Some investors consider cash to be one of the crucial areas to be focused on in an operational due diligence review. The thinking goes that cash flowing through a private equity firm is effectively the lifeblood of the organization. Without cash to call from investors, invest, or pay bills, there is little concern, the thinking goes, for the rest of the operational infrastructure of a firm. Certain operational due diligence reviews may even take a follow the cash approach, whereby the flow of cash from investor subscriptions through to redemptions are tracked.
Over the past several years, a trend had emerged of alternative investment firms seeking to outsource the cash management function in some regard. Part of the reasoning behind this trend is similar to our discussion of the use of placement agents: An alternative investment manager may feel they are capable of placing unencumbered cash into a checking account or in a money market
fund; however, some funds may not have the skills, time, or resources to be focused on generating increased return from this cash. In effect, these firms may be leaving money on the table as a result of excess cash sitting around earning lower rates of return.
In addition to generating increased return, cash management may also be of concern for a private equity fund with multiple fund vehicles in different currency denominations. In these cases, cash may be managed to reduce or hedge against certain currency exposures. Many private equity firms may not be focused on the macroeconomic aspects of different developments in currency markets on a daily basis and may rely on third-party cash managers to assist in this area. Furthermore, depending on the strategy of the private equity strategy, third-party cash managers may also provide assistance in the areas of collateral and margin management.
Despite these advantages however, with the recent turmoil in the markets many private equity funds have focused on bringing the oversight of the cash function in-house. As part of the private equity operational due diligence process, investors should approach the cash management function from multiple perspectives. One such approach is to consider the amounts of cash held by the fund. Additionally, investors should focus on the ways in which cash is managed and controlled internally.
In regard to cash management at the private equity fund vehicle level, questions investors should consider include:
How is unencumbered cash (also called cash on hand) managed?
Where is unencumbered cash stored?
What types of instruments are unencumbered cash held in (e.g., treasuries, direct cash, etc.)?
What rates of return are earned on unencumbered cash?
How much cash do the funds typically hold?
How have these cash levels varied over time?
How much cash is held by counterparties (e.g., prime brokers)?
If a third-party cash management firm is utilized, how is this process monitored internally by the private equity firm?
If the fund utilizes a third-party administrator, is a separate cash reconciliation performed by the administrator? If yes, how frequently is this cash reconciliation performed?
How often is cash reconciled?
Which individual or department at the private equity firm performs cash reconciliations?
How are bills of the fund paid?
If the private equity fund utilizes a third-party administrator, what reviews are performed internally before signing off on a cash transfer?
If the fund utilizes a third-party administrator, does the administrator require the private equity firm to send copies of invoices from third- party vendors with any wire transfer requests?
How are margin requirements managed?
What is the cash-reconciliation process?
Additionally, as part of the operational due diligence process, investors would also be well-advised to be cognizant as to the policies within a private equity fund organization to control the movement of cash. Diagnosing not only the policies and procedures but the overall nature of the control environment can be an important, and sometimes tricky, aspect of the cash oversight process to gauge. In particular, during the operational due diligence process investors should consider addressing the following issues:
How is cash moved within the organization?
What wire transfer controls are in place?
How are bills of the management company paid?
Who has authority to move cash within the organization?
Are there multiple signatories required to move cash?
Are there situations where only one individual has authority to grant signatory approval?
Are there different levels of cash signatories (e.g., an A list and a B list)?
Do different movements of different amounts of cash require different levels or numbers of cash signatories?
How are signature approvals granted? (i.e., electronically, via a physical form, etc.)
Who ensures that the correct number of signatures is received?
Is there an appropriate segregation of duties internally within the private equity fund as well as third-party oversight into the cash movement process?
Can approval signatures be granted remotely or can cash transfer instructions only be granted via certain computers (e.g., via a secure
key card device reader attached to computers)?
By taking the time to focus on such cash management issues, investors can gain a more detailed understanding of the seriousness with which a private equity firm approaches the issue of cash management. Areas such as the nature of the control environment of a private equity firm's cash management function can have a signaling effect as to how other, perhaps less perceived, important operational issues are addressed throughout the firm.