By Irfan Yunus, Global Head of Operational Due Diligence
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The importance of operational due diligence for hedge funds has grown in recent years. But it is just as essential in private equity and real estate.
When selecting potential private equity and real estate investments, investors typically focus on the likely valuations at which managers will acquire companies or properties and the amount of debt they will use to do so. Such considerations fall within the investment due diligence process (IDD). They are clearly critical to determining an investment’s return potential. However, IDD is only one dimension of the comprehensive due diligence that needs to be performed. Rigorous operational due diligence (ODD) – assessment of the manager’s operational risk – is just as essential.
Operational risk is the prospect of suffering losses arising from a wide variety of failings in relation to private equity and real estate firms’ staff, controls, governance, processes, practices, and systems. The ODD process seeks to determine whether the manager’s operational infrastructure can support the investment strategy. Areas considered as part of this evaluation include appropriate governance and controls, costs and fees, key technologies, as well as conflicts of interests. As private equity and real estate vehicles typically demand multi-year commitments from investors, Citi Private Bank’s dedicated ODD team seeks to identify and mitigate such risks prior to investing.
Recognition of the existence of operational risks within hedge funds has grown over recent years. Such risks resulted in hedge fund investors’ losses, as we explained here. By contrast, there has been less appreciation of operational risks in private equity and real estate firms. In 2018, however, the collapse of a prominent private equity firm from the Europe, Middle East & Africa region helped to highlight the importance of these issues. The organization – which specialized in emerging markets investments – had operating costs that outstripped revenues. To fund its operations, it therefore took out loans, which quickly mounted up. While private equity firms typically borrow money to finance investments, doing so to cover manager operating expenses is unconventional.
So, why are private equity and real estate managers – like hedge funds – subject to operational risks? Aside from select cases of outright dishonesty, a significant issue can arise from how such firms are set up. While they often possess significant expertise in investment matters, managers do not always have sufficient resources in vital auxiliary functions such as technology, information security or control functions. In the example above, the private equity firm admitted that the expansion of its back office functions hadn’t kept up with the growth of its funds.
When trying to identify specific investment opportunities, we stress the need for rigorous due diligence to address operational risks, specifically ODD. Due to the resources required and the complexity of risks that need to be assessed, it is important to have access to a private equity and real estate platform with a robust ODD framework. In our next article, therefore, we will set out what is required and how our dedicated Operational Due Diligence team approaches it.
Alternative investments are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk.
Asset allocation does not assure a profit or protect against a loss in declining financial markets.