Book Summary: Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation, and

Documentation (Wiley Finance) by Jason A. Scharfman

Number of Pages: 305 pages
ISBN-13: 978-1118113905
Book Finished: 26 Nov 2013
Note: This is a very concise paraphrased summary. Please support the author and buy the book.

Total Due Diligence = Investment + Operational Due Diligence

General Operational Due Diligence Process for Private Equity Typical Private Equity Decision-Making Process
1. Data
0. Define Collectio
Goals of = smell test
n and
ODD Analysis

2. Service
5. Continued Provider
Monitoring Confirmation
and Review

4. Report
Generatio 3. On-
n and Site
Recomm meeting
endations

0, Goals of ODD

Being able to understand the internal operational processes of a particular private equity fund and also be able to explain them to
another investor. Ask yourself: What are you trying to get out of the process?

1. Data Collection and Analysis

Preliminary Minimum Operational Due Diligence Requirements (‘smell test’):

 Investor will not allocate capital to a private equity fund that is not associated with a firm that has managed capital
before.
 Previous experience in managing funds in a particular sector.
 Perhaps a minimum track record of say 3 years.
 Certain firm-wide assets under management size e.g. $1 billion.

Confidentiality Agreement (“confi”) AND Non-Disclosure Agreement (NDA). NDAs could be referred to as a subset of
confidentiality agreements. Reciprocal confi’s are an important leverage point.

Core Operational Risk Factors vs. Expanded Operational Risk Factors

Trade Flow Analysis IT
Cash Management and Control Regulatory Interaction
Compliance Infrastructure Business Continuity
Human Capital Disaster Recovery
Legal Documentation Insurance Coverage
Valuation Board of Directors
Fund Service Providers Tax Practices
Custody Procedures and Third Parties Information Security

Suggested Baseline Document Request List:

For the Private Equity Management Company
1. Core Compliance / Regulatory Documentation
1.1. Compliance Manual
1.2. If not included in compliance manual:
a. Employee personal trading procedures
b. Electronic communication policy
c. Antimoney laundering policies and procedures
For the Private Equity Fund(s) under Consideration
3. Core Fund Legal Documentation
3.1. Offering Memoranda (OM)
3.2. Subscription Documents
3.3. Articles of Association
3.4. Limited Partnership Agreement
4. Other Core Fund Documentation

Copyright © 2013. Chris Pretorius

 1.3. Form ADV (if U.S. SEC registered)
2. Other management company core documentation:
2.1. Organizational charts
2.2. Business continuity and disaster recovery plan
2.3. Valuation Policy and Procedures
2.4. Certificate of incorporation
4.1. Previous similar fund’s audited financials
4.2. Letters to investors for previous funds
4.3. Performance Track Record for Similar Funds
4.4. Samples of recent marketing materials (pitchbook, etc.)
4.5. Certificate of formation
4.6. Details of insurance coverage

2. Service Provider Confirmation and Review

It is advisable that an investor reach out to a private equity fund's service providers to confirm, at a minimum, that the
relationship actually exists. Without the oversight of a third-party custodian (as opposed to self-custody), there are more
opportunities for this fund to either perpetrate fraud or operational issues resulting from this situation. Common Service
providers utilized by PE firms and funds include the auditor, administrator, legal counsel, custodian, information technology
providers, compliance consultants, and cash-management firms.

3. On-Site Meeting

Face-to-face communication provides enhanced quality and depth of information. Answer the following questions:

 Is the fund manager’s space shared or subleased to any entities that were conveniently not referenced in any of the
fun’s documentation
 Does the firm claim to have 50 employees but show only 20 desks?
 Is everyone conveniently out to lunch or on vacation during the day of the on-site visit?
 Is secure access maintained to the firm’s offices?
 Is secure access maintained to certain areas such as server rooms?

Appropriate interview questions may include:

Firmwide Issues Assets under Management

Have any partners or founders of the firm since departed the
firm?
Provide detail of any affiliated entities.
Are any members of the firm related?
What is the alignment of interests between the firm and its
investors? Amount of principal and employee capital invested?
Side Letters: Do other investors have them? What are their
terms?
Is the private equity firm locked into any long-term contracts,
such as office space leases, technology service contracts, and so
on?
Personnel and Employee Turnover
Provide details of historical employee turnover (additions and
departures).
Does the firm have any additional planned hires?
If the firm indicates that someone has left on good terms, can
you contact this former employee as a reference?
What does the firm do to ensure retention of key employees?
Are noncompete agreements utilized?
Insurance Coverage
What types of insurance coverage does the firm maintain?
What are the terms of this coverage?
Which carriers provide this coverage?
Has the firm ever issued a claim on any of its insurance policies?
Transparency and Fund Reporting
What types of reporting does the firm anticipate distributing to
investors in the new private equity fund?
What are the current assets under management for the
firm? For each fund?
What were the assets under management a year ago for the
firm? For each fund?
What has been the peak of assets under management?
When was it reached?
What is the breakout of investors by investor type in the
firm? In each fund?
What is the geographical breakout of the firm's investor
base?
What is the anticipated investor pipeline for the current
private equity fund under review?
When is the first anticipated closing date for the fund? Is it
a hard close or a soft close?
What percentage of assets under management do the
following represent (as a percentage of both firm and fund
assets under management): Largest investor & Three
largest investors?
Legal and Compliance
What is the structure of the firm's compliance
organization?
Are employees dedicated solely to compliance or do they
have shared responsibilities?
Does the firm work with any third-party compliance
consultants?
Is any compliance training performed? If yes, what topics
are covered by compliance training?
Do you perform any electronic communication
monitoring?
Has there been any previous litigation against the firm,
fund, or any employees?
Is there any pending litigation against the firm, fund, or
any employee(s)?
Firm and Employee Reputation
What is the employment history of the firm's senior
management? Did they leave their
previous firms on good terms? Can they provide
references?

Copyright © 2013. Chris Pretorius

 What is the timing with which such reports will be distributed?
What is the method of delivery of such statements (e.g., via e-
mail or via a centralized investor relations website)?
Information Security
What are the firm's information security defenses?
What kinds of firewalls are in place?
Does the firm log employee network activity?
How often are employees required to change their network
passwords?
Is there anything in senior managements’ past that is
noteworthy from a reputational risk perspective (e.g.,
criminal convictions, sanctions by regulators, etc.)?
Is senior management involved in any current litigation or
disputes that may be distracting (e.g., a messy divorce,
dissolution of former business partnerships, etc.)?
Does senior management have any outside business
interests? If yes, what is the nature of these interests? How
much of senior management's time do they take?
Quality Roles of Service Providers
What service providers do you anticipate utilizing for the
current private equity fund for which you are raising
capital?
How long have you worked with your current service
providers?
What services do you receive from each of your service
providers?

Important Lessons:

1. Operational Due Diligence is an ongoing process, not a one-time event. Operational Due Diligence > Fraud Detection,
however first priority is to detect fraud.

2. To determine whether fraud is material, must satisfy both conditions: (a) Whether the particular area matters to the investor?
(b) If overlooked can create losses or future liabilities?

3. With private equity, manager selection plays the most crucial role – look at competency, skill and quality of the private
equity managers themselves.

4. Common offshore hedge fund jurisdictions: Cayman Islands, Luxembourg, Liechtenstein, the Isle of Man, Jersey and
Guernsey. Common private equity offshore jurisdiction: Malta.

5. Most due diligence (including investment due diligence) is performed when the initial capital raise occurs.

6. Document everything and draw up a due diligence file. These documents in such a file can include:

 Copies of any communication (e-mails, document request lists, log of phone calls) between the parties.
 Details of any internal discussions regarding the decision to investor (or not to invest), including meeting minutes,
records of votes.
 Copies of any documents collected.
 Documentation of any analysis performed on these documents.
 Conclusions drawn based on reviewing documents.
 Details and agendas of any on-site visits.
 Details of any service provider reviews.

7. Four ODD Frameworks:

 Dedicated: At least one employee has full-time responsibility for ODD.

 Shared: No full-time dedicated ODD analyst.
 Modular: Parsed out among different specialists with relevant domain knowledge.
 Hybrid: Combination of the three above approaches.

8. Look at the meta-communication and -signalling effects present in communication (meta-data).

9. Document Request List should be topic driven, not name-driven.

10. A starting private equity fund is effectively not much more than a legal shell.

11. Document Request Lists (DDQs) [also called request for proposals (RFPs)], just like pitchbooks, are marketing documents.

12. NB: Try to develop an understanding of and inquire about operational procedures, as opposed to simply regurgitating a
private equity fund manager's own descriptions about their own processes.

13. Employee Compensation must vest. We want true alignment between investors and the general partner.

14. Additional considerations: Advisory Board, Financial Statement Due Diligence = Audit Standards + Accounting Standards.

15. Real Estate Process: 1) Initial Research 2) Sector Analysis 3) Feasibility Study 4) Analysis Tools 5) Acquisition Plan &
Committee Review 6) Technical Due Diligence 7) Property Acquisition 8) Logging of the Purchase and Sale of Assets 9)
Property Management 10) Post-Deal Management 11) Credit Research 12) Fund Procedures (e.g. valuations)

Copyright © 2013. Chris Pretorius

Overview of Valuation Methodologies As Applicable to Common Company Types

Commonly Accepted Milestones for Early Development Stage Companies

Sample Assets under Management Threshold for a Private Equity Firm to Use Third-Party Valuation Consultants

Diagram of Typical Private Equity Legal Structure

Copyright © 2013. Chris Pretorius