Private funds are rising in prominence for ultra-high net worth individuals and family offices seeking alternative investments, as the world attempts to shake-off the shackles of COVID-19. Our recently published Outlook 2021, which discusses investment in a post-pandemic environment, flags private funds as vehicles for generating potentially above-average investment returns.
Operational due diligence (ODD) – a fundamental part of the investment process predicated on scrutinizing investment managers’ operational capabilities, and the ability of their infrastructure to support the execution of their strategy – always raises the crucial topic of governance and its structural examination as part of wider scrutiny.
There are clear governance differences between publicly offered registered funds and private funds. In the case of publicly offered registered fund formats, there are often many stringent rules imposed to guide the formal governance structure required to be implemented by an investment fund. As such, there is greater consistency with regard to the typical framework in place for oversight of decision making in key areas of potential conflicts of interest between an investment manager and its clients.
Private fund structures can assume a broader variety of forms as a result of their less prescriptive requirements and therefore greater variation with respect to quality of governance in place. Given this consideration, investing in private funds requires a thorough review and understanding of governance each time one considers making an investment allocation. This is particularly important in instances of investing in funds lacking voluntary redemption features, where up front ODD can help ensure consummation of a strong partnership with governance attributes adhering to best practices.
Scrutinizing the quality of governance structures
The analysis of governance quality begins with understanding the degree of independence that can be anticipated from either the Board of Directors (BOD) in the case of a corporate structure or a Limited Partner Advisory Committee (LPAC), as would be expected to be in place for a limited partnership adhering to best practice standards.
Board members are frequently appointed from professional directorship firms staffed by individuals with strong experience in key areas of a fund management operation such as accounting, valuation, legal and compliance. In the former example, one would expect to see the voting majority represented by those unaffiliated with the investment manager. Going one step further, it is increasingly common to see Board members appointed from numerous third-party providers to encourage even greater diversity of thought and perspectives.
In a sign of evolving guidance, more recently a major North American exchange for publicly listed companies has gone a step further and filed a proposal with the US Securities and Exchange Commission to adopt new listing rules related to board diversity and disclosure. The proposal would require most companies to have or explain why they do not have at least two diverse directors, including a woman and minority.
In the case of the LPAC, investment managers have many different ways of arriving at their methodology for selection of appointment of limited partners (LPs). It is not always the case that a fund’s LPAC will be comprised of a list of LPs who have made the largest commitments to a particular fund. However, it should always be the case that LPAC appointees are arms’ length third parties unaffiliated with the manager.
An LPAC member may be appointed owing to their overall relationship and history with a manager or even their particular ability to negotiate representation on the basis of their value add to such a committee. Experienced LPs who have proven to act as strong sounding boards and partners through many market cycles will usually have an advantage in vying for voting or observer rights within an LPAC.
Importantly, an investment manager should be able to explain their rationale for LPAC member selection and a potential investor should be able to assess the rationality of the approach described. The determination of the ultimate composition of the LPAC can provide insight into the level of experience and strength of oversight welcomed by a manager.
Focusing on clarity and transparency
Another critical element to assess when sizing up a fund’s governance quality is the clarity and transparency around the governance body’s purpose. The mandate of the BOD and LPAC should be clearly defined, and include the frequency of meetings, description of standard reporting, evaluation of any conflicts of interest, or assessment of any material changes proposed to the fund’s terms.
Examples of items that may be discussed with the BOD or LPAC are valuations, fees paid to affiliates or cross trades. Experienced LPs and those with a history of strong value add can help negotiate the scope and breadth of items that merit escalation to review by an LPAC or a BOD.
A manager with a healthy respect for governance will not hesitate to provide transparency to the LPAC for any actual or perceived areas of conflict to ensure no ambiguity around reasons for actions taken. Ultimately, a manager erring on the side of transparency to mitigate any potential conflicts, is likely to be a manager who benefits from investors entrusting them over stewardship of capital through the many oscillations in an economic cycle.
While the aforementioned items are not a comprehensive list of all considerations to take into account when evaluating private fund structure governance, they generally highlight the importance of getting into the details when assessing a private fund investment opportunity on a holistic basis.
At Citi Private Bank we have established a dedicated global team focused on all operational due diligence items including critically important matters such as evaluating fund governance prior to investing into a private fund.
The ability to analyze and discern strong governance features and frameworks from weak ones, and to advocate for change where needed is one of the benefits of working with a platform of an institutional ODD program.