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FRM Part II · FRM Exam Part II · Private Markets Investing

During operational due diligence on a private equity manager, an analyst finds that the fund administrator, the auditor and the legal counsel are all small firms with no prior record, selected by the GP and affiliated with its principals. The strategy and track record appear strong. What is the most appropriate conclusion?

Operational risk is elevated, so the investment should be declined or conditioned on change. Small, unproven and GP-affiliated administrators, auditors and counsel remove independent verification of assets and valuations, a classic red flag seen in Madoff. Strong performance does not compensate for weak operational controls.

  1. AOperational risk is elevated because the lack of independent, reputable service providers weakens controls, so the investment should be declined or conditioned on changesCorrect
  2. BStrong performance offsets the concern, so only investment due diligence matters
  3. CThe concern is minor because private funds are exempt from audit requirements
  4. DThe investor should rely on the GP's own internal reports since they are the most informed

Explanation

Madoff-style red flags include affiliated or unqualified service providers, which remove independent checks on asset existence and valuation. Strong returns do not mitigate this and can mask fraud. Operational due diligence is a separate, often decisive, screen, so the investor should decline or require independent providers.

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