Service or product provider due diligence and SPVs

The purpose of a due diligence assessment is to consider the key risks presented by a product or a service provider. These risks can be classified into the following broad categories:

Poor performance
Risk or performance volatility not in line with expectations
Operational failure of service/product provider
Financial failure of service/product provider
Regulatory non-compliance of service/product provider
Fraud by service/product provider

Areas that need to be addressed through a due diligence assessment of the SPV and of the UIM should cover the following areas:

Regulatory compliance
Governance structures
Financial soundness
Operational reliability
Investment management

Regulatory compliance

Regulation 28 directs that funds shall invest a minimum of 1.75%, and a maximum of 3.5%, of the market value of its investments in unlisted investments in accordance with regulation 29. Regulation 29 is a globally unique framework for unlisted investments by pension funds. It defines the new concepts of 'special purpose vehicle' (SPV) and 'unlisted investment manager' (UIM) and directs that an SPV must be managed by an UIM. For these entities, the regulation prescribes the requirements for registration, management, ownership, powers, restrictions and duties, reporting and manner of operation.
Regulatory compliance requires that:

Both, the SPV and the UIM are registered by Namfisa before any capital is committed;
Both, the SPV and the UIM remain registered while holding capital of the fund;
The fund has entered into a subscription agreement with the SPV setting out the committed capital and the draw-down period afforded to the SPV, subject to this being limited to 24 months;
The fund maintains an investment of no less than 1.75% and no more than 3.5% of the market value of its investments in the SPV/s throughout;
Where the investment initially comprises only of a commitment of capital, the capital is actually drawn down within 24 months or is committed to another SPV prior to the expiry of this period.
If any of the afore going conditions cannot be met through circumstances considered out of the control of the trustees at any point in time, an application for extension or exemption is made to and granted by Namfisa.

Governance

Regulation 29 prescribes the governance structures of an SPV and a UIM. Once, and for as long as, an SPV and the UIM are registered, the trustees can accept that Namfisa has ascertained that sound governance structures are in place for these entities. Sound governance measures, however further require that:

Regular investment reporting is received from the UIM on the investments of the SPV;
The investment reports received do not evidently indicate a divergence of the SPV from the initial intentions and investment framework, on the basis of which the trustees selected the SPV;
Adequate professional indemnity and fidelity cover is maintained by the SPV and UIM;
Acceptable provision for liquidity is offered by the SPV;
Proposed fee structures are reasonable;
Any costs directly borne by the SPV are acceptable;
Subscription agreement is acceptable and sound;
Management agreement between UIM and SPV is acceptable and sound;
SPV management is appropriately qualified and experienced to maintain due care, skill and diligence;

Financial Soundness

Regulation 29 establishes the SPV as a separate legal entity, namely either as a public company, a private company or a trust. The UIM also must be constituted as a public company or as a private company. SPV's will in many cases be established with a fixed investment term due to the nature of the underlying investments, where investment returns will largely only be realised once the SPV exits the investment. The investment process entails funds to first commit capital, Only then will the UIM start to invest. Once the capital has been committed, the investing fund has no further influence on the investment decisions of the UIM.

The risk of the investing fund lies in the capabilities of the UIM to choose projects and investment objects that will produce fair risk adjusted returns and in the SPV not managing the relationship with due care and skill to ascertain that the investing funds' capital is managed diligently by the UIM.

The investing fund's concern about financial soundness should primarily be focused on selecting the right SPV/s and the UIM/s in terms of the UIM/s investment capabilities and the SPV's capabilities to monitor the UIM.
When choosing an SPV and its UIM, sound governance in this regard requires that:

The financial position of the UIM is satisfactory;
Assets under management of the UIM provide acceptable comfort of its sustainability;
Client base of UIM is diversified and provides acceptable comfort of its sustainability;

Operational Reliability

As elaborated in the discussion on 'financial soundness' above, once a fund has committed capital to an SPV, its fortunes are in the hands of the SPV and its UIM. The investing fund's concern should in this regard thus also be about selecting the right SPV/s and the UIM/s in terms of the UIM/s investment capabilities and the SPV's capabilities to monitor the UIM.
When choosing an SPV and its UIM, sound governance in this regard requires that:

Transparent and comprehensible reporting is provided regularly;
The UIM has appropriate skills to manage the business of the SPV in terms of accounting, valuation of investments, formulation and administration of agreements;
The UIM has appropriate systems to manage the SPV;
Operational policies of the UIM are sustainable and support the retention of key staff.

Investment Management

Proposed investment projects and investment objects of UIM are acceptable;
Investment track record of UIM is acceptable;
Investment plan of SPV is acceptable;
Investment staff of UIM is appropriately qualified and experienced.

Having provided an extensive process and checklist, good governance dictates that the attention trustees apply to unlisted investments should be commensurate with the attention they apply to the 'conventional' investments of their fund.

Important notice and disclaimer
This article summarises the understanding, observation and notes of the author and lays no claim on accuracy, correctness or completeness. Retirement Fund Solutions Namibia (Pty) Ltd does not accept any liability for the content of this contribution and no decision should be taken on the basis of the information contained herein before having confirmed the detail with the relevant party. Any views expressed herein are those of the author and not necessarily those of Retirement Fund Solutions.