Track record is, of course, the bedrock of any LP decision-making, but past performance is not enough to guarantee future success. In particular, GP team size and investment capacity are overwhelmingly viewed as critical considerations, cited by 91 percent of LPs in Private Equity International’s LP Perspectives 2022 Study as forming a major part of their due diligence process.
Similarly, succession and retention planning are deemed important issues for the majority of respondents. Meanwhile, there has been a significant increase in the proportion of investors that consider ESG to be key, rising from 38 percent a year ago, to 57 percent.
Bart Molloy, partner at Monument Group, says that these additional areas of due diligence have become increasingly important in an environment where overall performance has been very strong. “We often have managers come to us prior to fundraising, who feel that their previous fund’s performance has been off the charts,” he explains. “But the reality is, within the vintage, it may not be top decile, or even top quartile, given the incredible performance of private equity in general. That all means investors are having to look past track record.”
LPs are looking at the way the manager has responded to any headwinds, for example, by analysing how it behaved in specific situations where portfolio companies were impacted by covid, according to Molloy. “They are also exploring whether a strategy is well positioned for the future, including from a sourcing and value-add perspective. They are referencing CEOs and really trying to understand how the team operates.”
Rishi Chhabria, partner and head of sales for North America at Campbell Lutyens, agrees. “Track record has always been paramount but there are many other factors that we are seeing LPs spend time on as they think about underwriting new relationships,” he says. “Returns have broadly been strong across private markets over the last year, so differentiating between two 3x track records is challenging.”
Again, Chhabria says that LPs are instead focusing on other factors that they believe set up a manager for long-term success. In line with the survey results, he says depth of team is key.
“As we extend into the second decade of a bull market, investors want to see that the team that has been assembled can handle volatility in the markets and still protect capital whilst continuing to work on maximising returns for investors.”
Chhabria also cites differentiation as a factor. “Probably the thing I hear the most is how does a manager fit a niche or void in the investment landscape or within an investor’s own portfolio,” he says. “Tech, software and healthcare have dominated investment capacity for the past few years, so we are seeing renewed appetite today for strategies such as deep value and industrials.”
Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association, meanwhile, points to the profound impact that a proliferation of technology and cloud-based data have had on LP due diligence.
“Cybersecurity, in particular, has become a more prominent area of focus,” she says. “Other areas of increased LP scrutiny include the near universal use of subscription lines, the expanded use of GP-led secondaries and continuation funds, co-investment and succession planning.”
For Carolina Espinal, managing director at HarbourVest, however, the most important consideration beyond track record will always be alignment. “Alignment manifests itself in multiple dimensions,” she says. “It can refer to people, a team’s culture, strategy, fund structure, governance and economics. Understanding what drives a team to deliver in the future and how well positioned they will be to do so is fundamental to backing a private equity manager.”
The paramount importance of alignment is clear, and a terms and fees benchmark was deemed to be the second most significant element of due diligence, cited as a major factor by 81 percent of respondents. “Any terms that put at risk the alignment between LPs and GPs could be cause for concern for us,” says Espinal. “Substantial scaling of fund sizes is one LPA term that, given the favourable fundraising environment, has been a significant point of discussion with managers at this point in the cycle.”
Meanwhile, half of investors surveyed say management fees represent the most common cause of contention between LP and GP. “Depending on the strategy, we continue to see the biggest pushback on off-market management fees, probably more so than carry,” says Chhabria.
LPs seek clarity
But investors are not necessarily looking to squeeze GPs on fees. They just want to know that incentivisation mechanisms have not been skewed.
“Investors want management fees to be appropriate for the organisation. There is sensitivity to GPs being aligned with their LP base,” Malloy says. “GPs need to proactively explain their budget to reassure investors that their incentivisation is suitably back-ended. But at the same time, LPs want to know that the GP can attract and retain top talent so they are not necessarily fighting for the lowest possible management fee.”
Roy Kuo, head of alternative strategies for the Church Commissioners, which manages the Church of England’s endowment, cites the key-person clause as a potential cause for concern. Just under half of survey respondents agree this is a significant issue. “We see managers looking to make that provision more nebulous. So, instead of the departure of any one of five individuals triggering the clause, it may be that three out of five need to leave to make that happen. That is an issue for us because obviously it can impact the manager’s ability to execute on strategy.”