Alternative Investment Fund Due Diligence: Evaluating Managers and Mitigating Risks (Part 2)

Building upon the initial screening and basic infrastructure checks, sophisticated investors delve deeper into the qualitative and operational aspects of an Alternative Investment Fund (AIF). This phase of Investment Due Diligence (IDD) focuses on risk mitigation through the evaluation of governance policies, conflict management, and the fundamental calibre of the Investment Manager.

12.2 Investment Due Diligence by Investors (Continued)

The IDD process continues with a thorough investigation of specific institutional factors that influence the long-term sustainability and ethical standing of the fund.

Critical Evaluation Factors in IDD (Part 2)

While initial factors focus on structure and strategy, factors 13 through 16 address the contemporary requirements of transparency and ethical governance.

Note: Detailed text for factors 9 through 12 is not explicitly provided in the current source material snippets, though they typically encompass IT infrastructure, legal frameworks, and specific fee alignments.

13. Environmental, Social, and Governance (ESG) Policies

Institutional investors must rigorously analyse the ESG policies adopted by the fund. A manager with a reputation for unprofessionalism at the workplace or a failure to provide adequate safety may be disqualified, as investors prefer to avoid the reputational and operational risks associated with such entities. Furthermore, under the SEBI Stewardship Code, AIFs are required to monitor and engage with investee companies on ESG factors to manage inherent risks at the portfolio level.

14. Potential Conflicts of Interest

All potential conflicts of interest must be identified by the Investment Manager and disclosed in the Private Placement Memorandum (PPM) before capital is committed. These conflicts may arise with the fund sponsor, affiliates, trustees, or third-party service providers. Investors are tasked with evaluating every potential conflict and its projected impact on the fund's estimated returns.

15. Transparency and Investor Reporting Process

Institutional investors demand detailed and timely disclosure regarding the investments made by the fund. AIFs are mandated to provide disclosures on a monthly, quarterly, or yearly basis in SEBI-prescribed formats. High-quality managers often choose to report more frequently than the regulatory minimum to provide additional comfort and transparency to their investors.

16. Other Operational Factors and On-Site Visits

Investors often conduct thorough reviews and on-site visits whenever possible. The objective is to physically verify the existence of staff members, the implementation of stated policies, and the robustness of the procedures claimed by the AIF. Small and mid-size institutional investors may appoint third-party due diligence experts with specialized staff in investment management, finance, and legal compliance to conduct these reviews.

12.3 Manager Evaluation

The Investment Manager is considered the "backbone" of the entire AIF ecosystem. Unlike traditional mutual funds, the performance of an AIF is disproportionately tied to the individual calibre and decision-making of the manager.

The Value of Manager Calibre

Empirical evidence suggests that there is a substantial upside to a scheme's return based on the manager's expertise. Because AIFs often take unsystematic risks (specific to the businesses they invest in), a manager's ability to source high-quality deals, structure optimal investment contracts, and execute well-timed exits is the primary driver of Alpha generation.

12.4 Manager Selection

Selecting the right manager is not a mechanical process; it requires deep industry experience and significant resources to conduct both research and due diligence. Investors must ensure that the manager was selected through a proper, formal screening process rather than an informal appointment by a sponsor, which might indicate a lack of alignment with investor interests.

12.4.1 Ownership Structure and Continuing Interest

Under SEBI (AIF) Regulations, it is mandatory for the sponsor or manager to maintain a minimum capital commitment and a "continuing interest" in the AIF. This is colloquially known as having "skin-in-the-game".

• Verification: Investors verify the level of this commitment to ensure the manager shares the financial risk.
• First-Time Managers: Many first-time managers invest more than the regulatory minimum to provide greater comfort and signal confidence to potential investors.

12.4.2 Alignment of Interests

Ensuring that the manager's incentives are aligned with the investors' goals is critical for mitigating moral hazard. The IDD must examine several key areas of alignment:

1. Sponsor/Manager Commitment: The absolute and percentage amount of their own capital at risk.
2. Fee Structure: Management fees and Additional Returns (Carry), including "super-carry" arrangements for high-performing, sought-after funds.
3. Distribution Waterfall: The priority and sequence in which investors and managers are paid.
4. Catch-up and Clawback: Clauses that ensure the manager only receives their share of profits once investors have achieved their hurdle rate, and mechanisms to return overpaid carry if later investments underperform.
5. Co-investment Opportunities: Rights for investors to invest directly alongside the fund, potentially at lower fee rates.

Key Takeaways

• ESG is non-negotiable: Modern IDD treats ESG not just as an ethical choice but as a core risk management function.
• Verification is physical: Sophisticated investors do not rely solely on the PPM; they conduct on-site visits to verify the manager's "factory" and "human capital".
• The Manager is the Key: The selection process must be formal and rigorous because the manager's calibre is the single greatest factor in fund success.
• Skin-in-the-Game: Mandatory continuing interest from the manager is a primary tool for ensuring alignment of interest.

Important Terms

• IDD (Investment Due Diligence): The deep-dive investigation into a manager's strategy, operations, and ethics.
• Skin-in-the-Game: The manager's personal capital commitment to the fund.
• Moral Hazard: The risk that a manager might take excessive risks because they do not bear the full consequences of those risks.
• Super-Carry: Higher performance fees charged by elite managers with exceptional track records.
• SEBI Stewardship Code: Regulations requiring AIFs to act responsibly and transparently in their engagement with investee companies.