When a placement agent works with a private equity firm on a fundraise, in some ways it becomes an extension of the firm itself.
As such, it’s imperative the fundraiser knows as much as it possibly can about the firm and the fund – beyond even what a limited partner might seek to know.
“The worst thing that could happen to us and one of our clients is that we don’t find something in our due diligence that someone else finds,” says Jeff Eaton, partner and head of worldwide origination at Eaton Partners. “That can instantly hurt the credibility of a fundraise.”
But how does a placement agent go about sifting through the thousands of fundraising opportunities in the market each year to home in on the ones it wants to bid for? And how does it determine the difference between a relationship-ending red flag and a challenge that can be overcome?
The first cut
The first step is to whittle down the hundreds of private equity funds that cross the placement agent’s desk in a given year to viable opportunities. Eaton Partners, for example, looked at around 1,600 funds in 2019, and looks to work with between 12 and 15 each year.
Eaton says the firm takes a “top down” approach to the market, beginning with the question: what are investors looking for?
The firm has teams dedicated to different industries and sub-strategies who are charged with knowing all the players and how they’re performing. “We’ll map out the whole landscape for a given industry or strategy and then we’ll proactively start calling the best managers to see if they might be interested in working with us.”
This stage can also involve eliminating funds that are too small and doing a “quick screen” based on publicly available information, such as Preqin, Pitchbook or other databases, says Kevin Kuryla, global head of the private funds group at UBS, although he stresses a personal referral or recommendation often holds more weight.
“If an LP we’ve done business with talks in detail about why they like a particular GP, even if the screen coming back from one of the data providers is a little less than perfect, we would still try and meet them and get our arms around the returns and the strategy.”
Now it’s time to meet the managers. At this point the placement agent is ascertaining that not only is the strategy interesting and worth pursuing in that market environment, but that manager is the right one to do it, Eaton says.
Then comes more in-depth vetting of the track record, of both the firm (if it is not a first-time fund) and all the key individuals.
“We go through and match that track record and those cashflows to historic documentation, whether they be quarterly reports, annual meeting information, sometimes down to the actual accounts,” says Christoffer Davidsson, a partner heading up Campbell Lutyens’ New York office.
Assessing the dynamic of the team is key; question marks over power dynamics, the spread of compensation and cohesion are major red flags.
Campbell Lutyens meets with the team on an individual basis to get to know them and their backgrounds and understand individual track record, and as a team to get a read on the dynamic.
“These are 10-plus year partnerships. You want to make sure it’s a team that endures,” Davidsson says. “You don’t [want] key man risk sitting with any particular individual, but rather a team that if, for whatever reason, one falls away, they can still carry the show.”
Reference checks are a significant component of the due diligence process. Placement agents will reach out to both present and past limited partners, former employees, bankers and auditors, and portfolio company CEOs to gain a full picture of a manager.
“We don’t just call the reference list a firm provides, we explore off reference list [to hear about] the reputation and really try to put together a comprehensive picture,” Kuryla says.
In Kuryla’s experience, reference checks are typically where problems are found, for example around strategy drift or lacklustre support from existing investors. Sometimes portfolio company CEOs raise some red flags, too.
Davidsson says: “For example, if a GP claims they have a very hands-on operational approach, yet you find out through the CEO references that they show up to the quarterly board meetings only, there’s a disconnect there.”
For Eaton Partners, the last step in the process is a thorough background check.
“Typically, the last thing we do after completing other extensive due diligence is a background check, because that can be pretty invasive,” Eaton says. “We’re hiring a third party and asking for people’s social security numbers.”
Even at this 11th hour, something can come up that will mean the placement agent is no longer comfortable working with the client.
“We reserve the right to kill something all the way up until the PPM is printed and we’re in the market,” Eaton says.
“While very rare, there have been situations where we’ve told a client we can no longer work with them a couple of days before launch because we uncovered something in our underwriting that was different from what we were led to believe by the client.”
Fundraising red flags
Common issues placement agents look out for when assessing whether to work with a fund manager on their next raise
Uneven power distribution within the team
Everyone Private Equity International spoke to for this article stressed that issues around the team can be some of the biggest and most unsurmountable red flags. Fundraisers are looking for a cohesive team with power (and compensation) distributed fairly.
“Is there a good alignment of interest among the investment team? We’ll dive into compensation agreements and look at who owns the GP,” Jeff Eaton says. “Is there a succession plan in place? Are the economics pretty equitable, or are they disproportionately [weighted to] one or two people? If it’s the latter, how do the other team members feel about that? Is there a risk that they leave?”
A strategy too complex for LPs to get their heads around
Having a strong strategy is not always enough; it also needs to be a strategy LPs are comfortable finding room for in their portfolios. Some investors have fairly rigid definitions for what fits into a particular allocation – being the first firm to come up with a radical new strategy, even if it looks like it can generate strong returns, is not always a good thing.
Low support from existing investors
A major issue that can come up during reference checks is the sense that support from existing investors is nowhere near the level the manager has led the fundraiser to believe, whether that’s related to strategy or performance or it’s down to the LPs rebalancing their portfolios for their own goals.
Volatility of the track record
Digging into the details of the track record may reveal a more complex picture than originally thought.
“Somebody may have really, really strong overall returns, but investors often don’t have the stomach for volatility,” Kuryla says. “They usually prefer more consistency, as opposed to a couple of home runs and several wipeouts.”