Outlook 2013: Back office inspections

Expect LPs to conduct more intensive operational due diligence exercises of GPs in the year ahead, writes Corgentum Consulting managing partner Jason Scharfman.

As 2013 approaches, LPs' interest in operational due diligence of private equity firms continues to grow. This trend is important to GPs for several reasons. During 2012, many GPs likely noticed an increase in not only the frequency of communication from LPs regarding operational due diligence questions, but also in the depth of such questions.

Recognizing the increased importance of acknowledging LP operational risk concerns is also particularly relevant for GPs raising new funds. Having increasingly been through the operational due diligence review processes, many GPs are recognizing the benefits of being prepared for such reviews. These prepared GPs seek to proactively address any potential operational weaknesses or high concern areas with LPs before the LP has a chance to worry about them. LPs increasingly appreciate this proactivity, and such an attitude often reduces confrontation during operational due diligence.

LP sophistication has risen beyond stale answers, such as, 'We take compliance very seriously'

The subject of operational risk however, is a big area – so what is the biggest operational risk GPs should be concerned about in the new year? Perhaps the question is better rephrased in the context of what operational risk will be on the forefront of investors' minds in 2013? The answer, in one word – compliance.

2012 saw a number of game changing regulatory events that directly impacted the operations of GPs, including mandatory US SEC registration and the new Form PF filings, to name a few. These new compliance requirements raise a number of valid operational concerns in the minds of LPs. GPs may have increasingly had to answer seemingly rhetorical LP due diligence questions such as, “What is your biggest regulatory risk?” and “Why don't you have more resources dedicated to compliance?” This is on top of more practical questions, such as, “Will you be shifting Form PF filing costs to LPs?” Also fueling LP compliance concerns is spillover from the increased scrutiny and prosecution of insider trading at hedge funds. LPs read the papers and continue to have concerns that a GP may be trading on material non-public information and will be the next one to have their offices raided by the FBI. LP sophistication has risen beyond stale answers, such as, “We take compliance very seriously,” or “We perform annual ethics training,” to quell their concerns. GPs that are proactive in addressing LP compliance concerns will not only be able to demonstrate the strength of their due diligence programs, but will also have to perform less LP hand-holding throughout the year.