Operational due diligence, as applied by limited partners evaluating fund administration, is a formalized process by which potential investors assess a fund manager's accounting controls, reporting systems, third-party service providers, and operational risks. For institutional investors and fund-of-funds, this operational diligence is just as critical as the evaluation of the fund's investment strategy.
This process has become significantly more intensive since 2015, especially since 2020, as applied to emerging managers. Recent well-known manager failures involving late K-1s or restatements of audited financial statements have not decreased the scrutiny from LPs; they have actually made LPs more diligent about reviewing back-office operations. LPs that run dedicated operational diligence programs aren't looking for a perfect process; they're looking for evidence that the manager takes their back-office function as seriously as their investment function.
The Changing Tides of LP Expectations
Before 2015, questions about back-office operations were informal and rarely made or broke a fundraising deal. From 2015 to 2020, standardized due diligence questionnaires began to incorporate operational sections, typically separate from the investment section. Post-2020, operational due diligence has become a formal checkpoint and many institutional LPs and FOFs now have operational diligence staff dedicated solely to these reviews.
Between 2022 and 2024, our team looked at 60 LP due diligence questionnaires (DDQs) that we submitted to emerging managers. In 52 of the 60 cases, the DDQ contained a dedicated fund administration and back-office section. In 18 cases, the LP conducted an operational diligence call that involved the fund administrator separately, meaning the GP did not participate in the conversation.
The 5 Key Areas of an LP Operational Diligence Process
If your back-office is up for operational due diligence by an LP, they're going to be evaluating your process across five primary areas. Each area has its own set of LP diligence questions, and each area has its own set of red flags for LPs. Understanding the framework of the process can make it easier to prep not just for the questions that are being asked, but for the supporting evidence that the LP will expect.
The five areas that LPs evaluate in the operational diligence process: service provider quality, reporting infrastructure, internal controls, legal and compliance posture, and succession or key-person risk. Most LPs evaluate these five areas at a roughly equal weighting, with institutional LPs and FOFs generally placing a higher weight on internal controls and compliance.
1. The Quality of Your Service Providers
LPs will research your administrator, auditor, and counsel. They want to see providers that they recognize as top-tier or experienced for a private fund administration role. Having a regional or boutique administrator isn't necessarily a negative, but it is worth having a reason for your choice. If a provider is unfamiliar to LPs, this is a yellow flag that requires a follow-up question.
Auditor: LPs generally prefer auditors who are registered with the PCAOB and have experience auditing private funds. You don't necessarily need a Big Four firm, but LPs will generally look at the experience of an auditor and are more likely to have confidence in a regional CPA firm with private fund clients rather than a generalist CPA. Fund administrator: LPs look at whether the administrator is independent of the GP. They also look to see what other private funds are using that administrator, and the complexity of that fund's capital structure. Legal counsel: The quality of the fund agreement will be looked at. You don't necessarily need an LPA drafted by a large law firm, but using a standardized fund formation LPA from a high-volume fund formation firm is usually better than a "customized" LPA created by a generalist corporate lawyer.
2. Fund Reporting Infrastructure
LPs want to understand how capital account statements are created, how quickly, and to what level of automation. Funds with funds under management above $10 million that are using spreadsheets for the majority of their reporting are typically raising questions for LPs. LPs also like to know whether there is an LP portal that they can access at any time and whether documents are stored in an accessible repository from which documents can be easily produced.
Three LP reporting diligence questions that we saw in almost all LP ODD processes:
1. What is the standard timeframe for the LP reporting of a quarter to date? (Industry standard timeframe for private funds: 45 days after the quarter) Can LPs access capital account records and fund documents via an online portal? Who is responsible for generating quarterly reports, the administrator or your in-house team? We have frequently heard emerging managers assert that they manage fund reporting in-house using spreadsheets. When this is the case, our first follow-up question is always: What happens if a critical person is out of commission? The inability to provide a confident answer to that question has been an influential factor in why institutions have rejected otherwise compelling emerging manager candidates.
3. Internal Controls An evaluation of controls looks at how the GP segregates duties, how it authorizes capital calls and distributions, and how it discovers and corrects errors. LPs are seeking assurance that no individual person is able to make unilateral decisions over fund cash flows. Capital call authorization: Who originates the request, who reviews and approves it, who sends notices to the investors? Distribution authorization: Who prepares distribution amounts, the administrator or a person within the GP firm? Error correction: What occurs if a capital account statement contains an error? LPs sometimes will use the ODD process to walk through these scenarios in a test setting with a GP. The objective of this exercise is to have the GP describe what happens step-by-step, starting with the time a portfolio company requests capital and moving to the time the LP transfers funds into the fund bank account. GPs who can narrate the process clearly and competently demonstrate that they understand the mechanics of their internal controls, whereas GPs who cannot describe the process are a red flag for LPs.
4. Legal and Compliance Status An LP will review the LPA and the fund's registration or exemption with the SEC (or state), along with the overall entity structure of the fund. LPs are focused on identifying misalignment between what the LPA states and how the fund is actually operated. Some common compliance issues that LPs look for: The fund is operated as an exempt reporting adviser, but books and records are not being maintained. Provisions in the LPA for offsetting management fees are not being properly accounted for in the fund’s capital records. Side letters with special arrangements with certain LPs are not being reflected in the fund’s LP capital account records.
5. Key-Person and Succession Risk LPs want to be aware of how the fund will continue to be administered if a key operational person within the GP is absent from the picture. In the case of a one-person GP, that is of particular concern. A way to mitigate these risks is to ensure that the GP is able to demonstrate that fund administration occurs without reliance on a specific person at the GP. Many LPs will require some type of mitigation in this area.
What are the deal breakers in LP ODD? Typically, ODD processes with LPs generate questions rather than clear go/no-go recommendations, but there are some issues that will immediately disqualify a GP. The GP must be aware of and resolve these potential issues before beginning an active fundraise. No third-party fund administrator: Many LPs will not invest if the GP is self-administering the fund. Late or restated audited financial statements: The auditor or the LP must have evidence of a clear process of how errors are being addressed. Discrepancies in fund legal documents: Discrepancies or conflicts between LPA and subscription agreements or side letters indicate that the GP has not exercised proper diligence in reviewing its fund documents. No LP document access: Some LPs will expect a portal through which LPs can view their own fund documents. Many others accept email distribution; but the expectation for any of this is that a GP has a formal process for document and reporting distribution. The GP generates and maintains control over the bank account for capital calls: Many LPs expect that the administrator will process these requests, so the GP will not have access to the bank account to transfer funds.
How can a GP use operational quality as a fundraising asset? We have observed the best emerging managers utilizing their operational quality as a competitive advantage to attract LP investors, rather than as an obligation to simply comply with the law. Running a proper back office enables you to proactively give LPs the information they are asking for, rather than reacting defensively and trying to answer their questions.
To prepare, create a one-pager fund operations summary with the basics (administrator, auditor, counsel, how often the LP receives reports and if there is a portal for them to view information, summary of control practices) and include it with your data room. Provide a sample quarterly report to LPs during their diligence process so they can see what you are actually sending them at that frequency. Let LPs interview your fund administrator before you sign on with the fund. Provide an LP auditor (i.e., not GP references). Put in place a capital call and distribution process and document that process. Share that information with LPs and include it in your data room. If you have completed an audit cycle already, include management letters from the auditor with the data room for all interested prospects.
In our experience, the managers we see that receive commitment from institutional LPs at the emerging manager stage are not the most successful managers, or the managers with a strong track record. They are the managers who make the ODD process easy, fast and confirmatory, rather than investigatory.
FAQs
Do all LPs run formal operational due diligence? No. HNW LPs and some family offices run little if any ODD. However, institutional LPs, endowments, foundations and funds of funds almost always run some type of structured ODD process. If any of these make up your target LP base, you will have to deal with them and their process. Since 2020, many family offices have also begun implementing more rigor as they realize that the families they gave capital to have run into operational issues.
How long does LP operational due diligence take? For institutional LPs, an ODD process typically takes between 4 and 8 weeks from the first receipt of their DDQ until final decision. The same LPs that manage fund of funds with a team dedicated to ODD can take between 10 and 12 weeks. The faster you are with the ODD process, the faster the ODD process will be with the LPs who review your ODD. GP's that do not respond within a 5-day period are not seen as organized and will prolong the ODD process by that period.
What are the must have documents for an LP ODD data room? At minimum, a legal document pack with a LPA and all amendments, subscription agreement, and all side letter agreement templates, the fund administrator engagement letter and the most recent audited financials, a sample LP quarterly report, any fund filings (Form ADV or ERA filings) and management company organizational documents must be available. Also include the one page fund operations summary as discussed above.
If you have strong investment results, is that enough? In our experience, no. LPs look at the ODD from a separate lens than their investment diligence. The LP will look to the back office and ODD as a way to see if it will make sense to invest capital with the GP. Strong investment results cannot compensate for weak ODD because the LP does not believe they can realize returns from that fund without solid ODD. The LP is looking at things like late K-1s, inaccurate statements and poor controls. These things are costly to the LPs and will negatively impact their realized returns.
Is hiring a ODD consultant worth the investment to get ready for LP ODD? Yes, if this is the manager’s first institutional raise. We recommend that every manager have a formal ODD readiness review completed before starting their LP ODD process. We typically work with managers in our ODD readiness engagement that will run between $5,000 to $15,000. This is a one-time fee to help managers determine their ODD preparedness with the goal of improving the manager’s ODD readiness before an LP raises any ODD concerns or, even worse, pass on a commitment.