroups:GeneralStandards,StandardsofFieldWork,andStandardsofReporting.1

Depending on the type of audit engagement, these rules can become quitecomplexandgranular innature.Complicating thematterfurther,dependingonthetypeofauditengagement,thecontrollingauditstandardsrulesandrelevantguidancecancomefromawidevarietyofsources.IntheUnitedStates,thetwomajorsourcesofauthorityinthisregardaretheAICPAandthePublicCompanyAccounting Oversight Board (PCAOB). Depending on the type of audit,guidelines may come into play such as those from the GovernmentAccountability Office's Government Accounting Standards outlined in the so-calledYellowBook.TheAICPAhasalonghistoryofissuingguidancetotheaccountingprofession

with regard to audit standards dating back to the early 1900s. Despite thishistory, the AICPA did not formally establish the ASB until 1978. The nextmajordevelopmentintherecentU.S.historyofauditstandardscameaboutasaresult of the passage of the landmarkSarbanes-OxleyAct of 2002, thePublicCompanyAccountingOversightBoardwascreated.ThePCAOBdevelopeditsown series of standards and interpretations for the audit of public companies.

Manyof thePCAOBruleswerebasedonASBstandards.Indeed, thePCAOButilized the ASB rules as its temporary rules during 2003. Based on theestablishment of the PCABO the AICPA has since designated the PCAOBguidance as the leading authority with regard to the generally accepted auditstandards for public companies.TheASB standards are generally the point ofreferenceforauditsconductedofprivatecompanies.2PronouncementsmadebytheASBarereferredtoasStatementsonAuditingStandards(SASs).3

ISAOutsideof theUnitedStates, theprimaryaudit standardsutilizedare so-calledInternationalAuditingStandards(ISAs).ISAsweredevelopedandareissuedbythe International Federation of Accountants (IFAC) via the InternationalAccounting and Assurance Standards Board (IAASB). The history in thedevelopment of ISAs was rooted in the desire to progress toward moreuniformity in global accounting standards. It dates back to 1977 whenapproximately50countriesjoinedtogethertofoundtheIFAC.

ACCOUNTINGSTANDARDSNow that we have provided an overview of the guidelines for auditors inpreparing the financial statements (e.g.,GAASand IAS),we cannext discussthe accounting standards in place. The accounting standards in place directlyinfluence the format in which an investor will likely encounter financialstatementsduringtheoperationalduediligenceprocess.Therearetwoprimaryformatsutilizedtopresentfinancialstatements:GAAPandIFRS.

GenerallyAcceptedAccountingPrinciples(GAAP)GAAPis“atechnicalaccountingtermthatencompassestheconventions,rules,andproceduresnecessary todefineacceptedaccountingpracticeataparticulartime.”4 Inotherwords,GAAPis theumbrella termforone typeof thegeneralformatinwhichfinancialstatementswillbepresented.Itisworthnotingthat,inaprivateequitycontext,thisdoesnotmeanthatallGAAPfinancialstatementscontainexactlythesamecategoriesofinformationwithdifferentnumbersfilledin foreachdifferentprivateequity fundasapplicable.VariationamongGAAPstatements is perfectly acceptable depending on certain choices made by theauditor and the management company and the type of statements beingproduced.AnexampleofthisrelatestotheStatementofCashFlows,discussedinmore

detail further on. Under the guidance provided in a pronouncement from theFinancial Accounting Standards Board (FASB) Accounting StandardsCodification (ASC), a fund can be exempt from theGAAP statement of cashflows requirement. Specifically according to the Statement of FinancialStandards(SFAS)102(FASBASC230-10-15-4),afundcanbeexemptfromtheGAAPstatementofcashflowsrequirementifitadherestothefollowingcriteriaincluding:

Duringtheperiod,substantiallyalloftheenterprise'sinvestmentswerehighly liquid (forexample,marketable securities, andotherassets forwhichamarketisreadilyavailable).Substantially all of the enterprise's investments are carried at marketvalue.The enterprise had little or no debt, based on the average debtoutstandingduringtheperiod,inrelationtoaveragetotalassets.

Theenterpriseprovidesastatementofchangesinnetassets.IncountriesthatutilizeGAAP,therecanbevariationsonthetypeorformatof

GAAPutilized.ExamplesofthisincludeU.S.GAAPandU.K.GAAP.

InternationalFinancialReportingStandards(IFRS)Next toGAAP, the secondmajor format for accounting statements is what isknown as International Financial Reporting Standards (IFRS). IFRS areprinciples-based standards that comprise a series of historical standards. Inparticular,IFRSincludestwosetsofstandardsissuedbefore2001:InternationalAccountingStandards(IAS)andStandingInterpretationsCommittee(SIC).IAS can differ from GAAP not only in the format in which financial

statements are presented but also in the rules governing the way in whichpositions are accounted for. So returning to our Statement of Cash Flowsexemptionexample,underIAS7therearenospecificexemptionsprovidedforsmaller entities because the Statement of Cash Flows is viewed as a requiredstatement. This can be contrastedwith the guidance provided in the FinancialReportingStandardNo.1 (FRS1) in theUnitedKingdomunderU.K.GAAP,whichdoesprovideforStatementofCashFlowsexemptionsforsmallentities.Astheseexamplesillustrate,itisessentialforaninvestortobeconsciousoftheauditstandardsandpresentationformsoftheaccountingstandards.Itisalsoworthnotingthatsomefundsinthepastmayhaveproducedfinancial

statements in a modified format (non-GAAP or non-IFRS) depending on thejurisdictionandthefund'spreference.However,itisnotlikelythatinthecurrentenvironment, and particularly in light of the movement toward convergencediscussed inmoredetail in thenext section, that investorswouldbewilling toprovide capital to such funds without audited financial statements routed inGAAPorIFRS.

MovementtowardConvergenceInordertoleveltheglobalplayingfieldandfacilitatemoreuniformcomparisonof financial statements globally, for the past several years both the FASB andIASB have been pursuing a convergence of IFRS and GAAP standards.Additionally, the SEC has also been considering incorporating IFRS into theU.S.financialreportingsystem.5Regardlessofwhetherfullconvergenceof thestandardstakesplaceintheshortterm,itislikelythatinthelongtermtherewillbeacontinuedmovementtowardtheconvergenceofGAAPandIFRS.Itshouldalso be noted that the financial statement analysis techniques that this chapterdescribescanforthemostpartbeutilizedunderIFRS,GAAP,oranyvariationsthereof. The techniques do not include the finer points of IFRS and GAAPdistinctions(suchas thepreviouslymentionedexampleregardingStatementofCashFlow reportingexemptions), as suchdiscussionsarebest left for anotherbook.Rather,nowthatwehavelaidaframeworkofthebasicfundamentalsofprivateequityfinancialstatementsauditandaccountingstandards,wecanbegintodelveintothepracticalapplicationsofhowinvestorscangoaboutinterpretingsuchstatementstofacilitatetheiroperationalriskassessmentofaprivateequityfund.

OTHERFINANCIALSTATEMENTFORMATS

In certain cases, particularly for funds located outside theUnitedStates, theremaybecaseswhenauditedfinancialstatementsarepresentedinaformatofthatotherthenGAAPorIFRS.Thisisalsosometimesseenamongrealestatefundswhenamanagerforexamplewouldelecttopresentfundperformanceaccordingto methodologies and formats promulgated by an organization such as theEuropeanAssociationforInvestorsinNon-listedRealEstateVehicles(INREV).In these cases a fund manager may also present IFRS financial statementsalongsidethesenon-IFRSstatements.

AuditedFinancialStatementPresentationFormatsAsjustindicated,somefundsmayemploydifferentmethodologiesinoutliningtheformatofprivateequityfundsfinancialstatements.Auditfirmsmayhaveaparticularformthattheyusewiththeirclients.Otherfirmsmayaltertheformatslightly on a case-by-case basis.Of course, these variationsmaybe driven bychangesintheaccountingpronouncementsorstandardstobeemployed,whichmay require the inclusion or omission of certain pieces of information ordisclosures.However,inthiscase,referenceisbeingmademoretothefactthatcertainauditfinancialstatements,bythediscretionoftheprivateequityfirmandthe auditors, may present a single year's financials in each audit. This is thecommon practice. Still some other firms may opt to include year-over-yearfinancialstatements.Thesameauditfirmmayevenutilizemultipleformatsfordifferentfunds.Investorsshouldconsiderthesedifferentformatswhendesigningaplantoreviewauditedfinancialstatement.

AuditMaterialityAuditedfinancialstatementsfromaprivateequityfundmanagerareakeytoolthatshouldbeutilizedbyinvestorsinperformingcomprehensiveoperationalduediligence.Oftenthesestatementscontainawealthofinformationaboutnotonlythe financial position of a particular fund throughout a fiscal year, but alsoregarding any elections made by the fund, expense levels, and the overallopinionof theauditorof the financial statements.Theseopinionsare typicallyclassified into twogroups:qualifiedandunqualified.Unfortunately thedangerassociated with these qualifications is that an unqualified opinion is oftenthought to mean that everything is okay, whereas it can in fact reveal thateverythingisnotokay,andthatmoreduediligencerequired.This“everythingisokay”mentalitycanoftenprovideinvestorswithafalsesenseofsecurity.Manyinvestors do not take the time to understand what exactly an auditor isrecommending with an unqualified opinion. Effectively, with an unqualifiedopinion an auditor is stating that the financial statement contains no materialmisstatements. But who determines what is material and what is not? Abovecertainminimumstandards, theauditordoes.Thismateriality level isoftensetduring the design of the audit plan, which also contains a number ofopportunities for the auditor tomake certain discretionary judgments.With allthese qualifications and caveats it is understandable that confusion persistsregardingaudits.Academic research in the field of accounting demonstrates that an auditor's

judgments with respect to materiality are not solely formulaically driven bymathematicalcalculationsof,forexample,apercentageoftradevolume.Insteadstudieshavesuggestedthatmaterialityjudgmentsaresignificantlyimpactedbyapanoplyofqualitativefactors, includingclientintegrity,culture,andevenlevelofmoraljudgment.6Therearenohardrulesbywhichmaterialitylevelsorset.Statedanotherway,ascrazyasitmayseemtoaninvestorwhoreliesonaudits

toinformtheiropinionsaboutaprivateequityfund'sfinancialcondition,itmaybe perfectly acceptable within accounting standards for an auditor to makecertainmistakesandmisstatementsaslongastheauditiswithinthematerialitylevelforthefinancialstatementsasawhole.Indefiningperformancemateriality,ISA 320 outlines asmuch by stating that an auditor in setting thematerialitylevel should do so with the intent to reduce “to an appropriate low level theprobabilitythattheaggregateuncorrectedandundetectedmisstatementsexceed

materiality for the financial statements as a whole” (emphasis added).Translation:Auditwork that isnotcorrectorcontainsmisstatements is fineaslongasitdoesnotpasstheinvisiblelineofmateriality.This concept of audit materiality is often counterintuitive to what most

investorsbelievetheworkofanauditortobe.Auditorsdonotnecessarilytickandtieeverysinglepositionheldinafund.Fromtheauditor'sperspectivetheymaynotevenwanttodothis.Themoreworkanauditorhastodo,themoretimeittakes.Astheoldadagegoes,timeismoney.Auditorsattheendofthedayarenot the customers of investors, but of the private equity firms and funds thatultimatelysigntheirpaychecks.Assuch,whiletheywanttostillmakeaprofit,theyalsowant tokeep theclient (e.g., private equitymanager)happyaswell.Exorbitantauditfees,whichmayultimatelyreducethepoolofcapitalavailableto compensate private equity managers and deal teams, do little to fostergoodwill in this relationship. Furthermore, if the auditor charges a flat fee fortheirwork,thenitmaybeevenlessinanauditor'seconomicinteresttoexpendtheadditionalresourcesnecessarytogothrougheachindividualtrade.Topauseforamoment,thepurposeofthisdiscussion,lestitshouldbemisinterpreted,isnottomalignauditorsortheaccountingprofession.Auditors,generally,dofinework that is of great value to both theprivate equity firmand investors alike.Besides, therearenosecretsbetween theprivateequity fundmanagementandthe auditors as to what work will actually be performed. The scope of theauditor'swork isdetailed inaseriesofplaces, including theengagement letterbetween the auditors and theprivate equity firm/fundaswell as indocumentssuchasauditplansthatauditorsarerequiredtoprepare.Thisisall,ofcourse,inconjunctionwiththepreviouslydiscussedGAAPandIFRSrules.One of the more interesting questions in the context of an operational due

diligence process, which investors may ask when faced with analyzing theauditedfinancialstatementsofaparticularfund,isatwhatmaterialitylevelwasthe audit conducted? One may think that based on all of the disclosures andlegaleseitwouldonlybelogicalthat,ofcourseallowingforthediscretionoftheauditor to factor in both quantitative and qualitative factors in setting thismateriality level, that this seemingly harmless piece of information would bedisclosedsomewhereinthefoldsoftheauditedfinancialstatements.Perhapsinplain view in the opinion section proceeding the financial statements?Maybedeeperinthefinancialsectioninafootnotetooneofthestatements?Perhapsinamoreesotericlocation,ensconcedbetweentheboilerplatelegaleseaboutanewaccounting pronouncement and related party transaction disclosures? No.

Nowhereintheauditfinancialstatementsofaprivateequityfirmwillyoufindthis information disclosed. Furthermore, the authorwould hazard a guess thatmost private equity fund managers, and even their chief financial officers orchiefoperatingofficerswholiaisewiththeauditorsandsuperviseauditprogresswouldnotbeapttovolunteerthisinformation.Perhapstheyareuninformedofsuchminutiaof theaudit?Or, togivefunds thebenefitof thedoubt, they, justliketheauditors,donotwishtocallattentiontotheissueofmateriality.Todrivethe point home even further, itwould be almost unheard of for an investor tohavetheveritabletemeritytoinquireastohowauditmaterialitylevelsmayhavechangedorevolvedonayear-to-yearbasis.Sadly,inthenewworldofsupposedincreased transparency and the willingness of funds to demonstrate theiroperations prowess, the marketplace has not yet exerted enough pressure onprivateequityfundmanagerstocommonlyreachsuchlevelsofdisclosure.

AdditionalAuditConsiderationsInreviewingtheauditedfinancialsofaprivateequityfund,aninvestorislikelyto run the risk of being overwhelmed by a barrage of disclosures anddisclaimers.Suchconfusioncanresultininvestorsplacingtoomuchrelianceonthe shoulders of the auditors, while forgoing an independent operational duediligencereviewofaprivateequityfundmanager.Consequently,itisimportantthat investors overcome several commonly held misconceptions regardingauditor attestations and thework auditors actually perform.Someof themorecommonlyheldmisconceptionsregardingtheworkofauditorsinclude:

An audit consists of a detailed review of every position taken by aprivateequityfund.There isnodiscretionamongauditors indesigningand implementinganauditplan.All auditors set the same scope of audit and materiality levelsconsistently.Auditors must perform on-site visits with each private equity fundmanagertheyaudit.Auditors must perform a detailed review of private equity fund'scounterpartiesandserviceproviders.

While an auditor may adhere, either in part or fully, to the items listed,investors must remember that, above minimum standards mandated by theaccounting profession, auditors maintain a certain amount of discretion indesigning and implementing an audit plan. Depending upon the nature of theaudit engagement, best practice may dictate that different private equity fundstrategiesandfundstructuresrequiremoreauditscrutinythanothers.Onepointforinvestorstoconsideriswhetheraprivateequityfund'sauditoradheresonlytominimummandated guidelines or goes above and beyond tominimize notonlyauditriskbuttoalsodetectoperationalrisk.Thefactthatcertainaccountingrulesmaynothavecaughtuptoaparticularprivateequityfundpracticeshouldnotserveasanescapehatchforanauditorseekingtododgetheresponsibilityofbroadeningthescopeofarevieworincreasingthelevelofmaterialityemployedinanaudit.Whileaprivateequityfundinvestormaynotbeabletouncovercertainitems

regardingaspecificauditplan(e.g., levelofmaterialityutilized inaparticularaudit), it still behooves investors to attempt to ask questions about the audit

processandmethodology.Goingbeyondthefinancialstatements inthisregardwill often provide additional insights into both the quality andcomprehensiveness of the auditor's work. Additionally, and almost moreimportantly,investorswilllikelygainperspectiveintotheinvolvementandlevelofoversightexertedbytheprivateequityfundmanagerontheauditprocess.

CONSIDERATIONSTHATAREUNIQUETOPRIVATEEQUITYANDREALESTATE

FINANCIALSTATEMENTSIn the vast majority of cases, investors performing initial operational duediligenceonaprivateequityfundwillbefacedwithascenarioinwhichthefunditselfhasnotyetbeeninoperation.Indeed,itisduringthisinitialcapital-raisingperiod that a private equity fund is likely to receive the greatest number ofrequests to deal with investors’ operational due diligence inquiries. The otherscenario iswhenafundhasalreadyraisedsomecapitalbutmaybeseeking toraiseadditionalcapitalinordertoreachapreviouslyanticipatedsizesetbythefundmanager,perhapsinordertofullyfundtheportfoliosplannedinvestments.While these situation are admittedly much less frequent than operational duediligence opportunities during the initial fundraising period, an investor maycome into a fund once it has begun operating. Each of these cases presentinvestorswith a different series of operational due diligence opportunities andchallenges. Furthermore, regardless of whether the private equity fund inconsideration has been up and running before an investor begins to performoperational duediligenceon the fund, investorswill alsoneed to consider thehistory of the fund management company as well as whether the fund hashistoricallymanaged,orcurrentlymanages,other funds.By takingallof thesefactors into consideration, investors will be able to make smarter allocationdecisions.

TheVintageFundAdvantageIntheparlanceoftheprivateequityworld,borrowingnotunashamedlyfromtheworld of wine, the “vintage date” or “vintage year” of a private equity fundreferstotheyearinwhichthefundbeganitsoperationsormakinginvestments.Some reasonable peoplemay consider it to be the year that the private equityfundwasopenedforbusiness.However,toconfusematters,manyprivateequitypractitionersmayrefertothisastheyearinwhichthefundwas“closed.”Closedinthiscasedoesnotmeanthatthefundwasclosed(i.e.,shutdownoperations)but instead indicates theendof the fundraisingeffortsof the fund.Toprovidesomecontextinthefundraisingstage,afundmayusethetermopen,asinopenfor new investment, and various degrees of the term closed, often with amodifierbefore it, to indicate the relative statusof the fund'sopenness towardacceptingadditional capital from investors.Examplesof this can include “softclosed,” which means that a fund is only accepting capital from existinginvestors or people who are far along in the due diligence process, or “hardclosed,”whichmeansthefundisnotacceptinganynewcapitalfrominvestors.Duringtheinitialfundraisingperiodsmanyprivateequityfundsmaythrowthesetermsaround,perhapstoinstillasenseofurgencyamonginvestorsonthefenceor thosewho are dragging their feet with respect to due diligence efforts. Assuch,thedefinitionandapplicabilityofthesetermscanvaryfromfundtofund.Forthepurposesofourdiscussion,nowthatwehaveintroducedsomeofthis

admittedly confusing terminology, we have laid the groundwork to discussvintagefunds.Oneway to think of a vintage fund is to equate it to a sequel of a popular

movie.Hollywoodstudiostypicallyproduceasequelbasedonaudienceinterestanddemand to seemoreof their favoritecharactersand tocontinue the initialstory.The sequel is generally evenmore of a big budget blockbuster than thefirstfilm.Thesameistrueofprivateequityvintagefunds.Assumethatthefirstfund successfully raisedmoneyandgeneratedprofits.Seeking tocapitalizeonthismomentum, the private equitymanagement company has decided to raiseanotherfund.Incomparisontothefirstfund,thissecondfundissetupatapointlater in time than the first fund. Therefore, this second fund has a new anddifferentvintagethanthefirstfund.Thisiswherethetermvintagefundcomesfrom. In practice, these funds are typically established over a period ofsubsequentyearswhilethepredecessorfundsarestillinoperation.

Often these vintage funds will effectively be managed in a modified pari-passu format to the predecessor funds. In addition to adhering to similarinvestment philosophies, these funds will also generally have similarities inregard to not only the management company overseeing the funds, but thepersonnel responsible for managing the funds as well. These similarities willalso play into operational considerations, as vintage funds are almost alwaysservicedonafundmanagementcompany'ssameinternaloperationalplatformsand by the same operations personnel who previously services, or are stillservicing in the case of a fund that is currently still making and managinginvestments,thepredecessorfund.From an operational due diligence perspective the fact that a private equity

firm has previously managed a vintage fund can provide investors with asignificantadvantageascomparedtosimilarfirmsthathadnotmanagedvintagefunds.When an investor first approaches a private equity fund as part of the

operational due diligence process as previously described, one of the keydocuments that shouldbe requestedare the financial statementsof the fund. Ifthe fund has yet to beginmaking investments and is still only in the capital-raising stages, then the fund has not yet been through an audit cycle andtherefore,therearenoauditedfinancialstatementsforinvestorstoreview.Thispresents a bit of a chicken-or-the-egg scenario. On the one hand, a prudentinvestorwouldnotwanttoinvestinanyfundforwhichtheycannotreviewtheaudited financial statements.On theotherhand, if the fund isbrand-new, thenthere are no audited financial statements to review. One of the goals ofoperationalduediligence is tofacilitate the investmentprocessandnot tostopthe investor's ability to make investments cold in its tracks based on suchlogisticalconstructs.Besides,ifeveryinvestorcouldnotinvestinafundwithoutreviewing the financial statements, then no new funds would ever raise anymoney.Facedwiththisissue,whatisaninvestorstillseekingtoperformoperational

duediligenceonaudited financial statements todo?Oneway toproceed is toreviewtheauditedfinancialstatementsofthevintagefund.Toplaydevil's advocate for amoment, a skeptical prospective investormay

ask:WhyshouldIbotherreviewingthefinancialstatementsofadifferentfundthat is not the fund I am considering investing in?This is a fair question thatbearsaddressing.Thefollowingisapartial listofreasonswhyreviewingsuchfinancialstatementsisadvantageous:

If you do not review vintage year statements, or other financialstatements for other funds as available as discussed in more detailfurtheron,thenthereisnothingelsetoreview.Vintagefundstatementsarethenextclosestavailablematch/optiontothefundyouwillbeconsidering.Reviewing the audited financial statements can provide insight intoseveral areas of fund operations as well as the scope, quality, andtimelinessbywhichauditswillbegenerallyconducted.Thesepiecesofinformation can give a prospective investor in a private equity fundsomeperspectiveonhowsuchitemswillbehandledsimilarlyfor thefundtheyareconsideringinvestingin.

Whatisaninvestortodoiffacedwiththeoften-commonscenariooftherenotbeingapreviouslymanagedvintageprivateequity fund?The“new”fundmayeitherbea fundfromanestablishedprivateequity firmthat ispursuinganewstrategyorjustabrand-newfundstartedbyanewfirm.In theformercase, if the firmhasmanagedotherprivateequity funds in the

past, it is still worth an investor's time to examine these other statements. Ofcourse,vintagefundstatementswouldbepreferable;however,therearenosuchstatements available in this scenario. Audited financial statements from otherfunds,eveniftheyaremanagedbyacompletelydifferentinvestmentteamatthesame private equity firm, can still provide valuable insights into the firm'srelationshipwiththeauditorandthegeneralqualitywithwhichsuchauditsareperformed.If a private equity firm has, indeed, operated similar funds in the past, this

presentsinvestorswithadistinctopportunityfordata-gatheringthatabrand-newfirmwith no prior fund history cannot offer.Certainly, investorswill bemoredrawntoaprivateequityfirmwithapriorestablishedtrackrecord.Afterall,itmay seem as if it is only common sense to believe that if a firm has alreadystartedandmanaged,or is in theprocessofmanaging, a fund, then theyhavelearnedfromthisexperienceandwillbebettersuitedatleastoperationallythanabrand-newfund.Theseoverlybroadgeneralizations,however,aremadeonlybyfoolhardyinvestorswithout thetimeandresources toproperlyvetaprivateequity firm.Ofcourse, theremaybecertain institutionaloperationalcapacitiesandprocessesthathavebeendevelopedandrefinedintheestablishmentofthefirstfundmanagedbyafirm,butthisdoesnotremovetheonusontheinvestorto thoroughly vet the operational risks of each fund on an individual basis.Merelyrestingonthelaurels,operationalorotherwise,ofamanagerintheplace

ofproperduediligenceisadangerousgameofRussianroulettethateventuallywill not end well when the manager who the investor did not performoperationalduediligenceoncausesanoperationalblow-up.

UNDERSTANDINGFINANCIALSTATEMENTSECTIONS

Whenaninvestorapproachestheauditedfinancialstatementsofaprivateequityfund for reviewaspartof theoperationalduediligenceprocess, it isuseful toobtainabasicunderstandingofeachof thedifferentcommonsections thatarepresent.

OpinionLetterTheopinionlettersectionofthefinancialstatementsissometimesreferredtoastheindependentauditorsreport.ThisletteristypicallyaddressedtotheLimitedPartnersofaprivateequityfund.The opinion letter may then contain language that, in effect, attempts to

disclaim liability in this regard by stating something to the effect of “Thesefinancial statements are the responsibility of the fund's management.” Theopinion letter will next state the audit standard employed as well as a briefstandarddisclosureastowhatanauditentails.Finally,at theconclusionofthelettertheauditorwillexpressanopinionastowhetherthefinancialstatements,intheiropinion,fairlyrepresentthefinancialpositionofthefund.Investorswho begin to reviewprivate equity statementswith any frequency

maybegin to feel their eyes glaze overwhile perusing the often cookie-cutterpiecesofsuchstatements.However,theoneareathatisoftenoverlookedinsuchstatementsistheletterhead.Investorsshouldfirstchecktoseewhetherthelogoin the letterhead for the audit firm actuallymatches the corporate logo of theauditor. If financial statements have been fraudulently manufactured ormanipulated,thenthelogomightnotmatch.Asecond itemthat investorsshould lookfor in the letterhead is thenameof

the audit entity that is actually performing the audits. For offshore funds, theauditentitylistedintheletterheadwill likelybeanoffshoreaffiliatedentityoftheparentonshoreauditentity.Foronshorefunds,adomesticentitywilllikelybelisted.Afinalconsiderationwithregardtoletterheadrelatestotheaddressofthe audit firm.This can often provide insight into theway inwhich a privateequityfirminteractswiththeauditor.IfaprivateequityfirmislocatedinNewYorkbut theirauditor,or,at least, theauditoffice listed in the letterhead, is inAustin,Texas, investorsmaywant to consider discussing thiswith the privateequityfirm.Forexample,doestheauditornotperformon-sitevisits?Orperhapsthe New York–based private equity firm maintains a relationship with theAustin, Texas, office because of a legacy relationship with an audit partner.Investors can often gain useful insights by reviewing such seemingly minordetailsfoundinthefinancialstatementsandfollowingupwiththeprivateequityfundregardingsuchissues.

OTHERFINANCIALSTATEMENTSECTIONS

Inadditiontotheopinionletter,theauditedfinancialsforaprivateequityfundmay contain a number of different sections that are outlined in the followingsections.

StatementofAssetsandLiabilitiesTheStatementofAssetsandLiabilitiesisalsoknownasthebalancesheet.Thisfinancial statement will provide a summary of assets, liabilities, and partner'scapital.

StatementofOperationsTheStatementofOperations,Assets,andLiabilitiesisalsoknownastheincomestatement.Theincomestatementwillgenerallyprovideasummaryofanygainsallocations from affiliated entities, as well as a summary of income andexpenses. Investors can utilize the information contained on this statement tofacilitateananalysisoffundexpenseallocations.

StatementofCashFlowsTheStatementofCashFlowsprovidesasummaryofcashflowsfromoperatingandinvestingactivities.Thisfinancialstatementtypicallydetailsthemovementsof cash throughout the fund including net increase in partners’ capital fromoperations, and any reconciliation adjustments, details of proceeds from sales,and details of purchases of investments. Additionally, the Statement of CashFlowswill typicallyoutlineanycashflowsfromfinancingactivitiesaswellasanycashandcashequivalentsheldbythefund.

StatementofChangesTheStatementofChangesissometimesreferredtoastheStatementofChangesin Partners’ Capital. This statement will typically outline changes in thecontributionsandwithdrawalsoftheGeneralPartnerandLimitedPartnersoveraparticularperiod,which is typicallyannually.TheStatementofChangeswilllikely also detail the allocation of net increase in partners’ capital fromoperationsonaproratabasis.

ScheduleofInvestmentsThe Schedule of Investments is typically presented in condensed format inauditedfinancialstatements.TheScheduleofInvestments, if included,maybepresented as either a standalone financial statement or as part of the financialstatementnotes.TheScheduleofInvestmentsmaygroupinvestmentsbysector,region,orothermethodology.This schedulemaybepresented in anumberofdifferent formats thatmay include the cost of each portfolio asset, themarketvalueofeachasset,andthepercentoffundcapitalrepresentedbyeachportfolioasset.

FinancialStatementNotesDespite thefact that theyareoftencontainedat theveryendof thedocument,thenotesaccompanyingfinancialstatementsarekeycomponentsofthefinancialstatementsthemselves.Because of their informative value, one approach toward analyzing the

financial statements worth considering may be to read the notes first beforedigging into the relevant sections of the financial statements themselves.Throughout the financial statements youwill often see referencesmade to thenotes. In some audited financial statements the auditorsmake reference to thefinancial statement notes on almost every page of the preceding statements.Somestatementscanbequitecurt,suchas“Seeaccompanyingnotes.”Otherauditorsmaytrytobeatbitmorecordialwithreferencestotheeffectof,

“The accompanying notes are an integral part of these financial statements.”Regardless of the terms in the approach utilized, the notes can be gleaned byinvestorsforvaluable information.Whenincorporated intoa largeroperationalduediligencereviewofaprivateequityfund,theinformationnotonlyfromthefinancial statement notes but the entire financial statement review can furtherfacilitateinvestorsinthequesttoseparatethewheatfromthechaffandnavigatetheoftenseeminglyinsurmountabletsunamiofdocumentsthatmayoverwhelmeventhewell-intentionedinvestorwhoapproachestheprocesswithoutaplan.A few words of caution are advisable before an investor tucks into the

financialstatementnotes.First,inamannersimilartotheofferingmemorandum(Chapter6discussesthisindetail),thefinancialstatementnotesarerepletewithlegal platitudes, cover language, ambiguously perplexing disclosures,employment of reference by incorporation, and awhole host of other devicesthatmakethemnoteasilydigestible.Eventothetrainedeye,suchasaCertifiedPublicAccountant in theUnited States or aCharteredAccount outside of theUnited States, translating these notes into nonlegalesemay be somewhat of achallenge.Partofthebenefitofperformingoperationalduediligenceasaregularpractice

forallofaninvestor'sprospectiveandactualprivateequityinvestments is thatwitheachsubsequentreview,investorsbegintobuildupaninternaldatabaseofknowledge.As such, any investorwho has done thiswill begin to gain somelevel of familiarity with both the format and general content of the varioussectionsofauditedfinancialstatements.Thesameistruefortheanalysisofthe

notes contained in the audited financial statements of private equity firms. Sowhatexactlyiscontainedinthefinancialstatementnotes?Therearesevenmainareasthatarecovered.1.OrganizationandBusiness.Thissectiongenerallycontainsanoverviewofthe basic history and details of the fund. To begin with, this section mayinclude an overview of when the fund was incorporated and commencedoperations.Itisworthnotingthattheseareoftentwodifferentdates.Afundisoften incorporated for legal purposes on a date before operations actuallybegin.2.SummaryofSignificantAccountingPolicies. Inthissection, theauditorswilltypicallyrefertotheaccountingstandardsthatareemployedwithlanguagetotheeffectof“Thesefinancialstatementshavebeenpreparedinconformitywith U.S. generally accepted accounting principles (U.S. GAAP) and allamountsarestatedinU.S.dollars.”Thissectionmayalsoincludeavarietyofsubsections highlighting significant accounting policies including: cash andcash equivalents, due from brokers and unsettled transactions, investmenttransactionsandrelatedincome,valuationofinvestments,securitiespurchasedunder agreements to resell, use of estimates, indemnifications, income taxes,foreigncurrency,andnewaccountingpronouncements.3. Investments. This section will provide an overview of the type ofinvestmentsheldbythefund.Theinvestmentssectionmayalsodetailcertainriskexposures thefundmayhave, includingcredit risk,market risk,andoff-balance-sheetrisk.4. Commitments and Contingencies. In this section the details of anycommitmentstoaffiliatedentitiesandotherthird-partyfirmsisgenerallystatedsuchasacashdepositthatmayserveasacollaterallineofcredit.5.RelatedPartyTransactions.Thissectionoftheauditedfinancialstatementnotes will typically outline any transactions that a private equity fund mayengage in with other funds or the General Partner including fee-sharingarrangements.6. Financial Highlights. The financial highlights section is where certaininformation and ratios relating to the fund are typically presented by theauditor.Thissectiontypicallybeginswithanoutlineoftotalreturnforthefundfortheperiodcoveredduringthefinancialstatements.Thefinancialhighlightssectionnexttypicallycontainsanumberofratios,includinginvestmentincomeratioandexpenseratios.Theseratiosaretypicallycalculatedbasedonmonthlyaveragenetassetsduringtheyear.

7. Subsequent Events. This section of the audited financial statementstypicallyoutlinesthedetailsofanyaccountingchangesaswellassubscriptionsandredemptionsofwhichthefundhasbeennotifiedforperiodfollowingtheendoftheauditperiod.

FinancialStatementDueDiligenceConsiderations:WhyCan'tIJustAsktheAuditor?

The reader may pose the question. “Well, if the private equity fund managerwon'ttalk,whydon'tIjustasktheauditor?”Statedpolitely,theanswertothatis“Good luck.” Investors performingoperational duediligenceonprivate equityfunds will quickly realize by perhaps their second or third review that mostauditors give the impression that they live in a constant state of paranoia.Auditorsdonotliketoorwanttospeakwithinvestors.Yourauthorwouldliketo believe it is not because they are not proud of their work. No rather, thecommon logic is that the auditorswill point their finger at their lawyerswhohaveadvisedthemnottotalk.Indeed,auditorsmayalsoseektoblameinvestorswho have suffered fund losses and sued auditors, claiming in part that theymaterially relied on their audits and because the auditors [insert reason here](e.g.,didn'tdotheir job,werereckless,werenegligent,etc.).Regardlessof themeritsofsuchsuitsandwhethertheauditorsmayormaynotbeliable,thefactof thematter is that this has resulted in auditors constructing avirtualwall ofsilencearoundthemselves.Oneofthechallengesinperformingoperationalduediligenceisforinvestorstofigureouthowtopenetratethisfortress,andobtaineventhesmallestglimmersoftransparency.To see this in action, we can consider the service provider confirmation

processthatChapter3outlines.Unlessinstructedotherwisebyaprivateequityfirm,aninvestorwilltypicallyseektoconfirmafundorfirm'srelationshipwithanauditor.Typicallythisinitialconfirmationisattemptedbye-mailmessageorphone call. When such requests are made, the vast majority of auditors willsimply not respond. To borrow from the legal profession, this is a techniqueknown as stonewalling. The auditors likely figure that if they do not evenacknowledgetheinvestor'srequesttheyareoffthehookfromanyinvestorbeingabletoclaimthattheyreliedonanythingthattheymayhavecommunicatedtothe investor outside the audited financial statements, all of which have beenlikelyscrubbedbytheirattorneys.Nowwhatisaninvestorsupposedtodo?Forgetaboutdelvingintodiscussions

related to audit materiality levels or any actual questions about the auditedfinancialsthatyoumaywanttoaskofanauditor,ratherthantheprivateequityfundthemselves.Atthisstageinourexample,aninvestorisstillmerelytryingto confirm the relationship between the auditor and the private equity fund orfirm.Duringthisprocesstheprivateequityfirminquestion,perhapsrespondingto

requestsfromtheauditors,maysetupanumberofroadblockstowhatcouldbeasimpleandseamlessprocess.Thefirstofsuchhurdlescouldbethattheprivateequity firm will not provide investors with the specific details of whom tocontactattheauditfirm.Anexampleofhowthiscanoccurwouldbedisclosuresinafirm'spreparedduediligencequestionnairethatlistscertaincontactdetailsregarding service providers. When it comes to the auditor, however, the duediligencequestionnairewillmerely list thenameof the firm inquestionandavaguestatementsuchas“detailsavailableuponrequest”or“pleasecontactthefirmforfurtherinformation.”Thisthenrequirestheinvestortocontactthefundtoobtain thedetails,which, asoutlined inmoredetail later, theprivate equityfirmwillnotdirectlyprovide.Asecondtechniqueemployedbyprivateequityfirmsinattemptingtoskirtthe

actual independent audit confirmation issuewould be to point out that, in thecaseofavintagefundarrangementwherethesameauditfirmisbeingengagedfor the new fund, the previous audits were produced by the auditor on theirletterhead.Despite thecurrent stateof thepost-Madoffworld, aprivateequityfundmay, feigning naiveté, sheepishly pose the question, isn't that sufficient?Plainly, no. As a long list of historical frauds throughout the alternativeinvestmentworldhavedemonstrated—Sam'sIsraelBayouhedgefundcomestomind—letterheadscanbeforgedandauditfirmsmayevenbeentirelymadeup.Having jumped through thishoop,aprivateequity firmmaynextattempt to

quell any investor concerns by producing a recently dated and signedengagement letter from an auditor, once again on letterhead, for the proposedworkonthenewfund.Thisisnotsufficient,either.Thepointthatmanyprivateequityfundsmayoftenmissandwhichisworthhighlightingtoinvestorsistheimportance of independence in the relationship confirmation process. If theinformationbeingusedtoconfirmtherelationshipwithaprivateequityfirmisprovidedtoaninvestorbythatsameprivateequityfirm,then,statedplainly,theconfirmationisnotindependentlyobtained.Thewayinwhichmostauditconfirmationsproceedbeyondthispointvaries.

Oneway theymayproceed is thatoftentimesan investormust insist that they

needindependentconfirmationofthefirm'srelationshipwiththeauditor.Ifthisis the first time the fundhasdealtwith sucha request, theprivateequity firmthemselves, without the investor being involved, will typically contact theauditor and convey the request. The auditor will next likely provide aconfidentiality agreement and liability release for the investor to sign. This isalsosometimesaccompaniedbyasecondsimilarconfidentialityagreementandreleasewherebytheprivateequityfirmreleases theauditorfromliability.Thisdual release systemcanoftenbequite cumbersome for both investors and theprivate equity firms to navigate. Additionally, if investors prudently haveexternal legal counsel review thesedocumentsbeforeexecuting them, this canadd additional expense and significant delay in the operational due diligenceprocess timeline. Finally, once all these releases are in place the auditormayonly send the investor a letter, full of the standard disclosures and legalese,whichconfirmstherelationshipbutdeniesjustabouteverythingelseyoucouldthinkofinregardtotheoversightandworkoftheauditor.Withthisbackground,itisworthnotingthatincertaininstancesauditorsmay

actually reply to investor's inquiries thefirst time theyaremade.Theserepliescan range from basis e-mail confirmations to an actual phone conversation.While theremaybeveryvalid reasons forauditorsandprivateequity firms toestablishcertainsafeguardsthatmayleadtoanunintendedresultandencumberthe investor operational due diligence process, ultimately the onus is on theinvestortoputintheefforttoconfirmauditorrelationships.This seems a bit ridiculouswhenyou think about it.Consider the following

example:youareconsideringpurchasingahome.Yougotothebanktoobtainamortgage.Thebanktellsyouthat theywillextendamortgagetoyoubutonlyafter you have the home inspected by a certified engineer. Eager to get themortgage, yougoout andhire the inspection engineer.The engineer conductsthehomeinspectionandproducesareport,inwhichhestatesbasedonthehomeinspectionguidelinesissuedbytheCounselofAlmightyHomeInspectorsthatinhis opinion the report fairly shows that there are notmaterial issues with thehome.Heevensignsandstampsitwithhisofficialstamp.Youtheneagerlygotothebankwithyourreport.Thebankreviewsitbuthasafewquestionsaboutsome of the conclusions made by the inspector and wants more information.Theycall the inspector (hisphonenumber is listedon theopinionpageofhisreport).Aweekgoesbyandthehomeinspectordoesnotreturnthebank'sphonecall.You are stillwaiting to hear if the bankwill approve yourmortgage andinquire as to the status. The bank tells you that they attempted to contact the

homeinspectorbuthehasn'treplied.Youangrilycallupthehomeinspectorandaskwhyhehasn'treturnedthebank'sphonecalls.Thehomeinspectorexplainsthathehashadaproblemin thepastwithbankssuinghimandrequires them,andyou,tosigna30-pageconfidentialityagreementsandreleasesbeforetalkingtoanyone.Furious,youremindthehomeinspectorthathewashiredbyyou,youpayhisbill,andattheendofthedayitwouldbeonlycommoncourtesyforyoutogeton thephonewith thebank.He refuses.Frustrated,youwalkawayanddecidetobuyadifferenthouse.Thisexampleisabitequivalenttothewaysomeaudit firms dealwith their private equity clients and the frustrations investorsfacewhen dealingwith such firms. Investors should be prepared to dealwithsuch challenges during their operational due diligence processes, and developstrategiestoovercomethesehurdlessoasnottostalltheirreviews.

UNDERSTANDINGFAS157Inreviewingauditedfinancialstatementsofaprivateequityfundaninvestorislikely to come across FAS 157 breakouts. FAS 157was first implemented inNovember 2007. FAS 157 created a framework for categorizing valuations.Valuationsaresupposedtobecategorizedintooneofthreecategoriesaccordingtotheinputsutilizedtovalueeachposition.Thehigherthelevel,thelessreadilyobservable market prices and, therefore, the position is generally more thinlytraded and thought to be more illiquid.When it was first implemented as anaccountingrule,itwassupposedtoinitiallyhaveabigimpactonthealternativeinvestment industry. Level 1 assets are those with readily observable inputs.Level2assetsarethosewithnodirectlyobservablepricesthemselves,butthoseassets do have price inputs that are based on them (e.g., an interest-rate swapwhosecomponentsareobservablepoints—likeaTreasurybond).

TheLevel3AnathemaFinally we come to Level 3 assets. These are supposed to be assets with noreadilyobservableinputs.ThereisageneralstigmaagainstLevel3assets—bothprivate equity firms and investors seemingly want to avoid them at all costs.Why?Well,forstartersthereistheperceptionofthemarketpremiumplacedonliquidity. Whether or not you agree that the desire for enhanced liquidity isrational—the fact of the matter is that when given the choice, most groups,privateequityfunds,andinvestorswouldgenerallypreferthemoreliquidasset.

Privateequity funds inparticulardonot likeLevel3assets.WhenFAS157was first implemented in the private equity firm's 2008 audited financialstatements, therewasmuchhesitationamongauditorsandprivateequityfundsalikeregardinghowtoclassifythoseassetswithquestionableinputsoruncertainlevelsof illiquidity.Manyauditors tookaconservativehard-lineapproachandclassified these questionable assets and liabilities as being in Level 3. Whileinvestorsmayhavebeenoriginallyunhappy to learn thataprivateequity fundthat they thoughtmay have beenmore liquid than the FAS 157 levels in theaudited financial statements suggested, at least investors took somecomfort inknowingthattheauditorshadmostlikelybeenconservativeintheirapproachtolevelclassification.

WhereAreWeNow?AFloatingFAS157StandardFlash-forward a fewyears to thepresent, and theFAS157 level classificationsystem has reached a tipping point that threatens to render level classificationvirtuallyuseless.Whathashappened is thatprivateequity firmshave recentlyrediscoveredanimportantfact—theauditorworksforthem,andtheyarenottoosubtlyremindingauditorsofthisfact.UnhappywiththeirassetsbeingclassifiedasLevel2orLevel3,manyprivateequityfundshavecontinuallyarguedwiththeir auditors over the past few years that certain assets inputs are reallyobservableandthattheyshouldbemovedupfromoneleveltoanother.Thishasresulted in the gradual transition of assets from Level 3 to Level 2 and fromLevel2toLevel1.Part of the transitionmay justifiably come from auditor's increased comfort

with the FAS 157 rules over time, coupled with enhanced guidance from theauthor of FAS 157 the Financial Accounting Standards Board (FASB). ButFASB guidance and auditor knowledge levels aside, it would not beunreasonable to hazard a guess that the increasedprivate equity fundpressuretoward auditors to recategorize assets and liabilities as beingmore liquid hassomethingtodowithit.Afterall,ifaprivateequityfundandanauditorcannotagree, a private equity fund can always threaten to switch auditors or split uptheirauditworkfordifferentfundsamongmultipleauditfirms.While many auditors may publicly portray the image that they would not

consider compromising their standards at the beck and call of private equityfundsforissuessuchasFAS157levelclassification,itseemsasiftheauditorshave found somewiggle room in which to operate with regards to FAS 157.

AuditorsnowseemcomfortableinkowtowingtoprivateequityfundrequestsforFAS157 level reclassification as long as they have a leg to stand on, albeit ashakyone,intheformofsomesortofobservableinput.TheproblemisthataninputthatwasoncenotreadilyobservablewhenFAS157wasfirstimplementedhasnowenteredagrayareaofobservability,whichtheauditorusestolevel-upassetsandkeeptheprivateequityfundastheirpayingclient.Further complicating the issue is thatmanyprivate equity fundshavebegun

creatingtheirownFAS157classificationsystemsthattheyusetodistributeFAS157 statements to investors throughout the year. Some private equity fundadministratorshavealsogottenintotheFAS157businessandbegunprovidingclassificationguidanceaswell.ReconcilingtheselevelstoanyFAS157levelsinaudited financial statements can yield an interesting glimpse into potentialdifferencesinclassificationmethodologies.Furthermore,byanalyzingFAS157levelsovertimeaninvestorcouldbegintounderstandhowclassificationlevelsmayhavechangedovertime.

OperationalDueDiligenceInsightsintoFAS157Today

Detailedoperationalduediligencecanprovideusefulinsightsintothesetypesofissues. Often, yellow or red flags, such as a virtually captured auditor,inconsistencies in valuation methodologies, and overly optimistic statementsaboutliquidity,cometolightwhenanalyzedinthecontextofacomprehensiveoperationalduediligencereview.Suchanalysiscanbetime-consumingbutmayyieldsomeusefulinsightsintoanylatentoperationalrisksthatmaybepresentinafund.

CONCLUSIONThis chapter provides an overview of some of the techniques investors mayconsideremployingwhenperformingduediligencereviewsofaprivateequityfund's financial statements. This chapter also introduces several issues andconcerns investors may want to focus on in conducting these reviews. Insummary,somekeyquestionsthat investorsmaywant toaskthemselveswhendesigning the financial statement review component of their private equityoperationalduediligenceprogramcaninclude:

Forhowmanyyears shouldyou collect audited financial statements?Sinceinception?Howdoyouanalyzeandtrackfundexpenses?Areoperationalexpenselevelsappropriateascomparedtootherparipassufunds?Are audits being completed according to previously establishedtimelines?Howcanyoulocateevidenceofthis?Doestheauditorperformanyadditionalaudit,tax,ortestingservices?Howhavetheauditedfinancialschangedyearoveryear?Hasthefund'sauditorremainedconsistentsinceinception?Whatabouttheprimaryofficefromwhichtheauditisconducted?Doesyour reviewof the audited financial statements agreewithbothyourreviewofotherfunddocumentation(e.g.,offeringmemorandum,duediligencequestionnaire)aswellasmanagerstatements?Have you been able to receive independent confirmation, eitherformallyorinformally,fromtheauditorthattheyindeedperformauditworkforthefund(s)underreview?Areallaudits,includinghistoricalones,onappropriateletterheadfromtheauditor?Whatisthenatureoftherelationshipbetweentheauditorandthefundadministrator?Hastheauditorvisitedthefundadministrator'soffices?Howdoyoumonitorthingssuchasrelatedpartytransactionsandcashlevels?Are there any related or affiliated funds audited financials that youshouldrevieweventhoughyouarenotconsideringinvestingdirectlyintheseotherfunds?

NOTES

1.SeeGeorgeGeorgiades,GAASPracticeManual2009:CurrentSASs,SSAEs,andSSARSsinPractice(CCH,2008).2.SeeLouisBraiottaJr.,TheAuditCommitteeHandbook,5thed.(Hoboken,NJ:JohnWiley&Sons,2010).3.SeeVincentM.O’Reilly,Montgomery'sAuditing,12thed.(Hoboken,NJ:JohnWiley&Sons,1999).4.SeeBarryJ.Epstein,WileyGAAP:InterpretationandApplicationofGenerallyAcceptedAccounting(Hoboken,NJ:JohnWiley&Sons,2010).5.“AICPARecommendsSECAllowOptionalAdoptionofIFRSbyU.S.PublicCompanies,”August17,2011,www.aicpa.org/Press/PressReleases/2011/Pages/AICPARecommendsSECAllowOptionalAdoptionofIFRSbyUSPublicCompanies.aspx6.SeeGaryPrevits,ResearchinAccountingRegulation,vol.20(Oxford,UK:JAIPress,2008).

CHAPTER8

DistinguishingtheAssetsClass:RealEstate–SpecificConcerns

Someprivateequityinvestorsmayconsiderrealestatetobeadistinctassetclassthat has very little if any relation to private equity funds. Indeed, if investorsapproachthesubjectwithanyprivateequityfundmanagerthemselves,theyarelikely tohear a long litanyof reasons regardingwhy the twoasset classes aredifferent. Others may draw more similarities between the two types ofinvestments.From the investor's perspective it is easy to see fromwhere suchsimilarities arise. Both investments in real estate and private equity require alonger-terminvestmenthorizonascomparedtoperhapsmoreliquidassetclassessuchashedgefunds.Additionally,bothprivateequityandrealestatefundstendtoinvestinmoreilliquidpositions,ascomparedtohedgefunds.From the perspective of an investor seeking to perform operational due

diligence on both private equity and real estate funds, accompanying thesesharedilliquiditycharacteristicsaresimilaritiesinapproachestovaluingilliquidassetsaswellasfundstructures.Despite such similarities it is important for investors not to approach

operational due diligence reviews of both private equity and real estate fundswithablanketapproach.Suchauniversalapproachmayresultinahomogenizedapproach thatdiminishessomeof theparticularities regardingeachassetclass.Thischapterprovidesanintroductiontocertainissue-specificfactorsrelatingtoperformingoperationalduediligenceonrealestatefunds.

REALESTATETRADEFLOWPROCESSWhenbeginningtheoperationalduediligenceprocessonarealestatefund,itisoften helpful for Limited Partners to begin the process with obtaining anunderstanding of the investment research and trade flow process by which aparticular real estate fund invests. An understanding of such a process is

particularly useful due to the different types of unique asset classes related torealestate.Forexample,differentfundsmayinvestinawiderangeofpropertytypesincludingcommercial,residential,andagriculturalpropertytypes.

SAMPLEREALESTATEPROCESSIn order to provide the reader with an oversight of a typical process in thisregard, wewill walk through such a process inmore detail for a sample realestatefund,whichwewillrefertoasREFund,thatinvestsincommercialrealestate.

InitialResearchRE Fund maintains a research team that consists of three individuals: Mr. A(FundManager)andtworesearchanalysts.Invettingpotentialopportunitiesforthe funds, this team utilizes a combination of in-house economic forecasts aswellasavarietyofthird-partyresearchsources.

SectorAnalysisThe fund's management team defines the characteristics of commercial realestate assets into three different sectors: city centers, shopping centers, andsupermarkets.The firmutilizesan internalmatrixmethodology to identifyandmonitor these characteristics. This commercial matrix is utilized whenconsideringnewinvestmentsfortheREFundaswellasforselectingpropertiesfordispositionorredevelopment.Tofacilitatethequalityofdatautilizedinthematrix,themanagementteamforthefundseekstomaintainongoingdialogueswithagentsandretailerstomonitormarketconditions.

FeasibilityStudyA feasibility study is generally conducted for all new deals. As part of thisprocess,newinvestmentopportunitiesareappraisedviaaprocessthatincludesconsiderationoftherealestateassetunderreview.Ifafterthisinitialscreeningapropertyisstilldeemedtobeacceptable,amoredetailedreportispreparedforthefirm'sprogressreviewcommittee.

AnalysisTools

To facilitate further portfolio analysis, the fundmanagement teamwill utilizetwo proprietary applications. One application focuses on commercial propertyanalysis opportunity vetting. The second application allows for asset analysisand portfolio construction. The first application is utilized to focus on theidentification andmonitoring of real estate assets via a scoring system.Whenscoringaproperty, themanagement teamassignsdifferentweights todifferentindicatorsacrosseconomic,realestate,market,andretailexperiencefactors.Thesecond application tool is utilized to identify andbenchmark real estate assetswith a focus on identifying and tracking localmarket asset performance overtimeutilizingananalysisofavarietyofperformanceindicators.

AcquisitionPlanandCommitteeReviewOnceapotentialinvestmenthasbeenidentified,theREFundmanagercreatesanacquisitionplanforinvestments.Theseplansincludeananalysisofseveralareasincluding research, legal, tax, compliance, accounting, reporting, and technicalassetmanagement.Theplansarereviewedbyanappointedcontroller.In addition to these proprietary tools, the firm also performs competitive

analysis for each asset. The combined results of these efforts are listed in anannualreviewofholdorsellanalysisforthefunds,whichfeedsthedevelopmentofathree-yearbusinessplanfortheportfolio.Theanalysisincludesareviewofplans to acquire a new square footage once the properties under developmenthavebeencompleted.

TechnicalDueDiligenceREFundalsomaintainsatechnicalduediligencedepartmentconsistingoffourindividuals.Thisgroupisresponsibleforoverseeingtheworkofinternaleffortsand third-party firms that perform technical due diligence on properties. Thetype of technical due diligence performed include reviews of buildingconstruction, fire systems, and soil analysis to detect the presence of anypotentiallydangerousmaterials.

PropertyAcquisitionOncethefinalduediligencereviewiscompleteandalltheappropriateapprovalshave been obtained, RE Fund will then proceed with the acquisition of theproperty. This process includes the drafting and completing of all relevant

purchase documentation. To ensure the limited liability of each property, aholdingvehicleisusuallycreatedforeachproperty.Itshouldbenotedthatthefundwillnotbepermittedtoinvestmorethan18percentofthenetassetvalueof the fund into real estate assets that are subject to development or are heldvacantpendingdevelopment.Generally,atthetimeoftheacquisitioncapitalwillbedrawndownfrominvestorstofacilitatethepurchase.

LoggingofthePurchaseandSaleofAssetsOncea real estateassethasbeenpurchased,anapplication is submitted to theaccounting department for the creation of a project code in the RE Fund'ssystems.Theentirepurchaseprocessfromprojectinitiationtothepurchaseofanassetisadministeredthroughaseriesofoperationalchecklists.Forprojectsthatinvolve real estate that is yet to bebuilt, the constructionprocesswill alsobemonitoredaccordingtoafixedformat.Intheeventarealestateassetistobesold,asalesproposalisprepared.After

reviewandapprovalbytheacquisitionandsalesmanager,theassetisputonthemarket.Thebusinessunitthenprovidesthecorrespondingdocumentsrelatingtothe sale to enterprise system. Specifically, the required documents are acompletion statement and a sales agreement. Once RE Fund receives thesedocuments,thedataisreviewedbyatleastsevenindividualsfromthevaluationgroup. Similar procedures are in place for managing systems which includesdigitalstorageofdocuments.Theenterprisemanagementsystemisalsoutilizedformaking index-linkedcalculationsand loggingany rental increases foreachcontract.

UseofThird-PartyDevelopersInthepast,propertiesforthefundshavebeensourcedbyREFundviaforwardpurchase agreements, which are structured on a turnkey basis. RE Fund hasutilizedseveraldifferentthird-partydeveloperstofacilitatetheseagreementsandanaffiliatedentity,REFundDevelopment, tooverseeconstructionandleasingarrangements.Itshouldbenotedthattheresponsibilitytoperformduediligenceonthird-partydevelopersliesprimarilywiththefund'sportfoliomanager.

PropertyManagementOnce the asset managers have negotiated the specific deal terms, the process

movesovertoREFund'spropertymanagementteam.Thepropertymanagementgroupfirstensuresthatthespecificdetailsofeachpropertyandtenanthavebeenlogged into the firm's enterprise system.Thedailyworkofpropertymanagersfocuses on a variety of different tasks, which the team has divided into thefollowingareas:

Administration and riskmanagement. This involves inputting newinformation into the enterprise system as well as the propertymanagementfunction,whichservesasthefirstlineofriskmanagementdefense.Thisfunctionalsoincludesmaintainingrequiredgovernmentalpaperwork such ashealth, safety, and fire risk assessment certificateswiththerelevantgovernmentalauthorities.Financial control. This function involves overseeing all income andexpenditureflowsincludingrentcollection.Tenantoccupancy.Thisinvolvesoverseeingthatpropertiesdonotsitvacantandmaintaininggoodcontactswithtenants.Market information. Includes managing and collecting relevantmarketinformationwithrespecttotenantsandproperties.

The property management function is also responsible for overseeing thatappropriate insurance coverage is maintained for each property. Bids arereceivedfromanumberofdifferententities.Buildinginsuranceisassessedonaquarterly basis as part of the oversight work of external valuation agents.Insurancecoverageonbuildingsismaintainedacrossanumberofstandardareasincluding fire,water, andgeneral liability.The assetmanager alsomaintains acertain amount of discretion as towhether they feel certain types of coverageshouldbeinplace,suchasforahistoricalbuilding.REFundoutsourcesthemanagementofpropertytoanumberofthirdparties

tosupportthegroup'sinternalefforts.Twoexamplesare:Shopping Center Management. Daily management of the fund'slargercommercialpropertiessuchasshoppingcentersmallsandotherrentalpropertiestoawidevarietyofthird-partyfirms.Residential PropertyManagement. The management of residentialproperties suchasapartments isalsooutsourced toavarietyof third-partylocalspecialtyfirms.Inadditiontothefirmspreviouslyoutlined,the firmmaintains relationshipswith anumberof subcontractors thatareon-callforemergencyrepairs.AllcostsarebenchmarkedinternallyascomparedtothecostsofsimilarprojectsatotherpropertiesREFund

manages throughout the United States. For any large repair ormaintenance expenditures, there is an internal process that requiresdifferentofferstobereceivedfromseveralvendors.

Post-DealManagementAfter a property has been acquired,REFund conducts ongoingmonitoring oftheproperty.Thisincludesanongoingreviewofthetenant'screditquality.Onabiannualbasis, theREFund's InvestmentCommitteeconductsa full reviewofeach fund's portfolio. Additionally, on a quarterly basis the fund's board willreviewaninvestmentmanagementstatusreportontheportfolio.As a result of this ongoing monitoring, RE Fund may recommend the

implementation of management initiatives. Examples of these initiatives caninclude property refurbishment or the renewal of a tenant's lease. Theseinitiativesaresubjecttotheapprovalofthefirm'sInvestmentCommittee.

CreditResearchThroughout thedeal sourcing and reviewprocess, the fundmanager leveragesoff of the expertise of the fund's credit team. The credit team is a centralizedresource that provides credit analysis to many different funds throughout thefunds,includingthefirm'sfixed-incomeproducts.Aspartoftheiranalysis, thefund's credit team reviews a number of factors including the overallcreditworthiness of a particular tenant and an analysis of the predictability ofcashflows.Theresultsofthiscreditanalysisarearecommendationandrelevantcommentaryfromthecreditdepartmentthataresharedwiththefundmanagers.Portfolio managers are automatically alerted when any changes in creditrecommendations by the fund's credit team for relevant companies are issued.Often these recommendations are supplemented with discussions between thefundmanagersandthecreditteam.As thedescriptionoutlines there are a numberof different stages during the

private equity investmentprocess, eachofwhichhasdifferentoperational riskconsiderations which investors must consider during their operational duediligencereviews.

REALESTATEVALUATION

Realestatevaluationisacomplexanddauntingtasktoapproach,especiallyforinvestors seeking to performoperational due diligence.Aswith each differentprivateequityfundhasdifferentinvestmentconsiderations,sotoodoestherealestate asset class have similar unique considerations for each fund.With realestate,similartothecommonapproachesutilizedtovaluecertaintypesofassets,therearegenerallysomesimilaritiesinthevaluationofcommontypesofassets.During the operational due diligence process, investors should develop anunderstanding of the valuation approach and methodologies employed by thereal estate fund under review. Some of the key considerations regarding realestatevaluationareoutlinedinthefollowingsections.

SampleFundProceduresFrom the perspective of an investor, a real estate fund's internal valuationproceduresdrivethevaluationprocess.Whenbeginningananalysisofvaluationpolicies and procedures, investors should gain an understanding of the way afundapproachesthevaluationprocessaswellthenatureofindependenceintheprocess. So that the reader may gain familiarity with such processes, thefollowingparagraphsdescribeasamplefundvaluationprocessforourfictionalrealestatefund,REFund.ItisanticipatedthatvaluationsforREFundwillbeperformedonaquarterly

basis. It shouldbenoted that thesevaluationsareprimarilyperformedbyeachindividual deal team for a particular position. A variety of valuationmethodologies are utilized as appropriate, including discounted cash flowanalysis (for unstabilized properties), direct capitalization analysis (stabilizedproperties),comparablesanalysis,andmark-to-model for residentialmortgage-backedsecurities.Themethodologyutilizedand theresultsof thesevaluationsare documented in the RE Fund's proprietary valuation memorandum.Accompanying these valuation memorandums are details of financialcalculations utilized and any accompanying source documentation relied uponincludingappraisals,bids/offers,andsignedlettersofintent.After initialvaluationmemorandumsarecomplete, theyare reviewedand, if

acceptable,approvedbydealteamleaders.Afterapproval,finalvaluationdetailsandsupportingdocumentationareuploadedintothefirm'sdata-sharingsoftware.Inadditiontobeinguploadedintothefirm'ssystems,dealteamleaderssign-offon valuation memoranda. These signatures and hard copies of all valuationmemorandaandsupportingdocumentationarestoredinavaluationbinder.

Afterallvaluationshavebeenuploadedandconsolidatedforafund,valuationmethodologies and supporting documentation are reviewed for the real estatefundsbythemanagingdirectorforfinancialmanagement.Thesereviewsincludeananalysisofthevaluationmethodsappliedtoensureconsistencyofapproachas well as discussions with deal team leaders concerning specific deals asrequired.Afterthisreview,ifacceptable,valuationsareapprovedbythisteam.Thenextstageinthevaluationreviewprocessincludesareviewofvaluations

bytherealestateaccountinggroup.Thislevelofreviewincludesananalysisofanyfundcostsassociatedwithaparticularinvestmentaswellasananalysisofvaluations of prior quarter valuations and any changes to equity multiplesemployed. Ifapprovedby the realestateaccountinggroup, thevaluations thenmovetothefinalstageofreview.Thefinalstageofquarterlyvaluationreviewsinvolvesreviewsofconsolidated

executive summariesofvaluations.This levelof analysis includesa reviewofpositionvaluationsby fundand sector.Trendanalysis andany internal rateofreturn(IRR)changesarealsoreviewed.Additionally, in theeventanyspecificasset needs to be reviewed in more detail, this would occur as well. If thesevaluationsareacceptabletotheteam,thefinalapprovalofquarterlyvaluationsisprovided.

UseofValuationConsultantsCertain private equity funds may engage the use of third-party valuationconsultants to provide independence in the valuation process. Increasinglyinvestorsmaydemandtheemploymentofsuchconsultantstoprovideoversightandindependenceinthevaluationprocess.Somefundsmayutilizetheservicesofasingle third-partyconsultantwhileothersmayemploymultiple third-partyvaluation consultants.Theuseofmultiple consultants canprovidediversity inthevaluationprocess anddifferent valuation consultantsmayoffer specializedknowledgeinappraisingcertainpropertytypes.It is important for investors to assess how often consultants will perform

valuation reviews. During the operational due diligence process, investorsshould also assess to what standards the private equity fund's valuationconsultants may adhere. An example of such standards may be the so-called“RedBook”standardsintheRICSValuationStandards.During the operational due diligence process, investors should also gain an

understanding of the process by which a real estate fund may engage with a

valuationconsultant.

SampleValuationConsultantProcessThe following is an example of a valuation process for our hypothetical realestatefund,theREFund.Thequarterlyreviewprocessbeginswithexternalvaluationagentsproviding

RE Fund with a draft valuation of a single value for each asset. These draftvaluationsarereviewedbyREFund'svaluationgroup,whichisindependentoftheREFund.Afterthevaluationgroupcompletesitsreviews,asecondreviewisconductedbytheindividualREFund'sassetmanagersShouldtheREFundassetmanagerhavecomments,thesearecommunicatedtothevaluationgroup,whichwillreviewthecommentswiththeappraiser.Afteranycommentsorissueshavebeen investigated and resolved, the external valuation agent will approve thevaluation.After the external valuation agent's values have been approved, theinternal valuation group prepares a report outlining a reevaluation of allappraisals.CoordinatingthisprocessinternallyfromtheREFund'sperspectiveisthefirm'sheadoffinance,whohastheabilitytochallengeanysuchquarterlyappraisals. In the event a challenge is raised, another neutral third-partyvaluation agent would be brought in to settle any disputes. As part of thismonitoringwork, thevaluationgroupproducesan internal list that includesallrealestateprojectsfromthepreviousquarterandthenewvalues.Wherethereisadifferenceof0.07percentorgreater,thenamoredetailedreportismadethatlists why the value changed, and the value has to be approved by the assetmanager. Physical sign-offs have to occur on all valuation schedules. On anannualbasis,fullvaluations,whichmayincludeon-sitepropertyvisits,arealsoperformed.

CommonApproachestoValuationThereareanumberofcommonapproachestovaluation.Theseapproachescanincludethecostapproach,thesalescomparisonapproach,andincomeapproach.The cost approach is fairly straightforward and involvesholding apositiononthe cost that a private equity fund paid for a particular asset. The salescomparison approach, which may sometimes be referred to a “comparablesapproach,” focuses on the valuation of similar properties. This can include areviewofthepricesthatsimilarpropertiesmayhavecommanded.Additionally,in valuing such properties the sales comparison approach may also focus on

issuesrelatedtoregionalconcernsspecifictolocaljurisdictions.Theincomeapproachfocusesontheincomegeneratedbyaparticularproperty

todeterminevaluations.Duringtheoperationalduediligenceprocess investorsmust determine any assumptions that a private equity fundmayhavemade inestablishing valuation models under the income approach. These assumptionscan include future rates of property occupancy aswell as anymacroeconomicassumptionssuchascontinuingratesofinflation.Outside the United States, a number of different regional valuation

methodologies may be utilized. Many of those methods are similar to theapproaches justmentionedwith additional regional considerations included. IntheUnitedKingdom,forexample,thefollowingmethodsmaybeutilized:

Accounts/Profits Method. This method is utilized for certainresidentialproperties suchasmotelsandeatingestablishments.Thesemethods typically utilize income statements averages from multipletime periods to calculate yields that are utilized in the valuationprocess.ComparableMethod.Thismethodissimilartothesalescomparisonapproach that,as justmentioned, typicallyutilizesdata fromprevioussales.Development/Residual Method. This method is utilized to valuevacantlandunderdevelopment.Contractors’/CostMethod.Thismethodhasmanysimilaritiestothecostapproach,andistypicallyutilizedinevaluatingconstructioncosts.Investment/IncomeMethod.Thismethod isutilized in thevaluationprocesstodeterminethecashflowsgeneratedbyrentalproperties.

Finally,thelastvaluationmethodwewilldiscussarethosevaluationstandardspromulgated by the Royal Institution of Chartered Surveyors, which iscommonly referred to in the United Kingdom under the acronym RICS. TheRICSValuationStandardsiscommonlyreferredtoastheRedBook,outlininganumberofdifferentstandardsacrosspropertytypesandpropertyrelatedmatters,including commercial property, building surveying, and residential property.Exhibit8.1outlinesothercommonstandardvaluationapproachesorganizedbycountry.

EXHIBIT8.1CommonStandardValuationApproachesOrganizedbyCountryValuationMethod/ValuationOrganization Country

Comparablemethod UnitedKingdom

Investments/incomemethod UnitedKingdom

Accounts/profitsmethod UnitedKingdom

Development/residualmethod UnitedKingdom

Contractor's/costmethod UnitedKingdom

RICSappraisalandvaluationstandards UnitedKingdom

UniformStandardsofProfessionalAppraisalPractice(USPAP) UnitedStates

Wertermittlungsverordnung Germany

CouncilofLandValuers Israel

JapaneseAssociationofRealEstateAppraisal Japan

TheRussianSocietyofAppraisers Russia

MONITORINGCONFLICTSOFINTEREST

Whenperformingoperationalduediligenceonrealestatefunds,investorsmustbeconsciousof thepresenceofconflictsof interest.Theseconflictsof interestcan range across a variety of different topics from ethical monitoring,compliance oversight, and deal allocation. The following is a summary of aconflictofinterestpolicyforourhypotheticalREFund.Thefirmmaintainsaconflictof interestpolicyaspartof its larger firmwide

code of ethics policy. On a firm level, RE Fund requires that any action ordecision thatmay result in a conflict, including those among departments andfunds or between the firm and an investor, must be reviewed by seniormanagement, the chief compliance officer, or the general counsel. In addition,the firm's policies require the firm to promptly disclose apparent, potential, oractualconflictsofinterest.Onafundlevel,aspartofthereviewofpotentialconflictsofinterestforthe

real estate fund, the compliance department oversees any specific conflicts ofinterest related to who sourced the deal and management responsibility for aparticulardeal.Additionally,thefirmattemptstoremoveanypotentialconflictsofinterestamongrealestatepersonnelbyinstitutingappropriatesegregationofduties among individuals and departments as well as multiple levels ofintradepartmentalreviewforfundacquisitionsandquarterlyvaluations.For real estate funds, the firm's conflicts of interest policy also attempts to

resolveanypotential conflicts thatmaybe inplace shouldmultiple real estatefundsinadditiontotheREFundwhichmaybeinterestedinthesameproperty.In such an event the deal would be subject to multiple levels of review by

complianceandseniormanagement.Thisreviewwouldtakeintoaccountfactorssuch aswhich personnel first sourced the deal, and the appropriateness of thepropertyforeachfund.

PropertyManagementConsiderationsThe role of property management for real estate fund is one that should becarefullyanalyzedbyinvestorsduringtheoperationalduediligenceprocessforrealestatefunds.Thepropertymanagementfunctionisoftenonethat,althoughrootedinwhatcanbethoughtofastraditionalnoninvestment-relatedactivities,ismorealignedwiththeinvestmentsideoftheGPthantheoperationalfunction.To illustrate, one of the goals of propertymanagement is answering questionssuchas“Willaparticularpropertygenerateareasonablereturn?”andarguablyamoreurbaneconcern,suchas“Dotherealestateholdingsofthefundmaintainadequateinsurancecoverageintheeventthepropertyisdestroyed”?Despitethisseemingly uneasy alliance with the investment side of the world, propertymanagement may very well slip through the cracks of certain due diligenceprocesses thatmay be focused onmore traditional investment notions, and assuchaninvestorfacedwiththetaskofperformingoperationalduediligenceonreal estate property management may well fall within the domain of theoperationalduediligencerealm.Propertymanagement requires knowledge ofmultiple disciplines. The areas

coveredbyapropertymanagementfunctioncaninclude:CollectingrentfromtenantsDetermining the appropriate types and amount of property insurancecoverageNegotiatingleasetermswithtenantsManagingtheleaserenewalprocessasrebateleasesmaycomedueWorkingwithbrokerstofillpropertyvacanciesMaintainingcommonareasEmergencypropertyrepairs(e.g.,fixingaburstpipe)Anyrequiredenvironmentalremediation(e.g.,cleaningupoilthatmayhavespilledontheproperty)Ongoingpropertymaintenance (e.g., landscaping,waste removal,andsoon)Overseeingthecollectionofrentsfromoverduetenants

It is worth noting a few items regarding the previous list. With regard tocommercial property with tenants, the property management function alsogenerally must ensure that tenants’ spaces are maintained in acceptablecondition.Thiscanincludeongoingoversightofproperties,aswellasensuringthattenantsdonotoverstepboundswithregardtoextensiverenovations.Property managers generally also provide oversight with regard to property

security. Security for occupied properties includes preventing things such asvandalism. Examples of such property concerns for occupied properties caninclude providing adequate security at shoppingmalls to prevent occurrences,suchastheftorattacksonpatrons,suchamuggingsinapoorlylitparkinglot.The issue of property security is of particular concern for properties under

development or being refurbished. Security on these types of properties isessentialtoensurethatunauthorizedindividualsdonotaccesstheproperty.Suchproperty security concerns should be monitored because they can havesignificantimplicationsforthefund.Althougheachpropertyholdingistypicallyring-fenced into a separate legal entity, any suchpotential insurance claimsorlitigationresultingfrompropertyinjuriescanataminimumserveasadistractionforafundandatworstgeneratelossesforthefund.Withallofthesedifferentresponsibilities,theroleofmostpropertymanagers

atthemanagementcompanylevelistobe,asthenamesuggests,justamanager.Ifawaterpipeburstsandisfloodingaparticularproperty,itisnotthepropertymanager who typically grabs a wrench and a plunger. Instead the propertymanager grabs a phone and typically calls a plumberwithwhom they alreadyhaveacontract inplace toperformsuchemergencyrepairs. It is important forinvestors to understand the diverse roles and responsibilities of a propertymanagerduringtherealestateoperationalduediligenceprocess.

TenantPropertyConcernsRentCollectionInpropertieswithbuildings,asopposedtovacantproperties,realestateholdingsthat have tenants have a number of unique operational issues that investorsshould consider during the operational due diligence process. One examplerelatestothecollectionofrentsfromtenants.Whenprivateequityfundscollectrents, it is important for investors to track theflowofcashfromtenants to thefund.Someissuesinvestorsmaywanttoconsideraspartofthisprocessinclude:

Does the private equity fund utilize a special agency or vendor toaggregateorcollectfundrents?

Dorentsgotoseparatebankaccountsforthefundorarecollectedrentscommingledwithotherfundcash?

Investors may also want to take into account any issues related to thecollectionofoverduerentsfromtenants.Differentrealestatefunds,dependingon the property type as well as the general state of the economy, may havedifferent occupancy rates for properties. These factors can influence themagnitudeofoverduerents.Inthesecases,investorsshouldattempttogaugetheways inwhich the funds collect any overdue rents during the operational duediligence process. There are a number of different approaches that real estatefundsmay take in this regard. Generally, interest will be charged on overduerent,butarealestatepropertymanagermayofferatenantwhoisbehindontherent concessions such as a waiver of interest if the rent is paid in a timelymanner. Additionally, real estate fund managers may also attempt to obtainleverage over tenants to pay overdue rent via the threat of commencement offormal rent collection proceedings or the perhaps less aggressive tactic ofinvolving third-party collection agencies.During the operational due diligenceprocess investors should investigate not only theways inwhichoverdue rentsarecollectedbuttheamountsofoverduerentsaswell.

FRAUDCONSIDERATIONS:MORTGAGEFRAUDANDSTRAW-MANBORROWERSInvestorsshouldalsotakemeasuresduringtheoperationalduediligenceprocessto investigateways inwhich the fundmanagers attempt to avoid exposure tofraudulentactivities inrealestate transactions.Oneareawheresuchdeal fraudmay be particularly prevalent relates tomortgage fraud. Examples ofways inwhich real estate funds may be exposed to such mortgage fraud risk includethroughthebundlingofinvestmentsorviadirectrealestateinvestments.Inmostmortgagefraudsituations,thereiscollusionbetweentheloanoriginatorandtheproperty appraiser.1 Other groups may also participate in the fraudulentconspiracy, includingbrokers, title companies, and estate agents.Other relatedfraudulentmortgageschemesmayinvolvethecreationofastraw-manborrower.Anexampleofthiswouldbeatransactioninwhicharealestatefund'sholdingsareflipped.Thestrawmanwouldbeusedtopayaninflatedmarketvalueforapricethatwouldthenfeedintoasimilarlyphonyinflatedappraisalvalue.Investors should takemeasures during the operational due diligence process

for real estate funds to review any such questionable legal entities orrelationshipsbothat the realestate fund'spropertyholdings levelaswellasatthefirmwidelevelaswell.Bydevelopingsuchanunderstanding,investorsarelesslikelytobeexposedtofraudulentactivityinrealestateinvestments.

UNDERSTANDINGREALESTATEFUNDFEES

Inadditiontostandardprivateequityfundfees,suchasamanagementfeeandcarriedinterest,realestatefundsmaychargeavarietyofadditionalfees.Duringthe operational due diligence process, investors should take measures tounderstand exactly what additional fees, if any, are being charged to the realestate fundunderconsideration.Suchadditional fees,while individuallysmall,canaddupinaggregatetohaveamaterialeffectontheinvestor'srateofreturn.Notonlyisitadvisabletounderstandthebasicnutsandboltsofsuchfees,butinvestorsshouldalsoconsider themethodologybehindsuchfees.Examplesofadditional fees thatmaybechargedby realestate funds includeanacquisitionfee, property management fee, an income performance fee, and a forwardcommitment performance fee. In certain cases a real estate fund may becompared against certain benchmark indices. If a fund metric such as netoperatingincomeorperformancedoesnotexceedaparticularbenchmarkthenaresultinghigh-watermarkmayresultthatthefundneedstoclearbeforethisfeeis earned. In other situations, such as for acquisition or propertymanagementfees, such fees may be tied to individual real estate holdings, as opposed tooverall fund performance. In certain instances, the descriptions of certain feearrangements,particularly ina realestate fund'sofferingmemorandum,canbequite complex. This is particularly true when multiple scenarios under whichsuchfeemayormaynotbecollectedareevaluated.Foranysuchcomplicatedordifficulttounderstandfees,investorsshouldwalkthroughbasicfeecalculationswiththerealestatefundtoensurebothabasicunderstandingoffeecalculationsaswellastodetermineconsistencyofapproachinsuchcalculations.

PROPERTYHOLDINGSLEGALCONSIDERATIONS

As with most private equity property holdings, a number of asset specificconsiderations may come about, many of which are rooted in legalconsiderations.This is particularly true for real estate funds.However, certaincharacteristics of property ownership and management are more consistentacross different real estate funds than similarities may be across traditionalprivateequityportfoliocompanyholdingscompanies.Anexampleofthisrelatestopropertyinsurance.Regardlessofwhetherarealestatefundholdsvacantpropertyorpropertywith

actualstructuresbuiltuponit,itisrequiredinvirtuallyeverycircumstancethattherealestatefundwillmaintainsomesortofinsurancecoverage.Determiningnot only what coverage types are appropriate, but also the amount of suchcoverage isnotanexactscience.During theoperationalduediligenceprocess,investorsshouldtakecaretoevaluatethemethodologyutilizedbytherealestatefirminthisregard.Certainrealestatefirmswillutilizeachecklist-typeapproachtowarddeterminingwhatcoverageshouldbemaintainedatcertainproperties.Incertaininstances,dependingonthegeographicallocationofdifferentpropertiescertain types of coverage may be mandated (e.g., earthquake coverage inCalifornia).Coveragetypeandamountsmayalsovarybypropertytype.Soforexample, it is likely advisable for a shoppingmall thatmay be frequented byshopperswhocould tripandfallon theproperty tohaveappropriatecoverage.This could be compared to an agricultural or more undeveloped piece ofpropertywithmorerestrictedaccess.Additionally, depending on the nature of activities conducted on a property,

insurancecoveragemayvaryaswell.Forexample,arealestatefundthatownsproperty that is used inmanufacturing a flammable substancewillmost likelyhave increased coverage against fire damage as compared to a nonflammable-substance manufacturing operation. Additionally, the tenants of such propertyarelikelytoberequiredtohavecertaininsurancecoverageinplace,aswellasaconditionoftenancy.Duringtheoperationalduediligenceprocess, investorsshould takemeasures

to understand a private equity firm's approach toward determining insurancecoverage typeandamount.Furthermore, investorsshouldattempt togauge theway in which underlying tenant coverage is monitored by the private equityfirm.Another related legalmatter toconsider is theduediligenceprocess that the

realestatemanageritselfperformsontheunderlyingproperties.Oneexampleofthisduediligencecanrelatetotitlesearches.Typicallyaprivateequityfund,or

their attorney, will engage a third-party title search firm to perform thesesearches.Whilethetitlesearchfirmmayholdliabilityforanyerrors,duringtherealestatefundoperationalduediligenceprocessinvestorsshouldtakemeasuresto determine what actual title search efforts are being either performed orreviewedatthefundmanagerlevel.Ifafundcompletelyoutsourcesthefunctionand title issues that come tobear after a real estate fundpurchasesaproperty,while the fund may have recourse against the title company, such issues cancreatepotentialshort-termlossesforinvestorsaswellasserveasadistractiontofundmanagement.A third related legal matter regarding properties held by real estate funds

involves theways inwhich such properties are held by the fund.As outlinedpreviously,manyrealestatefundsdonotthemselvesownthepropertydirectly.Rather, a separate ring-fenced legal entity is established whose sole asset istypically theproperty.This is typicallydoneon the adviceof legal counsel tolimittheliabilityofthisseparateentitysolelytoissuesarisingfromaparticularpiece of property. If the property was owned by the fund directly, and largeliabilitiesensued,theamountofsuchliabilitiescouldextendbeyondthevalueofthesingleasset.Thiswouldlikelyresultinasituationwheretheliabilityclaimsreached through to the rest of the fund and created large-scale liabilityexposures.Inordertopreventsuchascenario,theseseparateentitiesareusuallyestablished. During the real estate fund operational due diligence process,investors should attempt to gain anunderstandingof theway inwhich a fundapproachestheownershipoffundpropertyholdingsfromatechnicalperspectiveand determine what legal entities are involved in the process. Suchdeterminationscanalsoprovideadeeperunderstandingofthepotentialforanyconflictsofinterestorself-dealingamongentities.

CONCLUSIONThischapterprovidesanintroductiontosomeofthesimilaritiesanddifferencesrelatedtotheoperationalconsiderationsinvestorsshouldtakeintoaccountwhenperforming operational due diligence on private equity and real estate funds.Real estate is aunique subsetofprivateequity investing thathasanumberofuniqueaspectsandpotentialoperationalriskexposuresthatinvestorsmusttakeintoaccountduringtheoperationalduediligenceprocess.Thischapteroutlinesbyexampleseveralofthefactorsinvestorsmustconsider,includingdevelopinganunderstandingoftherealestatetradeflowprocess.Otherareasthatinvestors

should vet carefully during the real estate operational due diligence processinclude valuation concerns and the use of third-party valuation consultants,developing an understanding of common approaches to valuation on a globalbasis,reviewingconflictsofinterestspresentatboththeGPandunderlyingrealestatefundpropertyholdinglevel.Thischapteralsointroducessomekeyareasinvestorsshouldconsiderduringtheoperationalduediligenceprocessrelatedtofraud oversight in real estate transactions, particularly in regard tomortgages.Finally,thischapteroutlinesseveralrealestatespecificconcernsrelatedbothtounderlying specific property types and fund structures, including tenant rentcollectionconcerns,fundfees,andlegalconsiderationsrelatedtofundpropertyholdings.Byproperlyincorporatingareviewofrealestatespecificrisksintotheoperationalduediligenceprocess, investorsare likely tobemoreawareof thepotential for exposures to property specific risks that may be overlooked byinvestorsperformingoperationalduediligencewhoseektooverlaymoregenericprivate equity operational due diligence processes onto the unique real estateassetclass.NOTE

1.CharlesJacobus,RealEstatePrinciples,11thed.(Mason,OH:CengageLearning,2010).

CHAPTER9

PuttingItAllTogether:AssetAllocationandOngoingMonitoring

After an investor has completed an operational due diligence review of aparticularprivateequityfund,theymustthencometoanoperationalconclusion.At first glance, this conclusion is binary in nature: a particular private equityfundmayeitherpassorfailaparticularinvestor'soperationalrequirements.Thisdecisionnecessarily influences the investmentdecision.Forexample, ifa funddoesnotpassoperationalmuster,evenifafundisacceptabletoaninvestorfromaninvestmentduediligenceperspective,theinvestorwilllikelynotinvestinthefund.Weare assuming that if an investor bothers to exert the time, resources,andenergyrequiredtoperformoperationalduediligence,thenheorshewillnotsimply discard the conclusions of this process and proceed blindly with anallocation based solely on investment considerations. Similarly, if a privateequity fund's operational infrastructure is strong enough to pass a particularinvestor'sinternaloperationalriskthresholdyetdoesnotpassinvestmentmuster,wewillassume that this investorwouldnotproceedwithan investmentsolelyontheoperationalstrengthsofafund.Yet what about the situation in which an investor has performed both

investmentandoperationalduediligenceandthefundpassesthebinary,allocateornotallocate,testonbothregards?Anotherquestionaninvestormayconsiderishowmuchcapital toallocate to thisparticular fund.While the intricaciesofportfolio construction and asset allocation from an investment perspective arebetterlefttoothertexts,wecanconsiderthisquestionfromanoperationalriskperspective.Thatis,whatifaninvestorbeyondaminimumpassingacceptablelevel of operational risk has different levels of conviction among differentprivateequityfunds?Shouldaninvestor'slevelofoperationalconvictionwithaparticular manager factor into the capital allocation process among multipleprivateequityfunds?Thischapterexaminesthisquestionanddiscusseswaysinwhich such operational considerations may be included when constructing aportfolioofprivateequityinvestments.

INCORPORATINGTHERESULTSOFOPERATIONALDUEDILIGENCEINTO

ASSETALLOCATIONIthasbeensaidthatassetdiversificationistheonlyfreelunchyouwillfindintheinvestmentgame.1However,whendiversifyinginvestmentsitisimportanttoconsiderfactorsbeyondthosegenerallyemphasized,suchaspurelyinvestment-relatedrisks.ItisperhapsevenmorecriticaltozeroinonthepotentialincreaseinOperationalDragthatonemaytakeonbyinvestinginaparticularfirmanddiversifythatriskaccordingly.2OperationalDragcanbedefinedasthenegativeeffects of operational riskon the efficiencyof anorganization.Even though aparticulartypeoffirmmayseemveryattractive,ignoringanyduediligenceredalertscanresultininvestmentproblemsthatfaroutweighanypossiblebenefits.Onewhoisjustsettingoutonthejourneyofassetallocationforthefirsttime

maybebewildered (and rightlyso!)byallof thechoicesand information thatmustbeprocessed.Thenumericalfinancialaspectsofassetallocationhavebeenstudiedandreportedoningreatdetail,butsignificantly lessattentionhasbeenpaidtothetypesofriskwhosepotentialnegativeexternalitiescanbemitigatedbycarefulduediligence.Recallthatcompleteduediligenceiscomposedoftwohalves:operationalduediligenceandinvestmentduediligence.Thisrelationshipis outlined in Exhibit 9.1. In the following, an algorithmic framework isdevelopedtohandlethesesometimesintangible,difficulttoquantifyelementsofassetallocationwithanoperationalriskbackdrop.

EXHIBIT9.1CompleteDueDiligenceIsComposedofTwoHalves:OperationalDueDiligenceandInvestmentDueDiligence

In Chapter 1, the common private equity operational risk categories areidentified.ThetableofthesecategoriesisreproducedforconvenienceinExhibit9.2.

EXHIBIT9.2CommonPrivateEquityOperationalRiskCategoriesRiskCategory

Cashcontrols

Tradelifecycleprocessing

Valuation

Transparencyandfundreporting

Liquiditymanagement

Technologyandsystems

Legalandcompliance

Counterpartyoversight

Qualityandrolesofserviceproviders

Businesscontinuityanddisasterrecovery

Amodelwillnowbedevelopedforminimizingthetotaloperationalriskofaportfolioconsistingofseveralprivateequityfunds.Notethatthismodeldoesnotincludefinancialrisk.Tobeginconstructingthemodel,leteachofthepotentialfundinvestmentsbeidentifiedbyXi,sothateachelementbelongsthesetofX={x1,x2,x3,...,xN}.Thiscanallbeexpressedasxi X.Eachxihasanassociatedrisk value, ri, which is the sum of all the risk values of all the different riskcategories (along with any other asset allocation due diligence risk types)presentedinExhibit9.2.mjrepresentseachoftheserisktypes.Theunitsofriare“risk,”whichcanbemeasuredin,forinstance,potentialdollaramountslostduetotheoperationalriskinessoftheprivateequityfirminthiscategory.TheyareallpartofthesetM={m1,m2,m3,...,mL},sothateachmj M.Eachrisktypehasacorrespondingriskamountuj,whereuj U={u1,u2,u3,...,uL}.Notethatthere is absolutely no restriction that N (the number of potential assetinvestments)beequaltoL(thetotalnumberofriskcategories).The ri equations are considered to be inputs to the operational risk

minimization problem. One may then pose the question as to how theseequationscanbedetermined.Throughtheduediligenceprocessoutlinedthusfarinthistext,itispossibletoassessthecontributionofeachrisktypetothetotaloperationalriskofaparticularprivateequityfirm.Inthemostgeneralcase,eachoftheriequationsisdifferentfromalloftheothers.Thisisduetothefactthatsome firms’ overall risk may be more strongly affected by a particular riskcategory thanwould be the case for others. Each of the ri can generally be adifferentfunctionofalloftheui.Notethattheribeingfunctionsoftheuimeansthat theui variables are present in the ri equations, but you could be raised topowers or have other mathematical operations performed on them in theseequations. For instance, if one is investing in a firm whose strategy is morereliant on technology and systems than other private equity firms, then thetechnologyandsystemsriskcategorymaycarrymuchmoreweightthansomeofthe other areas, because this aspect is fundamental to the potential profit thatwouldbeearnedontheinvestment.Determiningtheriequationsisaformidabletask.Itmaybenearlyimpossible

tofindinformationrelatedtothevariousriskcategories,andtheirimpactontheoverall risk of investment in a particular firm. The operational risk modelpresented here combines heuristics, data acquired from investigations, and amathematical framework into a generalized algorithm for quantifying the

minimization of total operational risk of an investment portfolio. These riequations are critical for both evaluating new potential fund investments andperforming operational due diligence on funds already in your portfolio. Forinstance,ifonefund'sequationclearlyyieldshigheroveralloperationalriskthanthat of another firm, it would be important to combine this information withfinancialdataindecidingwhichofthetwofirmstoinvestin.Let representthetotalriskduetoallofthexi,sothat .Inorderto

achieveanoptimalduediligenceassetallocation,it isdesirabletominimize .However,inpractice,thisisnotalwayspossible.Theoperationalduediligenceriskallocationfrontierisdefinedbyallofthepossiblevaluesthat canassumeby varying each of the uj that comprise all of the ri and, hence, . If is afunctionofonlyoneoftheuj,thentheoperationalduediligenceriskallocationfrontierisgenerallyacurveinthree-dimensionalspace.Inturn,ifitdependsontwo of the uj, then the operational due diligence risk allocation frontier isgenerallyasurfaceinthree-dimensionalspace.Mathematically, themethod tominimize is to take thederivativeof and

equate it to zero (see the Appendix for more details). Now the question thatarises regards which variable(s) should be taken to differentiate ? To bediligent,weshouldincorporateallofthemjforeachindividualriskfunctionri.This involves taking partial derivatives of with respect to each of theuj foreachri.However,since isafunctionofbothalloftheriandmj,itisnecessarytotakepartialderivativesusingthechainrule(seetheAppendix).

EXHIBIT9.3FlowchartofAlgorithmforOperationalDueDiligenceAssetAllocation

Therefore, the general equation for this set of derivatives would be thefollowing:

Since each of the , where k = 1 to L, this set of equations can bereducedtothefollowing:

Inmorecompactnotation,thiscanbeexpressedas:

Exhibit9.3showsasummaryflowchartoftheoperationalriskassetallocationalgorithm. This summarizes the process of arriving at the final equationpresented above. The result of the algorithm at the right is the MinimumOperationalRiskRegime(MORR).Thisisasetofcoordinatesinuj– spacethatdefinestheminimumtotalrisk, .Givenaparticularsetofriskfunctions,ri,theujintheMORRarethosethatminimizethetotalrisk.Ifonepondersthis,hemayencounterthequandarythatalowervalueofrisk

in a particular category (such asu1 = cash controls)may actually increase thetotalrisk, .Althoughthismayseemcounterintuitive,theissueisresolvedwhenone considers that the risk equations ri are indicators of themagnitude of thecontribution of each of the uj to the total risk, . If one risk type carriessignificantly more weight than another in one of the ri equations, then anincrease in theone thatcontributesmore to the riskof thatprivateequity firmmayoutweightherelateddecreaseintheothercategory.Forinstance,ifafirmimplements stricter cash controls, from the perspective of an investor theoperational risk in the human capital categorymay increase. Previously at thefirm,onlyonesignatoryapprovalwasrequiredforcashtransfers.Now,multipleapprovallistswithvariouslevelsofapproval,whicharestriatedbyvenderand

disbursement level, are required. This increased scrutiny necessarily requiresmore resources, personnel and other, to implement such controls. Focusingsolely on the human capital operational risk category in this regard, we cancompare the resource drain on human capital with the increased cash controloversight. If cash controls risk contributesmore to the risk of a single privateequity firm, then an increase in cash controls risk would outweigh a relateddecreaseinhumancapitalrisk.Let's take thesimpleexampleofoneprivateequity fund investmentandone

riskcategory,suchasbusinesscontinuityanddisasterrecovery.Therefore,NandL are both equal to 1 in this case.Nowdefine the risk function for the singleassettober1=λu1+5whereλissomedimensionlessconstant.Therefore,inthis

situation .Sincetheonlynonzeroriisr1, =r1.Then, .Therefore,

Thismakessensebecause, in thiscase,r1 isa linear functionofu1,which isminimizedwhen (seeExhibit9.4).At ,r1 = 5,which is the globalminimumof .Thisresultcouldalsobeobtainedifu1=0,whichistheassumedminimum value that it can have. In other words, if the first term in the r1equation,λu1,iszero,thenthe functionisminimized.Therefore,theMORRisasinglepoint:MORR={(0,5)}.

EXHIBIT9.4Example1RiskFunctionandItsFirstDerivative

Sincetheminimumvalueofr1occursatthepointu1=0,=r1hasaminimum

valueof5,ascanbeseenfromtheplot.TheriskfunctionanditsfirstderivativeforExample1areplottedinExhibit

9.4forλ=0.3.Nowamorecomplexexamplewillbeexamined.InExample2,thereare threepotential investments,buteachwithdifferentduediligenceriskcategories. The following is the operational risk paradigm for this particularallocation:

Sincenoneoftheuivariablescanbenegative(sincethiswouldimplynegativerisk,whichisnotpossibleinthismodel),thenu1=u2=1inthiscase.Itisnownecessary to check that these values of u1 and u2 actually minimize . Thedeterminantofthe2×2Hessianmatrixmustbecalculatedtoachievethisgoal.SeetheAppendixforthemathematicalexplanationofthisapproach.Asaresultofthismethod,M(1,1)>0and u1u1(1,1)>0,so(1,1)isindeedalocalminimumof .

EXHIBIT9.5AlternateViewofThree-DimensionalPlotof versusu1andu2

forExample2

EXHIBIT9.6AlternateViewofThree-DimensionalPlotofTotalOperationalRiskversusu1andu2forExample2

Exhibits9.5and9.6presentthree-dimensionalplotsofthe functionintermsof the amount of risk in two different categories, 1 and 2.Asmathematicallyshownabove, thisfunctionisminimizedforu1=u2=1.For thesevaluesofu1

and u2, = 6. The coordinate (u1,u2, ) = (1,1,6) makes up the MinimumOperationalRiskRegime(MORR)for thisproblem.ThiscanalsobestatedasMORR = {(1,1,6)}. If the results of the operational risk allocation algorithmyieldmultipleminimumpoints,thentherewillbemultiplepointsintheMORR.Forinstance,iftherewerethreepointsintheMORR,thenMORR={(u1A,u2A,

A),(u1B,u2B, B),(u1C,u2C, C)},whereA,B,andCare thepoint indices. If wouldhavedependedonalloftheujandtherewerethreecoordinatesatwhich wasgloballyminimized,thentheMORRwouldlooksomethinglikeMORR={(u1A,u2A,…,uLA, A),(u1B,u2B,…,uLB, B),(u1C,u2C,…,uLC, C)}.InExhibits9.5and9.6,totaloperationalriskassumesitsminimumvalueof6

atu1=u2=1.This was an example of a total operational risk function that could be

analyticallyminimizedrelativelysimply.However,foramorecomplicatedsetofoperationalriskequations,thisprocesscanbecomesignificantlymoredifficult.Numericalmethods,suchastheLevenberg-Marquardtalgorithm,arebestsuitedtosuchcomplexminimizationproblems.

EVOLUTIONOFMINIMUMOPERATIONALRISKREGIME(MORR)

Itisnowinstructivetoexaminewhatoccurswhentheriskfunctionschangeforsome reason. For instance, operational risk assessments in different categoriesmayvaryfromyeartoyear,causingtheriequationstovary.Ingeneral,theriskequationsforeachprivateequityinvestmentmayvarycompletely,buttobeginletusinvestigateseveralsimplechangesthatareeasytounderstandanalytically.

EXHIBIT9.7APureTranslationofTotalOperationalRiskUpwardIncreasesItsMinimumValue

Forinstance,inExample2,ifanyoftheriincreasesbyaconstant,suchas50,then increasesby50aswell.Now:

Nowtheminimumvalueof is56(50higherthanthepreviousminimum ),whichoccursatu1=u2=1(seeExhibit9.7).Thismakesintuitivesense: if therisk in any of the individual private equity funds in a portfolio increases by acertainconstantamount,thentheoverallpossibleminimumriskoftheportfolioincreases.If,ontheotherhand, isdecreasedby5fromtheoriginalvalue,thentheminimum atu1 = u2 = 1 is decreased to = 1 (see Exhibit 9.8). In otherwords, if the risk inanyof the individualprivateequity funds inaportfolio isreducedbyacertainconstantamount,thentheoverallpossibleminimumriskoftheportfoliodecreases.

EXHIBIT9.8APureTranslationofTotalOperationalRiskDownwardDecreasesItsMinimumValue

Itisalsopossiblethattheriequationsremainthesame,butthattheparticularvaluesof theuj fluctuateover time.Thiswould imply that the importanceandrisk structure of the various risk categories do not vary for a particular targetprivate equity firm investment, but that the risk in the different categorieschanges.OnecouldimaginewatchingtheplotinExhibit9.6changeovertime.For instance, letu1 refer to the “legal andcompliance” risk type andu2 be the“business continuity and disaster recovery” category. An example of this isshownasatimeseriesinExhibit9.9.Since dependsonlyonu1andu2,itmakessensetoplot overtime,aswell.The(possiblylarge)fluctuationsin overtimereinforce the notion that ongoingmonitoring is essential in order tomaintainappropriateoversightoverafund'sevolvingoperationalriskprofile.

EXHIBIT9.9ATimeSeriesRepresentation:TheValuesofu1,u2,andTotalOperationalRiskfortheOverallOperationalPortfolioRiskFunctionfromthe

OriginalExample2

AsshowninExhibit9.9,asu1andu2varyovertime,sodoesthevalueoftotaloperationalriskforthisparticularportfolioofprivateequityfunds.Althoughwehaveattemptedtocreateanassetallocationmodelthatfacilitates

theassignmentofquantitativefigurestooperationalrisk,suchamodelisonlyasgoodas the subjectivechoicesandpreferencesof the investordetermining theinput risk equations utilized in the model. Limited Partners can utilize theoperationalriskdatagatheredduringthefundoperationalduediligenceprocessto facilitate such judgments. However, assigning a fixed number to an oftenqualitativeriskfactoriswherethescienceofassetallocationmeetstheartofthediscipline.AsAlbertEinstein aptly noted, “As far as the lawsofmathematicsrefer to reality, theyarenotcertain,andas faras theyarecertain, theydonotrefer to reality.” Such a notion is fully appreciatedwhen attempting to “put anumber”onoperationalriskexposurespresentinpotentialinvestmentsinprivateequityfunds.

OPERATIONALRISKCORRELATIONSTOPORTFOLIOTRANSACTION

FREQUENCYWhenfactoringoperationalriskconsiderationsintotheassetallocationprocess,

investorsmaybefocusedonthetotalityofsuchrisks.Totaloperationalriskisabroad risk category that is made up of many subrisk operational risk factors.Earlierinthischapter,weintroduceamodelbywhichtotaloperationalriskdatacan be factored into the asset allocation decision process. While such totalassessment considerations, on the levels of both an investor's portfolio andindividual private equity firm, are certainly important, they should be the solefocusof theassetallocationprocess. Investorsmustalsobeconsciousof theseunderlyingoperationalriskcategories.Anexampleofsuchacategoryis tradingor transactionfrequencyofafund.

Portfoliotransactionfrequencyreferstothenumberoftradesexecutedbyafundduring a particular fixed time period, such as on a daily basis. As intimatedpreviously,investorsmayholdacommonmisperceptionthatthemorefrequentlya fund trades, the higher the total amount of operational risk in the fund. Assuch, investors may mistakenly equate the traditionally lower frequency withwhich private equity trades, as compared to funds that may trade morefrequently,suchashedgefunds,asrepresentativeofloweraggregateoperationalrisk exposures.As the following discussionwill indicate, the volume of tradefrequency executedby aparticular fund, includingprivate equity funds, is notnecessarilycorrelatedtototaloperationalrisk.

OPERATIONALLIFT-TO-DRAGRATIOA concept related to Operational Drag is that of Operational Lift. Inaerodynamics,dragistheforcethatactsinoppositiontothethrustofavehicle,suchasanairplane.Aliftforceiscreatedwhenairflowsaroundaplane'swings.Liftiswhatkeepstheplaneflyingandallowsittoascendinspiteofgravity(seeExhibit 9.10). Therefore, maintaining enough lift force is essential for flight.OperationalLiftcananalogouslybedefinedasthepositiveeffectsofoperationalstrengths on the efficiency of an organization. Returning to the aerodynamicsterminology,thelift-to-dragratioisthequotientoftheliftanddragforcesbeingexerted on a plane. This ratio varies with the velocity of the plane. A keyobjectiveofaircraftdesigners is toachieveahigh lift-to-drag ratio to improveefficiencyandperformance.Similarly, it shouldbe thegoalof any investor tomaximize the ratio of Operational Lift to Operational Drag. Just as theaerodynamic lift-to-drag ratio varies with velocity and other factors, theOperational Lift-to-Drag ratio varies from one asset to the next due to itsparticularcharacteristicsandhistory.

EXHIBIT9.10TheForcesActingonanAirplaneinFlightAreLift,Drag,Thrust,andtheVehicle'sWeight—ABalanceofForcesThatAlsoDescribesOperationalLift-to-DragRatio

Thefrequencyoftransactionsmadebyaprivateequityfundisnotareliableindicator of operational risk.Private equity funds trade less than, for instance,hedgefundsdueinparttothedifferentstrategiesemployedbyeach.However,this neither increases nor decreases the probability that investing in thatparticularassetwilladdtoOperationalDrag.Investorsshouldnotfallpreytothenotion that the lower frequency of transactions performed by private equitycompanies implies that theycreate lessoperational risk.Although the typesofriskmayvarybetweenhedgefundsandprivateequitycompanies,forexample,equal amounts of operational risk may still be involved in both classes ofinvestments.ThiscanbeseenbycalculatingthecorrelationbetweentransactionfrequencyandtheOperationalLift-to-Dragratio.

EXHIBIT9.11APlotofaPrivateEquityFund'sOperationalLift-to-DragRatioasaFunctionofItsTradingFrequency

Mathematically,thecorrelationbetweentwodatasetscanbecalculatedfromthefollowingformula:

whererxyisthecorrelationbetweenthedatasetsxandy,xiandyiaretheithdatapointsineachset,and and arethemeansofthexandydatasets.rxycanalsobe expressed as the ratio of the covariance to the product of the standarddeviations of the two data sets. The covariance,which is an indication of theextent to which variables increase (or decrease) jointly, is the expected value(mean)oftheproductof(xi– )and(yi– ).Thecorrelationcanrangebetween–1 and 1. Positive correlationsmean that as one variable increases, the otherdoesaswell,whilenegativecorrelationsimplythatanincreaseinonevariableresults in a decrease of the other.A correlationof zeromeans that there is noclear trend between the two variables. In other words, the two variables areuncorrelated.Incorrelationterminology,tradingfrequencyandtheOperationalLift-to-Drag

ratioareuncorrelated.Thiscanbeseenfromthefollowingplot(Exhibit9.11),whichshowshypotheticaldataforaparticularsetofprivateequitycompaniesina portfolio. Each firm makes a particular number of transactions each year,indicated on the abscissa. The ordinate displays the Operational Lift-to-Dragratioassociatedwitheachfirm.Alinear trendlinewasdeterminedfor thedata,and is plotted as the solid black diagonal line in Exhibit 9.11. TheR2 value,

which is thesquareof thecorrelation,rxy, forwhich theequationwasprovidedabove,determinesthe“goodnessoffit”of this trendlinetotheactualdata.Forthisdata set, theR2 value is about2percent.SinceR2 can takeonvaluesonlybetween0and100percent,thisR2valueindicatesthatalineartrendlinedoesnotaccuratelyrepresentthisdata.Thisisbecausethereisaweakcorrelation(near0)between the twoplottedvariables,whichare the transactionfrequencyand theOperational Lift-to-Drag ratio. Another way of thinking about this is thatvisuallyitisdifficulttodiscernanypatternsinthedata.Forvariablesthathaveacorrelationwithanabsolutevaluecloseto1,clearpatterns(eitherincreasingordecreasing)areexhibited.AsisclearfromExhibits9.11and9.12,thisisnotthecasefortransactionfrequencyandtheOperationalLift-to-Dragratio.

EXHIBIT9.12ASimplifiedDiagramoftheTrendlineofOperationalLift-to-DragversusTransactionFrequencyData

AsshowninExhibit9.11,itisclearthatthedatapointsdonotformaneasilydiscerniblepattern,andhencecanbeconsidereduncorrelated.Thismeans thatthere is no direct relationship between a fund's transaction frequency andOperationalLift-to-Dragratio.AsshowninExhibit9.12,astransactionfrequencyincreases,theOperational

Lift-to-Drag ratio remains constant, meaning that these two variables areuncorrelated.As the discussion above has outlined in general, there is not an easily

discernablecorrelationbetweenfundtradingfrequencyandthetotaloperationalriskofafund.Fromanoperationalduediligenceperspective,LimitedPartnersshouldthereforelookbeyondpreconceivednotionsthatsimplybecauseoflowertraditionaltradingvolumes,thereislessoperationalriskinprivateequityfunds.Investorscanthereforeusetheseresultstobemoreobjectiveinthisregardwhendistinguishing between operational due diligence resources allocated toperformingreviewsoffundswithdifferenttradingfrequencies.Additionally,byovercoming any potential deficiencies in operational due diligence resourceallocationsamongfundsofdifferent tradingfrequencies, investorswillbeableto not sacrifice scope or depth of reviews when conducting operational duediligencereviewsofprivateequityfunds.Since trading frequency has no net impact on any individual private equity

fund'sOperationalLift-to-Dragratio,thentheoverallriskoftheportfolioisalsounaffectedbytradingfrequency.Bytheprobabilisticpropertiesofanexpectationfunction(ormean),sincetheexpectationofthecontributionoftradingfrequencyto each fund's risk is zero, then the expectation of the impact of tradingfrequencyonthewholeportfoliosriskisalsozero.Inlightofthis,theequationsdevelopedintheprevioussectionstillholdtrueeveninthepresenceofvaryingtrading frequencies among different funds that may be held in an investor'sportfolio.

NEGOTIATINGPRIVATEEQUITYSIDELETTERS

This chapter so far provides an overview of considering the results of theoperational due diligence process into the asset allocation process for privateequity funds. Once the asset allocation percentages have been established,however,an investoractuallyneeds tocommitcapital toaprivateequityfund.Thisistypicallydoneviaadocumentknownasasubscriptiondocument.Beforesubscribing to a fund and committing capital, investorsmay have some itemsthattheymaywantattempttonegotiatewiththefund.Thisiswheretheconceptofasidelettercomesin.Asideletterisadocumentthataltersthetermsthataso-called regular Limited Partner would have when subscribing to the fund.These termsmay be items such as additional fund fees, or theymay involveitemssuchasfundtransparency.Beforeinvestinginafund,someLimitedPartnersmayhaveastandardpolicy

ofattemptingtonegotiatesidelettersbyaskingforcertaintermssuchasamostfavorednationsclause.Underamostfavorednationsclause,sometimesreferredto as anMFN orMFN clause, a Limited Partner is entitled to get the besttreatment possible among all Limited Partners. Other investors may be moreselectiveintheirnegotiationofsideletters.Suchsidelettersareoftennegotiatedby Limited Partners at the conclusion of the due diligence process. As such,during the operational due diligence process investorsmay note certain issuesthat they may table with an intention of negotiating around such operationalissuesinasideletter.A common example of an operational risk that investors may attempt to

addressinasideletterrelatestokeypersonrisk.Forexample,aprivateequityfund'sofferingmemorandummaycontainakeypersonclausethatprovidesonlyfor notification in the event of the departure, death, or incapacitation of thefund'sportfoliomanager.ALimitedPartnermaybeunhappywiththeextentofthisprovision.PerhapstheLimitedPartnerinourexampleprefersakeypersonclausethatnotonlyprovidesfornotificationtoLimitedPartnersintheeventakey person event occurs regarding the fund's portfolio manager, but that alsoallows for additional notifications if the General Partner's (GP’s) ChiefInvestmentOfficerdepartsthefirm.ThismaynotbeofmaterialconcerntootherLimited Partners (LPs), but the role of the Chief Investment Officer is

particularlyimportanttotheLPinourexample.TheLPmayattempttonegotiateasideletterthatrequirestheGPtoprovidenotificationtotheLPintheeventofthedepartureofthisindividual.Incertaininstances,anLPmayhaveseveraloperationalitemsthattheywish

tonegotiateforinasideletter.Aswithanynegotiation,theLPmustbepreparedto compromise with the GP. In these instances, an investor may be able toleverageinformationobtainedandtheoverallexperiencethattheLPmayhavehad during the operational due diligence process. Consider for example, aninvestorapproachingan investment inavintage fund.Furtherassume that thisLPwasnot invested in thepreviousvintagefund.Toassist this investor in theoperational due diligence process, perhaps the LP in our example requeststransparency into the portfolio of the vintage fund.Let us further assume thatdespiteseveralrequestsfromourLP,theGPagreesonlytoprovideasummaryofthetopfiveholdings.Now let us fast-forward to the endof ourLP's duediligenceprocess on the

currentvintagefund.Inthiscase,ourinvestormayhaveseveralissuesthattheywish tonegotiate in a side letterwith theGP.Letus assume thatoneof theseitems relates to portfolio transparency. Perhaps the GP in this exampleanticipates providing quarterly reporting updates on the portfolio. Our LP,however, wishes to havemore frequent transparency, perhapsmonthly.WhiletheGPmayobjecttoprovidingthistransparency,theLPcangentlyremindtheGP that theyhad refused toprovide the requested levelof transparencyduringthe LP's earlier operational due diligence process, and at the time the LPeffectivelygavethemapassanddecidedtoinvestanyway.Ofcourse,thereisnoguaranteethatsuchnegotiationtacticsmaybearanyfruit,butthisdoesnotmeanthat they should simply be disregarded. Oftentimes the side letter negotiationprocessmaybeleftfortheLPandGP'slawyerstoworkout.However,theLP'slawyermaynotbecuedintothegiveandtakethatmayhaveoccurredduringthe operational due diligence process. LPs should consider integrating theexperiences and resultsof theoperationalduediligenceprocess into such sideletternegotiations.

ONGOINGMONITORING:OPERATIONALDUEDILIGENCE

MONITORINGFORPRIVATEEQUITYFUNDS

WhyBotherPerformingOngoingMonitoringonPrivateEquityFunds?

After the initialallocation toaprivateequityfundinvestorsareeffectively leftwithtwooptionswithregardtooperationalrisk.Thefirstchoiceistodonothingmore.Thisisabadchoice.Thesecondoptionistoperformadditionalongoingoperationalmonitoring.Thisisthepreferredchoiceforseveralreasons.First,anLP has already devoted a significant amount of time and resources towarddevelopinganunderstandingofaprivateequityfund'soperationalinfrastructure.With this detailed understanding in place, the investor has effectivelyconstructedaroadmapbywhichoperationalriskcanbemonitoredthroughoutthe life of the fund.After such an investmentof resources and energy, simplythrowingtheoperationalroadmapasidedoesnotmakemuchsense.Somemayraiseanargument that statessomething to theeffectof,“What is

thepointofongoingoperationalduediligenceonaprivateequityfund, ifLPshave their capital effectively locked up for the life of the fund?” There areseveralresponsestosucharguments.Oneresponseisthat,ifaninvestordoesnotperformongoingoperationalduediligenceandaprivateequitymanagerhappensto be perpetrating a fraud thatmay have its roots inmanipulating operationalprocedures, such as cash flow throughout the organization, the investor is notlikelytoeithercatchthefraudulentactivityoruncoveranyredflagsorsignalsthat may cause concern. Readers who do not believe that such events arepossibleareencouragedtoseeChapter11.Putting fraudulent activity aside, a second response to the argument against

performing ongoing monitoring relates to the role of the advisory board. AsChapter10discusses,LPswhositontheadvisoryboardofaprivateequityfundwho uncover continued or new operational problems during the ongoingoperationalduediligencemonitoringprocessmayhavetheabilitytotakedirectactionwiththeGPregardingsuchissues.Finally, a third response that we will consider regarding objections to

performingongoingoperationalduediligencemonitoringrelatestotheissueoffeedback and a concept that we will call reverse signaling. Giving them thebenefit of thedoubt,we can assume thatGPs arenot interested in conducting

fraud. Furthermore, we will assume that some GPs are actually interested inadheringtooperationalbestpracticesintheiroperations.Ifthisisthecase,thenthey may actually be interested in hearing feedback from LPs who conductongoing operational due diligence on funds that they manage. This feedbackmaybeparticularlyuseful fromLPs thatengage inoperationalbenchmarking.(Chapter12discussesthistrendinoperationalduediligenceindetail.”Additionally, this feedback regarding operational practices may be of

particular use to GPs from LPs that allocate to many different private equityfunds, such as a private equity fundof funds.Even if suchLPsmaynot holdseatsontheadvisoryboardofaparticularfund,GPsmaybeopentohearingthisfeedbackandimprovingoperationsaccordingly.The concept of signaling is introduced in Chapter 3. Signaling effects with

regard to operational risk of a private equity firm refers to the presence ofindicatorsthatthemselvesarenotnecessarilydemonstrativeofoperationalrisk,but which should alert investors as to the need for further inquiries for thepresenceofoperationalrisk.Anexamplethatwaspreviouslyoutlinedwouldbethe signaling effects of a private equity fund that held self-custody of assets.Another example would be a private equity fund that engaged in numeroustransactions with affiliated entities. These transactions with affiliated entitiesthemselvesarenotnecessarilyinherentlyoperationallyriskybutthepresenceofsuch transactions raises the specter of potential conflicts of interest and self-dealing.Arelatedconcepttosignalingandsignalingeffectisreversesignaling.Inthe

contextofoperationalduediligenceof aprivate equity firm, reverse signalingreferstotheconceptwherebyanLP'sactionsandduediligenceinquiriessendasignal to theGP. To illustrate by example, consider a private equity firm thatraised capital and was closed to new investors in 2007. Next consider thediscoveryoftheBernardMadoffscandalin2008.Theroleofcustody,andself-custody in particular, was one of the litany of operational issues noted in theMadoffpostmortem.As a result of theMadoff Effect that we mention in Chapter 1, by which

investors tend to tailor their operational duediligence around recent frauds, inthepost-Madoffenvironmentmanyprivateequityinvestors,manyofwhichalsoinvest in hedge funds, began to inquire more closely regarding the custodyrelationshipsofprivateequityfunds.Forinvestorsalreadyinvestedinaprivateequity fund, such as those in our example, if they had been resigned not toperform ongoing operational due diligence, they perhaps were content not to

inquire in detail about such relationships with heightened scrutiny. Other LPshowever,may have taken the opportunity to inquiremore closely regarding aprivate equity fund's custodial relationships. Furthermore, many of these LPsmay have expressed their dissatisfaction with this relationship due to thegenerally cautious attitude toward such self-custody arrangements in the post-Madoffera.ThroughtheseenhancedduediligenceeffortstheLPswereineffectsendinga

signal to theGP that theyat aminimumweremoreconcernedaboutpotentialoperational issues surrounding the firm's self-custody relationship. This is anexample of a reverse signal. If the investors actually discussed these concernswith the private equity fund, this would be an example of feedback. If a GPreceivesanumberofreversesignalsfromLPsviatheseongoingduediligenceefforts,theGPmaybemoreinclinedtotakeactiontoremedysuchissues.Furthermore,iftheLPsprovidefeedbackontopofthesereversesignals,there

isanincreasedlikelihoodthatthismomentumcouldbringaboutchange.Inourexample, the LPs could perhaps suggest that the GP engage a third-partycustodianfortheremainderofthelifeofthefundor,perhapsmorepractically,theGPshouldengageathird-partycustodianforthenextvintagefundforwhichthey raise capital. If an LP invested in the previous 2007 is interested ininvestinginthisvintagefund,andmaintainingalong-termrelationshipwiththeGP, then, perhaps, their reverse signals and feedback communicated regardingoperational issuesduring theprevious2007 fundmayhave additionalpositiveramifications regarding future funds as well. Furthermore, if such changes infuturefundsarenotapplieduniversallytoallLPs,thoseLPsthatcommunicatereverse signals and provide feedbackmay be in a better position to negotiatefavorablesidelettersforthenewfund.

HowOftenShouldOngoingMonitoringBePerformed?

OnceanLPhasbeenconvincedofthebenefitsofongoingmonitoringofprivateequity funds from an operational due diligence perspective, they must nextconsider thequestionofhowfrequentlysuchmonitoringshouldbeperformed.Thereisnosinglecorrectanswertothisquestion.Inpractice,differentLPsoptto conduct ongoing monitoring with different frequencies. A general rule ofthumb is to perform ongoing operational due diligence—typically an on-siteoperational risk reviews—approximatelyevery12months.The frequencywith

whichLPsconductsuchongoingmonitoringmayalsodependonwhetherornottheyserveontheadvisoryboardofafund,aswellasiftheyhaveanyothersortsofcommunicationwiththefundonaregularbasis.

OngoingRemoteMonitoringTechniquesLimited partners can utilize a number of different techniques to facilitateongoing fund monitoring. These can include remote operational monitoringtechniques.Remoteoperationalduediligencemonitoringrefers towhenanLPconductssurveillanceandintelligencegatheringthatcanbeperformedoutsideoftheon-sitevisit.LPscanemployavarietyofmethodstomonitoroperationalriskexposuresincludingmediamonitoring,litigationandregulatorymonitoring,andGPcommunicationmonitoring.Media monitoring can range from basic Internet monitoring via automatic

alertsthataretypicallyfreelyofferedbymultipleservicessuchasGooglealerts.Such free services provide LPs with a way to organize and monitor multiplemediasearches.Adrawbackofsuchfreeservicesisthattheydonotnecessarilycover the types of media that may be relevant to a particular search.Furthermore,suchfreesearchesdonotnecessarilyscreenforfalsepositivesorrelevance. For a fee, there are a number of more sophisticated andcomprehensive tools in the marketplace that can be more useful to facilitateinvestors’ongoingmonitoringefforts.Litigationmonitoringreferstothenotionofcheckingtoseeifaprivateequity

fund,employees,oraffiliated firmsare suingsomeoneorbeingsued.LPscanmonitorsuchactivityelectronicallyutilizinglegaldatabasessuchasLexis-Nexisor Westlaw. In certain instances, court filings may not be updated on thesedatabases. In such cases, physically visiting a court and searching its recordsmay be the only way to effectively monitor a lawsuit, especially when itsprogressisofatime-sensitivenature.Itisalsoworthnotingthatthebenefitsoflitigationmonitoring canbecome significantlydiminished in countries that areeither not as litigious as theUnited States, where cases frequently are settledbetween parties out of court, or in countrieswhere court filingsmay bemorelikelytobekeptconfidential.Regulatory monitoring refers to the concept of monitoring any required

regulatory filings that a private equity fund may be required to make on acontinuing basis. Monitoring can typically be accomplished by LPs via therelevantregulator'swebsites.GP communication monitoring refers to an LP's review of any ongoing

monitoring produced by a private equity fund. This information can be in theform of annual reports or quarterly investor updates. There is no one uniform

format that GPs follow in distributing such information. Certain GPs mayinclude organizational updates or other operational details in thesecommunications.LPscanmonitor suchcommunications for insightsor signalsofanychangesintheoperationalriskprofileofthefund.Ifastheresultofanyoftheseongoingmonitoringeffortsoperationalrisksare

noted,or signalsare raised that require further inquiry, investorsmayconsiderramping up the frequency of their on-site ongoing operational due diligencereviewstofurthervetsuchissues.

CONCLUSIONThischapterprovidedanoverviewofincorporatingtheresultsoftheoperationalduediligenceprocessintotheassetallocationprocess.LimitedPartnersshouldconsider operational risk considerations when designing an asset allocationprogram consisting of private equity funds. This chapter introduced a samplemodel in this regard including the concept of theMinimumOperational RiskRegime. Incorporated into this discussion was an analysis of operational riskcorrelations to portfolio transaction frequency and the related concepts ofOperationalDragandOperationalLift.Thischapter thenoutlinedsomeof theconsiderationsthatLimitedPartnersshouldtakeintoaccountwithregardtosideletters. Finally, this chapter covered the benefits of ongoing operational duediligencemonitoringforprivateequityinvestmentsandoutlinedtechniquesforremoteoperationalmonitoring.LimitedPartners can further enhance thevalueof their initial operational due diligence reviews on private equity funds byfactoring the results into theasset allocationprocess andviawellplannedandexecutedongoingmonitoringtechniques.

NOTES

1.HenrySmith,“Diversification:TheOnlyFreeLunch?,”FTMandate,April2010.2.SeeJasonScharfman,HedgeFundOperationalDueDiligence:UnderstandingtheRisks(Hoboken,NJ:JohnWiley&Sons,2008).

APPENDIX9A

MathematicalConcepts

The purpose of this Appendix is to clarify certain mathematical conceptsintroduced earlier in this chapter. Each of these concepts is outlined in moredetailinthefollowingsections.

THEDERIVATIVE

A derivative is defined as the rate of change of one variable with respect toanother.Forinstance,inphysics,thederivative,orrateofchange,ofthepositionofanobjectisitsvelocity.Inotherwords,velocityistherateatwhichpositionvarieswith time.Whenone launches a rockvertically into the air, itwill stopmoving when it reaches the peak of its trajectory (see Exhibit 9A.1). At thispoint, itsverticalspeediszero.Inotherwords,at the instant that it reaches itspeak,itspositionisnotchanging,andhencethederivativeofpositioniszeroatthatmoment.Therefore,itbecomesapparentthatbysettingthevelocityofanobjectequalto

zero, it is possible to find the time at which the object reaches its maximumverticalposition.Thefollowingsetofequationsdefinethisproblem:In the following, x denotes height, is velocity, and is acceleration (an

overdotindicatesaderivativewithrespecttotime).First,lettheacceleration,=aandtheinitialvelocityoftheprojectilebe .Then,

Settingthelastequationequaltozeroyieldsthetime,t*,atwhichtheprojectilereachesitsmaximumheight:

t* is the time at which the projectile reaches its peak. The sign is negativebecause theupwardvelocityandaccelerationopposeeachotherand thushave

oppositesigns(ifupisdefinedasthepositivedirection,thenv0ispositiveandaisnegative).

EXHIBIT9A.1IllustrationofDerivativeUsingExampleofaRockProjectile

A similar argumentwould apply to amarble rolling through a bowl.At theverycenter(bottom)ofthebowl,themarblehasreacheditslowestpoint,anditsvertical speed is temporarily zero, since it is switching from upward todownwardmotion,orviceversa.Again, thederivativeofpositionwithrespecttotime,orspeed,equalszerohere.Inthiscase,asopposedtotheexampleofthevertical projectile, a minimum in height was found rather than a maximum.Settingthederivativeequaltozerowilldeterminethevalueofalocalminimumormaximumataspecificpoint.

THECHAINRULE

Lety,w,andxbevariables.Ifyisafunctionofw,andwinturnisafunctionofx,thentheformulaforthederivativeofywithrespect(inLeibniznotation)toxis:

This formula is sufficient to understand the discussion in the text. A moredetailedderivationofthechainruleisbeyondthescopeofthisbook.

THESECONDPARTIALDERIVATIVETEST

Thesecondpartialderivativetestisimplementedtoassesswhetherafunction's

criticalpoints are in factmaxima,minima,or saddlepoints.Acriticalpoint isoneatwhichafunctioniseithernondifferentiableorhasaderivativeofzero.Wewill ignore the former case because all of the functions considered herein are“well-behaved,” meaning that they are defined everywhere for independentvariableswithvaluesofzeroor larger.Asshowninthetext,criticalpointsarefoundbyequatingpartialderivativesofafunctionwithzero.Tocheckthenatureofthecriticalpoint(s),thesecondpartialderivativetestinvolvescalculatingthedeterminantofa2×2Hessianmatrixforafunctionf,denotedbyM(x,y),wherexandyaretheindependentvariablesandfisthedependentvariableasshownasfollows:

Thesubscriptsoffdenotethevariableswithrespecttowhichpartialderivatesof f are calculated. Two subscripts represent a second partial derivative. Thefollowingrulesdefinethenatureofacriticalpointwithx=aandy=b.1.IfM(a,b)>0andfxx(a,b)>0then(a,b)isalocalminimumoff.2.IfM(a,b)>0andfxx(a,b)<0then(a,b)isalocalmaximumoff.3.IfM(a,b)<0then(a,b)isasaddlepointoff.4.IfM(a,b)=0thenthesecondderivativestestisinconclusive.ThisprocessisnowcarriedoutforExample2inthetextofChapter9:

SinceM(1,1)>0andfxx(1,1)>0then(1,1)isindeedaminimum.

CHAPTER10

Boards,Committees,andActivism

AfteranewprivateequityfundhasbeenestablishedfromalegalperspectivetheGeneral Partner will go through a fundraising period during which capitalallocationsaresoughtfromthird-partyinvestors.Atthisstage,afterthefundhasalreadybeen established as a legal shell,manyof the keydecisions related toitemssuchasfundtermshavealreadybeendecidedbytheGPandmemorializedinthecorefunddocumentationsuchastheofferingmemorandumforthefund.WhileincertaincasestheGPmaybeopentorevisingsuchdocumentationbasedoninvestorfeedbackreceivedduringtheduediligenceprocess,ingeneralmostofthesebasicfundtermsanddecisionshavebeeneffectivelysetinstone.

PRIVATEEQUITYFUNDADVISORYBOARDS

Onecommonfeatureofprivateequityfundsthatisquasi–setinstoneatthetimeof the forming of most funds relates to a fund governance committee that iscommonlyknownasanadvisoryboard.Anadvisoryboard isaboard that typicallyconsistsof several representative

investorswho provide advice to theGP regarding themanagement of a fund.There is no requirement, legal or otherwise, that a private equity fund mustmaintainanadvisoryboard.Inreality,mostprivateequityfundadvisoryboards’roles focusmore on fund governance than they do on the role as consigliore.ThismakessensebecauseineffecttheyaresupposedtobeprovidingadvicetotheGPorfundmanagerthattheyhavehiredbecauseoftheirsupposedexpertiseinnotonlypickingprofitableportfolioholdings,but also in runninga fund ingeneral.Assuch,inthiscontextaprivateequityadvisoryboardcanbeviewedmoreas focusedonminding thestore,which is fundedwith theirowncapital,rather than providing actual advice with regard to fund management. Such adistinctionmay be a semantic one; however, because the role of the advisory

board is to act in the best interests of their own investments—which arenecessarilyalignedwiththeroleofthefundasawhole,sincetheprivateequityfundconsistsofthemembersoftheadvisoryboard'sowncapital.

DIFFERENTTYPESOFADVISORYBOARDS:LIMITEDPARTNERSVERSUS

PUREADVISORSAs just indicated, in most cases, the advisory board of a private equity fundconsists of representatives of several different Limited Partners. There is nofinite size that advisoryboardsmust consistof. Inpracticegenerally, advisoryboards consist of threeor fiveLPsbutmaygoup toninemembers. It is alsoworthnotingthatitisgenerallyconsideredbestpracticeforanadvisoryboardtoconsistofanoddnumberofmemberstofacilitateanydisputeresolutionandtiebreaking.Advisory boardswill typicallymeet at least once annually butmaymeetmorefrequently,contingentuponfundpolicyandanychangesthroughouttheyearthatmayoccurinthemanagementofthefund.Generally,theLPsontheadvisoryboardwill be someof the larger investors in theprivate equity fund.These larger investorsmayoftendemandapositiononanadvisoryboardasarequisitetotheirinvestinginaprivateequityfund.Therefore,inthesecasesanadvisoryboardconsistsofinvestorsintheprivateequityfund.Thetermadvisoryboardisalsosometimesemployedtorefer toaboardthat

doesnotconsistof investors in thefund.For thepurposesof this text,wewillrefertosuchboardmembersaspureadvisorsbecausetheyarenotadvisingonafundthatmanagescapitalthattheythemselveshaveinvestedinthefund.Rather,these pure advisors are simply providing guidance and advice to the GPregarding the management of the fund, and they are not themselves typicallyinvestedinthefund.Itshouldbenotedthatsimilartotheboardofdirectorsofan offshore hedge fund vehicle, these pure advisors are not providing suchadviceoutofthegoodnessoftheirhearts,butratherforcompensation.Assuch,the advisory boardmembers are effectively employees of, or at the very leastconsultantsto,thefund.Thebackgroundofsuchindividualscanoftenbequitevaried.SomeGPsmay

seek to construct such advisory boards with pure advisors with certain asset-specific or regional knowledge. Other private equity firms may select certain

pureadvisorsfortheirknowledgeoflargerglobalormacroeconomictrendsthatmayinfluencethefund'sportfolio.Stillothersmayattempttoplaceestablishedindividuals with renowned reputations on the board. This latter examplehighlightsthedualrolesthatsomeoftheseadvisoryboardsplay.Insomecases,aGPmayseektoutilizethemakeupofitsadvisoryboardasamarketingdeviceto demonstrate the quality of individuals who serve as advisers to the fund.Thereisnothinginherentlywrongwithutilizingthebiographiesorbackgroundsof thesepureadvisors infundraising.HoweverinsuchsituationspotentialLPsshould,during theoperationalduediligenceprocess, inquireas towhether thefundhasemployedsuchpureadvisorssimplyasaministerialmarketingdeviceorwhethertheGPandprivateequityfundmanagersareactuallyinterestedintheadviceofthesepureadvisors.It should also be noted that, as referenced earlier, these advisers are

compensatedgenerallyby theprivate equity fund itself, asopposed to theGP.Investorsshouldalsoinquireintothelevelsofcompensationpaidtothesepureadvisers.Awell-respectedpure adviserwith a highly regarded reputationmaynotnecessarilyserveonanadvisoryboardforaparticularlyreasonablerate.Inthesecases,theGPmayfeelthattheexpenseisworthit.Suchmotivationmaynotlieonlyinthepotentialadvicethatsuchapureadvisormaygivebutalsointheadditionalcapital that thispureadvisorbeingassociatedwiththefundmaybeabletoraise.Inthiscase,thepotentialforaconflictofinterestariseswheretheGPmayselectanadviser thatwouldhelphimorher toraisemorecapital,andtheGPiscompensatedinpartbasedonthesizeofthefundviamanagementfees. However, the expenses borne by the fund to pay for this advisor'scompensationmaynot particularly have an appropriate trade-off effect for theindividualLPs,particularlywhenthispureadvisorhasnotattheendofthedaybeenemployedbecausetheGPorportfoliomanagersareparticularlyinterestedinthisindividual'sadvice.A final consideration regarding the makeup of such pure advisor advisory

boardsrelatestothenumberofboardssuchindividualsmayserveupon.Somepure advisors may only be professional advisors. In many cases, theseindividuals have long work histories and take the pure advisor role afterretirement. Othersmaywork for firmswhose sole purpose is to serve on theboardsoffunds.Inbothcases,itisarealpossibilitythatanindividualcanserveon the boards ofmultiple funds. There is no single bright-line rule as to howmany boards an individualmay serve on, although the number of boards cansometimesborderontheabsurd(e.g.,over50).Inthesecases,whenanalyzing

themultiplehatswornbysuchboardadvisors,investorsshouldquestion,aspartoftheoperationalduediligenceprocess,whetherit isreasonabletoexpectthispureadvisorboardmembertodevoteasufficientamountoftimetoadvisingtheprivateequityfund.

ONGOINGOPERATIONALDUEDILIGENCEMONITORINGADVISORY

BENEFITSIn the context of an investor's operational due diligence review of a privateequityfund,aftertheinitialoperationalduediligencereviewiscompleteanLPwill then reach some sort of operational conclusion as to whether or not toallocatetoaprivateequityfund.Thisoperationalconclusionwill,ofcourse,betempered with appropriate investment allocation considerations, as well.Assuming that after shaking the Magic 8 Ball of due diligence, the readingsindicatethatallsignspointtoyes,andthedecisionismadetoallocate,investorsshouldsimplynotdisregardallofthehardworktheyputintotheduediligenceprocess.Rather,anumberofbenefitscanbegarneredfromongoingmonitoringas well. These ongoing benefits can translate through to LPs from both theinvestmentandoperationalperspectives.From an operational perspective such ongoing monitoring can provide an

investorwith a particularly unique voice if they sit on a private equity fund'sadvisoryboard.Thisisoneofthekeyreasonsthatitisadvisableforinvestorstoseek advisory board seatswhenever possible.A private equity advisory boardmaybe privy to certain pieces of information thatmaynot be actively sharedwith other LPs. In fact, the other LPs have given consent, either actual orimpliedviawaiver,fortheGPoftheprivateequityfundtohavetheauthoritytoletthoseLPsthatserveonaprivateequityfund'sadvisoryboardtohavecertainrepresentative decision making authority with regard to acting on thisinformation as well. For an LP that has performed extensive operational duediligencebeforeinvestinginaprivateequityfund,whonowsitsonanadvisoryboard, the oversight afforded to the advisory board can serve to substantiallybenefit the larger pool of LPs in just as a meaningful way as the investmentoversightorapprovalauthoritytheadvisoryboardmaycarryout,ifnotmoreso.Forexample,consideranLPwho,duringaninitialoperationalduediligence

review in the preinvestment stage, noted operational concerns regarding thefrequencyofcashreconciliationsperformedbythefund.Despitetheseconcerns,theLPallocatedfundstotheprivateequityfirm.LetusfurtherassumethatthisprivateequityfundmaintainsanadvisoryboardandthattheLPinourexample,hasaseatonthisadvisoryboard.Inthisroleasanadvisoryboardmember,theLPneednotonlyperformtheperhapsmoreministerialrolessuchasapprovingvaluations or casting a vote with regard to certain decisions asked of theadvisoryboard.ThisLPcanalsoutilizehisroleontheadvisoryboardtoproactivelymonitor

the way in which a fund continually deals with such operational issues.Remember,thisinvestor'sinteractionwiththeprivateequityfundisnotlimitedsolelytotheirroleasanadvisoryboardmember.ThisLPisalsoaninvestorinthe fund. As such, this LP should feel perfectly free to conduct ongoingoperational due diligence reviews of the private equity fund. The differencebetweenthisLPandotherLPsisthattheLPinourexamplealsohasaseatonthe fund's advisory board. While it would be nice to believe that a GP of aprivate equity fund would be receptive to each LP's concerns or suggestions,bothoperationallyrelatedandotherwise,inpracticetheymaynot.WhenanLPhasaseatonanadvisoryboard,theynotonlyhavemoredirectaccesstotheGPbut,perhapsmoreimportantly,theyhaveaforumbywhichtocommunicatewithotherLPswhoareadvisoryboardmembersaswell.This isanothersignificantadvantagethatisavailabletoadvisoryboardmemberswhoareLPs.OtherLPswho are not on a fund's advisory board might not have a forum, such as anadvisory board meeting, through which to communicate with other investors;furthermore,theymaynotevenknowtheidentityofotherLPs.Insuchcases,anLPwithconcernsregardingcertainoperationalrisksrevealed

during the ongoing operational due diligence monitoring process may not beable to discuss such concerns with other LPs who are invested in the sameprivateequityfund.Assuch,aninvestormayonlybeabletoexpresshisorherconcernstoaGP.Unfortunately,suchconcernsmayfallupondeafearsandtheGPmaynothaveanyreasontomaketheoperationalimprovementsrequiredtoaddress any deficiencies that may have developed or become exacerbatedthroughout the life of the fund.Contrast thiswith anLPwho sits on a fund'sadvisory board. In that case, the LP not only has more of a direct line ofcommunicationwiththeGP,butalsoandperhapsmoreimportantly, theabilitytoworkwithotherLPs.In this case, if an LP conducts their own ongoing operational due diligence

reviewsandhasoperationalconcerns, theycansharethesewithotheradvisoryboardLPs.IftheseotherLPsagree,theycanthenapproachtheGPoftheprivateequity fund with these concerns through a more unified voice of not onlymultipleLPsbutalso through the formal roleof theadvisoryboard.ConcernsthatarevoicedinthiswayaremorelikelytogetnotonlytheattentionoftheGP,butperhapsmotivatetheGPtoimplementactualoperationalchangesaswell.

BALANCINGTHEROLEOFINNERCIRCLEVERSUSBROADLY

REPRESENTATIVEADVISORYBOARDSAnadvisoryboardcanalsoserveanumberofpractical functions,aswell.Anexampleofthisrelatestotheabilityoftheadvisoryboardtoactwithauthorityon behalf of the larger pool of LPs, some of whom may be completelyunrepresentedon theadvisoryboard.This isoftenuseful froma standpointofefficiency. It is oftentimes much faster and more efficient for the GP to dealdirectlywith the smaller group of advisory boardmembers as opposed to thewhole group of all LPs. An example of how this would function in practicecouldrelatetothegrantingofcertainwaiverstotheGPbytheadvisoryboard.These waivers could include waivers of certain investment policies, waiversregarding certain potential conflicts of interest, or waivers regardingdiversificationguidelines.1

While theseefficienciesmaybothexpeditefunddecisionmakingandreducethe ongoing burden to be involved in the daily management or governancedecisionsofaparticularfundinothercircumstances,advisoryboardsmaynotbeso representativeof the largerbaseofallLPs. Interestingly, this representativerole can vary not only by private equity investment strategy but by region aswell.Forexample,U.S. andEuropeanventure firmsmaygenerally scorehighmarkswhen it comes to keeping all investors informed of fund developmentsthrough the advisory board. However, European buyout firms may limitinformation flow to only the key group of the inner circle of LPs who arefortunateenoughtositonafund'sadvisoryboard.2

ADVISORYBOARDCRITICISMS:

CROWDINGOUT,POWERAGGREGATION,ANDREDUNDANT

BOARDLAYERSCertain investorsmaynotdesireaprivateequity fund tomaintainanadvisoryboardatall. In thesecases, theLPsmayviewtheroleofanadvisoryboardasinefficient and redundant. Furthermore, they may view the advisory board ashampering the flow of communication to all investors. As discussed in moredetail in this section, these investors may feel that the advisory boardconcentratescertaindecision-makingauthorityintoofewLPswhileeffectivelycrowdingoutthesmallerLPs.Inthesecases,thelargerLPsmaynotagreewithalimitedgroupingofpoweratthetop.Additionally,dependingontheroleofLPsthemselves,certainLPsmayview

theroleofprivateequityboardsasplacinganadditionalonuson theiralreadyovertaxedgovernanceresponsibilities.Forexample,LPswhomanagecapitalonbehalf of other investors, such as a private equity fund-of-funds,may be in asituation where they have their own advisory board. This relationship issummarizedinExhibit10.1.

EXHIBIT10.1ExampleofRedundantAdvisoryBoardLayers

In these cases, the LPs, such as the private equity fund of funds in ourexample,mayalreadybesubjecttogovernanceandoversightbyLPswhoinvestin the fund it manages itself. These advisory board members may thereforeexpress their opinions and oversight to the GP of the private equity fund offunds. The GP of the private equity fund of funds may feel this oversight is

sufficient and, therefore, they may not want the burden, or responsibility, ofhaving toact inagovernance roleas anadvisoryboardmemberby switchingfromGPoftheirownprivateequityfundoffundstoanactiveLPasanadvisoryboardmember.Fromanoperationalduediligenceperspective,LPsattheprivateequityfundoffundslevelshouldbecautiousofthesignalingeffectofGPswhoexpress such objections to serving as advisory board members of underlyingportfolio private equity funds. While such advisory board members at theunderlyingportfoliofundleveldoespresentanadditionaltimecommitment,thisisinpartwhytheyarebeingcompensatedbyinvestors,tonotonlymakeinitialselections of underlying private equity funds but also to provide ongoingoversightandmanagementoftheportfolioofthesefunds.Having theGPserve in theirLPcapacityasamemberof theunderlyingLP

advisoryboard is an effectiveway toperformsuch responsibilities. Indeed, asoutlinedlater,dependingonthetypeofunderlyingprivateequityfund,aswellasthegeographicregioninwhichsuchfundsoperate,LPsthatdonotserveonafund's advisory board may be at a disadvantage because of the unevendistribution of information from the private equity fund's GP through to LPs,whichtendstofavoradvisoryboardmembers.

INFORMATIONFLOWCONSIDERATIONSFROMUNDERLYINGPORTFOLIOGENERALPARTNERTO

LIMITEDPARTNERSAdditionally,when theGPswho allocate to other private equity funds seek toabdicateresponsibilityofgovernanceandoversighttootherLPswhoserveonaprivateequityfund'sadvisoryboard,theseinvestorsmayberesponsiblenotonlyfor a general dereliction of duty but also with regard to certain fiduciaryobligations toappropriately report to their fund'sownLPson theperformanceandactivitiesoftheunderlyingportfoliocompanies’activities.Furthermore,bynot servingon the advisoryboardof theunderlyingportfolio company's fund,theseGPsoftheprivateequitysmaymakeitmoredifficultforLimitedPartnerstocomplywiththeirownreportinganddisclosurerequirementsduetoadearthofsufficientinformationfromtheunderlyingportfoliocompanytotheultimateendprivateequity fundof fundLPs.The typical flowof information from the

underlying portfolio fund GP level through to the LPs of the investmentallocator,suchasaprivateequityfundoffunds,issummarizedinExhibit10.2.

EXHIBIT10.2ExampleofInformationFlowWhenaGeneralPartnerofPrivateEquityFundofFundsServesasBothLimitedPartnerandGeneralPartner

Advisoryboardsoftenmaintainasignificantamountofauthoritywithregardtoapprovingcertainfundactivities.Onecorefunctionthatisoftengrantedtotheadvisoryboard is the approvalof theGP'svaluationof aprivate equity fund'sinvestments.3

LIMITEDPARTNERDUEDILIGENCECONSIDERATIONSFORAPRIVATE

EQUITYFUNDOFFUNDSContinuing our discussion of a private equity fund of funds, it is also worthconsideringtheuniqueduediligencerequirementthatmaybeperformedbyanLPthatallocatedtoaprivateequityfundoffunds.Inthesamewaythataprivateequityfundoffundsmayserveontheadvisoryboardofanunderlyingprivateequity fund, so toomay an investor serve on the advisory board of a privateequityfundoffunds.ThisrelationshipissummarizedinExhibit10.3.

EXHIBIT10.3DualRoleofCertainLimitedPartnersonPrivateEquityFundofFundsAdvisoryBoard

In much the same way that LPs investing in a regular private equity fundshould perform operational due diligence, so too should such operational duediligence be performed by LPs when considering an investment in a privateequityfundoffunds.Similarly,whenLPssitonanadvisoryboardofaprivateequity fund of funds, they can also express opinions regarding operationalconcerns that may have been raised during either the initial or ongoingoperational due diligence process. It is worth highlighting some of the keyconsiderations that LPs should consider when performing operational duediligence on a private equity fund of funds, some ofwhich are unique to thisfundstructure,asopposedtoperformingduediligenceonadirectprivateequityinvestmentfund.Whenperformingoperationalduediligenceonaprivateequityfundoffunds,

anadditional layer to theduediligenceprocessshould incorporatea reviewofthequality,nature,andframeworkoftheduediligencefunctioninplaceat theprivateequityfundoffunds.Asanexample,fourcommonlyutilizedoperationalduediligenceframeworksincludeadedicatedframework,asharedframework,amodularframework,andahybridframework.Thisreviewshouldencompassa

reviewoftheresourcesallocatedbytheprivateequityfundoffundstotheduediligence function.Additionally, this review should include an analysis of theprocessutilizedtoperformaninitialduediligencereviewaswellastheprocessandfrequencyforongoingmonitoring.Additionally,itispartoftheinitialandongoingduediligenceprocessesforan

investortoconductareviewofanyunderlyingprivateequityfundsthatafundof hedge fundsmay have a large exposures to. This review of the underlyingprivateequityshould includea reviewandanalysisofdocumentationfromtheunderlying private equity manager. This documentation analysis may beaccomplished via documentation collected directly from the underlying hedgefund manager, from the private equity fund of funds manager, or fromunderlyingfundserviceproviders.Thereviewof theunderlyingprivateequityfundmanagermayinvolveutilizationofduediligencetechniquesaspreviouslydescribed,including:

Evaluating the investment strategy of the underlying private equityfundmanagerEvaluating the operational infrastructure of the underlying privateequityfundmanagerReviewing the quality and appropriateness of the underlying privateequityfund'sserviceproviders

The operational due diligence process undertaken by an LP at the privateequityfundoffundslevelshouldalsoencompassadeterminationofthemanner,types,andfrequencyofinformationthataregenerallybeingtransmittedbetweentheunderlyingprivateequityfundmanagerandtheprivateequityfundoffunds.It should be noted that this information would be in addition to the types ofinformationobtainedby theprivateequity fundof fundsduring the initial andongoingduediligenceprocessoftheunderlyingfundmanager.For example, this information could include performance estimates of an

underlying private equity fundmanager, various types of risk data such as anunderlyingmanager's exposures to certain sectors ormarkets, and updates onoperationalinformation.Aspartofthisanalysis,anLPperformingduediligencewouldgenerallyconsidernotonlytheleveloftransparencyaffordedtothefundmanager,butthewayinwhichtheprivateequityfundoffundsverifiesthisdataandutilizes this data to performongoingmonitoringof the underlyingprivateequityfund.Finally,anLPshouldreviewandanalyzetheinformationprovidedby the underlying private equity fund to the private equity fund of funds. Assuch,whenanLPthatsitsontheadvisoryboardofafundofhedgefunds,they

should take into account the information obtained from these additionaloperational due diligence techniques to further enhance their active role as anadvisoryboardmember.

ADDITIONALPRIVATEEQUITYADVISORYBOARDCONSIDERATIONS

Bythe timeafund isupandrunningandacceptingcapital frominvestors, thebasictermsofthefundgenerallyhavebeenestablished.Thesetermscanincludebasicfeeschargedbythefundaswellasanumberofotherprovisionsthatareactivated or triggered only either when certain events happen or upon thedecision of the LPs.An advisory board of a fundmay serve a crucial role inmakingsurethattheGPstrictlyadherestosuchprovisions,aswellasassistingin coordinating efforts among other nonadvisory board LPs to trigger certainevents.Someofthesekeyprovisionsareoutlinedinthefollowingsections.

No-FaultDivorceandAssociatedProvisionsInmanycasestheLPsofafundwanttheabilitytoundothefundbyendingthefund'sabilitytoacquirenewassetsandforcingliquidationofexistingholdings.Thisisthepointofano-faultdivorceclause.Arelatedprovisionistheno-faultremovaloftheGPclausethatallowsLPstoremovetheexistingGPandinstallanewone.Anotherrelatedprovisionistheno-faultfreeofcommitmentsprovisionthatsimplysuspendstheacquisitionperiodof thefundtoallowLPstoput thebrakes,perhaps just temporarily,on theabilityof theGPtocontinueacquiringportfoliopositions.ThisisofcoursecontrarytothegoalsofGPsthatwantLPstocontinuethelife

ofafund,sothattheycancontinuetogeneratefees,aswellastostayinpowerasGPof the fund.Tobalance these competing interests inpractice,manyno-faultdivorceprovisionsrequireasupermajoritytobeenacted.SincetheadvisoryboardofafundistypicallymadeupofthoseLPswiththelargestinvestmentinthefund,theadvisoryboardwouldlikelyplayacrucialroleinvotingtowardtheactivationofthisclause.

LimitationonLiabilityAs outlined earlier, advisory boards that consist of LPs, as opposed to pure

advisors, serve two basic functions. First, they are generally supposed torepresentthebestinterestsofthelargerpoolofLPs,includingthosethatdonothaveadvisoryboardseats.Second,theyaresupposedtoserveasadvisorstothefund in terms of how to proceed in certain situations including portfoliomanagement advice.Advisory boardLPmembers however, do notwant to beliable to other LPs formismanagement of the fund.As such, advisory boardswill often request that the GP absolve them from technical legal liability formanagementandcontrolof thefund.Typically theadvisoryboardwill requestsuchanopinionintheformofalegalopinion.4

KeyPersonProvisionsAkeypersonprovision,sometimesreferredtoasakeymanprovision,atitsmostbasic leveloutlines that in theeventof thedepartureofakeyemployeeof theGP, such as a portfolio manager, investors will at a minimum be notified. Incertainsituations,keypersonprovisionswillnotonlyprovideLPswithanoticeofthetriggeringofakeypersoneventbutalsoofferthemaredemptionwindow.Inmostcases,whenanysortofredemptionwindowisprovided,nopenaltyfeesarechargedtoLPs.Key person provisions may be further expanded to include not only the

departureofemployeesbutalso to includeanumberofother terms, includingthe death of a key individual, incapacity of a key individual, or the lack ofmaterial involvementwith the business for a specific periodof time for a keyindividual. Another twist on key person provisions may be that once a keyperson event is triggered, the GP may not be permitted to engage in newacquisitionsforaspecifiedperiodoftimesubjecttoapprovalbythemajorityofinvestorsortheprivateequityfund'sadvisoryboard.Furthermore,akeypersonprovisioncouldprovidethattheGPwouldhavetoliquidatethefund,subjecttoapprovaloftheinvestorsorthefund'sadvisoryboard.Itshouldbenotedthatintheaboveexamples,wehavereferredtoakeypersonclauseasbeingactivatedinrelationtoasingularkeyindividual.Thesesituationscanbechangedtoreflectmultiple key individuals aswell.Whenmultiple key individuals are involved,differentscenariosexist.For example, let us consider a private equity firm with two coportfolio

managers:Mr.AandMr.B.Onesuchkeypersonscenariomaybean“or”keypersonclause.Underan“or”keypersonclause,theclausewouldbeactivatedintheeventofthedeparture(ordeath,incapacity,orlackofmaterialinvolvement

for a specified period of time, should it be applicable as outlined earlier) ofeitherMr.AorMr.B.Asecondscenariowouldbean“and”keypersonclause.Under this “and”keyperson clause, thekeyperson clausewouldbe triggeredonlyifbothMr.AandMr.Bdepartedthefirm.FromtheperspectiveofanLP,“and”keypersonclauses are thought tobe less advantageousbecauseof theirmorerestrictivemannerascomparedto“or”keypersonclauses.Theadvisoryboardcanhaveamaterialroleinmonitoringtheactivitiesofthe

GPintheeventakeypersoneventoccurs.Furthermore,theadvisoryboardmaybethebestadvocateforthelargerpoolofLPswhodonothaveadvisoryboardseats in monitoring any new acquisitions or fund liquidations during a keypersonevent.

CONCLUSIONThis chapter provides an introduction to the factors investors must considerwhen approaching operational due diligence upon a private equity fund'sadvisory board, including the different types of advisory boards that may bepresent at a private equity fund.We also provide an overview of some basicconsiderations LPs should consider when serving on an advisory board of aprivateequityfund.WhiletheremaybeanumberofadvantagesthatmayaccruetoanLPservingonanadvisoryboard,theremayalsobeanumberofpotentialdrawbacks.This chapter also provides an overviewof the benefits of ongoingoperational due diligence monitoring in an advisory board context as well asconsiderations of information flow from the GP of an underlying portfoliothroughtoLPs.WethenoutlineanoverviewofLPduediligenceconsiderationsforprivateequityfundoffunds,andtherolethatsuchconsiderationsmayplayinthecontextofanLP'sroleonanadvisoryboard.Finally,thischapteroutlinesadditionalprivateequityadvisoryboardconsiderations,includingtheroleoftheadvisory board in interactingwith no-fault divorce provisions and key personprovisions.NOTES

1.SeeJamesSchell,PrivateEquityFunds:BusinessStructureandOperations(NewYork:LawJournalPress,2004),9–10.2.SeeGuyFraser-Sampson,PrivateEquityasanAssetClass,2nded.(Hoboken,NJ:JohnWiley&Sons,2010).

3.JamesM.Kocis,InsidePrivateEquity:TheProfessionalInvestor'sHandbook(Hoboken,NJ:JohnWiley&Sons,2009).4.Ibid.

CHAPTER11

CaseStudiesandScenarios

When reviewing a private equity firm's operational data, there are often anumber of grey areas that come to the surface as part of the review process.Depending on where a particular investor's operational threshold lies, plusnumerous other factors, rational investors can come to different allocationdecisions.ThepurposeofthischapteristoprovidesomeperspectivetoLimitedPartners when they are approaching these operational crossroads by outliningseveral case studies and scenarios an investor may be presented with whenconductinganoperationalduediligencereview.Thischapterbeginsbyoutliningthedetailsofhistoricalprivateequityfrauds.Wethenproceedwithadiscussionofseveralhypotheticalsituations.Allsituationsandpersonsdescribed in thesescenariosarepurelyfictionalandsolelyfordemonstrativepurposes.

CASESTUDIESManyLimitedPartners(LPs),GeneralPartners(GPs),andothersinvolvedintheprivate equity industry, such as service providers, may in general have aperceivednotion that their industry isvirtually immunefromlarge-scale lossesas a result of fraud. Fueling such concerns could be the lack ofMadoff-typeeventsinrecentmemory,whichproducesensationalistheadlinesandwidespreadgloballosses.Areviewofrecenthistoryinthisregard,however,presentsastarkcomparisontonotionsthatprivateequityfunctionsinamoralvacuuminwhichfraudcannotsurvive.Fraudandlossesduetoprimarilyoperationalreasonshasbeen shown to exist on both sides of the private equity investing spectrum.Recentstudiesconcerningprivateequitymanagers’experienceswithfraudulentactivities at underlying portfolio companies suggest that fraud is certainlypresent at these firms. Similarly, and perhaps more notably from the LimitedPartner's perspective, are brazen fraudulent activities at the General Partnerlevel,whichhaveresultedinlarge-scalelossesforprivateequityinvestorsinthefundsthattheseorganizationsmanage.

CaseStudy1:DannyPangand$700MillionPEMGroupFraud

DannyPangwasborninTaiwanonDecember15,1966,andcametotheUnitedStatesasayouthandlaterenrolledattheUniversityofCalifornia,Irvine.PangostensiblyexemplifiedthegreatAmericansuccessstory,fromworkinghardasaTaiwaneseimmigrant,tograduatingfromauniversitywithanMBA,tobuildingacareeratMorganStanleyuntilhewasseniorvicepresident,andtostartinghisownfirm.Pang became a partner at Sky Capital Partners venture-capital firm in the

1990s,investingsomeofhisfamily'smoney.1In1997,PangwasfiredfromSkyCapitalbyPresidentandCEOMichaelHsu,wholatersaidinaninterviewthatPang“stolemypersonalmoney”bygettingHsutosetupabrokerageaccountandthenusingsomeof thecashforhimself. InJune1997,Hsuwrote inane-mailtotheWallStreetJournal thatPang“stole$3millionfroman investmentescrowaccountbyfakingsignature[s]ofmineand[the]CEOofourinvestmenttarget.”2 According to Hsu, when Pang was confronted he said that he “justneededthemoney.”Hsuclaimedthathedidnotreportthethefttopolicebecause

it was an embarrassing internal scandal and Pang's family, which was a biginvestor in SkyCapital, asked himnot to report it.Hsu says Pang traveled toTaiwanandconfessedthethefttoSkyCapital'sboardandthathehadrecoveredabout two-thirds of the stolen money by seizing Pang's share of the venture-capitalfirm.Inaninterview,HsusaidSkyCapitalfiredPang.DannyPangalsohadsomeissuesinhispersonallife.In1993,shortlyaftera

lavishengagementpartyattheRitzCarltonHotelinLagunaBeach,hisfiancéeElaine Fan refused tomarry him because she found out that he had a live-ingirlfriend.3Pang thenmarriedhisgirlfriendJanieLouiseBeuschlein,astripperwhomhehadmetataclubthathefrequented.Pang lived a lavish lifestyle in upscaleNewportBeach,California,with his

wife Janie Pang and their children. While Pang appeared to be a polishedbusiness executive in public, everything was not peaceful at home. In courtrecords, police reports detail how they were called to the home at least fourdifferent times.4 Janie Pang accused her husband Danny Pang of ongoingdomestic violence and expressed fear that Pangmight “kill her.”Additionally,whilethepolicewerethere,Mrs.PangaccusedMr.Pangofstealingmoneyfromherparents,breakinghernose,andforcinghertowithdrawlargesumsofcashforherhusbandtouseonwomen,gambling,andalcohol.However,policeneverarrestedPangandnocriminalchargeswereeverfiled.InMay1997,Mrs.Panghiredaprivateinvestigatorwhoreportedtoherthat

Mr. Pang had been out with another woman.5 Shortly after confronting herhusbandoverthephoneabouttheinvestigationwhilehewasawayonabusinesstrip,aclean-cutelegantlydressedmanwithabriefcasearrivedatthedooraskingforherhusband.Afterbeing let inby themaidandspeakingbrieflywithMrs.Pang,hepulledoutasemiautomaticpistol.TheterrifiedmaidrushedthePangs’childrenoutthebackdoorasthegunmanchasedMrs.Pangthroughthehome.Withinminutes, the killer foundMrs.Pang,who tried to hide in her bedroomcloset,andfiredseveral.380-caliberrounds,killingheronthedayofherfourthweddinganniversary.6

Pang claimed that since he was away, he was not connected to his wife'smurder,althoughhewaswidelybelievedtobeconnectedtoAsiancrimeringsandtohavehiredahitmantokillhiswifetoavoidamessydivorce.In2001,Mrs. Pang's son from her first marriage sued Mr. Pang over Mrs. Pang's$750,000lifeinsurancepolicy.7

In2001,Pangfounded,andnamedhimselfthechiefexecutiveof,thePrivateEquity Management Group and Private Equity Management LLC, or

PEMGroup, based in Irvine, California. In 2004, PEMGroup raised its firstround of funding by selling their products through six local Asian banks,including internationally known Standard Chartered Bank, EnTie CommercialBank,BankSinoPac,CosmosBank,HuaNanCommercialBank,andTaichungCommercialBank.8BankstrustedPangbecausehepresentedanauraofsuccessas an accomplished Taiwanese-American executive, with a history ofeducationalandbusinessaccomplishments,whilehostinglavishpartiesinluxurysuites at top hotels and flying around the globe in private jets. StandardChartered sold about US$221 million worth of PEMGroup securities, EnTieBank soldUS$52million, Bank SinoPac soldUS$146million, CosmosBanksold US$48million, Hua Nan sold US$205million, and Taichung Bank soldUS$70million.9

In2006,Pangusedfundsfrominvestorstobuythefirma$15millionprivateGulfstream jet, and then later used the jet to take private trips to LasVegas.10Employees stated that on theway homePang had a briefcase full of cash; hethrew$10,000bundlesatthem,thesamewayhethrewmoneytotheLasVegasshowgirls.TheWall Street Journal published an article onApril 15, 2009, questioning

Pang's credentials and alleging that his firm had been fraudulently stealingmillions of dollars from investors since 2003. Within a day, the SEC seizedcontrolofPEMGroup,whichwasbelieved tobevaluedat$4billion.11Shortlyafterthearticlewaspublished,itwasreportedthatPanghadhislawyerdraftanagreementwithanemployeewhoworkedwiththeWallStreetJournalofferingtopaytheemployee$500,000forsayingthattheirstatementswasfalse.12

In the SEC's complaint filed in April 2009, it charged Pang of defraudinginvestors of hundreds ofmillions of dollars by fraudulently offering securitiesfromhistwofirms.13TheSECallegedthatPangmisledinvestorsaboutthefacevalue of investments in real estate timeshares and life insurance policies. ThecomplaintstatesthatPEMGroupviolatedSection17(a)oftheSecuritiesActof1933, Section 10(b) of the Securities ExchangeAct of 1934, andRule 10b-5.InvestorsbelievedthatPang'sfirmswouldpurchaselifeinsurancepoliciesfromseniorcitizensandinvestthemoneyinrealestatetimeshares.Accordingto theSECcomplaint,over16,000Taiwanese investorsweresold

securities (debentures) under the assumption that they would be guaranteed a5.25 percent to 7 percent annual rate of return paid semiannually.14 WhileinvestorswereguaranteedprincipleandinterestontheirinvestmentsbyPang,hecommitted fraudbypayingold investorswithnew investormoney, essentially

runningaPonzischeme.Additionally,thefirmsforgedinsurancedocumentstofurthermisleadinvestorsthattheycarried$108millionofinsurancewhentheycarriedonly$31million,andclaiming that returnswere“guaranteed.”15Lastly,thefirmmisrepresentedPang'scredentials,includingfalsifyinghiseducationandemploymenthistory.Additionally,PEMGroupwaslaterchargedbytheSECforillegallystructuringfinancialdealstoevadecurrency-reportingrequirements.InapressreleasefromtheSEC,RosalindR.Tyson,DirectoroftheSEC'sLos

Angeles RegionalOffice, states, “Pang's alleged use of phony credentials andfalseinsurancecoveragetoguaranteehisinvestmentsunderscoreshowcriticalitis for investors to exercise due diligence before entrusting their savings topromoters.”16SimpleduediligencewouldhaveraisedseveralredflagsthatPangwas a fraud. He falsified his resume. According to university records, whichmany investorsdidnot seem tohave checked,Pangenrolledonly for a singlesummerterm,in1986,andneverreceivedthedegreesheclaimed.Additionally,MorganStanleyhasnorecordofPangeverworkingthere.17

While the SEC continued their investigation in September 2009, Pang wasrushedtothehospitalanddiedofanoverdoseofmedication.Hisdeathatage42was ruleda suicideby thepolicedepartment,althoughhis familystillproteststhathehadaheartcondition.18

CaseStudy2:JohnOrecchioandthe$24MillionAACapitalFraud

While cases of fraud at private equity firmsmay seem rare, the brazen fraudcommittedbyJohnOrecchioshouldbeaprimeexamplethatpublicandprivatepension fundmanagers investing inprivateequityshouldkeep inmind.Whilethescopeofthisfraudmayseemrelativelysmall,thecommonthemeoflackofattention to detail regarding operational due diligence for private equity firmswillcontinuetobeagrowingandongoingconcern.JohnOrecchioearnedhisundergraduatedegreefromtheUniversityofNotre

Dame and earned anMBA fromNorthwesternUniversity'sKelloggSchool ofManagement.19 Orecchio's notable employment history included working atHitachiCapitalAmericaasamanagingdirector.HealsoobtainedhisCharteredFinancial Analyst (CFA) certification. He went on to serve as a managingdirector in the Leveraged Finance Group at Bank of America (which hadresultedfromamergerwithContinentalBank),wherehewasresponsibleforthefinancingofadiverseportfolioofbuyouttransactionstypicallysponsoredbya

private equity firm. Orecchio later became a managing director of Bank ofAmericaCapitalCorporation,asubsidiaryofBankofAmericaCorporation.InthispositionOrecchiowasresponsiblefortheday-to-daymanagementwithoneothermanagerofa$5billionprivateequityfundinvestmentsportfolioandwasamemberofthefirm'sInvestmentCommittee.Orecchio was a married father of three, and he and his family lived in the

Chicago suburb of Arlington Heights in a modest home.20 He was a well-connectedfinancierandin2000,whenAACapitalPartnerswasspunoutfromABNAmro,hebecamethecofounderandCEO.21Atthattime,AACapitalhadmillionsundermanagement,whichwere invested in specialdirect investmentssuch as casinos and record labels, aswell as private equity funds.TheprivateequityfundmanagedbyAACapitalmanagedmoneyfromthepensionfundsofsixdifferentunionsbetween2001and2006.22Orecchiosolicitedunionpensioninvestmentsthroughheavylobbying,includingofferingluxuryseatsatsportingevents, extravagant wining and dining, and lavish gifts. Orecchio's firm alsomadepaymentstothegroupsledbyformermayorofDetroitKwameKilpatrickinexchangeforthesegroupsintroducingAACapitaltounionbosses.23

InAugust 2003, according to theSEC report,Orecchiobegan a relationshipwithawomanwhoperformedataDetroitstripclub.24Orecchiobegantoliveadoublelife,plunderinginvestoraccountstofinanceanextravagantlifestylethatincludeddrivingaBentley,luxurysuitesatsportingevents,tripsonprivatejetstotropicalandexoticdestinationswithhisyoungmistress,then“fiancée,”andastableofthoroughbredracinghorses.25

According to the SEC's complaint, a majority of investors’ money($126 million) was kept in the firm's private equity funds, but at least$68millionwaskeptincashinclient'strustaccounts.Thefirmaskedclientstoput millions of dollars in trust accounts for discretionary spending, such ascapital calls. 26Around May 2004, Orecchio convinced his CFO Mary BethStevenstogivehima“taxloan,”whichovertimeturnedintoover20differentloan disbursements to his personal accounts of approximately $5.7million ofinvestors’money.27

TheSECcomplaintalsonotedthatduringanErnst&Youngindependentauditof the 2004 financial statements for the funds, the lead accountant took theCFO'swordthatOrecchiousedthefundsfora“taxloan,”althoughtherewasnosupportingdocumentation,suchasthetermsoftheloan,toprovethatthefundtransferswereloans.28Additionally, theSEC'sDivisionofEnforcementandtheOfficeoftheChiefAccountantlaterchargedtheleadaccountantswithimproper

conduct, citing that they neither failed to confirm the CFO's statements thatOrecchiomadetaxpaymentsfor theloanamounttotheIRS,butalsofailedtoconfirmtheloanandrepaymentplanwithOrecchioinperson.29Additionally,thecomplaint stated that the Ernst&Young audit team failed to discuss the loanwith their colleagueswho prepared the tax filings for theAACapital fund ortheiraffiliatedPrivateEquityfunds.In2006,theSECbeganinvestigatingAACapital'sboutiquefirms’association

to unions. The complaint states that Orecchio and AA Capital defraudedinvestors by misappropriating funds for personal use, including funds for aDetroit“StripClub”andahorsefarminMichigan.30Additionally,thecomplaintalleges that AA Capital failed to keep the proper documentation, books, andfilings as required of a registered advisory firm. The SEC filed numerousviolations against AA Capital and Orecchio, including violating Advisers Act(204&206),andseizedcontrolofthefirm'sassets.31

On July 21, 2009,Orecchiowas charged by theU.S.Department of Justicewithonecountofwire fraudandonecountofembezzling fundsownedbyanemployee pension benefit plan.32 The combined charges carried a maximumpenaltyof25yearsinprisonplusfines.Thefilingchargesthatwhileactingasthe investment manager at AA Capital, Orecchio was accused of makingrepeated“capitalcalls”fromthe$169millionofpensionfundshemanaged.Itwas alleged that he converted over $24 million to his personal accounts andpersonal investments, insteadofusing the funds forhis investors’ investments,fundmanagementfees,orotherconventionaloverheadexpenses.In June 2010,Mr.Orecchio pleaded guilty andwas given a nine-year, four-

monthsentenceforhisactions.33Inaddition,hewasrequiredtopayrestitutionofmore than $26 million in addition to a $50 million civil judgment that wasawarded in a civil suit to theU.S.Department ofLabor.34 Earlier that year, inJanuary 2010, AA Capital's CFO and Chief Compliance Officer Mary BethStevenssettledwiththeSECoverchargesthatsheviolatedtheAdvisorsActandaided and abetted themisappropriation of funds byOrecchio.35 The settlementrequired Stevens to pay disgorgement of $79,583.50, including prejudgmentinterest of $22,472.24, and civil penalties of $50,000 to the Securities andExchangeCommission in five installments, but shewas not required to admitguilt.Additionally,Orecchio'spartner,PaulOliver,andcofounderofAACapitalwasalsochargedbytheSECandwasrequiredtopaydisgorgementof$49,786,prejudgment interest of $7,979, and a civil penalty of $75,000 to the SEC.Additionallyhewasnotallowedtobeaffiliatedwithanyinvestmentadvisorfor

12months.Lastly, in June2010 theDepartment ofLabor reached adealwithAACapital'sinsuranceproviders,includingIndianHarborInsuranceandFederalInsurance,torecover$7.8millionworthofinvestor'sfunds.36

CaseStudy3:PalmInvest€30MillionFraudIn2005,twoDanishbusinessmen,DannyKlompandRemcoVoortman,startedthe PalmInvest fund in Hilversum in the Netherlands. They put together aprofessional advertising campaign with television commercials, printadvertisements, and brochures to convince over 400 investors to give them aminimum of €50,000 each for real estate bonds.37 The bonds guaranteed a 9percent return on property investment inDubai for real estate investment anddevelopmentinPalmJumeirah.38Investorsweretoldthattheirmoneywouldbeusedtopurchaseapartmentsandvillasonthemanmadepalm-shapedislandsinDubai.InJanuary2008,90investigatorsseizeddocumentsandluxurygoodsduringa

raidofeightoffices,fivehomesintheNetherlands,andonehomeinMonaco.39Therealmasterdeveloper,afellowcalledNakheelwhowasresponsibleforthethreepalm-shapedislandsbeingbuiltofftheemirate'scoast,issuedastatementshortly after the raid saying that theyhadneverheardofPalmInvest and laterfiled legal action against the firm.40 Investigators arrested five employeeswithcharges of participating in organized crime, money laundering, andembezzlement. At least part of the cash was used to fund advisors’ lavishlifestyles including luxury homes, cars, jewelry and watches, travel, andclothing.41 Both founders were given sentences of 3.5 years in jail as well asbeingbannedbythecourtfromworkingasfinancialadvisorsforfiveyears.42In2010 and2011, auctionsof the fundmanagers’ luxurygoods andhomeswereheldtohelprecoupsomeofthemoneylostbyinvestors.

CaseStudy4:ChartwellPartnerEmbezzlementScheme

In1992,ToddBermanandapartner foundedChartwell Investments, aprivateequityfirmbasedinNewYork.43ToddBermanearnedhisundergraduatedegreefrom Brown University and an MBA from Columbia University GraduateSchoolofBusiness.44AccordingtotheU.S.State'sAttorney'sOfficedocumentsof1999,Bermancreatedseveral investmentcompaniesusingacombinationof

his own personal, his partner’s, and an investor's funds to create ChartwellInvestments tomanage the investment firms in the portfolio.45 The firmmadeequity investments in companies such as PlayCore Holdings, which madeplayground equipment, Richard Childress Racing, and Morris MaterialHandling.46Bermansatontheboardofdirectorsforthefirmsandhelpedwithstrategicdirectionandmanagement. In turn,Chartwell receivedamanagementfee fromeachof the firms in theportfolio plus expenses.For example, in theSECfilingsforMorrisMaterialHoldings, thesummarydocuments include thefollowinglanguagedetailingtheChartwellManagementConsultingagreement:The Company has entered into a management consulting agreement withChartwell Investments Inc. pursuant to which Chartwell Investments Inc.provides the Company with certain management, advisory and consultingservicesforafeeof$1.0millionforeachfiscalyearoftheCompanyduringthe termof theagreement,plusreimbursementofexpenses.The termof themanagement consulting agreement is 10 years commencing at theRecapitalization Closing and is renewable for additional one year periodsunless theBoardofDirectors of theCompanygives priorwritten notice ofnonrenewaltoChartwellInvestmentsInc.47

According to the U.S. State's Attorney's office documents, starting in 1999Berman set up a loan agreement between the funds to transfer money out ofinvestor's funds and firm funds for operating expenses.48 Over a series of 18months from 2001 to 2003, Berman misled his partner and investors byfraudulently transferringfundstohispersonalbankingaccounts.49Additionally,according to the SEC complaint he altered financial statements and told thefirm's third-party accountants not to tell anyone about the transfers. BermanfraudulentlycollectedadditionalfundsbybillingtheportfoliocompaniesforhispersonalexpensesinadditiontoChartwell'sexpenses.50Thesepersonalexpensesincludedatriparoundtheworld,rentingprivatejets,helicopters,andcars,andstayinginluxuryhotelrooms.In2003,Bermanwaschargedby theJusticeDepartmentofembezzling$3.6

million from his partner and firm,which included over 600 personal expensereimbursements.51Bermancouldhavereceivedamaximumprisonsentenceof20years,butpleadedguiltyin2004andwassentencedtofiveyearsinprison.52

CaseStudy5:DutchRealEstateFundSteals€200Million

In2006,thePhilipsPensionfund'sdirectrealestateportfolioPREIMwasworth€1.34 billion, and the entire Philips Pension fundwas valued at €14.5 billionaccordingtothefund'sannualreport.53In2006,thedirectrealestateinvestmentsyielded 10.5 percent.However, the fund fell 1.6 percent short of its goal, andreportedanoverallreturnofinvestmentofonly4.9percent.54

According to the ANP press agency, a company spokesperson from Philipsstated, “the company started an internal investigation into ‘irregularities inreporting’ by its pension fund and PREIM last year”55 The firm's growingsuspicions centered on the sale of unprofitable or less-profitable real estatetransactions,which led to a forensic investigationby the firm.Additionally inearly2007,adivisionofRabobankcalledRaboRealestategroupbeganitsowninvestigationintotheactionsofthefirmBouwfonds,priortotheiracquisitionofthecompany.56

Between2006and2007,thepoliceinvestigatedtheirregularities;investigatorstaped over 70,000 telephone conversations and used secret surveillance atmeetings.Accordingtoapublicprosecutor,“Thecasecametolightwhenataxinspector checked out one of Cees Hakstage's [former director at Rabobank'spropertydevelopmentarm,Bouwfonds]receipts.”57Itwasalsoreportedthatthetaxinspector“...askedquestionsbutdidnotgetaclearanswer.Hethencameacrossamoneytrailthatledtomoredubiousbills.”58

InNovember2007,67peoplewerearrestedinover50raidsinthreedifferentcountries including Belgium, the Netherlands, and Switzerland, which wereconductedbymorethan600policeofficers.59ThetwomainsuspectsinthecasewerethedirectorofBouwfondsandtheheadofPhilip'sPREIMfund,whowasaccused of charges such as forgery, money laundering, and participating in acriminalorganization.60

According to prosecutors, the fraud involved surveyors accepting bribes inexchange for undervaluing property,whichwas sold to a business connection,and thenwas sold again for the fullmarket value. The profits from the dealsweredivided among theplayers insteadof going to thePhilip's pension fundsinvestors.61 After the arrest, the prosecutor stated, “We think that the suspectshave received substantial amounts for awarding and processing large buildingprojectsandlargepropertytransactions,possiblyinvolvingdozensofmillionsofeuros.”62The investigationuncovered that the fraudwasbelieved tohavebeengoingonsince1995,andmost likelywasable tocontinueforso longbecausethe firm's regulators did not pay close enough attention to the division'sweakperformance.63Thecombined fraud is expected tohavecostover€250million

euros, with the Philips pension fund having lost at least €150 million andRabobankhavinglost€100millionthroughBouwfonds.64

Toillustratethefraud,considerthatonefirmthatwasallegedlyinvolvedwasthepropertycompanyCelonstate.Accordingtoapublicprosecutor,they“bribeda former director of PREIM, the real estate management subsidiary of thepension fund. They bought property from PREIM for too low a price, andallegedlypaidtheformerdirector'scompanyindirectly€5.4minreturn.”65

ManyofthedefendantssettledtheircasesandagreedtopaymillionsofeurosbacktothePhilip'spensionfundaswellastothejusticeministry.Additionally,manyofthesettlementsincludedmandatorycommunityserviceorashortstintin jail. Last, whilemany of the settlements included paying back the pensionfund, Philips filed many additional civil lawsuits against a majority of theconspirators. In 2008, Philips pension fund began to reduce their real estateportfolio,andsold15percentoftheirassetstotheDutchrealestatefundVestedaforapproximately€200millionandtoNjeuweSteenforover€142million.66

CaseStudy6:OnyxCapitalAdvisorsOnyx Capital Advisors was founded in 2006 by Roy Dixon Jr., and washeadquartered in Detroit, Michigan. Dixon's longtime friend Michael Farr, aformerNFLplayer for theDetroitLions, receivedOnyx investor funds forhisthree small businesses.67 In 2007, three Detroit pension funds invested $23.8million into the Onyx Capital Advisory Fund I, LP (“Onyx Fund”) startupprivateequityfund.68Theagreementsforthefundincludedcapitalcalls,aswellasadditionalfeesincludinganannualmanagementfeeof2percentofcapitalinthefundor$500,000payablequarterly.On April 22, 2010 the SEC charged Dixon, the fund, andMichael Farr of

stealingmorethan$3millionfromthefund.TheSEC'ssecurityfraudcomplaintalleged that shortly after the pension funds joined the fund, Dixon andOnyxCapital Advisors took $2.06 million from the Onyx Fund for advancedmanagement fees.Additionally, Farr transferred an additional $1.05million tohisownpersonalbusinesses.69AccordingtotheSECcomplaint,Dixonwithdrewmanagement fees atwill between 2007 and 2009, overcharged funds for fees,anddouble-billed the funds forcertain fees.70Merri JoGillette, theDirectoroftheSEC'sChicagoRegionalOffice,statedthat“FarrassistedDixonbymakinglargebankwithdrawals ofmoneyostensibly invested inFarr's companies, andtogethertheytreatedthepensionfunds’investmentsastheirownpotofcash.”71

Furthermore, Onyx Capital tried to hide the scheme from investors bywithholdingtaxreturnsandalteringinvestorreportsandfinancialstatements.The SEC securities fraud complaint also accuses Dixon and Onyx Capital

Advisors of misleading and making false statements to potential clients. Forexample,whena fundexpressedconcernoverDixon's lackofexperiencewithprivateequityfunds,hesentaletteronbehalfofthefirmtooneofthepensionfunds, falsely stating that the joint owner of Onyx Capital had extensiveexperienceevaluatingprivateequityinvestments,andthathewoulddevoteallofhis efforts to the Onyx Fund. The letter went so far as to contain a forgedsignature of an individual that freelanced for the firm but had never beenemployedbyOnyxCapitalAdvisors.72Whileitappearsthatasettlement,plea,orotherdealhasnotyetbeenarranged,theSEC'sfraudcomplaintasksthecourttocompel the defendants to “disgorge their ill-gotten gains and pay prejudgmentinterest and civil penalties.”Additionally, the pension funds involvedwith theOnyxFundarealsofilingseparatelawsuitsfordamages.73

CaseStudy7:AllianzBriberyIn2010,theWallStreetJournalreportedthattheSECwasinvestigatingAllianzSE, one ofEurope's largest insurance companies.According toAllianz's 2010Annual Report, the firm had a presence in approximately 70 countries, andserved over 76 million customers with comprehensive insurance and assetmanagementproducts.Asofyear-end2010, its totalassetsundermanagementwerereportedtobe€1,518billion.74

In September 2010,U.S. andGerman authoritieswere notified by companypersonnel from Allianz and Manroland that their internal investigation ofpayments made to groups without consent was an ongoing issue.75 Theseincludedincidentsinwhichpaymentsweremadewithoutproperdocumentation.InNovember2010, theSECrequesteddocumentsfromthefirmregardingoneofthefirm'sprivateequityholdings.Allianz had owned a majority stake in a German printing company called

ManrolandAGsince2006.ManrolandAGistheworld'smarketleaderinoffsetwebprintingandoneoftheleadingprintingmanufacturers.76TheSECbeganitsinvestigation under the Foreign Corrupt Practices Act (FCPA) regardingpotential bribery paymentsmade by a Swiss subsidiary ofManroland.77 Underthe Foreign Corruption Practices Act, companies with U.S. interests areforbiddenfrompayingbribestoforeignofficialstowinbusiness.

While Allianz is a European firm, it was listed on the New York StockExchange until October 2009 and therefore falls under the FCPA regulation.78Theinvestigationreviewedwhether theSwissbankaccountheldbyVostraSAreceivedmoney fromManroland from 2002 to 2007 to pay bribes to a Swisssubsidiary.Additionally,outsidecouncil is reviewingadditionalundocumentedtransactionsacrosstheglobethatmaybebribes,believedtototalmorethan$10million.79ThisisthefirstincidentoftheSECinvestigatingaprivateequityfirm'saffiliateactionsoverseasunderFCPA.ThisprobemaybreaknewgroundintheUnited States’ enforcement of the foreign bribery laws as the SEC has neverchargedaprivateequityfirmbasedontheconductofaforeignprivatecompanyinitsportfolio.However,atthispointnochargeshavebeenfiled.

HYPOTHETICALSCENARIOS

Scenario1:“FromRussiawithLove”:AreCountry-SpecificPoliticalRisksValidConcerns?

TheBaritone family amassed a great fortune at the turn of the century,whichwassafelymonitoredbythestewardofthefamilyfromgenerationtogeneration.In1998,threebrothersassumedtheresponsibilityforthefamily'smoneyforthefirsttimeandweregivencompletecontrolofthefamily'sestate.Thefamilyheldseveral dozen hotels throughout Europe and a fleet of luxury car dealerships,withthetotalestatevaluingover€3.95billion.Manyfinancialadvisors,hedgefunds, venture capitalist, inventors, and developers solicited the three brothersdailyattheirmansioninLondon.As the family had always been in the hospitality business, the brothers are

consideringwhethertoinvest30percentoftheirsizablefortunewithoneofthelargest private equity companies in France, Le Mette Bas. Specifically, thebrother'sinvestmentintheLeMetteBasfundwouldfocusondevelopingluxuryvacation property, retail entertainment complexes, and other forms ofcommercialpropertythroughoutEasternEurope.Theprivateequityfirmhashistoricallyalwaysfocusedonmanysmallprojects

throughoutEurope,buthasheavilylobbiedtheBaritonebrotherstoinvesttheirfundsintheirmostambitiousprojectsinRussia.Ifthebrothersfundtheprojects,the fund would allocate 50 percent of the funds to their resort propertydevelopment along the Chukchi Sea, and the other 50 percent to timesharepropertydevelopmentintheresorttownofBravania.Whilethebrothershavebeentaughtbythestewardsofthefamilythatwhen

considering investing in certain countries, specific consideration needs to begiven to the political climate and risks of a country, they feel that the fundmanagersatLeMetteBasarewell-versedintheriskstheyaretaking.Thatsaid,oneoftheBaritonebrothersstillhassomedoubtsaboutthevalidityofthefund'spractices,sotheysetupanothermeetingwiththemanagers.DuringthemeetingwiththeLeMetteBasprivateequityfund,thebrotherasks

what kinds of operational due diligence the private equity firm performs onportfoliocompanies.Thefund'smanagersgoontoexplainalistofoperationalchecks and ongoing monitoring that the funds perform on the portfolio

companies.However,fromthisdiscussiontheeldestBaritonebrotherlearnsthatthe portfolio companies do not use Western accounting standards and thatbecauseofongoingissueswithgraft,theportfoliocompaniesarenotsubjecttostrictregulatoryoversight.As the financial returns look extremely solid, the two younger brothers are

pushing the eldest brother to overlook the lax regulation and nonexistentcompliance mandates for the portfolio companies. However, throughout thecourseofthemeetingthebrothersalsolearnthattheLeMetteBasprivateequityfund itself has several Russian national officials and other close ties to thegovernmentservingontheboardsoftheportfoliocompaniesandthatapreviousemployeeworkedforthegovernmentpriortojoiningthefirm.Lastly,accordingtothemostrecentfinancialdocuments,atleast40percentofthefundsfortheseprojects were recently raised from a state-run pension fund, which createsadditional operational concerns for the brothers about the possibility of strictoversightoftheportfoliocompaniesbytheRussiangovernmentifthesetiesarebrokeninthefuture.With all these operational concerns, should the Baritone brothers invest 30

percentoftheirfamily'sfortuneintheLeMetteBasprivateequityfund?

Scenario2:“TheTaxManCometh”:ThinkingaboutTaxRegimes,UnintendedTaxConsequences,and

OffshoreHavensTheDanbeerfamilyhasalltheirincomeinvestedingrowingtheirbusinesscallcentersintheBoise,Idaho,area,whichactasthecustomercallcentersformanyFortune500companies.Whilethecallcentershavebeengrowing,theDanbeerfamily is increasingly concerned that the U.S. government's current trajectorywillleadtomoreburdensomeregulationandtaxesfortheirbusiness.Therefore,in1999,theDanbeerfamilydecidedtoselltheirbusinessfor$400millionandretiretoNaples,Florida.Thefamilydecidedtoinvesttheirmoneyinanumberofinvestmentvehicles,

includingaprivateequityfundcalledNotaxicothatisregisteredinthetaxhavenofGroto,butinvestsinmid-sizedcompaniesinAsia.TheDanbeersaretoldbytheprivateequitymanager that thefund is registered inGuernsey tominimizethe taxconsequencesfor theirprimarilyU.S.-based investors.As theDanbeerswereunfamiliarwithoffshoretaxregulation,theydecidedtodiscussthematter

withthemembersoftheircountryclubtogettheiropinion.TheDanbeersdecidedtotrustNotaxico'smanagersthattheywillnotbetaxed

on the income from the fund and invest $100 million. However, by notconsulting an accountant and lawyer, the Danbeers failed to realize that anyincome or dividends paid byNotaxico from their portfolio companies inAsiawould be taxed. The Danbeers failed to realize that the United States federalgovernment, regardlessof the tax statusof the fund, taxes alloffshore incomeand capital gains that are paid to U.S. citizens. Regardless of the fact theNotaxico'sprivateequityfirmwasaforeigncorporateentity,theDanbeerswerestillliablefor$15millionworthofincometaxesforpaymentsmadebythefundin2002,when they tried to repatriate the fundsback to theUnitedStates.TheDanbeers were furious at themselves for failing to understand the taxconsequences of Notaxico's action overseas, and at the fund managers forleadingthemtobelievethatthetaxhavenofGrotowouldprotecttheirearnings.Additionally,Notaxicofailedtoinforminvestorsthatifthefund'sregistration

wastransferredtoacountrywithanincometaxequaltotheUnitedStatesortoacountrythathadataxtreatyinplacewiththeUnitedStates,theywouldstillowetaxes.Inthisinstance,whiletheDanbeersmayhavebeeneligibletocollectataxcredit in the United States by paying at least $15 million worth of taxes toanothersovereignnation,theywouldstillhavepaidtaxestosomeone.While the U.S. federal government will almost always tax your income

regardlessofwhereorhowyoumakeitintheworld,manyinvestorsworkwithhighlyspecializedaccountants to trytoavoidit.ManyU.S. investorspostponethe payment of the taxes by sheltering their income overseas by using taxhavens, manipulating Subpart F rules, or setting up Controlled ForeignCorporations(CFCs),butsuchactionscanleadtounintendedtaxconsequences.

Scenario3:“SpiderMitesandTimber”:LearningaboutAsset-SpecificRisksandRiskManagement

ApproachesMurry Oakland is considering diversifying his investments by investing $50millionintheGreenTreeprivateequityfundinBurbank,California.Thefundisa traditional timber investment management organization (TIMO) fund thatinvestsinlandintheNorthwesternUnitedStatesandfocusesonseveralspeciesof trees that is used for lumber and paper.Amajority of the high-end lumber

fromtheoakandredwoodtreesisexportedforfurnituremaking,whiletherestis shipped to facilities throughout the United States and Canada. The fund'smarketing team provided all the typical documents to Oakland, including agenericoperationalduediligencequestionnaire that reviewed the firmsbuyingprocedures,portfoliomanagerbios,financials,andpertinentlegaldocuments.Oakland knows very little about commercial lumber or trees, but is fairly

confident that thefundwillgenerate thereturnshedesires.However,knowingvery little about this industry, Oakland decides to contact the fund's manageraboutvisitingtheforestlandthathewouldbeinvestingin,sohecanseethetreeshimself.OaklandtakeshisprivatejetuptothelargestplotoftreesownedbythefundandtakesahikewithhisdogBuddyandtheheadlumberjack,Paul.Whileheisoutontheland,Paultellshimaboutthedifferentacresoftreesthat

theywalkthroughandaboutthelongevity,temperament,andalmosteverythingOaklandwouldeverwant toknowabout the typesof trees.Paul tellsOaklandabout howhe is very happy that this season's trees are healthy, but alludes toproblemsinthepastwithanothertreefarmthathadfungus,fire,andtermites,allwithin19monthsofeachother.WhileOaklandfeelsthathisinvestmentwouldbewell taken care of by the tree staff, he has some additional concerns abouthow the fund handles disaster events such as fire and infestations, so heschedulesameetingwiththefund'smanager.At the meeting, the fund's manager reviewed the business continuity and

disaster recovery plan for the firm. They also discussed how the fund createsvaluation models for trees and land plots, including how they value stunted,damaged,ordeadtrees.Additionally,themanagerreviewsanexampleofatimewhen spider mites severely damaged 20 acres of American oak trees. Themanagerexplained that themiteswere similar to ticks, and that theybredandspread rapidly andwere almost impossible to remove. However, he reassuredOakland thatpreventivemeasureswerenowinplace toaggressivelycheckformites and that monthly pesticide applications were performed at all ofGreenTree's tree farms. Oakland walked out of the meeting feelingoverwhelmed,andconcerned thatheknewnothingabout spidermitesor treesbesideswhathehadlearnedinthepastfewweeks.DoyoubelievethatOaklandunderstandstheriskbehindhisinvestmentinthe

GreenTreeTIMOfund?WouldyouhavetakenthesameapproachasOaklandtooperational due diligence or would you gather more information about thesetypes of investments before committing? If you were unsure about the risks,wouldyouhireanoutsideconsultantbeforeinvestingyourpersonalmoney?

Scenario4:“ReconcilingwithDelay”:UnderstandingtheOperationalImplicationsforLowFrequency

TradingandLargeExposureStrategiesSophiaRobinshas traditionally invested inhedge funds and fundsof funds inthepast,butwould like toconsider investingaportionof theprofits fromhermediaempire inaprivateequityfund.Shereachesout to twodifferentprivateequityfundmanagerswhocometoherestateinAspen,Colorado,andformallypresent the benefits of their funds. However, while there seem to be manysimilaritiesbetweenhedgefundsandprivateequity funds,Ms.Robins realizesduringthecourseofvettingthefundsthatthetermofprivateequityinvestmentsaresubstantiallylongerthansheisusedto.She isuncomfortablewith the fact that theprivateequity fundsonlymakea

fewtradesayear,andthatherlossescouldbemuchlargerthanamissedtradeopportunityfromatraditionalhighfrequencyhedgefund.Whilesheisusedtolosing small fractions of the portfolio during trading, she is unsure about thehighly illiquidnatureofprivateequity investmentsand thefive-yearminimumlockup that theprivate equity funds are requesting.Additionally,Ms.Robins'sinvestment consultant is concerned that the small startup private equity fundsthatwereselectedbyMs.Robinsbeforehewashireddonotmeethisstandardsregardingoperationalpracticesandprocedures.Heisconcernedthattheprivateequity firms lack proper infrastructure, back-office personnel and well-documented policies and fund documents that he would typically like to seebeforeadvisingaclienttoinvest$10millionoftheirmoney.ShouldMs.Robinsmakeanexceptionforthelackofstandardsandprocedures

for theprivateequity firms?Whatwouldmakeyoucomfortablewithgivingaprivateequityfirm'sinvestmentmanager$10millionofyourmoneyforthenextfiveyears?

Scenario5:“SnowballEffect”:CanOneMinorIssueCreateaLargerProblem?

Kiekie Baron is considering investing $5million in the SilverMirage privateequity fund in Reno, Nevada. While the fund looks like a solid investment,duringtheoperationalduediligencereview,Baron'sindependentconsultantsrunaseriesofstandardbackgroundchecksonthekeyprincipalsofthefund.Oneofthe checks uncovers that a department headwas chargedwith amisdemeanor

criminal activity.Consequently, during ameeting, theSilverMiragemanagersreveal that the employee failed to notify the fund about the arrest.While theemployeehadnotbeensentencedyetforthechanges,theemployeeclaimsthatthe whole thing is a giant misunderstanding and that his lawyer expects thecharges to be dropped in the next couple of months. Additionally, the fundclaimsthattheywereunawareofthechargesasthecompany'spreemploymentscreeningcamebackclean,becausethechargesoccurredaftertheinitialdateofhire.

EXHIBIT11.1SnowballEffect:CanOneMinorIssueCreateaLargerProblem?

TheSilverMirageprivate equity fundmaintains a codeof ethics that states,“Employeesshalladvisecomplianceimmediatelyiftheybecomeinvolvedinorthreatenedwithlitigationoranadministrativeinvestigationorproceedingofanykind, or are subject to any judgment, order or arrest.” This senior employee'sviolationofthepolicyleadstoadditionalquestionsaboutthefunds’employeespotential for additional Code of Ethics violations, damage to the fund'sreputational risk, and additional questions regarding the culture of compliancewithin the firm. In addition, this could lead to potential issues with ADVdisclosures, the need to update policies and procedures regarding blatantdisregard of compliance procedures and lead to problems with personnelturnover.Lastly,Mr.Baronasksthefundiftheyplantonotifyexistingandnew

investorsregardingthiscomplianceissue,andtheynotethattheywillwaivehisfirst sixmonthsofmanagement fees if theycan“keep thebreachbetween thepeopleinthisroomonly.”Theseissueswillcauseanelongatedduediligenceprocess,andcanleadtoa

reduceinvestmentornoinvestment.Exhibit11.1providesasummaryof thesefacts.IfyouwereMr.Baronwouldyoukeepyourinvestmentthesame,reduceit,or

refusetoinvest?

Scenario6:“LittleThings”:DoMultiple“Small”OperationalIssuesMatter?

Maxine Park is considering investing $100 million in the Slacker Diamondprivateequityfund.However,duringtheoperationalduediligencereview,Mrs.Park's operational due diligence team uncovers a number of small operationissues,whichinclude:1.Negativemediacoverageofthefunds’employees,whichleadstoquestionsaboutthelevelofpreemploymentscreeningandadditionalreputationalrisks.2. Inefficient use of legacy administration and additional potential problemswithalackofserviceprovideroversight.3. Extended delay in Geneva implementation that is caused by a lack ofoperationalplanning.4.Nooffsitebusinesscontinuityordisaster recovery (“BCP/DR”)ordisasterrecovery site, which indicates a lack of input from the IT department intoorganizationalplanning.5. No internal valuation committee and a board comprising only affiliatedboardmembers,whichindicatesalackofindependentoperationaloversight.6.AChiefComplianceOfficer (“CCO”)who isunawareofoutsidebusinessdirectorships,whichmayindicatethatemployeesarenotrequiredtoreporttotheCOOorthatthefirm'spoliciesarenotbeingenforced.

Additionally this may show that there are additional Code of Ethicsviolations by junior personnel, or that there is a culture ofnoncomplianceoroutdatedpolicies.

7. High personnel turnover, which may indicate issues with the firm'scompensationstructureorissueswiththeretentionplanningforemployees.

Additionally, thismay lead to problemswith information security or

enhanceotherunderlyingissues.Theseminorissuescanleadtolargerquestionsaboutthefinancialstabilityof

thefunds,scalabilityof thebusiness,and if therearesufficient internalchecksandbalances.Exhibit11.2providesasummaryoftheseissues.

EXHIBIT11.2ExampleofMultiple“Small”OperationalIssues

Inaddition,theycouldleadMrs.Parkandotherpotentialinvestorstoconsiderif thereisappropriateoversightfromseniormanagement,andifdifferentpartsoftheorganizationarecommunicatingandcooperatingasneeded.So many additional “minor” issues will cause an elongated due diligence

processandcanleadtoareduceinvestmentornoinvestment.IfyouwereMrs.Parkwouldyoukeepyourinvestmentthesame,reduceit,orrefusetoinvest?

Scenario7:“TheNextMiracleDrug?”:IsaManager'sClaimtoBetheBestSourcetoValue

IlliquidUnrealizedProfitsValid?JoeCowstoy is considering investing in a private equity firm inAlbuquerque,New Mexico, called Vitrablife, which is focused on health-care investing.Vitrablife focuses on investing in portfolio companies that are developinginnovativedrugsthatareawaitingapprovalbytheFDA.Aspartofthevaluationprocess, the private equity fund tries to evaluate future revenue streams from

thesedrugs.In a meeting with the fund's marketing consultant, Cowstoy asks what

valuation methods they follow, and he is initially referred to the offeringmemorandum for the fund. After Cowstoy reads the documents, he notes areference that the fund uses “standard market practice” approaches. Cowstoyfinds this language extremely vague and calls the fund's manager to inquireabout what they actually do to calculate the valuations. The fund's managerclaims that the fund is amember of theFuturePharmaceuticalAssociation ofAmerica (FPOAA), and that the fund follows the standard market valuationprocedures implemented by the group. Cowstoy tries to find out about thisassociation,butcannotdiscoveranythingaboutitontheInternet.Hedecidestoask the fund's manager about this FPOAA, and after phrasing questions inmultiplewaysandaskingmultiplequestions,herealizesthatthefirmistheonlymemberofthisassociation.DoyouthinkVitrablifedidanythinginappropriatewhenansweringCowstoy's

questions?IsokaythatVitrablifeinventedtheirownmethodologyforvaluation?Wouldyoubeokaywithamanagergivingyoutherunaround,especiallywhenyourquestion isaboutsomethingasseriousasvaluation?Doyoustillwant toinvestinthefund?

Scenario8:“TooMuchofaGoodThing”:TheImportanceofUnderstandingandMonitoring

ConflictsofInterestandDealAllocationConsiderations

The Gutra pension fund is consider investing $20 million of their investor'sfunds in a traditional private equity firm calledLittle Stone based inBlarney,Ireland.Afterreviewingthefunds’documentsandspeakingwiththeinvestmentteam,theinvestmentteamnoticesthattherearenosetrulesorguidelinesforthewaysinwhichinvestmentsareallocatedamongthefirm'sfunds.WhiletheLittleStonefundsaremakingmoneyandtheyhavemadealotofgooddealsamongthefunds,theGutrapensionfundisconcernedthattheallocationbalancecoulddrasticallyshiftinthefuture.TheLittleStoneprivateequityfirmmanagesmultiplerealestatefunds,some

of which have similar investment mandates, including investing in retailproperty.WhenLittleStone'smanagers come across several newdeals,which

maybeappropriateformorethanonefund,therearenowrittenpoliciesinplacetodeterminehowthemanagerswillallocatethedealsamongthefunds.Whilethefund'smanagersclaimthattheydonotneedwrittenpolicies,Gutra's

operationalduediligence team is concerned that the lackof formalpolicies toavoid conflicts of interests raises red flags. Furthermore, there is concern thatthereispotentialforcherry-pickingdealsfromonefundtoanother,andthatthefirmhasnot demonstrated that the allocationpolicies are fair.Additionally, astheLittleStoneprivateequity firm is in theprocessof launchinganothernewfund,forwhichthesametypeofretailpropertieswouldalsobeappropriate,theyareinterestedinhowthefundwilldealwiththeallocationbalancebetweenthreefunds.LittleStone'smanagersindicateonaconferencecallthattheyareconsidering

writing a formal allocation policy for the fund, but at the earliest, itmight bereadynextyear.Additionally,thefundmanagersaregivenvagueanswerswhenGutra'sODDteamasksthefollowingquestions:

Isthereafixedtradeallocationratio,orisitdeterminedadhoc?Ifthereisafixedratioandhowoftenisitset,orisitdoneonadeal-by-dealbasis?

Howoftenisthefixedratioreset?Is risk management or other departments such as legal andcomplianceinvolvedwithresettingtheratio?

Withthepreviousquestionsstillunanswered,doyoubelievethatGutrashouldinvestwithanyoftheLittleStonefunds?

NOTES

1.MarkMaremont,“HighflyingFinancierFacesQuestionsoverFundEmpire,”April16,2009,www.marketwatch.com/story/highflying-financier-faces-questions-2009-04-152.SeeMarkMaramount,“TheTalentedMr.Pang,”WallStreetJournal,November21,2009,18–19.3.“TheLifeandLovesofDannyPang,”NewYorkMagazine,publishedNovember23,2009,http://nymag.com/daily/intel/2009/11/danny_pang_2.html.4.“TheUnsolvedMurderofJanieLouisePang,”WallStreetJournal,publishedApril15,2009,http://online.wsj.com/article/SB123976601469019957.html.5.SeeMarkMaremount,“TheTalentedMr.Pang,”WallStreetJournal,November21,2009,www.wsj.com/article/SB10001424052748704204304574545803280777032.html6.“TheUnsolvedMurderofJanieLouisePang.”7.“AndtheTitleforMostInsaneAllegedFraudof2009(SoFar)Goesto…,”NewYorkMagazine,April15,2009,http://nymag.com/daily/intel/2009/04/and_the_title_for_most_insane.html.8.CrystalHsu,“FBIagentsArrestTaiwaneseFinancierDannyPang,”TaipeiTimes,www.taipeitimes.com/News/front/archives/2009/04/30/2003442403.9.Ibid.10.“AndtheTitleforMostInsaneAllegedFraudof2009.”11.“SECFreezesAssetsofFinancierDannyPang,”April27,2009,www.sec.gov/news/press/2009/2009-89.htm.12.“AndtheTitleforMostInsaneAllegedFraudof2009.”13.“SecuritiesandExchangeCommissionvs.PrivateEquityManagementGroup,Inc.etal.,”www.sec.gov/litigation/complaints/2009/comp21013.pdf.14.Ibid.15.ResidualValueinsuranceDeclarations,www.wsj.net/public/resources/documents/hcc_policyOne_090415.pdf.16.“SECFreezesAssetsofFinancierDannyPang.”17.Maremont,“TheTalentedMr.Pang.”18.Maremont,“HighflyingFinancierFacesQuestions.”19.BloombergBusinessweek,“AACapitalPartners.”

http://investing.businessweek.com/businessweek/research/stocks/private/person.asp?personId=67584&privcapId=1609483&previousCapId=8388529&previousTitle=Ranch%20Capital,%20LLC20.JasonGrotto,“InvestorLivedDualLifeonPlunderedCash,”ChicagoTribune,June16,2010.21.BloombergBusinessweek,“LookingOutforNumberOne,”October30,2006,www.businessweek.com/magazine/content/06_44/b4007006.htm.22.Ibid.23.PaulEgan,“SuspectinCorruptionInquirySaysUnionOfficialGotFavors,”TheDetroitNews,October27,2009.24.“UnitedStatesDistrictCourtNorthernDistrictofIllinoisEasternDivision,UnitedStatesAttorneyChargesJohnA.Orecchio,”filedSeptember8,2006,www.justice.gov/usao/iln/pr/chicago/2009/pr0722_01a.pdf.25.LitigationreleaseNo.19826bytheSECv.AACapitalPartners,Inc.andJohnA.Orecchio,U.S.D.C.N.D.Ill.,CivilActionNumber06C4859,filedSeptember12,2006,www.sec.gov/litigation/litreleases/2006/lr19826.htm.26.BloombergBusinessweek,“LookingOutforNumberOne,”October30,2006.27.UnitedStatesofAmericabeforetheSecuritiesandExchangeCommissionAdministrativeProceedingFileNo.3-13553,July17,2006.28.LitigationreleaseNo.19826bytheSECv.AACapitalPartners,Inc.andJohnA.Orecchio,U.S.D.C.N.D.Ill.,CivilActionNumber06C4859,filedSeptember12,2006.29.Ibid.30.Ibid.31.UnitedStatesDistrictCourtNorthernDistrictofIllinoisEasternDivision,UnitedStatesAttorneyChargesJohnA.Orecchio,filedSeptember8,2006.32.UnitedStatesAttorney'sOffice,“InvestmentAdvisor,”July22,2009,www.fbi.gov/chicago/pressreleases/2009/cg072209.htm.33.JasonGrotto,“ManGets9YearsforEmbezzlement,”ChicagoTribune,July17,2010.34.Ibid.35.AdministrativeProceedingFileNo.3-13553,SECv.MaryBethStevens,January5,2010,www.sec.gov/litigation/admin/2010/ia-2973.pdf.36.TimothyInklebarger,“LaborDepartmentGetsMoreMoneyfromAACapital,”Pensions&Investments,June22,2010.37.AndrewWhite,“DutchDuoJailedfor$36mDubaiPropertyFraud,”

ArabianBusiness.com,April22,2010,www.arabianbusiness.com/dutch-duo-jailed-for-36m-dubai-property-fraud-157771.html.38.RobCorder,“DutchPoliceBustPalmScam,”ArabianBusiness.com,January21,2010,www.arabianbusiness.com/dutch-police-bust-palm-scam-53014.html.39.Elsevier,“MassaleFIOD-invalvastgoedfondsPalmInvest,”January21,2010,inDutchonly,www.elsevier.nl/web/Nieuws/Laatste-24-uur/154896/Massale-FIOD-inval-vastgoedfonds-PalmInvest.htm.40.SuzzanneFentonStaff,“DubaiNakheelTakesLegalActionagainstPalmInvest”GulfNews,January22,2010.41.RobCorder,“PalmFraudstersLivedPlayboyLifestyle,”ArabianBusiness.com,January22,2010,www.arabianbusiness.com/palm-fraudsters-lived-playboy-lifestyle-122060.html.42.DutchNews,“PalmInvestSwindlersJailedfor3.5Years,BothAretoAppeal,”April22,2010,www.dutchnews.nl/news/archives/2010/04/palm_invest_swindlers_jailed_f.php43.EdgarOnline,“ExcerptfromaS-4SECFiling,FiledbyMorrisMaterialHandling,Inc.,on5/13/1998,”http://sec.edgar-online.com/morris-material-handling-inc/s-4-securities-registration-business-combination/1998/05/13/section22.aspx.44.BloombergBusinessweek,“ExecutiveProfileToddR.Berman,”August1,2011.45.UnitedStatesAttorneySouthernDistrictofNewYork,“FounderofChartwellManagersPleadsGuiltyinU.S.CourttoStealingMoreThan$3.6Million,”December6,2004,www.justice.gov/usao/nys/pressreleases/December04/bermantddplea.pdf.46.Ibid.47.EdgarOnline,“ExcerptfromaS-4SECFiling,FiledbyMorrisMaterialHandling,Inc.,on5/13/1998.”48.UnitedStatesAttorneySouthernDistrictofNewYork,“FounderofChartwellManagersPleadsGuilty.”49.BloombergBusinessweek,“LookingOutforNumberOne.”50.UnitedStatesAttorneySouthernDistrictofNewYork,“FounderofChartwellManagersPleadsGuilty.”51.BloombergBusinessweek,“LookingOutforNumberOne.”52.UnitedStatesAttorneySouthernDistrictofNewYork,“Founderof

ChartwellManagersPleadsGuilty.”53.IPRealEstate,“PhilipsSchemeDismantlesRealEstatePortfolio,”December11,2007,www.ipe.com/realestate/philips-scheme-dismantles-real-estate-portfolio_26487.php?searchfor=philipsfraud.54.IPRealEstate,“PhilipsFundFraudBringsCallsforTransparency,”November16,2007,www.ipe.com/news/Philips_fund_fraud_brings_calls_for_transparency_26050.php55.Ibid.56.Rabobank,“InterimReport2010RabobankGroup,”http://2009.annualreportsrabobank.com/downloads/Real_estate_hjv10.pdf.57.DutchNews,“PropertySectorFraudTrialKicksOff,”November17,2009,www.dutchnews.nl/news/archives/2009/11/property_sector_fraud_trial_ki.php.58.Ibid..59.DutchNews,“MassivePropertyDevelopmentFraudCaseComestoTrialatLast,”March3,2011,swww.dutchnews.nl/news/archives/2011/03/massive_property_development_f.php60.IPRealEstate,“DirectorArrestedinPhilipsPensionsFraud,”November19,2007,http://ipe.com/realestate/director-arrested-in-philips-pensions-fraud_26074.php?categoryid=1035.61.IPRealEstate,“PhilipsFundFraudBringsCallsforTransparency.”62.Ibid.63.DutchNews,“PropertyFraudCostsPhilips,Rabobank€250m,”November4,2009,www.dutchnews.nl/news/archives/2009/11/property_fraud_costs_philips_r.php.64.Ibid.65.IPRealEstate,“PhilipsSchemeReclaimsMillions.”66.IPRealEstate,“CostofFraudTriplesforPhilipsFund,”August4,2008,www.ipe.com/news/Cost_of_fraud_triples_for_Philips_fund_28738.php.67.BloombergBusinessweek,“SECAllegesFraudinHandlingofPensionMoney,”April22,2010,www.businessweek.com/ap/financialnews/D9F8D3B80.htm.68.Case2:10-cv-11633-DPH-MKMDocument1,“U.S.SecuritiesandExchangeCommissionv.OnyxCapitalAdvisors,Llc,RoyDixon,Jr.,andMichaelA.Farr,”Filed04/22/10,www.sec.gov/litigation/complaints/2010/comp-pr2010-64.pdf.69.U.S.SecuritiesandExchangeCommissionLitigationReleaseNo.21500,

“SecChargesPrivateEquityFirmandMoneyManagerforDefraudingDetroit-AreaPublicPensionFunds,”April23,2010,www.sec.gov/litigation/litreleases/2010/lr21500.htm.70.Case2:10-cv-11633-DPH-MKMDocument1,“U.S.SecuritiesandExchangeCommissionv.OnyxCapitalAdvisors,Llc,RoyDixon,Jr.,andMichaelA.Farr,”Filed04/22/10.71.JonathanOosting,“SEC:FormerLionMikeFarr,PartnerStoleMoreThan$3MfromDetroit-AreaPensionFunds,”Mlive.com,April22,2010,www.mlive.com/newsF/detroit/index.ssf/2010/04/sec_former_lion_mike_farr_part.html72.Case2:10-cv-11633-DPH-MKMDocument1,U.S.SecuritiesandExchangeCommissionv.OnyxCapitalAdvisors,Llc,RoyDixon,Jr.,andMichaelA.Farr,filed04/22/10.73.JustiaDockets&Filings,GeneralRetirementSystemoftheCityofDetroitetal.v.OnyxCapitalAdvisors,LLC,http://dockets.justia.com/docket/michigan/miedce/2:2010cv11941/248682/.74.AllianzGroup,“AnnualReport2010,”March18,2011,www.allianz.com/static-resources/en/investor_relations/reports_and_financial_data/annual_report/ar2010/v_1301386895000/ar2010_group.pdf75.JosephPalazzolo,“CorruptionCurrents:USProbingAllianzforPossibleBribery—Sources,”WallStreetJournal,December22,2010.76.Manrolandwebsite,“Company,”August22,2011,www.manroland.com/com/en/company.htm.77.Palazzolo,“CorruptionCurrents.”78.Ibid.79.Ibid.

CHAPTER12

TrendsandFutureDevelopments

Theprivateequityindustryisconstantlyevolving.Dependingonthestateoftheeconomy, different types of strategies or fundsmaybe in vogue one year andthenshunnedthenext.Somemayfeelthatfromanoperationalperspective,thischangeoccursataslowerpacethanthesupposedlyfast-movinginvestmentsideof business.Both private equity investing and private equity operations are influx.Privateequityoperationalrisksinparticular,becauseoftheevolvingnatureoftheprivateequityindustryaswellasanenvironmentofincreasedregulatoryscrutiny, have undergone significant changes in recent years. This chapterprovidesanintroductionofcertaintrendsandanticipatedfuturedevelopmentsinthisspace.Itisimportantforinvestorstounderstandandanticipatesuchtrendssothattheiroperationalduediligenceprocessesdonotbecomestale,butratheradapt toappropriately reviewthecontinuallychangingnatureofprivateequityoperationalrisk.

USEOFTHIRD-PARTYADMINISTRATORS

The issue of fund administrator is one that has evolved in recent years acrossdifferentpartsof the investment industry.Thesechangingattitudeshavehadadirect impact on the services offered by administrators.A private equity firm,when launching a new fund, has two primary options for fund administration:self-administrationorthird-partyadministration.In self-administration, a private equity management company makes the

determination that it will perform administration services for the fund it ismanaging.An examplewould be an instance inwhich administration servicesarecarriedoutbytheGeneralPartnerorviaanaffiliatedentity.Inmanycases,aprivate equity firm opting for self-administration may create an entity thatperforms several services (e.g., custodial) for affiliated funds, includingadministration.

The second option is third-party administration.As previouslymentioned inthisbook,third-partyadministratorsgenerallyoffertwotypesofcoreservices:fund accounting and shareholder servicing. Amyriad of different services areoffered by third-party administrators in addition to those previously outlined,includingperformingenhancedinvestorreportingandvaluationoversight.Withanunderstandingofthetwoprimaryadministrationoptionswecannow

discusstrendsintheadministrationspaceasapplicabletoprivateequityfunds.Historically, certain private equity funds, as compared to their hedge fundcounterparts, have relied more heavily on self-administration of funds. Thosefunds that have historically self-administered point to a number of differentfunctionsof thisself-administrationframework that theyfeelarebeneficial forbothGPsandLimitedPartners.First, a private equity firm that supports self-administration may feel that

significantcost savingsmaybe realizedbyself-administering.Effectively, thisargumentreliesonthenotionoftakingfromonehandandgivingtotheother.Insuchcases,ratherthanspendfeesonthird-partyadministrators,aprivateequityfund expends its own resources to self-administer the fund. In these self-administrationcases,particularlywhentheGPhasestablishedanaffiliatedentityforthepurposesofself-administration,theprivateequityfundmaychargefeesto thefundforsuchservices.Suchfeesarenot likely tobeutilizedasaprofitcenter for the affiliated, or in-house, self-administration entities, but rather tocoverthecostsofadministration.Manycriticsofself-administrationmaypointout, in criticism of this model, that administration is an industry whereeconomiesofscalecanberecognized.Aprivateequityfirmthatself-administersthefundsitmanages,evenonewithmultiplefunds,isunlikelytorealizethecostsavings and process efficiencies that a large administrator will manage.Furthermore,third-partyadministratorsintheprivateequityindustry,asinmostotherassetclasses,generallychargefeesonaslidingscaleasapercentageofthefund'sassetsundermanagement.Inthesecases,fromtheLPperspective,thoseinsupportofthird-partyadministrationmayarguethatonaproratedbasisacrossthe entire spectrum of fund expenses the trade-off of benefits with non-self-administrationmaytipthescalesinfavorofthird-partyadministration.A second argument that a GPmay raise in favor of self-administration is a

feelingthatathird-partyadministratorisunnecessarybecauseinmanycasesitisduplicative.Fromanoperationalperspective, it isgenerallyconsidered tobeabestpracticeforafundtoshadowtheworkoftheadministratorinternally.AGPmayarguethatsuchduplicateeffortsareunnecessary.Afterall,theymayargue,

“Why can't a fund perform the traditional fund administration fund workcorrectlyonce, rather thanhave itperformedtwice?”In this regard, thosewhoareagainstsuchself-administrationmodelsmaycitethefactthatthewholepointof a private equity firm producing parallel books and records is not solely aduplicationofeffort.Rather,whenaprivateequityfirmparallelstheworkofathird-party administrator a numberof benefits accrue to both theGPandLPs.First,aprivateequityfirmthatshadowstheworkofanadministratorislikelytobemoreinvolvedin,andfamiliarwith,theworkthatisactuallybeingperformedbytheadministrator.Insuchcases,asignalingeffectisalsopresent.Thethird-party administrator will know that the private equity firm is watching theiractivitiesmorecloselyascomparedtoaprivateequityfirmthatisnotcognizanton amore granular basis of suchwork.This increased frequency of oversightalsohas ramificationsfor thefrequencyofcommunicationbetween theprivateequity firm and the third-party administrator. A private equity firm that isrunningparallelfundbooksislikelytoengageinmoreofanongoingdialoguewith a private equity firm to discuss anyongoing issues thatmay come aboutthroughout the administration cycle.With this ongoing communication comesincreased oversight and an increased likelihood of a lack of errors in fundaccountingproduction.Suchoversightisnotgenerallypresentwhenafundself-administers.Assuch,thosewhodonotsupportfundself-administrationcitethislackofoversighttobeaknockagainstself-administration.Afundseekingtosupportitsdecisiontoself-administermaypointtothefact

that there isgenerallyno requirement, legalorotherwise, that aprivate equityfirmengageathird-partyadministratoraswell.Inresponsetothisargument,itmaybesuggestedthatameasureoflegalityorillegalityisnotnecessarilytiedtothequalitiesofbestpracticeornot.Justlikefinancialindustryregulation,theneteffectofsuchregulationisoftentimestocreateaminimumoperationalfloor,notaceiling.Thereisoftensignificantroomforimprovementaboveminimumlegalorregulatoryrequirementsandoperationalbestpractices.Those investors who do not support self-administration oftentimes cite a

numberofbenefits tobe found inemployinga third-partyadministrator.First,there is potential for a conflict of interest in self-administration. Third-partyadministrators provide a degree of independence that is not available in self-administeredfunds.ConsidertheNAVcalculationanddistributionservicesoftenperformedbyathird-partyadministrator:Bycontrast,aGPthatself-administersthe funds itmanages, even via an affiliated entity, lacks this independence tohavefundstatementsindependentlypreparedanddistributedtoinvestors.

In reviewing trends in the private equity administration function, investorsmayhavebeenlessinsistentinthepastindemandingthatafundemployathird-party administrator. Due in large part to the awareness that the potential forconflictsof interest is toogreat,manyLPshaveexerted increasedpressureonGPstoengagethird-partyadministratorsforprivateequityfunds.Itislikelythattherewillcontinuetobeatrendtowardprivateequityfirmsdemandingtheuseofthird-partyadministrators.With this trend,LPsmust be conscious that all private equity administrators

arenotcreatedequal.Administratorscanvaryintheservicestheyoffer(i.e.,fullNAV, NAV-lite, shareholder services, etc.) and the functions performed (i.e.,valuationagent,maintenanceofofficialbooksandrecords,etc.).Investorsmayfind if they invest in several different private equity funds that even twomanagers that utilize the same administrator may have completely differentopinionsandexperiences.Suchdifferencesmaynotonly relate tomorepatentinvestorconcernssuchasthetimeittakestocutthefinalmonthlyNAVfigures,but the less obvious aswell, includingwhich fund hasmore senior personnelservicing their account. Investors who take care to understand the often-overlookedspecificsofaprivateequityfund'srelationshipwithitsadministratorcan often gain an informational advantage over those who do not—andultimately reduce their overall operational risk exposures. The following aresome key questions investors may want to pose to both private equity fundmanager(s) and their administrator(s) as part of the operational due diligenceprocess:FortheThird-PartyAdministrator

Whatisyourexperienceindealingwiththeprivateequityfundstrategyofmymanager?Whatareyourtotalassetsunderadministration,bothfirmwideandforthisparticularstrategy?Do you perform any other services besides administration? (i.e., sellsoftware,custody,companysecretarial,etc.)How many individuals are dedicated solely to my private equitymanager/fund?Howmanyareshared?Whathasbeentheannualrateofteamturnoveronthefundaccountingside?How often do you hear from my private equity manager? Are theyactivelyinvolvedintheprocess?

Whatpricingsourcesdoyouutilizeandwhichinstrumentsarepricedviathesesources?Is thereanything in theportfolio thatyouas theadministratordonotpriceindependently?Doyouhaveadialoguewithmyprivateequity'sauditor?Howdoyou receivedata frommyprivateequity fund?Doyouhavedirectaccesstotheirprimebrokersystems?Isthislevelofserviceyouprovidetypicalofallyourclients?

ForthePrivateEquityManagerHaveyouevervisitedyouradministrator'soffices?Why did you select your current administrator? What otheradministratorsdidyouconsider?Whendidyoulastnegotiateyouradministrationcontract?What are your administration fees? Do you feel these fees arecompetitive?Do you provide your administrator with copies of all relevantdocumentation related to pricing, cash movements, and so on (e.g.,copiesofinvoicestobepaid,internallyproducedvaluationmemos)?Whataresomethingsyouradministratorcanimproveupon?

INCREASEDFOCUSONMATERIALNONPUBLICINFORMATIONINTHE

UNITEDSTATESDuring the course of a private equity firm's investing activities, they willtypically come across a number of different entities in both the public andprivate space. An example of this may be in PIPE transactions, where thepotential for the transmission of material nonpublic information between apublic company and a private equity firm is an ongoing risk that both entitiesmustmonitor.The prosecution of Raj Rajaratnam'sGalleonGroup and associated raids of

fundmanagers’officesbytheFederalBureauofInvestigationmakeitclearthatcracking down on allegedly illegal insider trading is a priority in the U.S.government's financial regulatory agenda. This is also highlighted by the

increasedscrutinyfacedbyexpertresearchnetworksinrecenttimes.Traditionally, many investors have equated the use of material nonpublic

information with boiler-room insider trading rings and backroom corporatetipsters.However,manyinvestorsmaynotrealizethenumerouswaysinwhichperfectlylegitimateprivateequityfundsduringthecourseofdailybusinessmaycomeintocontactwith,eitherdirectlyorindirectly,datathatcouldbepotentiallyclassifiedasmaterialnonpublicinformation.Privateequityfundsmayreceivematerialnonpublicinformationinadvertently

(i.e.,anunsolicitedfaxcomesintothefirmwithquestionableinsiderinformationor a hedge fund receives an unsolicited email offering material nonpublicinformation).Alternatively,aprivateequitymanagermaybedirectlyexposedtosuch information during the course of otherwise perfectly legal investmentresearch.Thiscansometimeshappenwhenaprivateequityfundmakesuseofthird parties to provide research or perspective on a specific industry orcompany. In recent years, an industry has blossomed of expert networks orconsultant networks that effectively provide a matchmaker service betweenindustryorcompanyexpertsandprivateequityfunds.Expert networks oftenmake the experts agree in advance that theywill not

disclosematerialnonpublic information.However, thefirms thatmanage theseexpert networks themselves are rarely, if ever, on call to ensure that thedisclosure ofmaterial nonpublic information takes place. Indeed, even if suchinformation were disclosed, it may be difficult for someone without specificknowledge of an industry or company to detect what information is bothmaterial and nonpublic in the first place. It is within this nuanced legal grayarea,betweenlegalinvestmentresearchandmaterialnonpublicinformation,thattheU.S.governmentandprivateequityGPsandLPsperformingoperationalduediligence on private equity funds must navigate, while at the same timemaintainingaprivateequityfund'scompetitiveadvantages.The United States has a long history of case law that provides guidance

regarding liability, particularly for thosewith fiduciary obligations, for tradingonmaterialnonpublicinformation.1In2000,theSECcodifiedrulesprohibitingtheusesofmaterialnonpublicinformationunderSECRules10b5-1and10b5-2.Dependingonahedgefund'sinteractionwithmaterialnonpublicinformation,anumber of defenses may be invoked when allegations of wrongdoing arebrought, including an affirmative defense for preplanned trades (the so-called10b5-1 loophole), use of mosaic theory, a lack of awareness that the privateequity fund traded on material nonpublic information, use of information

barriers, and the implementation of reasonable policies and procedures topreventtradingonmaterialnonpublicinformation.

LimitedPartnerOperationalDueDiligenceConsiderationsforHedgeFundsandMaterial

NonpublicInformationDuringtheoperationalduediligenceprocess,investorsshouldasktheirprivateequity managers a number of questions in order to diagnose both a fund'spotentialexposures to the risksassociatedwithmaterialnonpublic informationaswellaswhatpreventativemeasures,ifany,aGPmayhavetakentoinsulatethemselves against the liability associated with receiving or trading on suchinformation.Specifically,thetypesofquestionsthatcanbeaskedinclude:UseofExpertNetworks

Doesyourprivateequityfirmmakeuseofthird-partyexpertnetworks?Ifyes:

Whichexpertnetworksareutilized?Howfrequentlyaretheyused?Hastheprivateequityfirmvettedtheproceduresinplace, ifany, at the expert network to prevent the transmission ofmaterialnonpublicinformation?Hastheprivateequityfirmfundproactivelycommunicatedtoexpert networks that they do not wish to receive materialnonpublicinformation?Is the private equity firm's internal compliance departmentinvolvedinprovidingtrainingtoanalystsaboutwhatmaterialnonpublic information is and the associated tradingrestrictions?Is compliance involved in random audits of interactionbetweenahedgefund'sanalystsandexperts?Are any restrictions in place regardingwhat kind of expertsmaybespokento?Doesthefirmhaveasysteminplacetotrackallinteractionswith such expert networks, including which firms andindustrieswerediscussed?

OtherThird-PartyFirmsThatProvideInformation

Does your private equity fund receive trading ideas or other marketintelligence fromanyother third-party sources, such as smaller nichebrokersorlawfirms?Ifyes,whattypesofinformationdoesyourhedgefundreceivefromthesesources?In the case of law firms, does the private equity firm typically steercertainlegalworkinexchangefordealflow?

InternalPrivateEquityFundProceduresDoes your private equity firm have any explicit policies regardingmaterialnonpublicinformation(i.e.,inthecompliancemanualorcodeofethics)?Has the private equity firm internally performed any training withrespecttomaterialnonpublicinformation?Does compliance perform any testing or historical trade analysis totrackpotentialusesofmaterialnonpublicinformation?In the event the private equity firm may come into contact withmaterial nonpublic information, does the firm maintain a clearprocedureastowhatemployeesshoulddo,including:

Procedure to report the source of information and nature ofinformationtocomplianceImplementationofbotha restricted listandblackoutperiodsfor trading in such information (perhaps both for the firm'sfundsandpersonalaccountdealing)

Goingforward,itislikelythatincreasedattentionwillbepaidinthisregardtothescrutinyexercisedbyregulatorsandLPsinthisarea.Thistrendislikelytocontinue,particularlyfortheprivateequityspace,withinvestmentsthatcontinuetoblurthelinebetweenpublicandprivateinvestments.

INCREASEDRELIANCEONAUDIT-TYPECERTIFICATIONS

With investors focusing with increased attention to operational robustnessthroughout the asset management industry, fund managers have sought toincreasethewaysinwhichtheycandemonstrateoperationalquality.Perhapsinacknowledgmentof thefact that regulatory-prescribedminimumguidelinesarenolongersufficienttosatiatetheoperationaldemandsofmanyinvestors,many

fund managers have sought certification of their operational controlenvironments.Intheprivateequityindustry,manyfirmsofavarietyofsizesandassetlevels

havesoughtformalauditcertificationsof theirpractices.Prior to the increasedfocusintheseauditcertifications,itwascommonplaceforonlylargehedgefundservice providers such as administrators to undergo such detailed operationalreview processes. In pursuing these audit certifications, many private equityfirms have taken cues from their hedge fund counterparts who have led thechargeinpursuingsuchcertifications.Hedgefundsthemselveswereinfluencedbytheauditcertificationspursuedbymanyoftheirownserviceproviderssuchasthird-partyadministratorswhohadtraditionallypursuedcertifications,suchastheSAS70standard.The Statement on Auditing Standards (SAS) No. 70, Service Organizations,

commonly known as an SAS 70 report, is an example of a common auditcertification that has been increasingly pursued by private equity firms. TheAuditing Standards Board of the American Institute of Certified PublicAccountants (AICPA) issues the auditing standards. Technically, today, themajority of such SAS 70 audit firms conduct audits not only in adherence toSAS70,butalsoinadherencetothesubsequentamendmentsknownasSAS88,Service Organizations and Reporting on Consistency, and SAS 98,OmnibusStatementonAuditingStandards.Thesereportsaregenerally titled“Reportonthe Processing of Transactions by Service Organizations,” but may also bereferred toas“ReportonControlsPlaced inOperationandTestsofOperatingEffectiveness,”orsomevariationthereof.Formally,anSAS70canbedefinedasareport“whereprofessionalstandards

are set up for a service auditor that audits and assesses internal controls of aserviceorganization.”SAS70reportscomeintwoforms:ATypeIreportdetailstheauditor'sopinionas to the fairnessof thepresentationof theorganization'sdescriptionofcontrolsaswellasthesuitabilityofthedesignofsuchcontrolstoachieve the specified control objectives. A Type II report contains all of theinformationinaTypeIreport,aswellastheauditor'sopinionastowhetherthespecificcontrolshadoperatedeffectivelyduring theperiodunder review.SAS70reportshaveequivalentsinothercountriesaswell.InCanada,areportsimilarto SAS 70 is known as Section 5970. Exhibit 12.1 provides a summary ofcommonglobalauditcertifications.

EXHIBIT12.1CommonGlobalAuditCertifications

Country Standard

UnitedStates StatementonAuditingStandards(SAS)No.7

Canada CanadianInstituteofCharteredAccountants(CICA)5970

UnitedKingdom AuditandAssuranceFacultyStandard(AAF)01/06

Australia GuidanceStatement(GS)007

HongKong HKSAStatementsAuditingPracticeNote860.2

Japan AuditStandardsCommitteeReportNo.18

Germany IDWPS951

As indicated earlier, private equity firms and real estate firms in particularhaveenhancedsuchauditcertificationsmorebroadlyinrecentyears.Onetrendthat has emerged is the increase in global harmonization of such auditcertifications.CapitalizingonthistrendhasbeenthegrowingpopularityoftheInternational Standard of Assurance Engagements (ISAE) 3402, AssuranceReportonControlsataServiceOrganization,anditsU.S.equivalentSSAE16.AnISAE3402isnotmeanttoreplaceanycountry-specificauditcertifications,butrathertoaugmentglobalstandardsasinvestorshavesoughtbroadercontrolreportsassessmentsthatnotonlyfocusoninternallyfinancialreportingcontrolsbut also extend into regulatory compliance, business continuity, and disasterrecovery control evaluation.2 Similar to the SAS 70 the ISAE 3402 reportcertification isgranted in twopartsvia ISAE3402Type1andType2reports.Indeed, the SAS 70 was effectively replaced by ISAE3402 and SSAE 16 in2010,butLP'smayindeedstillcomeacrossthetermSAS70.As the methodologies related to such certifications continue to be more

broadenedinscopeandharmonizedglobally,itislikelythatprivateequityfirmswillcontinue toembracesuchauditcertifications,whether itbeanactof theirownvolitionorbecauseLPsforcethemto.

INCREASEDUSEOFOPERATIONALDUEDILIGENCECONSULTANTS

With increased focus on operational quality and operational due diligence ingeneralacrossthefieldofprivateequity,therehasbeenanincreasingnumberofinvestors who engage the services of a third-party consultant to assist in theoperational due diligence process. Capitalizing on this trend, any traditionalinvestmentconsultantsandeveninvestmentbankingorganizationshavesoughtto add “operational due diligence provider” to the list of service offerings.

Despite the convenience of such one-stop shopping for both investment andoperational advice, many investors have shunned such solutions due to theinherentconflictsofinterestthatarepresentwhenofferingbothinvestmentandoperational advice. Indeed in many cases, investment consultants arecompensatedbasedontheinvestmentadvicetheyoffer.Ontheotherhand,theseinvestmentconsultantstrynottoremindtheirclientsofanysuchcompensationarrangements when they tout the benefits of their operational due diligenceprocesses.Suchpotentiallyconflictedadvicehasfoundmanyinvestorsseekingthe use of independent operational due diligence advice in the private equityspace.Thisisabitofanicheareaoftheconsultingbusinessthatmanyinvestorshave

beguntoacknowledge.Indeed,CorgentumConsulting,yourauthor'semployer,is such a consulting business focused on working with clients to provideindependentoperationalriskreviewsoffundmanagers,includingprivateequityfunds. Many clients approach consulting companies with a strong sense ofcomfort with the investment side but are cautious about the operational duediligenceside.Indeed,theseclientsmaylackbandwidth,competency,ordesiretobuildaninternaloperationalduediligencedepartmentoftheirown.Stillotherclientsmaymaintaintheirowndedicatedoperationalduediligencedepartments,and utilize the services of an operational due diligence consultant to augmenttheirexistingfunctions.Indeed, investors who first begin to consider private equity often take a

numberofdifferentapproachestowardduediligence.Dependingonanumberoffactors,includingtheirowninternalresources,institutionalcapacity,amountofcapitaltoallocate,thenatureofalternativesstrategiestheyareconsidering,andinvestmenthorizon,investorsgenerallytakeoneofseveralpaths.Sometypicaloptionsinclude:

Directlyinvestingintothealternativesthemselves.Utilizingatraditionalinvestmentconsultantforguidance.Investingwithapooledallocator,suchasaprivateequityfundoffundsormanagedaccountplatform.

Each of these options presents its own unique benefits and challengeshowever,theydoshareonecommontheme—thequestionofhoweachoftheseoptionsapproachesduediligence.

HedgeFundOperationalDueDiligence:ASpecialized

SkillSetForthesakeofsimplicity,letusclassifyduediligenceintotwobroadcategories:investmentandoperational.Inmuchthesamewaythatinvestmentduediligencehasbecomea specialized field, so toohas operational duediligence.Over thepast several years, operational due diligence has developed into a similarlyspecializedpracticearea.Regardlessofwhetherinvestingdirectlyintoaprivateequity fund, utilizing a traditional investment consultant, or investing with aprivate equity fund of funds or platform, investors still should consider thebenefitsthatanindependentoperationalduediligenceconsultantmayadd.

ComplementingtheDueDiligenceofTraditionalInvestmentConsultants

Operational due diligence consultants work with traditional consultants tocomplement the investment due diligencework of their traditional investmentconsultants.Asoutlinedearlier,itisinherentlyaconflictofinterestforthesameparty offering investment recommendations to similarly offer advice on theoperational merits of a hedge fund or private equity manager. Biases areinherently present, based on the investment consultant's opinion as to theinvestmentmeritsofamanager,andthepotentialistoogreatforaninvestmentconsultant'soperationalconvictionstobeswayedonewayortheother.Assuch,many investors who utilize traditional investment consultants also work withthird-party operational due diligence consultants to assist in their reviews ofprivateequityfunds.

GaugingConsultantQualificationsandExperienceInvestors must take steps to ensure that their private equity operational duediligence consultant possesses the qualifications and experience to conductthoroughoperationalduediligencereviews.Somequestionstoaskinclude:

Isamultidisciplinaryteamofprofessionalsutilizedorisonearea(i.e.,accountingorcompliance)focusedon?Doesexperienceexistcoveringdifferenttypesofhedgefundstrategiesindifferentregionsthroughouttheworld?Is the hedge fund operational due diligence process institutional innature?Does the hedge fund operational due diligence process evolve over

timetoadapttochangingindustrypractices?

TrustbutVerify:DueDiligenceontheDueDiligenceProviders

Investors shouldperformduediligenceon their private equity operational duediligence consultants to ensure that they are not simply checking the box andtellinginvestorsto“trustthem”thatamanagerisoperationallysound.This includes not just outsourcing the operational due diligence process but

becominganactiveparticipantintheprocess.Theoldauditors’adage,“trustbutverify,” is applicable not only when performing operational due diligence onhedgefundsandprivateequityfundsthemselves,butalsoonthoseperformingtheduediligence.Investors ranging from large institutions and professional allocators such as

fundofhedge funds tohigh-net-worth individualscanbenefit fromemployingoperationalduediligenceconsultantstoaugmenttheirowninternalefforts,anditislikelythatthispracticewillincreaseinthefuture.

POOLINGOPERATIONALDUEDILIGENCERESOURCESAMONG

MULTIPLELPSPrivate equity, particularly in the context ofmonitoring operational risks, canperhaps best be thought of as the beginning of a long-term relationship. Inprivate equity funds, as compared tomore traditional long-only funds or evenhedgefundswithlockups,aninvestorallocatingtheircapitalinvestorswillbeinbusinesswith a private equity firm for a periodof several years as a result oftheselonglockupperiods.A number of efficiencies, from cost, time, and resource expenditure

perspectives, may be realized if investors, particularly in initial fund closingsituations, are fairly limited in number. This may generally be the case if aninitialfundraisingperiodisapproachingacloseandalargeamountofcapitalisbeingsoughtfromonlyahandfulofinvestors,eachofwhomintendsto,intheparlance of the private equity world, “write big tickets” (i.e., make largeallocations). Rather than each of these big-ticket investors each performing

distinct operational due diligence, they could pool resources to conduct acombinedreview,perhapsviaanoperationalduediligenceconsultingfirm.Ofcourseitisunlikelythatsuchsharedapproacheswillobviatetheneedfor

individual LP due diligence reviews. However, there has been an increasingtrend among LPs to develop dialogues in this regard. Indeed, via informalinformation-sharing or private industry networking events for LPs, there is anincreasing trend toward information-sharing of not only investment data, butoperational data, aswell.Whether or not such shared resource approaches areutilized broadly, the concept of such information-sharing, either formally orinformally,islikelytoincrease.

OPERATIONALBENCHMARKINGOncetheoperationalduediligenceprocessiscomplete,aninvestorissometimesleft facingaproblemthat theydidnothavebeforestarting theoperationalduediligence process. Before beginning the operational due diligence process, aninvestor likely had some vague notions regarding the investment skill andoperationalqualityofaparticularmanager,buthad littleharddata togoon inmakingadeterminationonthemanager'soperationalstalwartness.Wecanfast-forwardandcomparethepre–duediligenceinvestor,whomwewillcallI,tothepost-operationalduediligenceinvestor,whomwewillrefertoas,I′.WhatisthebasiccoredifferencebetweenIandI′?Information.Ifaninvestor

performingoperationalduediligenceinanyformgainsanythingonthejourneyfrom I to I′, it is basic operational risk data.Utilizing a bareminimumof thetechniquesdescribedinthisbooktheI′investor,ascomparedtoI,likelyknowswhathappensafterabuyorselldecisionismadeinaparticularPEfund.Thesedetails could include items such as who executes the trade, how the trade islogged in the firm's systems, what are the firm's trade order and executionsystems,andsoon.AmoresophisticatedI′mayevenknowdetailssuchashowconflicts of interest are preventedwhen entering into trading. For example, isthere an appropriate segregation of duties among execution, settlement,reconciliation, and even potentially the valuation function? But putting theadvancedI′asideforamoment,andreturningtoourbasiccomparisonofIandourbareminimumI′,thelatternowhasaseriesofoperationaldatapointsthathemustnowanalyze.Howisthisprocesssupposedtobeundertaken?AtrendthathasrecentlygainedtractionasLPshavebeguntoperformmore

operationalduediligencereviewsandamassmoreoperationaldataistoanalyzeand mine such data. This has created an area of comparison among privateequity funds’ operational practices that we will refer to as operationalbenchmarking.Thistrendofoperationalbenchmarkingallowsinvestorstomakemore informed operational decisions because they have the ability to rely ondata, however limited, that provides some insight into which operationalpracticesareemployedbyaprivateequityfund'speers.Theoveruseofsuchbenchmarkingrunstheriskofturningtheoperationaldue

diligenceexerciseintoanexception-reportingprocess.Justbecausethebulkoftheprivateequityfirmsthataninvestorhaspreviouslyreviewedtocompiletheirown individual operational risk database adhere to a particular operationalpracticedoesnotmean that this is representativeofmorecommonoperationaltrends.Furthermore,theminorityoftheparticipantsofaninvestor'soperationaldatasetmaybethegroupthatisadheringtooperationalbestpractices.However,aninvestorfocusedonexceptionreportingofdeviationsfromlargertrendsmaymistakesuchbestpracticesforlesser-usedpractices.Toovercomesuchpotentialpitfalls investors can benefit from the use of a third-party operational riskconsultantthatcanserveasanoperationalbest-practiceadviserandhasalreadydevelopedfulleroperationaldatasetsthatcanfacilitatebenchmarking.Despitethepotentialpitfallsthatmaybepresent,itislikelythatinvestorswill

continue to embrace a trend of increasing utilization of operationalbenchmarking techniques to further facilitateoperationalduediligencereviewsofprivateequityfunds.

ILPAGUIDELINESTheInstitutionalLPsAssociation(ILPA)isanorganizationthatfocusesonLPadvocacy.In2009ILPAfirstpublishedaseriesofPrivateEquityPrincipleswithagoalofencouragingdiscussionsbetweenLPsandGPs.3InJanuary2011ILPAreleasedversion2.0ofitsPrivateEquityPrinciples.Thenewprinciplesfocusonthreeguidingprinciplesthat,astheprinciplesespouse,areessentialforaprivateequitypartnership.Theseprinciplesare:1.AlignmentofInterest2.Governance3.TransparencyAdditionally, ILPA is leading an effort to create a number of standardized

templates to facilitate uniformity and transparency across multiple areas,includingcapitalcallsanddistributionnoticesandannualquarterlyreporting,aswellasportfoliometrics.4

It may be argued that the ILPA guidelines place an unnecessary burden onGPs.SomesmallerinvestorsmayattempttousetheILPAguidelinesasaswordratherthanashieldtobullyGPsintoincreasedtransparencysubmission.Ontheother hand, as absurd as it may seem, some other LPs may not even wantincreasedtransparencybecausethey,eitherforregulatoryorotherreasons,maybeforcedtodisclosetheinformationreceivedfromGPs.Thisoutofsight,outofmindattitudemayhaveitsplace,butitcanleadtolossesthattheLPscouldhavepotentially avoided, or at least would have beenwarned about had they beenotherwiseopen to receiving such information.TheseLPsmaybe leftwithnotonly losses, but if they are representing other investors, potentially also withclaims ofwillfully ignoring or recklessly disregarding the truth.Regardless ofthe arguments for and against the ILPA standards, the trend toward increasingtransparencywillultimatelybeanetbenefitfortheprivateequityindustryasawhole.Suchtransparencywillalsolikelycontinueatrendofinvestorsseekingtobetterunderstandprivateequityoperationalpractices.

FROMSELF-REGULATIONTOMANDATORYREGISTRATION

It seems as if there has been a sustainedmovement among the private equitycommunity toward developing standards and practices with a focus on self-regulation.That iswhere thestandardsandpractices towhichaprivateequityfirmadheresarethemselvesdevelopedbyprivateequityfirms.Thiscanbeseenin the development of policy documents such as theWalkerGuidelines in theUnitedKingdom.Perhapstakingapageoutof theplaybookofthehedgefundcommunity, the private equity community over the past several years hasfocusedonpresentingamoreorganizedpublicfacethatperhapscoincideswithmore streamlined and focused lobbying efforts. Such a development hasseeminglyincreasedwiththethreat,andnowreality,ofincreasedregulationoftheprivateequityindustryviasuchregulatorydevelopmentsasDodd-FrankandAlternative Investment FundManagersDirective (AIFMD). It seems as if themarkets have in effect said “Thanks for the effort, but no thanks,” to self-regulationofnotonlytheprivateequityindustrybutmostfinancialmarketsas

well.Oftentimes however, it seems there is a disconnect between these self-

developed private equity guidelines and any recently enacted regulatoryconstructs.Self-regulationrulesaregenerallycraftedinsuchawayastoprovidemorewiggleroom.Forexample,theWalkerGuidelinesoutlinedinpartthat“aprivateequityfirmshouldcommittoensuretimelyandeffectivecommunicationwith employees.” While such aspiration policies are admirable, it is unclearexactly what is meant by timely and effective communication. Wouldcommunication be timely if it were within one day of the occurrence of anevent? What about two weeks? As compared with more rigid regulatoryrequirementssuchself-regulatoryguidelinestendtobemoreflexible.It is worth noting that the goal of this discussion is not to criticize the

development of self-regulation. The development of these self-regulations iscertainly better than an environmentwith no regulations at all.However,withthe increasingly complex web of heightened global financial restrictions, it ishighly unlikely that many private equity firms, regardless of their homejurisdictionortheportofcalloftheirportfolioholdings,willbeabletoremainunregulated.

IMPACTOFDODD-FRANKONOPERATIONALDUEDILIGENCE

The broad impact of the Dodd-Frank Wall Street Reform and ConsumerProtection Act has a number of implications for the private equity industry.While the full impact of this legislation is still unfolding, Dodd-Frank has anumberoframificationsthatwilldirectlyinfluenceoperationalduediligenceonboth U.S.-based private equity managers and those managers that have apresenceinorinteractwithU.S.markets.Subsequently,investorswillneedtorevisetheirapproachestowardoperational

due diligence in order to determine if a private equity manager has reactedeffectively to this landmarklegislation.Specifically,onearea thatwillbemostreadilyaffectedisaprivateequityfund'sapproachtowardcompliance.InvestorsmustalsoconsiderDodd-Frankinthecontextofotherrecentlypassedrulessuchas theSEC's amendments toRule206(4)-2of the InvestmentAdvisorsActof1940(theso-calledCustodyRule).Otherkeyareasthatmaybeaffectedincludeinformation technology requirements, fund reporting, recordkeeping, and

transparency. With the passage of Dodd-Frank, LPs had a number ofopportunities to gauge the way in which GPs approached the registrationprocess. The seriousnesswithwhich a private equity fund took the regulatorychanges may have a strong signaling effect regarding not only their attitudetoward ongoing compliancewith the law, but also their attitude toward futurecompliancebestpractices.Aspartoftheoperationalduediligenceprocess,LPscouldinquireaboutanumberofdifferentitemsrelatedtothepost-Dodd-Frankenvironment,including:

WhatchangeshasaprivateequityfundmanagermadeinanticipationofDodd-Frankpassage?Has a private equity fund appropriately budgeted for the increasedcostsofcomplianceassociatedwithDodd-Frank?With the increased focus on compliance, has a private equity fundspoken to the appropriate service providers (i.e., legal counsel,compliance consultants, etc.) to ensure that quality individuals andadequateservicesarededicatedtotheprivateequityfund'saccount?What changes in compliance policies and procedures has a privateequityfundundertaken?Howhavethesechangesbeencommunicatedtostaff?Howhavechangesbeendocumentedinthefirm'scompliancemanual?Ifchangeshavenotbeenmadeyet,whenwilltheybemade?IfaprivateequityfundmanagerwasnotregisteredwiththeU.S.SECrelying previously on an exemption such as Section 203(b)(3) of theInvestmentAdvisersAct,whatistheirplanforregistration?If a private equity fund is already registered, will they fall into thecategoryofmanagerthatmayneedtopotentiallyderegister?Ifso,arethey prepared to deal with local state registration requirements? Forexample,dotheyfall intoNewYorkorWyomingBlueSkythresholdexemptions?Has a private equity fund developed a reporting and technologyinfrastructuretomeetnewrequirements?

In conclusion, the passage of Dodd-Frank and related legislation has had adramaticeffectonthewaysinwhichprivateequitymanagersapproachtheissueof compliance and controls. LPswill likely need tomonitor compliance, bothinitialandongoing,with regulations suchasDodd-Frankonanongoingbasis.ThiswilllikelyresultinatrendofincreasingresourceallocationsbothfromGPstoward compliance relatedmatters, aswell as fromLPs toward due diligence

resourcesaimedatvettingcompliancewithsuchregulations.

CONCLUSIONThis chapter provides an overview of developing trends regarding operationalriskintheprivateequityindustry.Thetrendsthatthischapterdiscussesoriginatenotonlyfromexternalsourcessuchasregulations,butalsodirectlyfromprivateequityfundsandinvestors.Oftenthesetrendsinfluenceallthreegroupsdirectly.Anexampleofsucharecenttrendthathasrepercussionsforallthreegroupsisthe increased focus on material nonpublic information in the United States.Otherexamplesoftrendsdiscussedinthischapterthathavemoredirecteffectson the relationship betweenGPs and LPs are the increased use of third-partyfund administrators and increased reliance on audit-type certifications. ThischapteralsoprovidesadiscussionoftheincreasedusebyLPsofoperationalduediligence consultants and the ILPA guidelines. Finally, this chapter provides adiscussion of legal-and compliance-related trends, including a trend towardrequiring mandatory regulatory registration for private equity funds and theimpactofDodd-Frank.ItisespeciallyimportantforLPstobecognizantofsuchtrendswhendevelopingandmaintaininganeffectiveprivateequityoperationaldue diligence program. By remaining aware, LPs will be more likely toeffectively gauge not only howGPs plan for such change, but also how theyadapttheiroperationstoaddressinvestors’presentandfutureconcerns.NOTES

1.See,forexample,UnitedStatesv.Carpenter,484U.S.19(1987);UnitedStatesv.O’Hagan,521U.S.642(1997).2.SeeFionaGaskin,“GoodbyeSAS70,HelloISAE3402?,”http://download.pwc.com/ie/pubs/pwc_goodbye_sas_70_isae_3402.pdf.3.InstitutionalLimitedPartnersAssociation,“PrivateEquityPrinciples,Version2.0,”January2011.4.InstitutionalLimitedPartnersAssociation,“ILPAPublishesUpdated2011PrivateEquityPrinciplesandFirstStandardizedReportingIndustryTemplatetoHelpEnhancethePrivateEquityAssetClassGlobally,”January11,2011,http://ilpa.org/index.php?file=/wp-content/uploads/2011/01/Principles-Version-2.0-Press-Release.pdf&ref=http://ilpa.org/principles-version-2-0/&t=1316768530.

AbouttheAuthor

Jason A. Scharfman is the Managing Partner of Corgentum Consulting, aprovider of comprehensive operational due diligence reviews of alternativeinvestments including hedge funds, private equity, real estate, and funds ofhedge funds. He is recognized as one of the leading experts in the field ofoperational due diligence and is the author ofHedge Fund Operational DueDiligence:UnderstandingtheRisks(JohnWiley&Sons,2008).Mr.Scharfmanhasparticipatedinoperationalduediligencereviewsofover200privateequityand real estate funds ofmultiple strategies across the globe, includingREITs,clean-tech funds, direct property holdings, multiyear vintage funds, Asianinfrastructure funds, Eastern European utility and infrastructure funds,commodityfunds(timber,oil,gold,etc.),andprivateequityfundsoffunds.Before founding Corgentum, he oversaw the operational due diligence

functionforGraystoneResearchatMorganStanleyandwasaseniormemberofateamthatoversawallofMorganStanley'soperationalduediligenceeffortsforhedgefunds,privateequity,realestatefunds,andfundsofhedgefunds.Priortojoining Morgan Stanley, he held positions that focused primarily on duediligenceandriskmanagementwithinthealternativeinvestmentsectoratLazardAssetManagement,SPARXInvestmentsandResearch,andThomsonFinancial.Mr.ScharfmanreceivedaBSinFinancewithanadditionalmajorinJapanese

fromCarnegieMellonUniversity, anMBA in Finance fromBaruchCollege'sZicklinSchoolofBusiness,andaJDfromSt.John'sSchoolofLaw.Heholdsthe Certified Fraud Examiner (CFE) and Certified in Risk and InformationSystems Control (CRISC) credentials and has consulted with the U.S. HouseJudiciaryCommitteeonthesubjectofhedgefundandprivateequityregulation.Additionally, he has provided training to financial regulators on the subject ofhedge fund and private equity due diligence. Mr. Scharfman has served as aconsultant and expert in hedge fund and private equity litigation, and haslecturedonthesubjectofalternativeinvestmentoperationsandoperationalriskasanadjunctprofessoratNewYorkUniversity.Hehaswrittenextensivelyonthe subject of operational due diligence and travels and speaks worldwide onhedgefundoperationalrisks.

AbouttheWebsite

This book includes a companion website, which can be found atwww.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 diligencereviews of private equity funds. This website also includes links to laws andregulations that are cited in the book. The password to enter this site is:Scharfman.

IndexAAACapitalfraudAccessoryliabilityActualfraud.SeeFraudAdministratorADV.SeeFormADVAdvisoryboardAgapeWorldAllianzSEAlternative Investment Fund Managers Directive (“AIFMD”) AlternativeinvestmentsAmazon.comAmericanResearchandDevelopmentCorporation(ARDC)AssemblyBill1743AssetallocationAssetsundermanagement(AUM)AuditmaterialityAuditedfinancialstatements.SeeFinancialstatementsAuditor

BBackgroundinvestigationBadfaithBadenv.SocieteGeneraleBalancesheet.SeeFinancialstatementsBaringsBankBarlow Clowes International Ltd (In Liquidation) v. Eurotrust InternationalLimited Basel Committee on Banking Supervision Benchmarking. SeeOperationalBenchmarkingBerman,ToddBlackstoneGroupBoardofdirectorsBoesky,IvanBritishVentureCapitalAssociation(BVCA)Broker-dealerBullmore v. Ernst & Young Cayman Islands Business continuity and disasterrecoveryplanning(BCP/DR)Businessrisk.SeeOperationalriskCCadburyCommission

California Public Employees’ Retirement System (CalPERS) California StateTeachers’RetirementSystem(CalSTRS)CarlyleCarnegieSteelCompanyCarnegie,AndrewCarriedinterestCashoversight,managementandtransfercontrolsCaymanIslandsChannelIslandsChartwellInvestmentsChiefComplianceOfficerChiefFinancialOfficerChiefOperatingOfficerChiefTechnologyOfficerCliff vesting. See Compensation structures Committee of SponsoringOrganizations(COSO)CommitteeofWiseMenCompensationstructuresComplianceInfrastructureManual

Compton,CarlConfidentialityagreementConflictsofinterestContinentalAirlinesCooke,JayCore operational due diligence process. See Operational due diligence Coreoperational due diligence process. See Operational due diligence CorgentumConsultingBenefitsofoperationalduediligencecasestudiesIncreaseduseofoperationaldue diligence consultants Operational due diligence process documentationOperationalbenchmarkingOperationalduediligenceframeworksanalysisTrends in indemnificationandexculpationclausesCosmo,Nicholas

CounterpartyoversightCounterpartyrisk.SeeCounterpartyoversightCountryspecificrisksCreditMobilierCrossoverfunds

CustodianCustodyCustodyRuleCustomerrelationshipmanagement(CRM)systemsDDedicatedframeworkDepartmentofJusticeDeutscheBankDigitalEquipmentCompanyDirectorliabilityDirectors’andofficers’liabilitycoverage(D&O)DiscoveryDishonestyDistresseddebtinvestingfundsDixon,Roy,Jr.Dodd-FrankWallStreetReformandConsumerProtectionActDom,TelongeDomino'sPizzaDoriot,Georges,GeneralDraperGaitherandAndersenDreier,MarcDrexelBurnhamLambertDuediligenceequationDuediligencefileDuediligencequestionnaire(DDQ)EEBITDAEffectivelyconnectedincome(ECI)EnronEquityownershipmodelErrorsandomissions(E&O)insuranceEUpassportEuropeanAssociationforInvestorsinNon-listedRealEstateVehicles(INREV)ExculpationandIndemnityExceptiontoHistoryofUses inprivateequityofferingmemorandaExculpation.SeeExculpationandIndemnityExogenousrisks

Expanded operational due diligence process. See Operational due diligenceExpertresearchnetworks

FFAASystemSafetyHandbookFairvalue.SeeValuationFAS157FASBASC820Fat-tailriskDefinedRelationtofrauddetection

FinancialAccountingStandardsBoard(FASB)FinancialHighlightsFinancialInstitutionsReform,RecoveryandEnforcementActof1989FinancialstatementsAuditstandardsDuediligenceonReviewofincoreprocessSections

FirmandemployeereputationForeignCorruptPracticesActFormADVFormPFFraudApplicabletoexculpationandindemnityBenefitsofcasestudiesinCasestudiesinDetectionofInvestorrecoveryfromLevelsofPrivateequityfundfailureconsiderationsduetoFraudinfact.SeeFraudFundAdministrator. See Administrator Fund advisory board. See Advisory boardFundreporting

GGalleonGroupGeithner,TimothyGeneralCounselGeneralPartner(GP)Defined

DistinctioninvaluationapproachesRelationtoadvisoryboardsInformation flow with Limited Partners Generally Accepted AccountingPrinciples(GAAP)ConvergencewithIFRSU.S.GAAPU.K.GAAP

Generally Accepted Auditing Standards (GAAS) Global InvestmentPerformanceStandards(GIPS).SeeValuationGoldmanSachsGoldstein,PhilipGrahamv.Allis-ChalmersMfg.Co.GreenburyCommitteeGrossnegligenceGuernseyGuidelines for Disclosure and Transparency in Private Equity. See WalkerGuidelinesHHampelreportHarvardHealthcarefundHedgeClausesHedgefundoperationalduediligenceDifferenceswithprivateequityoperationaldue diligence Similaritieswith private equity operational due diligenceHedgefundRegistrationRuleHedgeFundTransparencyActHighVoltageEngineeringCorporationHumancapitalHybridframework

IILPA.SeeInstitutionalLPsAssociation(ILPA)GuidelinesInparidelictoIndemnity.SeeExculpationandIndemnityIndiaprivateequityfundsIndustryspecificrisksInformationbarrierInformationsecurityInformationsiloInformation technology (IT). See Technology and systems InformationtechnologyconsultantsInformedoperationalopinionformationInstitutionalLPsAssociation(ILPA)GuidelinesInsurancecoverage

InternationalAuditingStandards (ISA) InternationalBusinessMachines (IBM)InternationalFinancialReportingStandards(IFRS)InternationalPrivateEquityand Venture Capital Valuation (IPEV) Guidelines Discount cash flows orearnings (of underlying business) approach Discounted cash flows (from theinvestment) Industry valuation benchmarks approach Multiple valuationmethodologyNetassetsapproachPrice of recent investment approach International Standard of AssuranceEngagements(ISAE)3402

IntervalfundsInvestmentAdviserInvestmentAdvisersActof1940InvestmentdecisionmakingauthoritymodelInvestmentduediligenceComparisontooperationalduediligenceDefinedInsharedduediligence framework IntegrationwithoperationalduediligenceProcesstimingRelationtofrauddetectionResource allocation versus operational due diligence Role in private equitydecision-makingprocessStagesofanalysis

ISDAIsleofMan

JJerseyJurisdictionalrisksJ.P.MorganJunkbonds

K

K1Group

Keypersonclause

Keypersoninsurance

Keynes,JohnMaynard.SeeKeynesianeconomicsKeynesianeconomicsKiener,HelmutKKRKlomp,Danny

LLamfalussyprocedureLascauxCaveLegalandcompliancerisksLegalcounselLegaldocumentationreview.SeeLegalduediligenceLegalduediligenceLesson,NickLeveragedbuyout(LBO)LBOfundsRJRNabiscotakeover

Levine,DennisLiabilityreleasesLiechtensteinLimitedliabilitycompanyLimitedPartnerDefinedDistinctioninvaluationapproachesServingonAdvisoryboardsInformation flow with General Partner Fund of funds due diligenceconsiderationsLitigationsupport

LockupLuxembourg

MMadoffEffectMadoff,BernardMalfeasanceMaltaManager. See Investment adviser Markets in Financial Instruments Directive(“MiFID”)MaterialnonpublicinformationMezzaninefinancingfunds

Minimumoperationalriskregime(MORR)MITModularframeworkMoralfraud.SeeFraudMortgagefraudMüntefering,Franz

NNadel,ArthurNational Commission on Fraudulent Financial ReportingNegative operationalduediligence.SeeOn-sitevisitsNetscapeNo-faultdivorceprovisionNondisclosureagreement(NDA)Noninvestmentrisk.SeeOperationalriskOOffering memorandum (OM). See Private placement memorandum OffshoreblockcorporationOffshorejurisdictionsOnshore versus offshore considerations in legal document analysis PrivateequityfundmanagerschoiceofServiceproviderslocationinTaxpolicy

OngoingmonitoringOn-sitevisitsDocumentationforlitigationsupportInterviewtechniquesandquestiondesignNegativeoperationalduediligencePrivateequityfundmanagerconsiderationsUnderlyingprivateequityportfoliocompaniesOnyxCapitalAdvisors

OperationalBenchmarkingOperationalDragOperationalduediligenceArgumentsinfavorofperformingonprivateequityBelow-coreprocessComparedtooperationalriskContrastedwithaninsurancepolicyCoreprocessDefinedDistinguishedfromoperationalmanagementDocumentcollectionExpandedprocessFilteringstagesFive-stageprocessFrameworks

LackofuniversaldefinitionPrivateequityprogramdesignProcessgoalsProcesstimingResourceallocationTimeversusresourceallocationTrendsinUnderstandingtimeallocationtoUniversaldefinitionVersusoperationalrisk

Operational due diligence consulting firm. See Corgentum ConsultingOperationalfringeOperationalLiftOperationalLift-to-DragratioOperationalriskCommon private equity operational risk categories Compared to operationalduediligenceDefinedOperationalriskplaneRisk commonalities between private equity and real estate Risk differencesbetween private equity and real estate Operational risk consulting firm. SeeCorgentumConsultingOperationalriskmanagement(ORM).SeeOperationalrisk Operations risk. See Operational risk Opinion letter. See FinancialstatementsOpsdd.SeeOperationalduediligenceOrecchio,John

Organizationalrisk.SeeOperationalriskPPalminvestPang,DannyPaperTrail.SeeLitigationsupportPariPassuPay-for-play.SeePay-to-playPay-to-playPEMGroupFraudPerformance vesting. See Compensation structures Personnel and employeeturnoverPetcoPettersGroupWorldwidePetters,TomPhilipsPensionfundfraud

Picasso,PabloPiñataproblemPIPEtransactionsPonzischemePonzimoniumPortfoliocompaniesPositivefraud.SeeFraudPrivateEquityPrivateequityfundoffundsPrivateplacementmemorandum(PPM)ProcesshomogeneityPublicCompanyAccountingReformand InvestorProtectionActof2002.SeeSarbanes-OxleyActQQuakerOats

RR.AllenStanfordRajaratnam,RajRealestateDistinguishedfromprivateequityFeasibilitystudyFundfeesPropertymanagementRisk commonalities with private equity Risk differences with private equitySampleprocessTechnicalduediligenceThird-partydevelopersValuation

Rebate.See Sales chargeRegional risk.See Industry specific risksRegulatoryrisksReputationalrisk.SeeFirmandemployeereputationResourcedilutionRICSValuationStandardsRiskcontrolmodelRoguetradereventsRoyalBruneiAirlinesSdn.Bhd.v.TanRoyalInstitutionofCharteredSurveyorsRule206(4)-2.SeeCustodyRuleSSaleschargeSanDiegov.AmaranthSarbanes-OxleyAct(SOX)

Savingsandloans(S&Ls)Scheduleofinvestments.SeeFinancialstatementsScoopManagementSecuritiesandExchangeCommission(SEC)Servicelevelagreement(SLA)ServiceprovidersSFAS157.SeeFAS157SharedframeworkSidelettersSignalingeffectSiliconValleySnappleBeveragesSnowballEffectStandardCharteredStanfordFinancialGroupStatementofAssetsandLiabilities.SeeFinancialstatementsStatementofCashFlows.SeeFinancialstatementsStatementofChanges.SeeFinancialstatementsStatementofFinancialAccountingStandards157.SeeFAS157Statement of Operations. See Financial statements Statement on AuditingStandards(SAS)No.70Straw-manborrower

TTaxhavenTaxpracticesTechnologyandsystemsThird-partymarketerTimber investment management organization (TIMO) Time vesting. SeeCompensationstructuresTradeflowanalysisTradelifecycle.SeeTradeflowanalysisTranscontinentalRailroadintheUnitedStatesTransparencyandfundreportingTreadwayCommissionTycoInternational

UU.S.GAAP.SeeGAAPU.S.GenerallyAcceptedAuditingStandards(GAAS).SeeGenerallyAccepted

AuditingStandards(GAAS)UltraviresUninterruptiblepowersource(UPS)Unrelatedbusinesstaxableincome(UBTI)VVaisey,HarrySirValuationConsiderationsfornewlyformedfundsConsultantsDistinctionbetweenfundandportfoliocompanylevelFairvalueGIPSStatementofPrivateonPrivateEquityRealestateReviewofincoreprocessThird-partyconsultants

VenturecapitalfundsVesting.SeeCompensationstructuresVillalobos,AlfredVintagefundFinancialstatementduediligenceonValuationconsiderationsSideletternegotiationconcernsViscountoftheRoyalCourtofJerseyv.SheltonVoortman,Remco

WWagonerDoctrineWalkerGuidelinesWeather-relatedrisksWillfuldefaultWillfulfraud.SeeFraudWorldcom

YYahoo!