CAIA L2 - 8.5 - Due Diligence of Terms and Business Activities Flashcards
List
Types
of documents collected
(in a DD)
8.5 - Due Diligence of Terms and Business Activities
-
Legal documents specific to the fund
(e.g., LP agreements and articles of association)
Legal and compliance documents specific to the firm
(e.g., code of ethics and compliance manual), -
Financial documents
(e.g., audited financial statements) -
IT (Information Technology + Other (Marketing communications) documents
(e.g., policy manual, valuation policies/procedures, organizational charts, business continuity plans, and insurance coverage documents)
’–
Issue: naming convention for documents is not uniform
8.5 - Due Diligence of Terms and Business Activities
List
3 Alternatives for LPs (investors)
if fund manager
does not want the document requested
to leave the premises
(in a DD process)
8.5 - Due Diligence of Terms and Business Activities
often for proprietary and confidentiality reasons
Alternatives:
* Collect sample of entire document (compromise documentation) - a portion or sample of the entire document, such as the table of contents
* Simply analyze the documents as part of the in-person review.
* Request that a GP fill out a due diligence questionnaire related to specific areas of fund operations. In some cases, GPs will have such questionnaires (and associated responses) already completed in advance.
8.5 - Due Diligence of Terms and Business Activities
List
5 common
operational fund committees
8.5 - Due Diligence of Terms and Business Activities
- operations
- valuation
- business continuity and disaster recovery
- best execution
- compliance
8.5 - Due Diligence of Terms and Business Activities
List
6 Common duties
of board members
8.5 - Due Diligence of Terms and Business Activities
- Monitoring the enforcement of any redemption gates
A redemption gate is the means by which a fund can limit the redemptions in a fund during any redemption period. During the financial crisis, many funds and their directors “lowered the gate” on investors to limit fund outflows. - Reviewing and approving a fund’s audited financial statements
- Approving changes to legal documentation
- Approving the manager’s changes to or use of certain mechanisms, such as audit holdbacks. An audit holdback occurs when a manager retains a portion of investors’ redeemed capital prior to audit completion. The holdback acts as a reserve in case the fund’s redemption payment was inaccurately computed.
- Reviewing fund manager valuations and ensuring use of proper valuation techniques
- Evaluating performance of fund service providers and approving new fund service providers
8.5 - Due Diligence of Terms and Business Activities
List
4 Examples
that show how LPs
control GP activities
8.5 - Due Diligence of Terms and Business Activities
- Adding or removing investment restrictions
- Extending the fund duration
- Managing key person–related issues
- Serving on an LP advisory committee (LPAC)
Decisions from LPs can be made either under
* a simple majority (> 50% required) or
* a qualified majority (> 75% required)
Obs:
LPs can lose their limited liability status if are too involved
= may be deemed to be GPs.
8.5 - Due Diligence of Terms and Business Activities
Describe
How
master-feeder trusts
work
8.5 - Due Diligence of Terms and Business Activities
Onshore and offshore investors each use different feeder funds to receive returns from the same master trust
Master Trust
is the trading vehicle that
receives funds from onshore and offshore investors
and is set up for tax efficiency
(purpose = tax neutrality)
Feeder funds
= conduit of master trust to investor / often structured as hedge funds /
8.5 - Due Diligence of Terms and Business Activities
Define
side pocket
arrangement
8.5 - Due Diligence of Terms and Business Activities
When
illiquid investments in a hedge fund (<=side pocket)
are separated from
liquid investments
In this arrangement,
fund’s overall performance excludes the results of illiquid assets
=>
They are not universally accepted because the fund’s overall performance excludes their results.
8.5 - Due Diligence of Terms and Business Activities
Quote
Redemption periods
=>which is most common?
notice period?
lock up period?
Gate
8.5 - Due Diligence of Terms and Business Activities
Redemption periods
quarterly or semiannual is more common
monthly is also used
‘–
notice period
~ 30 to 90 days generally
‘–
lock up period
= or(inception ; each investor initial investment)
lock up ~1-3 years (can get to 10y for PE)
hard lockup period = no withdrawals are permitted the entire time
soft lockup period = redemption permitted paying 1%-5% fee
‘–
Gate =
cap on the permitted withdrawal amount / number
Gates apply at any time after the end of the lockup period
8.5 - Due Diligence of Terms and Business Activities
Define
Private Fund
advisory committees
8.5 - Due Diligence of Terms and Business Activities
Committees
to address fund issues like
* valuation of illiquid assets
* willingness/ability to accept additional investors
=> provide LPs some control.
If too much, LP can be reclassified as GP
8.5 - Due Diligence of Terms and Business Activities
Define
bad-leaver clause
and
good-leaver clause
8.5 - Due Diligence of Terms and Business Activities
bad-leaver clause
* simple majority (> 50% of LPs) to remove a GP for cause and cease investing activity until a replacement manager is found
* no compensation / carried interest for manager
good-leaver clause
* qualified majority (> 75% of LPs) to stop providing funds to the partnership. deisgned to remove a GP without cause and move on to better investment opportunitites
* compensation of 6-12m of management fees to manager
8.5 - Due Diligence of Terms and Business Activities
Define
safe harbor provision
8.5 - Due Diligence of Terms and Business Activities
limit reporting requirements
by keeping the number of investors low
8.5 - Due Diligence of Terms and Business Activities
List
Key functions
of the offering memorandum (OM)
(Private Placement Memorandum - PPM)
8.5 - Due Diligence of Terms and Business Activities
OM = Main legal document
pertaining to the PE fund
- Educating LPs. The OM/PPM will provide details regarding investment strategy, key personnel, and the GP. For PEs, information related to prior vintage-year funds with the same investment objective may also be included.
- Risk disclosure. The main risk disclosure relates to illiquidity and other relevant risks, which should be emphasized and thoroughly discussed in the OM/PPM.
- Risk assignment. Risk assignment covers the ways in which the blame for different risks are attributed to different parties. Two key terms associated with risk assignment include exculpation (absolving someone from responsibility) and indemnification (specific parties are held liable for actions or losses and must provide adequate compensation). Establishing those assignments will alleviate confusion if an error/event occurs and someone must accept the blame. The more detailed and clear the assignments are, the less confusion there will be if a situation occurs. Defining the legal terms will also allow differentiation between actions like gross negligence, deliberate errors, or fraud versus honest errors.
- Assignment of decision-making authority. A carefully written OM/PPM can provide guidelines for investors (prior to committing funds) for resolving issues. It can clarify what constitutes the responsibility of the GP versus the responsibility of the fund. For example, would an inadvertent accounting error that leads to a late fee on a payment to legal counsel be the responsibility of the GP or the fund? Once the rules are in place and documented in the OM/PPM, the best opportunity an investor has to negotiate certain risk assignments with the GP is before committing capital.
’—
Other info:
* fund domicile,
* distribution terms,
* capital and unfunded commitments,
* tax considerations, and
* conflicts of interest, relating to 1. Allocations of investment opportunities between different funds, 2. conflicts due to asset sales, 3. outside business activities
* key person provisions
8.5 - Due Diligence of Terms and Business Activities
Explain
Basic characteristics
of fees collections
(in a fund)
8.5 - Due Diligence of Terms and Business Activities
Period of fee collection:
* in advance (at the start of the period)
* in arrears (at the end of the period) <= preferred by LPs
based on a commitment (rather than invested capital) => avoids bias to invest as quick as possible
in the end => fees are assessed only against capital that remains under management
8.5 - Due Diligence of Terms and Business Activities
Define
Hurt money
8.5 - Due Diligence of Terms and Business Activities
Capital contribution by the GP of the fund’s committed capital
* usual amount = 1% in pure cash
* 99% = LPs
8.5 - Due Diligence of Terms and Business Activities
List
Sections of
fund’s
audited financial statements
8.5 - Due Diligence of Terms and Business Activities
- Opinion letter
- Statement of assets and liabilities (balance sheet)
- Statement of operations (income statement)
- Statement of cash flows
- Statement of changes (capital contributions, allocations, and withdrawals)
- Schedule of investments (investment holdings)
-
Notes ( disclosures and information about the fund ):
- accounting policies
- investments
- commitments and contingencies
- related-party transactions
- subsequent events
8.5 - Due Diligence of Terms and Business Activities
