For people doing operational due diligence on fund managers and other service providers for institutional investors, the examination of audited financial statements, a crucial part of the process, can be particularly difficult. Here’s a guide from Castle Hall, the global due diligence specialist.

In the latest ‘primer’ in its ‘Due Diligence University’ industry education series, Castle Hall says that an audited financial statement (AFS) provides “foundational” evidence, particularly for ongoing monitoring of existing investments.

“However, the review of an AFS is a challenging due diligence obligation,” the primer says. “The AFS review process is time compressed, the workload can be voluminous, and spreadsheets are inflexible and cumbersome as reporting tools.

“Above all, how does the diligence team validate and evidence that 80 per cent of funds have no financial reporting issues – and then target in on the 20 per cent where the financial statements could raise diligence issues?”

Being a global firm, Castle Hall points out the variance in the use of different accounting standards around the world. While most managers use either the US ‘GAAP’ or International Financial Reporting Standards, it is not uncommon for private equity managers, in particular, to use their non-standard limited partners’ agreement as the accounting framework.

“A large portfolio of funds (hedge funds, private equity, long-only managers) would typically follow a wide range of different accounting standards and related accounting frameworks,” the client note says.

One of the interesting things to look for is any change in the general partner’s (manager’s) equity. “If the AFS review identifies material withdrawals of GP capital – or a failure to reinvest fee income back into the fund – investors may wish to follow up with targeted due diligence questions to the manager,” the note says.

With respect to fees and charges, Castle Hall suggests Investors should highlight all funds where the expense ratio has increased year on year. Such increases may be the result of a change in fund net assets (the expense ratio would be expected to increase if AUM falls, given that certain fixed operational expenses will be spread over a reduced asset base). However, an increase in the expense ratio may indicate higher costs or new types of expenses being charged to the fund. Such situations should be subject to escalated diligence inquiry following the AFS review.

Also, with respect to organisational costs, investors should be conscious of:

• funds looking to raise relatively small amounts of committed capital which nonetheless have high organisational costs
• (ii) follow on funds with high expenses (offering documentation and legal work will be largely copied from prior funds), and
• (iii) potential for expenses such as travel and entertainment costs during the fund-raising period. PE funds, in particular, frequently include marketing expenses within organisationals costs, which would not be permitted in a hedge fund or long only vehicle.

The absolute dollar value of expenses is relevant. “Particularly for larger funds, the overall expense ratio may be relatively low, but the absolute dollar value of expenses charged to the fund may remain significant,” the note says.

“Highlighting these costs can identify multi-billion-dollar funds which elect to pass high dollar value expenses (such as research costs, technology expenses, backoffice costs, legal fees and so on) even if the fund continues to have an ‘acceptable’ expense ratio. Investors should consider the nature of “other” expenses and consider the manager’s rationale for charging costs to the fund.”

– G.B.