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Once an investor begins developing an operational due diligence program, there is a likely tendency over time for the nature of fund manager reviews to change over time. This could be in part due to changes in the market environment in which fund managers operate. An example of this would be regulatory changes such as changes in SEC registration requirements. Such changes would affect the nature of a fund manager's operational risk environment and therefore, investors would need to tailor their operational due diligence programs accordingly. The nature of operational due diligence reviews can also change among different fund managers within the same asset class. For example, an investor might be required to perform a different type of operational due diligence review on the valuation practices of a long/short equity fund manager as compared to a distressed manager. Similarly, operational due diligence techniques may also vary among asset classes. This is particularly true in comparing operational due diligence approaches to hedge fund and private equity funds. When investors begin the operational due diligence process, they may develop a core process around a certain asset class. In recent years, many investors developed their operational due diligence programs around hedge funds. The logic behind this may have been that many investors may have viewed hedge funds to be the riskiest parts of their overall investments, at least from an operational risk perspective. Over time, more and more investors have begun to realize the benefits of a well-developed operational due diligence program which reviews operational risk across fund managers from all asset types including hedge funds, private equity and long only managers. Focusing on private equity in particular, there are a number of different operational due diligence approach commonalities and differences between hedge funds and private equity. Some common similarities between hedge fund and private equity operational due diligence include the shared process goals of evaluating operational risk. Additionally, among hedge funds and private equity operational due diligence approaches for most investors, there will also likely be an overlap in core operational risk areas reviewed such as valuation, technology, regulatory and compliance It is also worth considering the ways in which the underlying fund managers themselves are different from an operations perspective. As compared to their hedge fund counterparts traditionally, private equity managers trade less frequently than hedge funds. Investors may dangerously equate less trading frequency with less operational risk. While increased trading frequency may increase the time span over which a trading problem may occur, this does not necessarily decrease the magnitude of potential losses. Operational problems in private equity firms may result in trading losses which are more consolidated and may still lead to equal or greater losses, as compared to more frequently traded hedge funds. As such investors which initially developed an operational due diligence program centered around hedge fund investments, one must not ignore operational risks relating to trade operations when applying this core program to private equity.Other key traditional differences between hedge fund and private equity funds that investors might want to consider in tailoring their operational due diligence programs include: Private equity portfolios may be more concentrated as compared to hedge funds After initial fund raising, many private equity funds generally do not have as actively traded portfolios as hedge funds Beyond certain core documents, hedge funds and private equity funds will generally have different series of documents which an investor will need to collect and review during the operational due diligence process
Investors may need more asset specific knowledge to effectively perform operational due diligence on certain private equity funds
Due to these differences, investors should consider the benefits of not employing one single approach towards operational due diligence which lumps together all asset classes and fund managers. Instead, investors should take measures to adapt their hedge fund operational due diligence programs appropriate so as to ensure the key operational risks associated with private equity funds are appropriately vetted. The results will be better tailored operational risk reviews which afford investors with the opportunity to drill down on operational risks specific to each asset class.
Originally posted in the February 2012 edition of Corgentum Consulting's Operational Due Diligence Insights. For More Information
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About Corgentum Consulting:
Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers. The firm works with investors including fund of funds, pensions, endowments, banks ultra-high net-worth individuals, and family offices to conduct the industry's most comprehensive operational due diligence reviews. Corgentum's work covers all fund strategies globally including hedge funds, private equity, real estate funds, and traditional funds. The firm's sole focus on operational due diligence, veteran experience, innovative original research and fundamental bottom up approach to due diligence allows Corgentum to ensure that the firm's clients avoid unnecessary operational risks. Corgentum is headquartered at 26 Journal Square, Suite 1005 in Jersey City, New Jersey, 07306. Phone 201-360-2430. For more information visit, www.Corgentum.com or follow us on Twitter @Corgentum.