Due Diligence Preparation Can Pay Off

Date: Friday, February 22, 2008
Author: Mark DiMaio & Scott Gallagher, Ernst & Young LP

The key to efficiently and effectively responding to investors' growing demand for information disclosure from both investors and regulators is due diligence.

Investors in alternative investment vehicles such as hedge funds, funds of funds, private equity funds, commodity pools and venture capital funds are increasingly conducting substantial levels of due diligence to identify both investment and operational risks. U.S. and European regulatory authorities are also requiring increasing levels of public disclosure by alternative investment vehicles. Driving factors include:

An increasing trend of consolidation in the hedge fund and private equity world with more alternative investment funds seeking to sell out to larger competitors and investment banks. The largest 100 hedge funds control approximately 70% of invested assets, up from less than 50% at the end of 2003, according to the Wall Street Journal.

The President's Working Group on Financial Markets has created two advisory groups to develop best practices for hedge fund investors and managers. These advisory groups are developing due diligence guidelines for investors including the types of information that investors should receive and what valuation and performance data should management divulge. Results are expected in the first quarter of 2008. In a similar vein, the European Hedge Fund Working Group is developing a framework for voluntary global disclosure, and operating practices to stave off calls for statutory regulation of the industry.

In a changing regulatory environment the U.S. Securities and Exchange Commission and other regulatory bodies are increasing scrutiny of alternative investment vehicles, as well as the basis for statutory exclusions and safe harbor provisions that enable these vehicles to avoid various security regulations.

The SEC continues to push for increased hedge fund investment disclosure, particularly in private investments in public equity (PIPE) deals where it is requesting information about finders, brokers, promoters as well as fund employee conflicts of interest in PIPE deals.

Credit rating agencies are conducting their own due diligence exercises to support credit rating assignments to post-initial public offering hedge fund and private equity vehicles.

In this changing competitive and regulatory environment it is important for fund managers to get ahead and stay ahead of this demand for information as investors and regulators will comparatively assess ability to respond efficiently and effectively versus peer entities. Therefore, in the interest of sound management, alternative investment managers should develop practices to minimize response time while maintaining consistency in disclosures to investors and regulators.

In our experience, the volume of documentation required can be very large, putting managers at risk of straining organizational resources to meet data requests from multiple parties. The table below outlines the categories of documentation generally requested by the various parties. The actual number of documents will vary, but will likely be in excess of several hundred. Most organizations underestimate the time and resources required to develop consistent data and maintain version control for this level of documentation. Proactive managers understand this challenge and are taking a strategic approach to developing processes for creating, cataloguing, storing and disseminating proprietary information in a controlled manner. Efficiency is especially important because, unlike buyers, sellers want to limit the time and resources required for these exercises.

In many cases an organization will have to start from scratch, developing policies and procedures documentation designed to meet third-party requirements. Selective high-level operational reviews and process mapping should be done to improve the quality and clarity of the data. These time-consuming exercises can, if not well focused, be a strain on management resources. Prior preparation is vital to meet realistic timetables. At the very least, thought should be given to developing a process for the maintenance and updating of existing information, as well as protocols for its dissemination. This will lessen the likelihood of inadvertent disclosure of essential or proprietary information.

A fundamental step in sell-side due diligence preparation is the creation of a central document repository with appropriate security and access controls, time stamping and version control. Some clients achieve this with commercially available document management tools, while others prefer to build it themselves within the LAN environment. Roles and responsibilities should be developed to facilitate document capture and sign-off, internal and external legal counsel review, final authority to release and ongoing maintenance of the documentation.

It is clear that both the investors' and regulators' appetite for increasing levels of financial and operational disclosure from alternative investment vehicles is not abating. Better preparation and packaging of disclosure documentation will increase response time and minimize strain on the organization.

Due Diligenge: What do They Want?

Typical data requested by investors and regulatory bodies include:
corporate records and company structure
securities
financial documents
asset valuation policies and procedures
credit arrangements
material contracts
intellectual property
management and employees
property and equipment
systems
litigation and other contingent liabilities
risk management and compliance procedures
regulation
taxes
sales, marketing and distribution
business and strategy

A summary of the key points:

1. The level of disclosure for hedge funds, private equity firms and other alternative investment vehicles is rapidly increasing due to increased interest by investors, and calls for enhanced regulatory oversight.
2. Disclosure requests are comprehensive in nature and will be disruptive to organizations that are not prepared. Clients should proactively prepare for these requests to minimize the effect on the organization, and overall response time. This will reflect positively on the organization when compared to less organized peers.
3. Organizational roles and responsibilities should be defined, and a document repository tool developed.