Investments Program
Final Audit Report
Report Nr. 15/12
November 22, 2012
Distribution:
To:
President & CEO
Senior Vice President & Chief Financial Officer
Senior Vice President, Financing
Senior Vice President & Chief Risk Officer
Vice President, Investments
Vice-President & Corporate Controller
Vice-President General Counsel & Senior Assistant Secretary
Director, Corporate Accounting
Lead Investment Manager, General Industry Direct Investments
Lead Investment Manager, Fund Investments
Lead Investment Manager, Tech Direct Investment
Lead Investment Manager, Connect & Value Creation
Senior Investment Manager, Tech Direct Investment
Portfolio Manager, Portfolio Oversight
CC:
Senior Vice President, Human Resources & Communications
Senior Vice President, Business Development
Senior Vice President, Insurance
Senior Vice President, Business Solutions & Innovation
Senior Vice President, Corporate Affairs & Secretary
Director, Planning & External Relations
Principal, Office of the Auditor General
Director, Office of the Auditor General
Audit Team:
Adam Stratas
Eric Hunter
Lindsay Schoutsen
David Gauthier
Vice President Internal Audit
Monica Ryan
Table of Contents
Introduction ........................................................................................................... 3
Audit Objectives & Scope ..................................................................................... 3
Internal Audit Opinion........................................................................................... 3
Audit Findings & Recommendations................................................................... 4
Conclusion ............................................................................................................ 9
Investments Program | November 22, 2012
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Introduction
In accordance with our FY2012 Audit Plan, EDC Internal Audit performed an audit of the Investments
Program within the Financing Group. As of Q2 2012, EDC‟s investment portfolio consisted of 45 active
fund investments with a Fair Value (FV) of approximately CAD 756 million, while EDC‟s direct
investment portfolio included 13 active investments with a FV of approximately CAD 38 million.
Audit Objectives & Scope
The overall objective of this audit was to evaluate both the design and operating effectiveness of controls
surrounding the Investment process. The scope of this audit included detailed testing of controls
pertaining to program reporting, Private Equity Office (PEO) data integrity, mandate and Canadian
benefits, deal analysis, monitoring of investments, and valuation of investments. Detailed fieldwork was
performed from June through August 2012.
Internal Audit Opinion
In our opinion, Opportunities Exist to Improve Controls1 surrounding the Investments Program. Effective
business practices are in place to analyze and approve individual investments and monitor individual
investments. However, we found that some of the information regarding the overall results of the program
that is reported to management lacks accuracy or cannot be substantiated. This reduces the effectiveness
of these reports as a monitoring control. Also, user acceptance of the PEO system is low and as a result
significant information on individual investments and the program continues to be maintained off-line.
Finally, controls pertaining to the reconciliation of fund statements to PEO subledger balances and the
reasonability of management fees need to be designed and implemented.
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Our standard audit opinions are as follows:
Strong Controls: Key controls are effectively designed and operating as intended. Best in class internal controls exist. Objectives of the
audited process are most likely to be achieved.
- Well Controlled: Key controls are effectively designed and operating as intended. Objectives of the audited process are likely to be
achieved.
- Opportunities Exist to Improve Controls: One or more key controls do not exist, are not designed properly or are not operating as
intended. Objectives of the process may not be achieved. The financial and/or reputation impact to the audited process is more than
inconsequential. Timely action is required.
- Not Controlled: Multiple key controls do not exist, are not designed properly or are not operating as intended. Objectives of the process are
unlikely to be achieved. The financial and/or reputation impact to the audited process is material. Action must follow immediately.
-
Investments Program | November 22, 2012
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Audit Findings & Recommendations
1. Reporting of Program Activities and Results
The Investments Committee (IC) was established earlier in 2012 to provide guidance and oversight of the
Investments Program on both a strategic and transactional level. Consistent with this objective, the IC
receives monthly and quarterly updates on the activities and results of the Investments program. The
information contained in these reports is also used to provide updates to the Risk Committee of the Board
of Directors on the Investments Program. The topics covered in these reports provide a good basis for
monitoring the Investments Program and include: investments by type, stage, and region, number and
dollar value of active versus matured (inactive) investments, total invested capital, realized and unrealized
gains, rate of return metrics such as IRR and MOC, and cash available for future investing. However, we
found that some of this information either lacked accuracy or could not be validated. For example:
 Recently, the IC received an update that cash available for future investing was in the range of $580M
to $520M. However, this range is based on two key assumptions that should be validated. First, that
the assumed realized rates of return are realistic given EDC‟s experience and investment objectives.
(We noted that the rates of returns used to calculate cash available for forecasting did not correspond
to the amounts included in the 2013 Corporate Plan.) Secondly, that the estimated average draw down
of committed capital by fund managers is realistic;
 The Q1 2012 report highlights that there are 22 active direct investments. However, this includes
investments that have been written down to nil and/or sold. Exclusion of nil and sold investments
would decrease the number of active investments by 40% to 13 which could influence capital and /or
resource allocations between direct and indirect investments;
 Reported Internal Rate of Return (IRR) results by stage of investment could not be validated as
supporting documentation was not retained; and
 The methodology for determining total invested capital, realized proceeds and unrealized proceeds
contains errors which impacts the accuracy of amounts reported to management and metrics such as
Multiple of Capital (MOC) and Total Value to Paid-in Capital (TVPI). For example, capital
reimbursements2 are included in realized proceeds and, realized gains and losses are deducted in error
when calculating unrealized fair value.
We have recommended that a review process be implemented for program reporting to senior
management and the Board. This should include a review and validation of how key data/metrics are
calculated including any assumptions and reconciliations to the subledger and/or corporate plan.
Capital Reimbursements occur when a fund makes a capital call against EDC‟s commitment and then returns a portion or all of the capital to
EDC without investing the capital.
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Investments Program | November 22, 2012
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Rating of Audit Finding - Major3
Action Owner – Portfolio Manager
Due Date – Q2 2013
2. Private Equity Office (PEO) System Configuration & User Acceptance
User acceptance of the PEO system is low. As a result, we found that significant information on
individual investments and the Investments Program continues to be maintained off-line. In addition, we
found a number of configuration issues with PEO some of which make the system less intuitive for users
and, are likely contributing to low user acceptance. For example, it is unclear how certain fields in PEO
are derived including foreign exchange amounts and exposure amounts; the latter of which is used to
calculate TVPI. We were also unable to determine how the gross IRR rate on the Historical Performance
Report was configured to be calculated. We also noted some issues with respect to how PEO reports have
been configured and labeled. For example, the Fund Fair Market Value (FMV) Report includes “total
capital distributions”. This labeling could be confusing to a user as it has been configured to include all
cash distributions. The same field in another report is labeled „cumulative distributions‟. The FMV report
has also been configured to include the total capital distribution field when calculating FMV for each
fund. As a result, FMV balances on this report include realized gains. We have recommended that
management revalidate PEO functionality in relation to the business and user requirements. The outcome
of this review should then be used to prioritize the resolution of configuration issues.
Rating of Audit Finding - Major
Action Owners – Portfolio Manager in collaboration with Lead Investment Managers
Due Date – Q2 2013
3. Accounting & Financial Controls Surrounding Fund Investments
At the end of Q2 2012, EDC had committed approximately $756 MCAD to 45 domestic and international
funds. To date fund managers have placed capital calls of just over $435 MCAD against this commitment
level. During the audit, we found issues with respect to the reconciliation of fund statements and how
some fund transactions are being accounted for. Specifically:
 Monthly and quarterly statements are received from each fund but are not being reconciled to
subledger balances. This includes subledger balances pertaining to invested capital, management fees,
recallable distributions, realized and unrealized gains/losses, and carried interest.
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Our audit findings are ranked as follows:
Major - a key control does not exist, is poorly designed or is not operating as intended and the financial and/or reputation risk is more than
inconsequential. The process objective to which the control relates is unlikely to be achieved. Corrective action is needed to ensure controls
are cost effective and/or process objectives are achieved.
- Moderate - a key control does not exist, is poorly designed or is not operating as intended and the financial and/or reputation risk to the
process is more than inconsequential. However, a compensating control exists. Corrective action is needed to avoid sole reliance on
compensating controls and/or ensure controls are cost effective.
- Minor - a weakness in the design and/or operation of a non-key process control. Ability to achieve process objectives is unlikely to be
impacted. Corrective action is suggested to ensure controls are cost effective.
-
Investments Program | November 22, 2012
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 A variance or reasonability analysis is not performed of the management fees paid to fund managers.
In addition, management fees are being expensed as a fair value adjustment for financial statement
purposes but are being capitalized for internal reporting purposes. Approximately $32 MCAD have
been incurred to date; and
 Carried interest amounts withheld by fund managers when an investment is sold and placed in escrow
are currently being expensed as management fees. However, the rationale for treating these amounts
as a period expense is not clear given that the amount due to the fund manager cannot be reasonably
determined.
Given the materiality of the amounts invested with domestic and international funds we have
recommended that fund statements be reconciled on a monthly basis with PEO subledger balances. In
addition, consideration should be given to aligning the treatment of management fees for both internal and
external financial reporting purposes. The reasonability of management fees should be reviewed on a
quarterly basis. Finally, we recommend that the current practice of expensing carried interest be reviewed
in relation to the nature of the underlying transaction.
Rating of Audit Finding - Major
Action Owners – Portfolio Manager in collaboration with Director Corporate Accounting
Due Date – Q2 2013
4. Mandate & Canadian Benefits
EDC‟s mandate is to support and develop, directly or indirectly, Canada‟s export trade and Canadian
capacity to engage in that trade and to respond to international business opportunities. Consistent with
this mandate, investments in foreign funds are approved based on a reasonable expectation that there will
be future Canadian benefits. Specifically, the Mandate Guidelines for Equity (the Guideline) states that
there should be a reasonable expectation that Fund portfolio companies will procure Canadian goods and
services at least equal to EDC‟s investment. However, the Guideline is silent with respect to the period of
time within which goods and services are to be procured. As a result, investments in successor funds may
be approved even though the 1:1 proportionality may not have been achieved through EDC‟s investment
in the predecessor fund. We have recommended that the Guideline be updated to provide clarity with
respect to a reasonable period of time for achieving the 1:1 proportionality from investments in foreign
funds. Furthermore, we have recommended that consideration be given to factors such as emerging versus
developed markets when establishing timelines.
The Investment team has developed metrics to track the success of their connect activities. These metrics
include introductions, qualified business opportunities, signed contracts, and business partnerships.
However, these metrics were not constructed to support tracking of Canadian benefits. Accordingly, the
definition of certain metrics is not well suited for measuring Canadian benefits. For example, the value
assigned to signed contracts represents future year revenue forecasts under master agreements versus the
value of procured goods and/or services. We have recommended that metrics be developed for tracking
the Canadian benefits associated with foreign fund investments once the Guidelines have been updated.
Investments Program | November 22, 2012
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Rating of Audit Finding - Moderate
Action Owners – VP, General Counsel & Sr. Assistant Secretary in collaboration with Lead Investment
Manager, Connect & Value Creation
Due Date – Q2 2013
5. Deal Analysis – Fund & Direct Investments
In Q2 2012, governance controls surrounding the Investments Program were enhanced through the
introduction of the Investments Committee (IC). The purpose of the IC includes deal triaging at an early
stage (i.e. approving the flightpath for each deal) and recommending investment deals for endorsement.
Concurrent with the creation of the IC, the Investments team also made significant changes to streamline
their deal analysis documents and facilitate their review by the IC. Extensive deal analysis documents
referred to as “bricks” were replaced by Level 1 and Level 2 IC Memos. The objective of the Level 1
memo is to obtain IC approval of the flightpath for the deal. Accordingly, the content of the Level 1
Memo is based on a preliminary due diligence only. The Level 2 memo is prepared after the due diligence
is completed and is the basis for endorsement recommendations and deal approval.
During the audit, we found that the IC memos do not always contain the relevant information to support
endorsement recommendations for two reasons. First, the IC memos are structured to provide most of the
detailed analysis about an investment deal as part of the Level 1 IC memo. However, the content of the
Level 1 memo is based on the results of a preliminary due diligence only and an update of this
information is not always included in the IC memos once the due diligence is completed. Accordingly, we
found that some of the information included under the Key Risks and Financial Sustainability sections of
the IC memo was vague or had changed as a result of the completed due diligence. Secondly, the IC
memo templates do not include sections for some information that would be helpful to the IC when
recommending transactions for endorsement. For example, the IC memo templates for direct investments
do not include sections on key business milestones and cash forecasts.
We have recommended that management review the content of the Level 1 and Level 2 IC memos with
the objective of better aligning the extent and type of information included in these memos with the
objective of the corresponding IC meetings. In addition, we have provided suggestions regarding
additional information that could be provided to the IC to support their endorsement recommendations.
Consistent with their continuous improvement focus, the team is already making changes to the IC
memos to better align their content with the objective of the Level 1 and Level 2 IC meetings and ensure
relevant information is consistently provided to the IC.
Rating of Audit Finding - Moderate
Action Owner – Senior Investment Manager, Tech Direct in collaboration with VP, Investments
Due Date – Q2 2013
Investments Program | November 22, 2012
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6. Monitoring of Investments – Fund & Direct Investments
Investment managers actively monitor the key business activities and performance of individual
investments in their assigned portfolio. However, a standardized approach has not been developed to
ensure consistency and that the level of monitoring is aligned with the risk and/or connect opportunity
related to EDC‟s investment. For example, all IC memos include an investment thesis section outlining
the rationale for EDC‟s investment. However, investment monitoring activities do not always include
follow up on the key elements of the original investment thesis. Collectively, these two issues make it
difficult to aggregate the results of monitoring activities to gain a portfolio view. We have recommended
that the Investment team establish clear objectives regarding the purpose of the monitoring process then
standardize the approach based on the type/stage of investment. Consideration should then be given to
further leveraging the functionality of PEO to support monitoring activities. This will facilitate
monitoring at a portfolio level and help ensure information concerning the monitoring process is easily
accessible. Finally, we recommended that consideration be given to the creation of an overall
performance rating for each investment in order to influence both the tempo and depth of monitoring
activities.
Rating of Audit Finding - Moderate
Action Owners – VP, Investments in collaboration with Lead Investment Managers
Due Date – Q2 2013
7. Valuation of Direct Investments
Valuations of direct investments can be complex and often require significant judgment as they are
largely based on unobservable data. Overall, we found that the process followed to determine the FVs of
the direct investments each quarter was reasonable. However, we found that the fair value of an
investment is not always accurately recorded in PEO. For example, we reviewed the Q2 2012 FV
calculation for two direct investments and found both were incorrectly recorded in PEO. The errors were
off-setting and therefore did not have a significant impact on the reported FV of direct investments for
Q2 2012. We recommend that the valuation memos be updated to include a conclusion section outlining
the FV adjustment for each instrument. Valuation memos should be provided to Loans Services as
supporting documentation for each FV adjustment.
Each quarter, the investment managers prepare a two to three page Valuation Memo for each direct
investment outlining any recommended fair value adjustment and the supporting details. A short
summary is then prepared and submitted to the Valuation Committee for their review. We have
recommended that the practice of further summarizing valuation memos be discontinued as important
information relevant to the Valuation Committee‟s review is sometimes omitted.
Rating of Audit Finding - Moderate
Action Owner – Portfolio Manager in collaboration with Director, Corporate Accounting
Due Date – Q2 2013
Investments Program | November 22, 2012
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Conclusion
The audit findings and recommendations have been communicated to and agreed by management, who
has developed action plans that are scheduled for implementation no later than Q2 2013.
We would like to thank management for their support throughout the audit.
Investments Program | November 22, 2012
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