Hedge Fund & Private Equity Fund Operational Due Diligence Since 2009


Overall, the choice of a bank is an important one to support the operations of the fund and the investment manager. The bank provides custody, lending, an audit trail, and investor comfort….

Funds typically keep one bank account at each entity level to pay expenses and process investor transactions (e.g. subs/reds or cap calls/distributions). If there is a fund administrator in place, these banks are generally controlled entirely by the fund administrator or co-controlled by the fund administrator and the manager. These bank accounts are generally sweep accounts that keep minimal or zero balances. The market share leaders in this space are First Republic, Northern Trust, and JP Morgan. For private equity funds, the bank may also provide the subscription line of credit. In some cases, a lender will require a bank account to provide collateral for the line. Other banks leading this market for lending are Bank of America and Wells Fargo.
The bank for the fund is also often the bank for the investment manager, the manager’s principals, and any lines of credit for the management company. Overall, the bank can be a key counterparty to the investment management organization and funds. Investors should assess whether this relationship presents any conflicts of interest, or whether the bank is a strong enough counterparty.Another item to review on banking is AML. Does the bank have a reputation for having weak or strong controls in anti money laundering?How does the bank respond to ODD inquiries? Not at all, quickly within minutes, or over a week or two with multiple reviews and a secure method of emailing the response? Today, the confirmation responses vary as banks become more accustomed to answering ODD confirmations.Funds holding whole loans or bank debt will also use a bank account to receive its interest on the loans. Whether this is received into a prime brokerage or bank account, managing the loan operations and its receipts daily is key to the bank debt operation and overall fund operational risk.The importance of these bank accounts is growing as more and more US managers start to use the banks to pay fund expenses, instead of using the prime brokerage account as a checking account. Generally speaking the bank accounts are almost always used to pay fund expenses directly to vendors in areas outside of the United States, but the United States lags in this area but is improving. Nonetheless, there are still a large amount of institutional managers who act as paying agent and pay the funds expenses, only later to get reimbursed. This reimbursement process creates a related party transaction and complicates the audit and due diligence process.PRISM often notes that it is critical for manager back offices and CFOs to reconcile the fund bank accounts daily and ensure that wires are processed correctly and the correct amount of assets are at risk with the correct financial institution. Other issues to look for are bank fees, late subscriptions, and human error on wire amounts. In the end, the counterparty risk management process should be dealt with daily to ensure that assets are not held unsegregated over night at risk with the bank. Most banks and prime brokers today offer overnight money market sweep programs to aid in this process. This is a quick snapshot on PRISM’s banking ODD.