Making the grade

The theory that if you invest in a large enough universe of managers you will hardly lose any money unless you are stupid is a fallacy. Investors do not invest to lose money, they invest for the return. Private equity is a risky asset class and you want to take the risk but you also want to mitigate the risk to the best of your abilities.

The manager selection process is a critical element for a successful investment programme given the large dispersion of return among managers as experienced over the years, and empirical studies have also demonstrated that given some attributes best performing managers tend to continue performing over time.

Best practices for manager selection require extreme prudence and detailed work by the potential limited partner, with no stone unturned and every question asked of a fund manager entity. Investors have every right and requirement to understand perfectly the manager’s team structure and culture as well as some part of their private lives; how the manager conducts its investment business; how well its many processes have been developed; the manager’s expertise and ability in finding the best deals available in any given vintage year; and how the manager’s corporate governance procedures stand up to close investigation. All of these assessments of manager-related risk deserve the greatest attention that any responsible investor is capable of delivering, but if there is a deficiency in assessing these risks then this raises some serious issues about the investor’s own fiduciary role in the whole investment process.

 Réal Desrochers

The common denominator of buyouts and venture capital is that institutional investors are looking for a demonstrable corporate structure with a good alignment of interest whereby the fund’s partners have their own money invested alongside their limited partners’ money and they share the time of the investment horizon being asked of limited partners. In the context of ten-year life funds, it is important to make sure that managers are incentivised for the life of the fund and do not go to the bank to sell the net present value (NPV) of the money they receive (i.e. not to collect or monetise it right now) on one hand and on the other the carried interest, the ultimate reward, should vest only when the limited partners have received the whole of their money back.

It is vitally important to understand the corporate organisation and the ownership of the fund in terms of carried interest – you do not want to invest in a fund where the economic interest of the entire firm and the entire fund is owned by one or two individuals. Rather, it is better to look for firms where the share of carry is spread across a number of managers. Finally, it is also critically important to assess for the larger-size fund (typically medium and large-size private equity houses) the importance of the fee to be earned by the general partner from arranging the financing and or monitoring of portfolio companies.

Some limited partners have talked about hiring psychologists or investigators to evaluate managers but this is not an agreeable approach.

The normal sharing of these fees should be credited 100 percent to the limited partners as the capital is the key ingredient for a general partner to conduct his business but depending on the investment cycle the sharing arrangement can be in a big range. It is particularly important to assess this aspect of a large buyout firm and mostly for the few ones that have become public as they have the need to earn current income for their stock prices. An investor has to assure himself that he is investing with a pure private equity house and not an asset manager.

Sizing up GPs

Some limited partners have talked about hiring psychologists or investigators to evaluate managers but this is not an agreeable approach. Though due diligence on the fund manager is all about knowing and understanding people, there have to be limits. That said, you should want to know about a manager’s motivations to the extent you can and you should definitely want to be very close to the firm and know how it operates as a fund manager and investment manager. On a personal level, you need to know that you are working with people who will share information with you and will ensure that this information is kept in confidence; that is what makes a good relationship in private equity. When any confidence is broken and the information is revealed in the public domain the private equity relationship is damaged. Essentially, you need to know what makes the investment manager tick on many different levels.

Crucially important for every limited partner is the quality of communication it has with the general partner with whom it has entrusted its valuable funds. Communication broadly encompasses an understanding of the investment environment, financial reporting on the portfolio company holdings and most importantly what the inner workings of the management team are. A large pension fund or a fund of funds investor will typically develop a closer working relationship with its general partner investment manager, usually starting early on in the fundraising process.

While smaller or new firms can outsource these communication services for the first fundraising they are still, nevertheless, at a disadvantage. This is why the first and the second funds are so difficult to raise for general partners. What limited partners will predominantly focus on is track record and processes, but they will need to develop a critical understanding of the inner workings of the fund managers. They will need to learn and understand how they source their deal flow, how an investment house develops its thought processes, and how it develops and maintains its angle with the corporate finance world, industry specialists and investment universe. Knowing and understanding what is going on in a manager’s back office is a vitally important part of the assessment of a fund manager’s processes and should be undertaken with as much diligence as with any assessment of front-office processes.

Generally, a good way of appraising a GP is by assessing three key components: quality of management team; investment strategy; experience.

You can have a good management team and an investment strategy, but if you do not have deals then you are not going to survive as a private equity fund manager. Managers need to be able screen and select the best deals and to be able to do that they need to see a lot of deals, and their industry expertise has to be developed too. In order to reach a level of comfort with a general partner it is imperative to scrutinise its deal book, examine in detail its monthly meetings minutes, and then supplement this analysis by talking to chief executive officers the manager has links with and more generally with people in the industry.

Surveying the competition

It is also very important to understand which other fund managers the fund manager you are assessing will be competing with or indeed likely to partner with in the market. The reason behind this is to avoid double, triple or even quadruple exposure to a single corporate through separate fund managers to which as an investor you have allocated funds.

Multiple exposure to a single company is a constant concern for limited partners and most investors want to avoid it because it really is an extra risk to the portfolio in terms of concentration risk. In all reality, investors do not have much control over multiple exposure other than when selecting the manager because when an allocation is made the money is held in blind pool and investment decisions have obviously been delegated to the fund manager. The work has to be done a priori. Essentially, you pick one from a group of very similar private equity houses because you set out with the objective of not doubling up your exposure at a company level. This requires a lot of analysis ex-ante from the limited partners and is a key aspect in the due diligence process more specifically in the larger size fund managers.

Double (or more) exposure is probably a phenomenon of the bubble years that reached bursting point in 2006 and 2007. At the time, banks were throwing money at every deal, with many deals featuring stapled financing. As this level of lending exuberance has passed for at least the foreseeable future, it is highly unlikely that double exposure will really be a big concern for large investors in the private equity asset class.

One area where the issue could raise its head once again, however, is if the large buyout funds decide to do minority deals in large public corporations, which might very well happen. They could join force to take 10 to 15 percent of a very large public company. But if they go down that route they will have a hard time getting the money from private equity investors. It would be totally unreasonable to expect a limited partner to allocate funds to a buyout house that added leverage to a minority stake in a public company and at the same time taking a 2 percent management fee and 20 percent of the profit.

Governance matters

The private equity industry has changed tremendously over the last couple of years and it is clear that effects of the problems in the capital markets and also on the back of events like the Madoff affair are yet to be felt fully by everyone in the asset class.

Deficiencies in working with the public at large can seriously impact on a private equity firm’s reputation.

Governance relates to decisions that define expectations, grant powers or verify performance. Typically it consists either of a separate process or of a specific part of management or leadership process. In a private equity firm the governance standard is the primary responsibility of the leader of the firm and it can be reviewed and evaluated against consistent management process, cohesive policies and definition of areas of expertise and responsibilities clearly delineated and controlled by senior member of the firm that have responsibilities to fire or authority to take correctives measures. In asset management and private equity, fiduciary responsibly is the cornerstone of the limited partners and this has to be clearly understood and enunciated at the most senior level of the firm.

In today’s environment all private equity firms have added responsibility as they invest across different regions and have to comply with government regulations, regulatory entities, labour unions and foreign governments that make up some of the stakeholders of a portfolio company. Governance is extending to private equity to be extremely responsible for a whole series of constituents that have other business motivations than simply making money. Accordingly, understanding how a firm operates in the ever-changing wider world is very important for limited partners.

Investors should keep a keen eye on a fund manager’s abilities to act faithfully and responsibly in the communities in which their investment activities have an impact. Deficiencies in working with the public at large can seriously impact on a private equity firm’s reputation, no matter whether it is a small or large organisation, and any high-profile, negative press can also tarnish the reputations of the fund manager’s LPs simply by association. 

Réal Desrochers retired in February 2009 as director of alternative investments at the California State Teachers’ Retirement System.

More information on PEI’s Risk Management in Private Equity book is available