JASON A. SCHARFMAN is a Managing Partner at Corgentum Consulting. He performs operational due diligence reviews of hedge funds, private equity, and real estate funds on behalf of institutional investors, pensions, high net worth individuals, and ERISA plans. Prior to forming Corgentum, he was the Director of Operational Risk at Graystone Research (Morgan Stanley). As Director, he was responsible for managing global operational risk assessment for all U.S., Asian, and European funds. His articles have appeared in Pension & Investments and FINAlternatives.com. He also teaches a course at New York University, has consulted with the U.S. House Judiciary Committee on the subject of hedge fund and private equity regulation, and provided training to financial regulators on the subject of hedge fund and private equity due diligence.

• Preface xiiiChapter 1 Introduction to Private Equity Operational Risk 1Introduction to Operational Risk 1Operational Risk Compared to Operational Due Diligence 3What Is Operational Due Diligence? 4Operational Due Diligence in the Field of Private Equity 8Operational Due Diligence as Distinguished from Operational Management of Portfolio Companies 9Timing of Operational Due Diligence in the Investing Process 10Operational Due Diligence Process 13Historical Perspectives of Private Equity Operational Risk 16Items Typically Covered during the Operational Due Diligence Process 23Core versus Expanded Operational Due Diligence Reviews 25Shared Commonalities between Private Equity and Real Estate Operations Risk 30Differences in Operational Risk Factors between Private Equity and Real Estate 32Country- and Industry-Specific Risk Considerations 33Investment and Operational Due Diligence: Nexus or Blurred Lines? 39Differences and Similarities with Hedge Fund Operational Due Diligence 40Notes 49Chapter 2 Importance of Operational Due Diligence for Private Equity Funds 51Understanding the Goals of the Operational Due Diligence Process 52Common Arguments against Operational Reviews of Private Equity Funds 55Common Arguments in Favor of Performing Operational Reviews of Private Equity Funds 75Conclusion 82Notes 82Chapter 3 Beginning the Operational Due Diligence Review: Core Issues 85Goal Self-Assessment 85Designing an Operational Due Diligence Program for Private Equity 87When Does the Operational Due Diligence Process Begin? 101Signaling Effects of Operational Flags 104Requesting and Collecting Documentation 104Nondisclosure and Confidentiality Agreements 106Document Collection: What Documents Should Investors Request? 113Document Collection Negotiation Techniques: Avoiding a Pass-the-Buck Environment 117Document Collection: Hard Copy or Electronic? 119Fund Manager On-Site Due Diligence Considerations 125Key Risk Consideration Areas to Cover 128Conclusion 133Notes 133Chapter 4 Additional Operational Due Diligence Considerations: An Expanded Analysis 135Core Issues versus Expanded Analysis 135Compensation Structures 138Introduction to Private Equity Fund Fees 139Manager Investment in Funds 140Evaluating Service Providers 141Additional On-Site Visit Considerations: Negative Operational Due Diligence 148Additional On-Site Visit Considerations: Interview Techniques and Question Design 150Asset Raising and the Use of Placement Agents and Third-Party Marketers 159Cash Management and Controls 162Business Continuity and Disaster Recovery 165Understanding the Trade Life Cycle Process 168Legal, Compliance, and Regulatory Risks 171Insurance 173Technology and Systems 174Tax Practices 175Diagnosing and Mitigating Reputational Risk 177Conclusion 179Notes 179Chapter 5 Valuation Techniques, Methodologies, and Standards 181Limited Partner Distinction between Fund Level and Portfolio Company Valuation Approaches 181Valuation Considerations for Newly Formed Funds 182Introduction to Valuation 182GIPS Statement on Private Equity 183IPEV Guidelines 185Fas 157 189Use of Third-Party Valuation Consultants 191Valuation Output Process Documentation 194Valuation Committee Review Scope 196Additional Limited Partner Valuation Considerations 197Conclusion 197Notes 198Chapter 6 Legal Due Diligence 199Operational Due Diligence Specialists versus Generalists 199Common Private Equity Fund Structures 201Understanding the Private Placement Memorandum 201Common Document Risk Assignment Terms 206Exculpation and Indemnity 206Trends in Indemnification and Exculpation Clauses 217Other Legal Documents Considerations 227Conclusion 228Notes 228Chapter 7 Financial Statement Due Diligence 233Audit Standards 233Accounting Standards 235Other Financial Statement Formats 237Considerations That Are Unique to Private Equity and Real Estate Financial Statements 241Understanding Financial Statement Sections 244Other Financial Statement Sections 245Understanding FAS 157 251Conclusion 254Notes 254Chapter 8 Distinguishing the Assets Class: Real Estate–Specific Concerns 257Real Estate Trade Flow Process 257Sample Real Estate Process 258Real Estate Valuation 262Monitoring Conflicts of Interest 266Fraud Considerations: Mortgage Fraud and Straw-Man Borrowers 269Understanding Real Estate Fund Fees 270Property Holdings Legal Considerations 271Conclusion 272Note 273Chapter 9 Putting It All Together: Asset Allocation and Ongoing Monitoring 275Incorporating the Results of Operational Due Diligence into Asset Allocation 276Evolution of Minimum Operational Risk Regime (MORR) 283Operational Risk Correlations to Portfolio Transaction Frequency 285Operational Lift-to-Drag Ratio 286Negotiating Private Equity Side Letters 290Ongoing Monitoring: Operational Due Diligence Monitoring for Private Equity Funds 292Conclusion 296Appendix: Mathematical Conepts 297The Derivative 297The Chain Rule 298The Second Partial Derivative Test 299Notes 300Chapter 10 Boards, Committees, and Activism 301Private Equity Fund Advisory Boards 301Different Types of Advisory Boards: Limited Partners versus Pure Advisors 302Ongoing Operational Due Diligence Monitoring Advisory Benefits 303Balancing the Role of Inner Circle versus Broadly Representative Advisory Boards 305Advisory Board Criticisms: Crowding Out, Power Aggregation, and Redundant Board Layers 306Information Flow Considerations from Underlying Portfolio General Partner to Limited Partners 307Limited Partner Due Diligence Considerations for a Private Equity Fund of Funds 308Additional Private Equity Advisory Board Considerations 311Conclusion 313Notes 313Chapter 11 Case Studies and Scenarios 315Case Studies 315Hypothetical Scenarios 326Notes 335Chapter 12 Trends and Future Developments 341Use of Third-Party Administrators 341Increased Focus on Material Nonpublic Information in the United States 345Increased Reliance on Audit-Type Certifications 348Increased Use of Operational Due Diligence Consultants 350Pooling Operational Due Diligence Resources among Multiple LPs 352Operational Benchmarking 353ILPA Guidelines 354From Self-Regulation to Mandatory Registration 355Impact of Dodd-Frank on Operational Due Diligence 356Conclusion 357Notes 358About the Author 359About the Website 361Index 363

JASON A. SCHARFMAN is a Managing Partner at Corgentum Consulting. He performs operational due diligence reviews of hedge funds, private equity, and real estate funds on behalf of institutional investors, pensions, high net worth individuals, and ERISA plans. Prior to forming Corgentum, he was the Director of Operational Risk at Graystone Research (Morgan Stanley). As Director, he was responsible for managing global operational risk assessment for all U.S., Asian, and European funds. His articles have appeared in Pension & Investments and FINAlternatives.com. He also teaches a course at New York University, has consulted with the U.S. House Judiciary Committee on the subject of hedge fund and private equity regulation, and provided training to financial regulators on the subject of hedge fund and private equity due diligence.

• Preface xiiiChapter 1 Introduction to Private Equity Operational Risk 1Introduction to Operational Risk 1Operational Risk Compared to Operational Due Diligence 3What Is Operational Due Diligence? 4Operational Due Diligence in the Field of Private Equity 8Operational Due Diligence as Distinguished from Operational Management of Portfolio Companies 9Timing of Operational Due Diligence in the Investing Process 10Operational Due Diligence Process 13Historical Perspectives of Private Equity Operational Risk 16Items Typically Covered during the Operational Due Diligence Process 23Core versus Expanded Operational Due Diligence Reviews 25Shared Commonalities between Private Equity and Real Estate Operations Risk 30Differences in Operational Risk Factors between Private Equity and Real Estate 32Country- and Industry-Specific Risk Considerations 33Investment and Operational Due Diligence: Nexus or Blurred Lines? 39Differences and Similarities with Hedge Fund Operational Due Diligence 40Notes 49Chapter 2 Importance of Operational Due Diligence for Private Equity Funds 51Understanding the Goals of the Operational Due Diligence Process 52Common Arguments against Operational Reviews of Private Equity Funds 55Common Arguments in Favor of Performing Operational Reviews of Private Equity Funds 75Conclusion 82Notes 82Chapter 3 Beginning the Operational Due Diligence Review: Core Issues 85Goal Self-Assessment 85Designing an Operational Due Diligence Program for Private Equity 87When Does the Operational Due Diligence Process Begin? 101Signaling Effects of Operational Flags 104Requesting and Collecting Documentation 104Nondisclosure and Confidentiality Agreements 106Document Collection: What Documents Should Investors Request? 113Document Collection Negotiation Techniques: Avoiding a Pass-the-Buck Environment 117Document Collection: Hard Copy or Electronic? 119Fund Manager On-Site Due Diligence Considerations 125Key Risk Consideration Areas to Cover 128Conclusion 133Notes 133Chapter 4 Additional Operational Due Diligence Considerations: An Expanded Analysis 135Core Issues versus Expanded Analysis 135Compensation Structures 138Introduction to Private Equity Fund Fees 139Manager Investment in Funds 140Evaluating Service Providers 141Additional On-Site Visit Considerations: Negative Operational Due Diligence 148Additional On-Site Visit Considerations: Interview Techniques and Question Design 150Asset Raising and the Use of Placement Agents and Third-Party Marketers 159Cash Management and Controls 162Business Continuity and Disaster Recovery 165Understanding the Trade Life Cycle Process 168Legal, Compliance, and Regulatory Risks 171Insurance 173Technology and Systems 174Tax Practices 175Diagnosing and Mitigating Reputational Risk 177Conclusion 179Notes 179Chapter 5 Valuation Techniques, Methodologies, and Standards 181Limited Partner Distinction between Fund Level and Portfolio Company Valuation Approaches 181Valuation Considerations for Newly Formed Funds 182Introduction to Valuation 182GIPS Statement on Private Equity 183IPEV Guidelines 185Fas 157 189Use of Third-Party Valuation Consultants 191Valuation Output Process Documentation 194Valuation Committee Review Scope 196Additional Limited Partner Valuation Considerations 197Conclusion 197Notes 198Chapter 6 Legal Due Diligence 199Operational Due Diligence Specialists versus Generalists 199Common Private Equity Fund Structures 201Understanding the Private Placement Memorandum 201Common Document Risk Assignment Terms 206Exculpation and Indemnity 206Trends in Indemnification and Exculpation Clauses 217Other Legal Documents Considerations 227Conclusion 228Notes 228Chapter 7 Financial Statement Due Diligence 233Audit Standards 233Accounting Standards 235Other Financial Statement Formats 237Considerations That Are Unique to Private Equity and Real Estate Financial Statements 241Understanding Financial Statement Sections 244Other Financial Statement Sections 245Understanding FAS 157 251Conclusion 254Notes 254Chapter 8 Distinguishing the Assets Class: Real Estate–Specific Concerns 257Real Estate Trade Flow Process 257Sample Real Estate Process 258Real Estate Valuation 262Monitoring Conflicts of Interest 266Fraud Considerations: Mortgage Fraud and Straw-Man Borrowers 269Understanding Real Estate Fund Fees 270Property Holdings Legal Considerations 271Conclusion 272Note 273Chapter 9 Putting It All Together: Asset Allocation and Ongoing Monitoring 275Incorporating the Results of Operational Due Diligence into Asset Allocation 276Evolution of Minimum Operational Risk Regime (MORR) 283Operational Risk Correlations to Portfolio Transaction Frequency 285Operational Lift-to-Drag Ratio 286Negotiating Private Equity Side Letters 290Ongoing Monitoring: Operational Due Diligence Monitoring for Private Equity Funds 292Conclusion 296Appendix: Mathematical Conepts 297The Derivative 297The Chain Rule 298The Second Partial Derivative Test 299Notes 300Chapter 10 Boards, Committees, and Activism 301Private Equity Fund Advisory Boards 301Different Types of Advisory Boards: Limited Partners versus Pure Advisors 302Ongoing Operational Due Diligence Monitoring Advisory Benefits 303Balancing the Role of Inner Circle versus Broadly Representative Advisory Boards 305Advisory Board Criticisms: Crowding Out, Power Aggregation, and Redundant Board Layers 306Information Flow Considerations from Underlying Portfolio General Partner to Limited Partners 307Limited Partner Due Diligence Considerations for a Private Equity Fund of Funds 308Additional Private Equity Advisory Board Considerations 311Conclusion 313Notes 313Chapter 11 Case Studies and Scenarios 315Case Studies 315Hypothetical Scenarios 326Notes 335Chapter 12 Trends and Future Developments 341Use of Third-Party Administrators 341Increased Focus on Material Nonpublic Information in the United States 345Increased Reliance on Audit-Type Certifications 348Increased Use of Operational Due Diligence Consultants 350Pooling Operational Due Diligence Resources among Multiple LPs 352Operational Benchmarking 353ILPA Guidelines 354From Self-Regulation to Mandatory Registration 355Impact of Dodd-Frank on Operational Due Diligence 356Conclusion 357Notes 358About the Author 359About the Website 361Index 363