While the focus of most investor's on-site operational due diligence processes may be squarely centered on the operational policies, procedures, and processes in place at the private equity fund, there is another aspect of due diligence that many investors may overlook. This relates to a concept which for the purposes of this book will we refer to a negative due diligence.
This concept relates to the understanding that the investor due diligence process is a reciprocal one. If private equity firms and investors are honest about the operational due diligence process, it is one in which each party has certain wants and needs. An investor wants, at a minimum, to avoid exposure to fraud and weak operations and, at best, select private equity firms with strong operational infrastructures. To accomplish this, an investor needs the cooperation of the private equity firm to collect certain pieces of information and to conduct certain steps, such as an on-site visit, to complete this process. Turning to the private equity firm, it too has wants and needs in this process. It wants to ultimately obtain investment allocations from investors to be placed in the funds that it manages. In order to accomplish this from an operational perspective, the private equity firm needs to demonstrate, or at least convince, investors that it is not a fraud and that strong operations are in place. Because of sometimes conflicting wants and needs, the private equity operational due diligence process can have an adversarial aspect. When going up against an adversary, even one that you are not looking to defeat but rather enter into a business relationship with, it is useful to learn as much about your adversary as possible. This book is primarily about methodology, tools, and techniques that investors can use to diagnose, monitor, and analyze their adversary in this process—the private equity firm.
On the other side of the table we have the private equity firm. This is where the concept of negative due diligence comes into play. Negative due diligence, or reverse due diligence, refers to the process that the target of a due diligence analysis itself performs upon the investor that is investigating it. This is not to imply that the private equity firm has any right to begin submitting document requests lists to investors or seeking an on-site visit with them. Private equity firms should not be performing the same type of due diligence on investors that the investors are performing on them. This is not the type of due diligence we are referring to in this case; instead, we are referring to a different type of due diligence. It could almost be thought of as due diligence light. The relationship between traditional due diligence and negative due diligence is summarized in Exhibit 4.4.
EXHIBIT 4.4 Comparison of Traditional and Negative Due Diligence Processes
Putting aside any anti-money-laundering safeguards, under the negative due diligence concept a private equity firm should take basic steps to gather initial background information about the investor. Generally, a private equity firm will have a basic understanding of an investor's investment organization, but they may not have taken the time to maintain an understanding of who is actually performing operational due diligence. This can be particularly true when an investor may engage a third-party consultant to assist in the operational due diligence process. In these cases, from the perspective of the private equity firm, this lack of due diligence can put them at a significant disadvantage during the operational due diligence process. What types of information are we talking about?
As indicated earlier, operational due diligence does not need to be adversarial in nature, but it can certainly evolve into an adversarial process. If such an adversarial development is the case, it is certainly reasonable for a fund to know their adversary. For example, has the investor published any articles that could provide insights into particular operational views that the investor holds? Does the investor have a certain background, either professionally or from his or her educational discipline, that could provide guidance as to any areas they might focus on in the operational due diligence process?
Consider if the individual performing operational due diligence has a background working at a former financial regulator. For the purposes of our example, we can refer to him as Joe Regulator. While your author is not a gambling man, we could likely wage dollars-to-doughnuts that during the course of his operational due diligence review process Joe is likely to focus more
heavily, or at least have the ability to dig deeper, on certain regulatory-and compliance-related matters, compared to an average investor. Contrast this with another investor performing operational due diligence who used to work as Chief Technology Officer at a hedge fund. For the purposes of our continuing example, we can refer to this investor as Mr. Micro Chip. As compared to Joe, Micro would likely, at a minimum, want to poke around the server room of a private equity firm. If he sees something he doesn't like, Micro is likely more equipped than Joe to dive deep into information technology-related issues. The point of this example is to demonstrate that if a private equity firm is armed with such knowledge, they can prepare accordingly. Unfortunately for many private equity firms, and perhaps fortunately for many investors, remember that, after all, in the context of our present discussion operational due diligence is a somewhat adversarial exercise; many private equity firms do not devote the necessary time or resources to take a few moments to learn about investors’ or operational due diligence analysts’ backgrounds.
Such a lack of effort in the negative due diligence process certainly could have a signaling effect to investors. An investor may well posit that, if a fund has not taken the time to learn some basic details about the investor performing operational due diligence beyond when they are planning to invest and how much, this may be a red flag representative of larger operational problems, such as a lack of thoroughness. For example, is the fund equally lax when examining any trading counterparties or similar firms with which it might have balance sheet exposure?