Jason A. Scharfman - Private Equity Operational Due Diligence, + Website: Tools to Evaluate Liquidity, Valuation, and Documentation

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding.

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.

For a list of available titles, visit our Web site at www.WileyFinance.com .

Copyright 2012 by Jason A. Scharfman. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com . Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions .

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com .

Library of Congress Cataloging-in-Publication Data:

Scharfman, Jason A., 1978

Private equity operational due diligence : tools to evaluate liquidity, valuation, and documentation / Jason A. Scharfman.

pages cm. (The Wiley finance series ; 731)

Includes bibliographical references and index.

ISBN 978-1-118-11390-5; ISBN 978-1-118-22416-8 (ebk);

ISBN 978-1-118-23747-2 (ebk); ISBN 978-1-118-26243-6 (ebk)

1. Private equity. 2. Real estate investment. 3. Reasonable care (Law) I. Title.

HG4751.S33 2012

332.632dc23

2011048538

I dedicate this book to my wife, Rachel, for her endless support, to my brother, Barry, to my parents, Gloria and Michael, and to my entire family for their never-ending encouragement.

Preface

People tend to not take operational due diligence in the field of private equity very seriously. The risk category that operational due diligence is supposed to evaluateoperational riskis not as narrowly defined as other related types of risks, such as credit risk, counterparty risk, currency risk, and so forth. Depending on the context, the implications of the term operational risk can change. In part, the broadness of the field and subsequent confusion about exactly what is meant when discussing operational risk and operational due diligence are likely contributing factors to the lack of attention paid to this risk category.

When an investor first decides to take the plunge into private equity investing, it is often an anticlimactic choice. In some cases, hundreds of millions of dollars are committed by institutional Limited Partners (LPs) to private equity funds, but the money may not generate returns for years. Yet, with such a long-term commitment of capital into a traditionally illiquid and complex asset class, it would seem only logical that LPs would seek to perform at least as rigorous a due diligence analysis on a private equity fund as they perform on other asset classes, such as hedge funds. In investing arenas outside of private equity, operational due diligence has slowly gained acceptance over the years. Within the alternative investment arena in general and hedge funds in particular, a key driver of increased focus is the losses that have been caused by fraudulent activity, which in turn was facilitated by weak operations. In recent memory, investors have seen a number of headlines and articles about the hundreds of millions in losses associated with names such as Bernard Madoff, R. Allen Stanford, Jerome Kerviel, Tom Petters, and Samuel Israel III, which help to explain the meteoric rise in interest in operational due diligence in the alternative space. Even as this book is being written, alleged UBS rogue trader Kewku Adoboli has been charged with fraud that resulted in a loss of over $2 billion. Because of a series of similar private equity frauds, LPs and, however begrudgingly, General Partners (GPs) have begun to respect the need for private equity operational due diligence.

But operational due diligence involves a great deal more than fraud detection. Sometimes honest GPs and LPs simply do not have the requisite skills, resources, or foresight to avoid underperformance or losses due primarily to operational concerns. Proper operational risk management within a fund is not simply a matter of throwing experience or money at the problem. Rather, operational risk evolves within a fund organization over time. To effectively manage its own internal operational risk exposure, a fund's management must be actively involved in all aspects of operations oversight. At different times and during different types of market events, private equity funds may react differently and the ensuing consequences may not be uniform for their internal fund operations.

Operational due diligence is an ongoing diagnostic process. Much like private equity investing itself, however, operational due diligence on private equity investments requires a measured dose of patience. Due diligence can be more art than science, and a thorough analysis will allow investors to detect funds that will have an increased likelihood for underperformance or for failure in the event of unexpected stresses.

This book seeks to accomplish several goals, but in particular the author wishes to convince LPs of the benefits of designing, performing, and maintaining a robust operational due diligence program for private equity funds. To support this cause, I have outlined a brief history of operational risk coupled with an introduction to the unique aspects of operational due diligence on private equity funds.