The recent story broken by the Miami Herald on JES Capital highlights how important it is for institutional investors to conduct thorough operational due diligence (ODD) for all alternative investments including private equity. In this case, allegations claim JES forged signatures on subscription agreements totaling $85 million to secure a subscription line of credit.

While subscription credit facilities are commonplace, they do expose limited partnerships (LP) to risk. As the National Law Review notes, “In the JES case, the key question is who ultimately bears responsibility for repayment of the fund’s debt. If there are genuine investors in the fund, then under typical documentation such investors will be obligated for the debt of the fund on a pro rata basis up to the amount of their unfunded capital commitments. This would depend on the exact wording of the fund’s limited partnership agreement, but it is not unusual for investors to be required to fund drawdown notices without set-off, counterclaim or defense.”

By vetting the operating infrastructure of the fund, the investor will identify inadequate internal processes or red flags that may foreshadow potentially nefarious behavior.

Prospective LPs can mitigate the risk of investing in a potential fraudulent situation by performing a thorough operational due diligence. By vetting the operating infrastructure of the fund, the investor will identify inadequate internal processes or red flags that may foreshadow potentially nefarious behavior. For JES, a background check likely would have found that Elliot Smerling filed for bankruptcy in 1993.

What does a good diligence process consist of?

A good diligence process includes a review of manager documents and policies to gain an understanding of operations, valuation policy, lifecycle of a trade, IT infrastructure and compliance. Once the ODD team understands the basic operating setup, it should conduct meetings with key personnel including the chief financial officer (CFO), chief compliance officer (CCO), chief operating officer (COO) and head of trading to determine the institutional quality of operations. The objective of these meetings is to ensure implementation of written policies, adequate internal controls and proper segregation of duties.

The ODD team should study changes in assets under management, capital commitments, the ownership structure, key hires and departures, compensation structures, strategic plans and other material issues. 

Key ODD questions include:

  • Are any of the terms in the offering memorandum outside industry standard? 
  • What are the details of key vendor relationships?

A thorough examination includes a background check on the manager and key employees, and verification of third-party service provider relationships. Operational due diligence should not stop after the initial diligence. In addition to an annual review, ODD consists of ongoing manager monitoring including an investigation of any updated documents, regulatory filings and audited financial statements.

Operational due diligence for LP investments in private equity funds is catching up to more refined checklists for hedge funds. In 2018, the Institutional Limited Partners Association, which is focused on private equity, issued a revised 29-page Due Diligence Questionnaire. A completed DDQ is not a rubber stamp. Diligence starts here, but red flags should be probed and background checks conducted to avoid ill-fated investments.

The challenge for many institutional investors is lack of sufficient resources or expertise to properly perform operational due diligence. Fortunately, there are providers with both the scale and know-how to do this critical review.

Did you know that nearly half (47%) of institutional investors recently polled use multiple systems for investment processing and their staff uses offline spreadsheets for some manual processes?

Sample due diligence report overview to be released soon.

Request your sample operational due diligence report overview, including all the relevant components of an effective review of an investment manager’s operations. Fill in this brief form, and we'll email your copy as soon as it is released. 

Request the Sample Report Overview

Join the Investment Office Roundup

Get the latest perspectives for in-house executives


I understand SEI may send future emails to me, even if I opted-out before, and that I can opt-out again later.
Photo: Patrick Carlevato blogs for the Investment Office Roundup

Legal Note

This information is provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company (SEI). Investing involves risk including possible loss of principal. There can be no assurance that your investment objectives will be achieved nor that risk can be managed successfully. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be interpreted as legal opinion or advice.