STATESIDE: Open for inspection

We’d be hard-pressed to find an institutional investor that did not think that it was conducting sufficient due diligence on its managers. But two recent examples of firms behaving badly would suggest that investors would be wise to do more.

First, there’s private equity firm GTCR’s sale of its majority stake in real assets consultant The Townsend Group to NorthStar Asset Management. GTCR, via its subsidiary Aligned Asset Management, had owned its interest in Townsend for four years, so given that private equity firms typically exit investments after five years to seven years, nothing appeared to be out of the ordinary.

But PERE understands that the Townsend sale actually had less to do with GTCR’s maturing investment than it did with violations that the latter firm had committed.

According to filings with the US Securities and Exchange Commission, in December 2013, GTCR subsidiary ConvergEx pleaded guilty to wire and securities fraud charges by the US Department of Justice and subsequently was barred from acting as an investment advisor for 10 years. This ban, however, applied not only to ConvergEx, but also Aligned Asset Management and any investment advisory firms in which Aligned acquired a controlling interest – including Townsend. GTCR and Aligned went on to file a request for an exemption from the disqualification, but then withdrew that request in July.

While the firms did not provide a reason for the withdrawal, the timing is interesting, as Townsend’s sale to NorthStar was announced just three months later. It is unclear how much of a role the consultant had in driving the transaction, but one thing is certain: Townsend faced the very real risk of losing its registered investment advisor status. Clearly, that would adversely impact the business.

Some industry observers have noted irony in the situation. To them, Townsend, which vets investment managers on behalf of its numerous institutional investor clients, and which itself acts as investor through its principal investing business, had failed to do sufficient due diligence on its own recapitalization deal with GTCR. Townsend declined to comment on the matter.

Another manager that was recently caught up in a compromising situation was Hines, which as PERE reported last month, saw its longtime Brazil head, Douglas Munro, resign amid allegations of improper payments relating to office leases with embattled state oil company Petrobras. Those allegations first surfaced in July, when the Brazilian newspaper O Globo reported Hines Brazil had allegedly made improper payments in the form of real estate commissions paid to a broker in connection with office leases with Petrobras in Rio de Janeiro between 2004 and 2009. In response to the O Globo report, Hines began an internal review of the transactions, during which time Munro resigned. The audit subsequently confirmed some impropriety with the commission payments.

Following Munro’s resignation, the firm also notified its investors, including the California Public Employees’ Retirement System, which has been one of Hines’s largest investors in Brazil, about the change in leadership. The firm’s approach, however, ultimately seems more reactionary. It’s a shame its actions – whether the internal audit, Munro’s resignation or the investor outreach– did not happen until O Globo published its story. Hines’ alleged broker payments began more than a decade ago, but in all that time, no one at the firm evidently had picked up on any wrongdoing – that is, until it ran its internal review.

You could argue that both Townsend and Hines could have avoided these worrying situations if they had made more thorough inspections – Townsend in its due diligence of GTCR and Hines in its monitoring of its Latin American operations. Both of these cases should thus serve as a lesson to investors that probing deeper could help to prevent making costly mistakes down the road.

Some people might argue that institutions already are bombarding managers with questions through due diligence questionnaires and the like, and simply don’t have the staff and resources to do even more.

Also, regardless of how hard they may try, institutions are simply not going to be able to uncover everything.

While all of that may be true, we’d argue that the diligence process should ultimately to boil down to one key criteria: transparency. The manager in question should be as upfront and proactive about delivering the bad news as it is the good. In fact, multiple investors at both the PERE Investor Council in late October and PERE New York Summit last month spoke about how they valued such communication. It’s perhaps the single biggest indicator that a firm is open for inspection.