Due Diligence for Fund of Funds Investments

The decision to use the practical expedient (as defined in ASU 2009- 12) for estimating the fair value of an alternative investment is most precise when management has set in place a robust set of procedures and controls for oversight of their portfolio of alternative investments.

Discussed below are some examples of best practices for management oversight of alternative investments.

Initial Due Diligence

Initial due diligence procedures are those procedures that should be performed prior to making an initial investment in an alternative investment fund. These types of procedures include:

• Making a site visit to the investee's office, including face-to-face meetings with the investee firm's management team and reviews of back office and operational due diligence areas.
• Evaluating the investee's valuation procedures, historical performance, investment strategy and process.
• Reviewing the investee's governing documents and periodic reports such as:
• Offering memorandum
• Legal agreements such as partnership or LLC agreements
• Financial statements. 
• Performing third-party background checks on senior management of the investee entity.
  1. Verify biographical information.
  2. Perform criminal background search.
  3. Perform reference checks.
   

After initial due diligence is completed, a formal investment memorandum/write up documenting the investment approval review process and decisions reached should be prepared.

Ongoing Monitoring/Due Diligence

After making the initial investment, and through the term that an investor entity holds an alternative investment, management of the investor entity needs to perform ongoing monitoring procedures. Examples of recommended ongoing procedures that the investor entity should consider include the following:

• Conducting periodic meetings with the investee entity's management team to review the investee's interim results.
• Obtaining communications issued by the investee entity. Management of investor entity should maintain necessary documents evidencing that they completed the following:
  1. Reviewing and filing fund's communications including monthly/quarterly shareholder's letters, etc.
  2. Reviewing the investee fund's annual financial statements. Noting the basis of presentation (U.S. GAAP, IFRS or other comprehensive basis). Is the auditor's report qualified?
  3. Requesting and reviewing change in valuation policies and procedures.
   
• If the investee entity utilizes a fund administrator for preparing its books and records, find out if that administrator has a SAS 70 report and obtain a copy.
• Tracking the investee entity's portfolio performance:
  1. Comparing performance to benchmark and expected returns if appropriate.
  2. Comparing performance to publicly available data (for example, public sector indices for hedge funds).
  3. Comparing cash returns to previously reported market values throughout the year.
  4. Reviewing portfolio holdings on a regular basis and inquire periodically as to the total long and short positions throughout the year (for hedge funds)
  5. If the investment strategy changes from the original investment approach, conducting comprehensive review of manager/team/strategy
   

Timely communication with the investee fund combined with appropriate levels of oversight and ongoing analysis of investee fund data will enable management to derive the most current and accurate understanding about their alternative investment portfolio. Valid, timely and reliable information, combined with diligent oversight exercised by management, will significantly assist management in refining their estimates of fair value.

This article first appeared as in the November 2009 edition of Insights, our financial services newsletter.