Private Fund Due Diligence: A Checklist For Reviewing Governing Documents And Operational Controls

For most of our history, the domain of the financial advisor has been helping clients to invest their savings in publicly traded stocks and bonds that create opportunities for long-term growth, in order to achieve clients’ retirement and other savings goals. While the particular vehicles have changed over time – from individual securities, to mutual funds, to exchange-traded funds – the underlying continuity has been that all of these issuers are registered with and are subject to the reporting standards of the Securities and Exchange Commission (SEC), which mandates detailed and extensive disclosures about the issuer, its business, and the securities being offered. More recently, as companies are staying private longer and issuing more private equity and debt, private investments and funds have proliferated, and more and more advisory firms are now exploring whether to add allocations of private funds into their client portfolios. However, without the rigorous disclosures required of issuers because of SEC registration and reporting, it is significantly harder for advisors to conduct due diligence on private funds, which present investment and legal risks not typical for most public investments.

In this guest post, Rich Chen, founder of Brightstar Law Group, explores the practical due diligence considerations that advisors must navigate when considering a private fund investment, with a particular focus on what to look for in governing documents and the operational systems of the private fund.

The starting point in due diligence is to recognize that what is stated in legal governing documents can differ quite significantly from a private fund’s marketing materials, as the latter is written to attract investors to the fund by focusing on the opportunities, while the former is written to minimize the risks for the fund sponsor (and thus more clearly articulates the rights of investors who put dollars into the fund). Accordingly, a detailed review of governing documents can highlight conflicts of interest (e.g., between the fund sponsor and affiliated parties), reveal restrictions on an investor’s ability to exit the fund investment (which can often be significant), identify red-flags regarding indemnification provisions, and detail how expenses will be allocated between investors and fund management. In addition, due diligence of governing documents provides an opportunity to ask about “side letters” to determine if other investors might have preferential or different rights or return opportunities.

Beyond due diligence of legal documents, it’s also important to evaluate a private fund’s operational systems, and how effectively they are built to protect investors. For instance, does the private fund segregate key functions, ensure dual authorizations for disbursements, use an outside custodian or separate accounting firm, and conduct annual audits? These measures can significantly mitigate risks of fraud or misappropriation by the manager or its personnel. Similarly, advisors can inquire about the firm’s cybersecurity and client data protections, engage in background checks of the fund sponsor’s history (to ensure no prior legal issues or enforcement actions!), and determine how the firm values its assets (especially in cases where it calculates carried interest or other management fees based on those valuations).

Ultimately, Chen provides a due diligence checklist to help support the process, though notably it’s not enough to just ‘mechanically’ complete a checklist; instead, the SEC expects to see advisors showing contemporaneous documentation that they were thoughtful in their questions and evaluation of the answers provided, to demonstrate robustness of the process itself – for which advisors may even wish to engage outside providers to support in due diligence (especially if their internal resources are limited). The growth of companies in the private markets represents a significant opportunity for clients to invest, but those who are accustomed to the natural protections the SEC has built into public markets need to be cognizant that there are unique risks of private equity and debt funds that, at the least, require a substantive proactive due diligence process from financial advisors (with the SEC increasingly applying enforcement actions against advisory firms that “just” relied on the marketing materials and representations of the private fund sponsor alone).