SUMMARY
Private equity and real estate investments involve allocating capital into illiquid investment structures for extended holding periods. Hence, getting the investment manager due diligence review right ahead of such a commitment is absolutely vital.
Ultra-high net worth individuals and family offices are on a strategic quest for more alternative and long-term investment avenues in the current macroeconomic climate. It has meant that private markets – broadly inclusive of private equity, real estate, infrastructure and venture capital – are witnessing a rise in interest due to their potential for generating above-average investment returns.
For those heading down this pathway, investment manager due diligence, is a fundamental part of the investment process. It is the analysis of investment managers’ operational capabilities and the ability of their infrastructure to support the execution of their investment strategy.
How we carry out effective investment manager due diligence for private equity and real estate (PERE) investments
At the start of the process, we typically review the fund’s investment and operating processes, alongside an analysis of the viability of the firm. If the fund is being run by first-time manager, we dig even deeper into the team and its relatively nascent investment strategy via an in-depth breakeven analysis.
This is followed by an examination of the governance and organizational structure. PERE funds are typically organized as partnerships with a general partner (GP) driving decisions on behalf of the entire partnership which includes limited partners (LP). This is in comparison to typical public corporate structures with shareholders and an independent board of directors.
Instead of a company board, investors may encounter a Limited Partnership Advisory Committee (LPAC), which represents significant investors. LPACs can play an instrumental role in the review of changes to the Limited Partnership Agreement (LPA), an underpinning legal document used for PE funds formed as limited partnerships. LPACs also oversee conflicts of interest, supervision of key personnel changes, deviations from key policies such as valuation, and changes to service providers’ appointments.
The ODD process also involves sending a due diligence questionnaire (DDQ) that’s been specifically created based on the latest industry standards set by the three main sources: Invest Europe, British Private Equity & Venture Capital Association (BVCA) and Alternative Investment Management Association (AIMA). This questionnaire has been further enhanced by our ODD team’s experience and depth of knowledge. Sample categories and questions could include:
How is the firm structured organizationally? What is the governance framework and executive decision making process? How are staff – including back-office as well as front-office employees – incentivized? How do the non-investment (Operations, Finance, Legal, Compliance, IT) managers operate? What controls are in place to monitor the fund’s service providers?
The diligence process
As part of the diligence process, onsite meetings are also required with key personnel generally including, but not limited to, for instance the Chief Financial Officer, Chief Commercial Officer and Lead Investment Manager. With COVID-19 social distancing measures in place, these meetings are currently being conducted via tele- and video-conferencing.
This process covers a comprehensive review of the PERE funds’ governing documents including investment terms, regulatory compliance structures, statutory requirements and exemptions.
We also review key service providers with an emphasis on administrator and auditor relationships. The exercise includes scrutiny of the professional standing of managers, and any unqualified signoffs or unexplained changes in auditors. We examine the caliber of the service providers as well, and cross reference that to industry rankings where applicable.
Particular focus is required on the fund administrators’ experience in PERE asset classes. For example – how many clients do they have in the same asset class? Do they use specific systems? In the case of the auditor, we generally focus on top four audit firms. But there are instances where a non-top four audit firm may be considered for specific expertise, e.g. venture capital.
In addition, detailed background checks are a must. They are performed on GPs, investment managers and operations staff concerning their employment, education and criminal record checks over the last 10 years.
Finally, Enhanced Monitoring and Active Monitoring need to be conducted. Enhanced Monitoring has proactive premise, and involves subjecting certain higher-risk managers and funds to a quarterly review relating to specific aspects of their investment risk profile as well as ODD risks.
Active Monitoring process
Active Monitoring, which is reactive in nature, entails scrutiny of circumstantial or emerging risks in response to a developing situation or market event. For instance, as part of our Active Monitoring process, when COVID-19 was potentially designated as a pandemic originating in Asia in February 2020, we contacted all our Asia-based managers and investment teams, and began increased monitoring their portfolio and investments closely alongside the research team. Subsequently in March 2020, this process was carried out on a global basis, formulating a focus on managers who may potentially be subject to valuation or business continuity risks.
Ultimately, investment manager due diligence involves a series of measures to comprehend, analyze and diagnose operational risk unique to every fund we review. We account for additional complexities the process involves over and above the scrutiny required of hedge funds. In the current macroeconomic climate, the process has become ever more crucial.
