Interview With Jason Scharfman, Author of Private Equity Due DiligenceVW Staff
We are pleased to present our interview with Jason Scharfman, the author of a new book titled on Private Equity. Jason was kind enough to sit down and talk about his experience, his book, and views on the industry. His full bio is at the bottom of this article.
What inspired you to write the book?
While both individual and institutional investors had performing due diligence on their hedge fund investments before frauds such as Bayou and more recently Madoff, after the Madoff crisis a number of investors started to refocus their efforts around operational issues such as traditional back office procedures such as trade processing and cash management, as well as valuation, custody, compliance, business continuity and disaster recovery and service providers. Many investors were seeking guidance in this area as to what items were standard to cover during an operational due diligence review. That was the impetus behind my first book of Hedge Fund Operational Due Diligence.
Although there has been no similar Madoff like major fraud in recent years in the private equity world, many investors have seen the merits of performing operational due diligence reviews on all fund managers. While some investors may have viewed hedge funds as the riskiest parts of their portfolios, more investors are beginning to realize that private equity funds can be equally fraught with operational risks. There has been an increasing interest among investors seeking to perform deep dive operational review on private equity funds. This is especially important when investors realize there have been a series of historical private equity frauds as well.
Due to the unique aspects of private equity, many investors face questions about how to perform comprehensive operational due diligence reviews of private equity funds. My new book, Private Equity Operational Due Diligence, provides investors with the tools to develop an operational due diligence program which addresses the unique risks of private equity investing.
Can you discuss the various structures of private equity firms?
Private Equity has now become a political issue with attacks on Mitt Romney and Bain Capital? Do you think private equity is a positive for society? Any thoughts on Bain in particular?
As with most types of investments there are political and economic ramifications which may result. Private equity is no different and, while certain private equity investing may have negative consequences such as job loss, private equity investing can also promote entrepreneurship and job creation as well.
What do you think of a lot of IPOs lately by Private Equity and asset management firms?
IPOs by asset managers such as BlackRock, Inc. (NYSE:NLK), Man Group Plc (LON:EMG) and the Carlyle Group LP (NASDAQ:CG) often serve multiple functions including providing these firm’s with equity financing. Overall at Corgentum Consulting we believe that IPOs are a positive development for the industry because as publicly traded companies, these entities are subject to additional oversight and regulations such as Sarbanes Oxley. This fosters an environment of increased transparency which is good for the overall private equity and larger asset management industry.
You mention that General partners of private equity firms have not always been the best operators. The interviewee would agree without stating more, would you expand on this?
General Partners have not necessarily been placed under the same scrutiny as their counterparts in regards to their operational infrastructures. This has perhaps been facilitated by a lack of interaction between Limited Partners and General Partners as compared to hedge funds. As such, even Limited Partners who may have criticisms of certain General Partner operational practices have not necessarily may have had their opinion fall on deaf ears. These criticisms may have ranged from the types of fund accounting systems utilized, and questions about the service providers the fund works with such auditors and fund administrators to compliance or valuation concerns. Now as more investors are shinning a spotlight on General Partner operational activities, Limited Partners are being forced to pay more attention to these issues.
How important is the ‘back office’, which is a derogatory firm used by most on Wall Street, vital to the firm?
The term back office should not be viewed as a derogatory term. Without a strong back office even the most brilliant money manager could not succeed. The back office of a private equity firm is the support system which allows investment professionals to focus on generating alpha. Without it private equity funds would not be able to trade and capital could not be called. Furthermore, an efficient back office can actually enhance returns.
Is there a difference between small private equity firms, large ones like Carlyle, and big banks with private equity divisions?
From an operational perspective there are notable differences between small and large private equity firms. These differences can include scalability of operational processes and rigorousness of operational policies and procedures in place. Similar differences exist between firm’s which tend to focus on private equity and private equity divisions of large banks such as Goldman Sachs Group, Inc. (NYSE:GS). In these cases, investors should understand how the private equity division functions and what larger operational concerns may be in place.
Can you discuss fraud in the industry? Can regulators prevent this? Can institutional investors avoid this?
My firm Corgentum Consulting, is of the opinion that fraud cannot be modeled. The next fraud will be different than previous frauds. In certain cases frauds might share common elements but each fraud presents a unique set of facts and circumstances. Regulators cannot prevent every possible instance of fraud but by performing a consistent set of due diligence procedures on fund managers they can take steps which are likely to detect yellow flag and red flag operational issues which might be representative of fraud. Institutional investors can take similar steps in attempts to detect and avoid fraud. Many firms might not have the internal capabilities or expertise to conduct comprehensive multi-disciplinary operational due diligence reviews of private equity funds. In these cases working with specialty operational due diligence consultants such as Corgentum Consulting can add value.
You mention a stunning amount of fraud in offering memorandums; can you elaborate for the readers?
To clarify the book focuses not so much on fraud in offering memorandums, but the often high legal standards General Partners put in place in fund legal documents to prove either fraud, recklessness or negligence. The point of this discussion in the book is that the General Partners often indemnify themselves from certain types of activities in the offering memorandum in
different ways, and only through due diligence which includes not only reading the legal documentation but discussing the terms with the manager, will an investor be able to determine what the standards actually are and what the fund manager’s intentions in implementing such standards were.
That being said, there are historical instances of fund managers making certain fraudulent claims in offering memorandum such as fraudulent relationships with legal counsel or other service providers, or even misstating an investment strategy.
Can you discuss a case study from the book or mention signs investors might notice of possible fraud?
One case study presented in the book is the case of private equity fraud is Danny Pang’s PEMGroup Fraud. Some key items which might have been detecting during the investor operational due diligence process which might raise flags as signs of possible fraud include:
* Mr. Pang’s questionable educational credentials
* Mr. Pang’s previous terminations from another asset management firm related to allegations of theft and misusing brokerage accounts
* Reputational issues including reported lavish personal expenditures
* Media reports which raised questions concerning Mr. Pang’s operations
* Mr. Pang’s questionable claims of “guaranteed” investment performance and further questions surrounding operational processes at his firm including cash controls
Does private equity have more fraud problems than other industries?
Due to the often larger individual investment sizes and smaller number of positions private equity investing can present a greater likelihood of fraud then other industries. The reason in part also relates in part to liquidity. Private equity investments tend to be more illiquid. When there is a lack of independence in the valuation in these illiquid investments, there is a greater potential for fraudulent activity.
There has been a lot of regulation on hedge funds, banks etc. why do you think Private Equity has not been a major topic?
Despite the size of the industry, from a regulatory perspective private equity it seems has often been lumped together as a bit of an afterthought with other types of investments such as hedge funds. Perhaps private equity has flown under the radar from a regulatory perspective because there hasn’t been a large scale blowup in recent years and therefore, the political will is not there to focus in on this industry.
Additionally, due to the nature of private equity trading activities, the argument could be made that they have been less of a major player in moving markets one way or another as compared to their hedge fund counterparts. Therefore, it is easier perhaps for regulators to focus on hedge funds as opposed to private equity due to this increased trading frequency,
What do you think about the recent controversy about Private Equity firms valuing private assets?
Private equity valuations will continue to be topic which receives much interest. Regardless of the approach followed from an investors perspective the most important factors in evaluating the valuation process of General Partners should be:
1) Is there sufficient independent oversight of General Partner valuations?
2) Is there transparency into the valuation process?
If investors can answer these questions then they are on the road to ensuring that they have properly vetted a General Partner’s valuation processes. This should also be complimented by ongoing monitoring of valuations which can be accomplished through the ongoing operational due diligence.
You talk about the future of private equity; do you think it will be dramatically different than today’s landscape?
Yes, the future of the private equity industry will definitely be dramatically different in the future however, this will take time to evolve. As more investors continue to perform due diligence on private equity operations, similar to the hedge fund industry, General Partners will be forced to improve their operations. This will result in more transparent and more efficient private equity firms.
Who is this book aimed for? Private Equity professionals? Institutional investors? Retail investors?
This book is aimed at multiple types of private equity participants.
Limited Partners can benefit from this book by learning how to develop an operational due diligence program for private equity funds. Additionally this book provides guidance for both retail and institutional investors to incorporate operational due diligence into their existing due diligence programs.
By reading this book private equity professionals will learn not only what is considered best practice with regards to operations, but also how investors will go about evaluating operational risk at private equity firms.
Also, private equity fund service providers can also benefit from this book by learning in more detail how private equity firm’s operate as well as the types of operational questions investors may ask when evaluating these firms.
Jason Scharfman is the Managing Partner of Corgentum Consulting, LLC. He is recognized as one of the leading experts in the field of hedge fund operational due diligence and is the author of Hedge Fund Operational Due Diligence: Understanding the Risks (John Wiley & Sons 2008) and the forthcoming Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation and Documentation (John Wiley & Sons 2012).
Before founding Corgentum, he previously oversaw the operational due diligence function for a $6 billion alternative investment allocation group called Graystone Research at Morgan Stanley. While at Morgan Stanley, Mr. Scharfman was also a senior member of a team which oversaw all of Morgan Stanley’s hedge fund operational due diligence efforts allocating in excess of $13 billion to a firm-wide platform of over 300 hedge fund managers across multiple investment strategies. Prior to joining Morgan Stanley, he held positions which primarily focused on due diligence and risk management within the alternative investment sector at Lazard Asset Management, SPARX Investments and Research and Thomson Financial.
Mr. Scharfman received a B.S. in Finance with an additional major in Japanese from Carnegie Mellon University, an M.B.A. in finance from Baruch College’s Zicklin School of Business and a J.D. from St. John’s School of Law. He is admitted to the practice of law in New York and New Jersey. Additionally, he holds the Certified Fraud Examiner (CFE) and Certified in Risk and Information Systems Control (CRISC) credentials. He has consulted with the U.S. House Judiciary Committee on the subject of hedge fund regulation. Additionally, he has provided training to financial regulators on the subject of hedge fund due diligence. Mr. Scharfman has served as a consultant and testified as an expert in hedge fund litigation, and has lectured on the subject of hedge fund operations and operational risk as an adjunct professor at New York University. He has written extensively on the subject of operational due diligence and travels and speaks worldwide on hedge fund operational risks.