Alternative Investment Fund Due Diligence: Comprehensive Guide for Sophisticated Investors (Part 1)

Fund selection is a primary driver for achieving favourable outcomes within an Alternative Investment Fund (AIF) investing strategy. Fund Due Diligence (FDD) serves as the essential foundation for prudent investors to make better-informed investment decisions. This process involves a rigorous investigation and evaluation into the operational and management details of a potential investment to verify all material facts. Because AIF products are marketed privately, they are intended for informed investors who must conduct their own due diligence to ensure the fund aligns with their specific risk appetite and investment objectives.

12.1 The Essence of Fund Due Diligence

Fund Due Diligence is the process of investigation and evaluation performed by investors into the details of a potential investment, including an examination of operations, management, and the verification of material facts. Investors use this process to safeguard their capital and ensure the Investment Manager's potential and track record are sufficient to meet desired outcomes. Distributors play a significant role in this ecosystem by assisting investors in procuring required information from fund documents and through direct solicitation from fund offices.

12.1.1 Scope and Uniqueness of AIF Due Diligence

The scope of AIF due diligence is unique because information regarding these funds is not typically available in the public domain. The Private Placement Memorandum (PPM) circulated by the fund serves as the primary source of information for any proposed scheme. Beyond the PPM, investors must often collect supplementary information directly from the fund house or the Investment Manager's office. Managing this information-gathering activity effectively is considered a main source of competitive advantage for potential investors.

12.2 Investment Due Diligence by Investors

Investment Due Diligence (IDD) is performed by institutional investors after an initial screening of potential funds based on pre-determined risk-return objectives. This process should ideally be completed before signing any legal documents or investment agreements that bind the investor to a capital commitment.

Initial Criteria for Fund Selection

To narrow down the selection process, investors typically utilize a combination of the following four criteria:

1. Quantitative Selection: Investors develop templates based on objective criteria such as investment horizon, hurdle rates, past performance records, capital commitment requirements, and drawdown phases.
2. Investment Management Team and Infrastructure: Since alternative investments are driven by the calibre of the manager, the quality of human capital and the supporting infrastructure are evaluated.
3. Investment Strategy: Investors examine whether the fund's focus (e.g., a sector-specific fund for infrastructure) aligns with their current comfort level regarding gestation periods and sectoral risks.
4. Past Performance Review: This involves a peer comparison and benchmarking against listed markets to explore the manager's potential for Alpha generation.

Critical Evaluation Factors in IDD (Part 1)

Institutional investors conduct a thorough review of various factors disclosed in the PPM and through on-site visits. The following eight factors represent the initial phase of a comprehensive IDD:

1. Ownership Structure and History

Investors investigate the founding and subsequent history of the AIF Sponsor and Investment Manager. This includes examining any predecessor or parent firms and tracking any changes in ownership since the firm's inception. Any plans to expand the AIF structure or launch subsequent schemes are also scrutinized.

2. Capital Structure and Financial Health

The financial strength of the management company is vital for long-term stability. Investors review the latest audit reports for the fund and management company to identify any qualified audit opinions received during the firm's ownership period.

3. Investment Team Composition

The team's background, including their qualifications and prior experience in similar asset classes, is a heavy weight in the investment decision. Investors verify how long the key team members have worked together and identify any key employees who have departed in the past.

4. Deal Sourcing and Pipeline

An essential skill for a fund manager is the ability to showcase an impressive pipeline of investment opportunities. Investors evaluate the manager's proprietary network of contacts used to identify opportunities and the robustness of their deal flow generation process.

5. Investment Process and Discipline

The IDD process examines the screening and due diligence protocols the manager uses on potential investee companies. This includes reviewing internal due diligence checklists, financial models, and the Investment Memorandum prepared for the Investment Committee (IC).

6. Valuation Policy and Practices

Investors describe and evaluate any significant changes in the firm's valuation policy over previous years. They check for deviations between the fund’s policy and established law, regulation, or the International Private Equity and Venture Capital Valuation (IPEV) Guidelines.

7. Exit Strategy and Realisation Track Record

A manager's expertise in exit management is crucial for harvesting returns. Investors review the details of past exits, including the Internal Rate of Return (IRR) and cash flows achieved. They also discuss instances where investments did not meet expectations to understand lessons learned.

8. Operations, Compliance, and Risk Management

The internal audit and governance functions are reviewed to identify any major control weaknesses. Investors verify the statement of compliance with SEBI-prescribed Compliance Test Reports (CTR) and look for any past or present proceedings with regulators like SEBI or the Securities Appellate Tribunal (SAT).

Key Takeaways

• FDD is a Requirement: It is the basis for safeguarding investments and ensuring alignment with risk appetite.
• Information Asymmetry: Because AIF info is private, the PPM and direct solicitation are the only ways to gain transparency.
• Calibre Matters: The Investment Manager is a "Key Person," and their selection is not mechanical but requires deep industry experience.
• Timely Completion: IDD should be finished before signing binding agreements to allow for the negotiation of terms.

Important Terms

• PPM (Private Placement Memorandum): The primary disclosure document detailing fund terms and strategies.
• IDD (Investment Due Diligence): The specific review of the investment manager's strategy and processes.
• CTR (Compliance Test Report): An annual report filed with SEBI to furnish details of regulatory compliance.
• Alpha: The excess return generated by a manager over a benchmark.
• IPEV Guidelines: International standards for valuing private equity and venture capital investments.