The changing landscape of private fund investor due diligence

The importance of private fund investor due diligence in the investment allocation process, in capital formation and in private fund litigation has reached unprecedented levels and is further increasing. Using two datasets: (1) private investment fund advisers’ SEC Form ADV II filings from 2007 to 2014 (N=100392), and (2) the publicly available litigation record pertaining to private fund investor due diligence from 1995 to 2015 (N=572), my paper (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2811718) provides the first and only theoretical and empirical evaluation of the evolving private fund investor due diligence requirements and the applicable legal environment in the United States. I highlight important changes in the quality and quantity of private fund investor due diligence in SEC Form ADV Part II and evaluate the corresponding litigation record as well as expert guidance on applicable best practices.

The private fund industry has incrementally improved due diligence standards and requirements in the aftermath of the financial crisis of 2008-09. Before the financial crisis of 2008-09, investment advisers/managers usually performed at least part of their due diligence by starting with the AIMA or MFA due diligence questionnaires and edited the templates to suit their circumstances. The old versions of those questionnaires were often used in attempt to avoid investors’ questions challenging the manager on possible weaknesses in their controls.  In the aftermath of the financial crisis of 2008-09 and various associated crises, such as the Madoff scandal, among others, investors, at least those on the relatively more sophisticated end of the continuum, such as pension funds, etc., no longer accepted the slanted phrasing of the due diligence questions and their answers. As a result, the questionnaires became relatively more rigorous.

Since 2010, investment due diligence has also become an increasingly litigated issue in the capital formation and allocation process. In lockstep with the growth of the private investment fund industry, private fund investor due diligence litigation has increased significantly since the financial crisis of 2008-09. Courts in early 2010 started to set out private fund investor due diligence standards and provided guidance on the requirements and limits. The increasing due diligence litigation record underscores the heightened importance of due diligence in the capital formation and allocation process since the financial crisis of 2008-09.

Little to no guidance exists, other than in my paper, on applicable standards for investment due diligence. Despite the increasing relevance of investment due diligence in the capital formation and allocation process and despite increasing litigation in the context of investment due diligence, the industry is mostly left to its own devices to ensure adequate due diligence standards apply.  Available resources describe best practices but do not sufficiently outline the legal requirements pertaining to private investment fund due diligence. The available case law only marginally provides relevant guidance on private fund investor due diligence.

In the paper, I provide evidence that from 2007 to 2014 an increasing number of SEC Form ADV II filers deemed investor due diligence worth mentioning in their filings and an increasing number of SEC Form ADV II filers qualitatively intensified their due diligence disclosures in Form ADV II brochure filings. More specifically, an increasing number of SEC Form ADV II brochure filers included investor due diligence disclosures since 2010. However, the number of filers who include those disclosures has remained relatively even between 2012 and 2014.

The intensity of investor due diligence mentioning relative to total SEC Form ADV II brochure filings, however, has increased substantially; the due diligence count exceeded the total ADV II filings for the first time in 2014. The data suggests that SEC Form ADV II brochure filers take investor due diligence disclosures in Form ADV II much more seriously since the year 2010 and especially since 2012. Filers appear to see a need to increase the quantity of investor due diligence disclosures in Form ADV II between 2011 and 2014.

Moreover, the data on case law between 1995 and 2015 suggests that private fund investor due diligence has reached new and lasting prominence in the court system. The increasing caseload on private fund investor due diligence since 2005 could suggest that applicable legal standards need to be further clarified to protect investors. Madoff-related cases in the aftermath of the discovery of the Madoff Ponzi scheme in 2008 help explain the significant increase in the prevalence and importance of private fund investor due diligence after 2009.

The increasing caseload on private fund investor due diligence since 2005 could suggest that applicable legal standards need to be further clarified. The data shows that between 1995 and 2015 private fund investor due diligence has reached new and lasting prominence in the court system. Madoff-related cases in the aftermath of the discovery of the Madoff Ponzi scheme in 2008 only partially explain the significant increase in the prevalence and importance of private fund investor due diligence after 2009. Private fund investor due diligence is intended for investor protection. My study has demonstrated that the legal standards applicable to private fund investor due diligence are somewhat inconsistent and suboptimal and merit clarification.

Examining the litigation record with regard to expert testimony helps identify prevailing best practices for private fund investor due diligence. Experts are often testifying on behalf of plaintiffs attempting to establish that proper due diligence industry standards should be applied in a given case. Experts provide the court with feedback about the standard due diligence practices and point out specific failings that could make a certain defendant liable. Expert testimony can also provide private fund managers with guidance on how their applied due diligence practices compare with purported industry standards.

Using Westlaw’s Expert Materials tool, I synthesized the applicable cases to identify expert testimony on applicable private fund investor due diligence standards. Westlaw’s Expert Material tool’s coverage begins in 1996  and assesses “selected reports, affidavits, deposition (both full and partial, and trial transcripts from expert witnesses from the state and federal courts of the United States.” I hand-selected relevant expert reports to the court that dealt specifically and in-depth with private fund investor due diligence.

Major failures or “red flags” in private fund investor due diligence among private fund advisers include: the lack of written policy or processes in place to ensure compliance, little to no experience of the individual conducting the due diligence (especially on the particulars of hedge funds), use of basic spreadsheet formulas unable to account for subjective data or systematically update information, not checking paper statements or election records to confirm trade data, not checking credentials and background checks on fund staff, dealing with firms with no third party controls (broker-dealer, custodian, administrators) or substantive auditors (with no auditing history), failure to assess fund performance against common benchmarks  and assess how a fund could make money in declining markets.

Commonalities in expert testimony and expert consensus on applicable standard private fund investor due diligence industry practices, as stipulated in the examined litigation record, include: qualitative review of firm marketing materials, offering documents, subscription documents, manager track records, onsite manager meetings, detailed due diligence questionnaires, monthly portfolio analysis- regression analysis, style drift analysis, qualitative reviews of fund employees including background checks, assessment of fund processes (including buy sell disciplines, risk management, investment research, team approach, technology and infrastructure), assessment of management fees, review of public documents such as SEC Form ADVII, confirmation and assessment of an independent auditor and the fund having an extensive audit record, and regular peer reviews and benchmarking. Specifically, in addition to testifying experts, the SEC has also pointed to Form ADV as a major step in creating sufficient transparency to conduct due diligence effectively.

The heightened emphasis on private fund investor due diligence as demonstrated in my study could foreshadow the possibility of standardization of private fund investor due diligence. Lacking standards for private fund investor due diligence can partially be attributed to private funds’ unique position in markets – unlike mutual funds, private funds evolved as unregistered entities, free from most regulatory oversight. Accordingly, the private fund investor due diligence evolved without regulatory oversight. In analogy to banks’ risk evaluation, 15 years ago banks operated with general risk evaluation strategies but no uniformity and no applicable standards, whereas today bank’s risk evaluation is heavily regulated and turned into a science. Private investment fund due diligence may follow the same evolution. Private fund advisers will likely pass associated costs through to their investors.

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Wulf A. Kaal

Wulf Kaal is a tenured associate professor of law at the University of St. Thomas School of Law in downtown Minneapolis. He is a leading expert on hedge fund regulation in the United States and the European Union.  Before entering the academy, Kaal worked for Cravath, Swaine & Moore LLP in New York and Goldman Sachs in London.  Kaal has published more than two dozen articles in the United States and Europe. His articles were published in leading peer reviewed law and finance journals and in American law reviews such as the Minnesota Law Review, the Washington & Lee Law Review, and the Wake Forest Law Review, among others.  Kaal’s study on the effects of hedge fund registration requirements under Title IV of the Dodd-Frank Act has gained national attention and was covered in a Business Week article and other journals. He is the author of a book chapter on Investment Advisers and Investment Companies in the Securities Law Handbook published by Edward Elgar.
He has also been a consultant to major corporations and hedge funds regarding various aspects of financial markets and regulation.

 Wulf A. Kaal
Associate Professor
University of St. Thomas School of Law
1000 LaSalle Avenue
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Minneapolis, MN 55403
United States
 

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