Operational Due Diligence Provides Assurance for Private Market Transparency

The private market space stands apart as unique from other asset classes in many ways. Valuations require greater investment manager input and are less frequent. The investment timeline is also much longer, with a period of time that can expand into years between when capital is called to when it is distributed. As private market investments grow in popularity with institutional investors, these key differences have led investors to request increased transparency from their private capital managers. This desire for greater transparency accelerated with the onset of the Covid-19 pandemic and market disruptions that have raised uncertainty levels.

Here, Sebastien Sacre, Chief Operating Officer of Northern Trust Private Capital Administration and Vincent Molino, Head of Operational Risk Management Solutions with Northern Trust Front Office Solutions, discuss investor appetite for increased transparency and how operational due diligence can help provide assurances in private market investment practices.

Sebastien Sacre: The private market space has grown tremendously in a few years, and it is expected to grow further yet. The increasing asset allocation to private capital by sovereign wealth funds and pension funds has resulted in investor need for additional transparency and due diligence reviews. Investors are increasingly focused on their liquidity, particularly as the pandemic has taken hold, and really desire a full picture of it, including metrics such as committed capital versus funded capital – which includes the need to know if an investment manager is deploying capital through capital calls or the use of a line of credit. With that, it’s fair to say that the need for increased transparency did not start with the pandemic, but it certainly did exacerbate this trend. When concern over COVID-19 began causing market upheaval in March 2020, investors sought greater liquidity, and with that, greater understanding of the values of their very illiquid private investments.

Vincent Molino: I see the rising pressure for increased transparency as dating back to the adoption of private capital fund administrators after the Global Financial Crisis. Prior to this, fund accounting would mostly occur internally within private capital managers’ back offices. While hedge funds predominantly adopted the use of third- party administrators nearly two decades ago, the private market space has been slower to make it the status quo. Working with a fund administrator greatly increases transparency because, from the operational due diligence (ODD) perspective, having that third-party input and not solely relying on the investment manager is very valuable for our work. When we can also call upon a third party, it lends additional organization, control, and transparency to the review of activities like fund accounting and cash management.

VM: Investors are very focused right now on knowing if and how their investment managers can continue their operations while staff mostly work from home and not in the office. That includes ensuring from a technology perspective, everyone working remotely has the necessary tools to do their jobs. Investors also want to be sure that staff such as portfolio managers or research analysts still have full capabilities to vet new investment deal opportunities for private markets, particularly doing so in a controlled compliance environment, for those managers registered with a regulator like the SEC in the U.S.

SS: We’ve also seen an uptick in communication between the investment manager and their investors during the pandemic, as well as an increase from fund administrators. This has highlighted the importance of having the right tools to stay informed. For example, Northern Trust already provides its manager clients with online tools available 24/7, allowing them to quickly answer inquiries from their limited partners. These tools are designed to provide comprehensive information in flexible formats, and our reports help investment managers respond quickly and thoroughly to their investors. This is particularly important for managers that have a close relationship with their investors and, especially during a pandemic, prefer to conduct all communication with them, rather than relying on their fund administrators. It is crucial for managers to have that easy, direct access to underlying fund and investor information.

VM: Reviewing private capital managers is different from doing so for hedge, mutual or UCITS funds in a few ways. The fact that third-party fund administrators haven’t been as frequently utilized in the private market space as has been for hedge funds is key – and it affects how ODD teams pull together information, especially related to NAV calculations, fee calculations and cash management operations. When those operations are conducted internally rather than outsourced, that can potentially increase the risk for fraud and other operational issues. When reviewing private capital managers for operational risk, there is a much larger emphasis on asset valuation, since their assets are typically not publicly valued and require greater input from the manager. From our perspective, we pay special attention to determining the risk of their valuation policies and methodologies, to ensure consistency. Again, this provides greater transparency from our perspective if the manager uses a third-party fund administrator who can provide independent confirmation of how these processes are carried out.

SS: I agree with Vin’s points – the ODD process is different for private capital managers by design of how the private market space functions compared to other asset managers – generally bringing higher risk and lower liquidity. For example, with private investments, investors are committed for the life of the fund, unlike other asset classes where they can redeem and subscribe on an ongoing basis. These factors make for a unique due diligence review and highlight the importance of fund administrators because of the increasing percentage of investors that do value that second set of eyes for private capital managers’ back-office operations.

VM: The documentation review process is much different. In the past, we would go onsite and in person to review sensitive materials such as certain compliance policies or valuation documentation, but now we are viewing many documents digitally or via videoconferencing software, with our team signing non-disclosure agreements.

Fortunately, technology has evolved to allow us to do that in a controlled manner. Another big change is that meetings with portfolio managers, COOs, CFOs, CCOs, and others are conducted via distinct videoconferences, which has actually presented an unexpected benefit – more time for detailed conversations. When we meet on-site, our meetings tend to occur within one day, often leading to a rush to fit it all in. Now, as meetings can be broken up over multiple days via videoconference, we have the opportunity for longer, more meaningful discussions, while avoiding the pressure of running out of time and pursuing follow-up points.

SS: As Vin touched on, technology is front and center during the pandemic and this new way of conducting ODD. Private capital is a more manual asset class than others, particularly if you look at how managers determine their NAVs. During the COVID pandemic, we’ve seen that private capital managers are more willing to engage with higher-tech operational processes. Many are embracing videoconferencing technology, file sharing applications, and data portals from their fund administrators. Each of these helps to boost the productivity of virtual ODD reviews. As they realize the efficiencies, I believe we’ll begin to see private capital managers embrace more integrated technology solutions to improve their own processes, as well as empower their fund administrators’ workflows.

SS: There is potential for less oversight when working from home, and the private market space tends to have more complex transactions with intermediaries.

Cybersecurity and data privacy become even more crucial, and as new data privacy frameworks emerge globally this creates greater compliance accountability for private capital, just as it does for all players. Due diligence reviews and partnership with third-party fund administrators are key elements in helping private capital managers meet growing compliance expectations.

VM: Agreed, Seb. And in holding a comprehensive ODD review, there should be an entire section which covers business continuity and compliance. The focus of this topic is changing as of late – we used to ask about business continuity largely from the perspective of following a plan for only a few days or weeks at a time, for example in the instance of a natural disaster. This pandemic has showed us that going forward we need to evaluate business continuity plans as a long-term event, like the current Covid-19 pandemic.

Also, from the perspective of ODD analysis, I don’t see the practice of remote work changing all that much after we emerge from the pandemic, especially since some managers will benefit from the reduced office location costs. So, from a compliance standpoint, we’re taking a new view of managers’ compliance processes, asking how current operations are being monitored day-to-day and what they could look like if remote work becomes a permanent part of the manager’s operations.

VM: Over the last several years, industry associations for limited partners have emerged in an effort to normalize transparency best practices in the private market space. Most of the larger private capital managers with the best infrastructure and resources have already made the jump to standardize these best practices within their operations. Then there are smaller private capital managers with fewer staff and resources, which can make it difficult to adopt these measures. Though it may be tougher for this group of managers to adapt, it’s ultimately in their best interest. ODD reviews tend to assign less risk to a fund’s analysis when we work with a third-party administrator, as that additional layer of control and transparency should in theory reduce risk and be attractive to institutional investors.

SS: I see limited partners pushing more to access and analyze their private investment data at all times. This expectation won’t be realized without the use of third-party fund administrators that have the technology to make that possible. And the pressure to do so is already picking up in jurisdictions outside of the North American private market. Europe has experienced greater pressure for outsourced fund administrators in private capital as a result of increased regulatory standards. This could drive change here in the U.S. as well. If U.S. private capital managers want to operate globally, they’ll have to consider the transparency norms overseas.

These themes of greater transparency via technology and outsourced back-office operations existed before the pandemic. But the instability and lack of certainty that accompanies a pandemic has only intensified the pressures. Through the volatility, we feel we’ve adapted quickly to the new environment, and we’ve seen our clients do the same. Given this, I have confidence that together we’ll weather future storms that may come our way during this pandemic and beyond.