LP Radar: The cultural audit

It’s clear that in the last few years, limited partners have been getting ever more sophisticated in  their manager selection process. Whether it’s through employing new metrics to analyse performance, assessing the impact of value creation efforts, or examining the reality behind ESG claims, LPs have certainly raised the bar in terms of what it takes to be seen as a top-performing fund manager. 

Unfortunately, many of these investors have found that these new tools can only take them so far; they’re still committing to GPs who seem to tick all the boxes, but in practice fail to deliver the requisite performance. So inevitably, they’re trying to take their due diligence one step further. 

“LPs are looking at [returns] and saying, ‘There’s got to be a better way,’” says one LP source. “Over the next five years, you’re going to see a movement towards this idea of getting more tools in place to better assess the GP.” 

Part of the problem is that some of the old truisms on which LPs have traditionally relied when thinking about managers just don’t apply in the same way anymore. 

For instance, the long-held idea that staff turnover at private equity firms should be seen as a red flag was called into question last year, when Capital Dynamics and the London Business School released a study analysing the effect of turnover on performance from one fundraising to the next. Its conclusion was that funds in the highest turnover tercile produced a 25 percent net IRR on average, while funds in the lowest turnover tercile had an average net IRR of 11.5 percent. 

The LP agrees that this benchmark is probably no longer valid. “These firms have to start becoming more like meritocracies. With that, you’re going to have more turnover. I think you’re going to see a massive change in that regard.” 

But the more significant issue is that even these sophisticated new metrics, for all the added insight they clearly provide, are still not always able to capture that special ingredient that separates the great from the good. There’s something more intangible, too – and that can’t always be captured on a spreadsheet. 

One of the biggest challenges in identifying these intangibles is trying to distinguish between the corporate messaging and the reality behind the scenes. 

GPs can boast about a firm’s culture of collegiality, relationships between global offices and the strong bond between investment professionals. But it’s incredibly difficult to prove that statements like these are actually true. 

“How do you get to that level of truth versus the story you’re hearing?” the LP asks. “I think the smarter LPs are waking up to that.” 

One way to address these types of concerns involves doing what is sometimes called a “cultural audit”, where an LP engages a consultant to focus on the internal dynamics at a private equity firm, in addition to conducting the normal analytical processes involved in due diligence. 

This might sound excessive – but the more progressive LPs are already thinking in these terms. “They’re starting to ask themselves, ‘What are the intangible qualities that we should be trying to assess and how do we asses them?’” the LP says. 

Admittedly, firms with smaller investment teams might not warrant such formal inquiries into their internal practices. “It’s always been part of our normal due diligence to understand the way [GPs] behave and how they interact,” says one North American fund of funds manager who focuses on small and mid-market buyout funds. “We don’t need a formal cultural audit or anything like that to be able to get to know them, [but] I could understand why [LPs] might see a need for a more formalised process.”