Operational Due Diligence, Venture Capital

Client objective

The internal investment team of a large UK insurance company was looking to make an allocation to a venture capital fund and required a detailed ODD review to support the Investment Committee in approving the investment. Robust engagement was anticipated, especially in view of the fact that the selected strategy was a first-time fund from a new asset management firm: the objective was not simply to validate the decision but to support the manager—if appropriate—through recommending improvements to its risk control framework and relevant operational processes. Since the manager had appointed a third-party Alternative Investment Fund Manager (“AIFM”) for a Luxembourg-domiciled vehicle to satisfy the requirements of AIFMD, ODD would involve analysis of the manager themselves, the AIFM and the Fund’s Administrator.

Outcomes

• Delivering a comprehensive assessment and identifying weaknesses: Bespoke strategy-specific due diligence questionnaires, comprehensive reviews of documentation and meetings with the relevant senior personnel as well as the manager’s IT provider underpinned a detailed review of the operational control framework. This process identified several material deviations from best practice and the bfinance ORS team then engaged with the manager to agree a programme of improvements.
• Scrutinising trading practices: The fund’s governing documents stated that the manager could execute an FX hedging programme, but the firm lacked a documented policy for the approval and ongoing oversight of trading counterparties. They also lacked a formal Trade Error policy detailing the processes that should be followed in the event of an error. The manager, based on this guidance, implemented a Broker and Counterparty Risk Management policy and a Trade Error policy. The ORS team subsequently advised the investor that the new Trade Error policy allocated all trading-error-related losses to investors – an approach that we do not believe is consistent with best practice, although it does align with observed market norms for private market strategies.
• Improving valuation governance: While the AIFM is responsible for the valuation of the portfolio, the team identified that they would delegate responsibility for the valuation of the fund’s assets to the manager and the manager’s Valuation Committee was chaired by the firm’s CEO (who also chaired the Investment Committee), implying a lack of independence. The bfinance ORS team requested that the firm’s CFO be appointed as chair of its Valuation Committee and the manager agreed to make this change.
• Upgrading cyber risk controls: Notable weaknesses included an absence of penetration testing, vulnerability scanning, cyber security training, phishing testing and policies related to the secure disposal of electronics, as well as weaknesses in password protocols and procedures surrounding administrative access rights. Through engagement with the manager and its IT service provider, these control shortcomings were addressed through the introduction of new processes and vendors.
• Flagging other concerns: The bfinance ORS team identified a number of issues within the fund’s governing documents. These included: a vaguely worded key person clause that lacked clarity on what constituted a key person event and when investors would be notified (investor was advised to address this via a side letter with the manager); a 5% NAV error materiality threshold (permitted by the Luxembourg regulator but, in our view, high); very broad scope for the manager to allocate operational expenses to the fund.