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FRM Exam Part II · Private Markets Investing

Due Diligence, Valuation and Governance of Private Funds

Updated 11 October 2026 · Fact-checked

Due diligence is the investor's structured review of a private fund manager before and after investing. It covers strategy, people, operations, valuation and terms. Illiquid holdings are valued using models and comparables, so governance must limit manager conflicts. To answer exam questions, find the risk, name the control, and judge who it protects.

Understand Due Diligence, Valuation and Governance of Private Funds

A private fund (private equity, private credit, real assets, hedge fund) holds assets that rarely trade. You cannot read a market price. You rely on the manager, called the general partner (GP), to run the portfolio and report values. You, as the limited partner (LP), hand over capital and have little say after that. This gap creates the core problem: the GP knows more than you and may not act in your interest.

Due diligence is how you close the gap. Investment due diligence tests the strategy, edge, track record and team stability. Operational due diligence (ODD) tests the business behind the investments: independent administrator, auditor quality, custodian, cash controls, valuation policy, compliance, IT and cyber, and key-person dependence. Many fund failures, including frauds, were operational, not investment-driven. Due diligence continues after you invest, through reports, meetings and annual reviews.

Valuation is the hardest part. Typical methods are market comparables (multiples of similar firms), discounted cash flow, and recent transaction price. Private credit is often valued with a discount rate based on spreads. All of these need judgement. Valuations are also often smoothed: reported values move less than true values, so volatility and correlation with public markets look too low, and risk is understated. Stale marks also let managers flatter performance before fundraising.

Governance aligns the GP with LPs. Key tools are the limited partnership agreement (LPA) terms, an LP advisory committee (LPAC), an independent valuation committee, and third-party administrators and auditors. Fees matter too: a management fee on committed or invested capital, carried interest (a share of profits, often above a hurdle rate), clawback and key-person clauses.

Typical conflicts: valuing assets high to earn fees or raise the next fund; allocating deals between funds; charging portfolio companies fees; taking excess risk because carry is like a call option on performance; and holding assets longer than ideal. The exam wants you to match each conflict to a control.

Key formulas to remember

Net asset value (NAV) of a fund
NAV = Fair value of assets − Liabilities (incl. accrued fees and carry)
Fair value inputs are the main source of GP discretion.
Management fee
Fee = fee rate × (committed or invested capital)
Fees on committed capital are paid even on undrawn money; fees on NAV reward higher marks.
Carried interest with hurdle (simple, no catch-up)
Carry = carry rate × (profit − hurdle amount)
With a full catch-up, carry is the carry rate × total profit once the hurdle is cleared. Read the LPA terms in the question.
Unsmoothing of returns (one-lag)
R(true, t) = [R(reported, t) − a × R(reported, t−1)] ÷ (1 − a)
a is the smoothing coefficient between 0 and 1. Unsmoothing raises measured volatility.
Autocorrelation red flag
High positive autocorrelation in reported returns suggests smoothing or stale pricing
It is a flag, not proof of misconduct.

How to solve Due Diligence, Valuation and Governance of Private Funds questions

Use this order for any scenario question on private fund selection, valuation or governance.

  1. 1Identify the party and the problem: is it investment risk, operational risk, valuation risk or a conflict of interest?
  2. 2Find the information gap: what does the GP know that the LP cannot see?
  3. 3Name the specific control that fits: independent administrator, auditor, valuation committee, LPAC, clawback, fee terms or key-person clause.
  4. 4If numbers are given, compute the fee, carry or unsmoothed return carefully, using the terms stated in the question.
  5. 5Check for red flags: unaudited or small auditor, no independent administrator, one person controlling cash, stale or smooth returns, unexplained consistent performance.
  6. 6Judge who benefits from each option and eliminate answers that favour the GP.
  7. 7Pick the answer that is both correct in principle and most directly addresses the stated risk.

Quickest way: Problem-to-control matching

When to use it: For conceptual multiple-choice questions where you have under two minutes.

  1. Label the risk in one word: valuation, conflict, operational, fraud or liquidity.
  2. Recall the matching control: valuation means independent pricing and audit; conflict means LPAC and fee terms; fraud means independent administrator and custodian.
  3. Remove options that rely on the GP's own word or self-reporting.
  4. Choose the option that adds independence or alignment.

Common mistakes in Due Diligence, Valuation and Governance of Private Funds

  • Treating due diligence as only a review of past performance.

    Track record is the most visible item, so it feels most important.

    Fix: Always include operational due diligence. Operational weaknesses cause many failures, and strong returns do not cure them.

  • Assuming low reported volatility means low risk.

    Reported NAV from appraisals looks stable.

    Fix: Recognise smoothing. Unsmooth returns to see higher volatility and higher correlation with public markets.

  • Believing an audit guarantees correct valuations.

    An audit sounds like proof of accuracy.

    Fix: An audit gives reasonable assurance on the financial statements. Level 3 valuations still rest on judgement, so check the valuation policy and who approves marks.

  • Mixing up hurdle rate, carry and clawback.

    The terms are used together in the LPA.

    Fix: Hurdle is the minimum return before carry. Carry is the GP's profit share. Clawback returns excess carry to LPs if later losses reduce total profit.

  • Choosing a fee on committed capital as always the most LP-friendly.

    Assuming bigger base means bigger cost without comparing.

    Fix: Compare bases. Fees on invested capital or cost are generally friendlier than fees on committed capital; fees on NAV give the GP an incentive to mark up.

  • Stopping due diligence at the investment date.

    Selection feels like the finish line.

    Fix: State that monitoring is ongoing: reports, valuation changes, staff turnover, and LPAC matters.

Worked examples

Example 1

A private equity fund has ₹200 crore of profit on realised investments. The LPA gives the GP 20% carry above an 8% hurdle. The hurdle amount over the holding period equals ₹40 crore of profit. There is no catch-up. How much carry does the GP earn?

Show the solution
  1. Profit above the hurdle = ₹200 crore − ₹40 crore = ₹160 crore.
  2. Carry = 20% × ₹160 crore = ₹32 crore.

Answer: The GP earns ₹32 crore of carry.

Example 2

A fund reports returns of 4.0% this month and 3.0% last month. Its smoothing coefficient a is 0.40. What is the unsmoothed return this month, and what does unsmoothing do to measured volatility?

Show the solution
  1. Apply R(true) = [R(reported, t) − a × R(reported, t−1)] ÷ (1 − a).
  2. Numerator = 4.0% − 0.40 × 3.0% = 4.0% − 1.2% = 2.8%.
  3. Denominator = 1 − 0.40 = 0.60.
  4. R(true) = 2.8% ÷ 0.60 = 4.67% (rounded).

Answer: The unsmoothed return is about 4.67%. Unsmoothing raises measured volatility, which shows that reported figures understated risk.

Exam tips

  • Expect case-style questions: a fund description with hidden red flags. Scan for missing independence in administrator, auditor or custodian.
  • When a question asks who should value illiquid assets, prefer an independent valuation function over the deal team.
  • Read the LPA terms in a carry question exactly. Check hurdle, catch-up and fee base before calculating.
  • For conflicts, link each to a named control, such as LPAC approval for related-party deals.
  • Smoothed returns understate volatility and correlation. Remember the direction.

Practice questions from Private Markets Investing

Due Diligence, Valuation and Governance of Private Funds in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Due Diligence, Valuation and Governance of Private Funds: frequently asked questions

What is operational due diligence in private markets?

It is the review of the fund's non-investment functions. These include administration, custody, valuation process, compliance, IT and cyber, cash controls and service providers. It aims to catch fraud and process failures that returns alone will not reveal.

How are private equity investments valued?

Managers use market comparables, discounted cash flow and recent transaction prices, then report a NAV. These inputs need judgement, so valuations are often stale or smoothed. Governance such as independent valuation committees and audits reduces bias.

What are the main GP-LP conflicts of interest?

Common ones are inflated valuations before fundraising, deal allocation between funds, fees charged to portfolio companies, and risk-taking driven by carried interest. LPAs, LPACs and clawbacks are used to manage them.

Why does smoothing matter for risk?

Smoothed returns lower measured volatility and correlation, so risk measures and diversification benefits look better than they are. Unsmoothing gives a more realistic picture.