Fund due diligence: Why the soft factors matter

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When running the rule over a prospective fund offering, LPs should start, naturally, with the numbers, specifically: the track record.

“Track record analysis is essential; looking at the returns of all the funds, all the underlying deals, getting the cashflows for everything and making sure everything is lining up correctly,” says Meredith Gendron, a partner at private equity placement agent Monument Group.

For 95 percent of limited partners, track record is a “key driver” of their investment decision-making process, according to the 2016 Private Equity LP Due Diligence Trends, a study among pensions, endowments and funds of funds undertaken by investment technology business eVestment. Of the respondents, 43 percent say they will be upping their quantitative diligence.

Track record analysis and a focus on quantitative due diligence does not necessarily give LPs all the answers, “but it gives them the questions they need to ask in the due diligence process”, says Graeme Faulds, a former fund investor and the co-founder of eVestment’s private equity solutions business.

Probing the “softer” elements of a general partner is becoming increasingly important. Of LPs surveyed by eVestment, 61 percent say they are increasing their qualitative diligence.

“When LPs conduct due diligence they should be aware if GPs are hungry and know what kind of mindset they are in,” says Jonathan Grabel, chief investment officer at New Mexico Public Employees Retirement Association (New Mexico PERA). “Have they created their generational wealth so that their desire now is just to ‘clip coupons’? Do they want to reduce risk in their style of investing?”

This is an example of the types of soft cue an LP will notice once they have met a lot of GPs. LPs need to develop some sort of pattern recognition framework and be able to read body language, Grabel says. “The soft aspect is important. That qualitative aspect of diligence, of knowing your manager is so important. Especially in an era where all the data exists. Anybody can do the data analysis, but understanding who it is that you want to make a 10-year commitment to, that’s the really hard aspect and I don’t think that enough people focus on that.”

Christopher Wagner, principal investment officer at the Los Angeles County Employees Retirement Association (LACERA), adds that its due diligence process to assess and monitor existing GP relationships involves individual meetings with partners, interaction with the portfolio company management and discussions with consultants and other LPs.

GPs should be aware that LPs will look under the bonnet of the data they put together – in particular the IRRs they report. Three-quarters of respondents to the eVestment survey recalculate fund performance more often than not. More than one in four (28 percent) said they rarely or never trust the high-level performance numbers provided by fund managers.

There is little point, then, in GPs trying to gloss over previous portfolio blips. 

Gendron says that they should do the opposite: “Being really transparent, being upfront about everything is important. If there is a bad deal just address it, everyone has one. It’s important to make sure that investors are comfortable that they have the full picture of what’s going on. GPs need to be really open with the information, willing to share the good and the bad.”

In addition to the typical materials included in the due diligence process, Gendron says GPs should be willing to provide investment committee memos to make sure that their investors have insight into the investment process, “which means really bringing them in and making them understand what it’s like to be a part of your organisation so that they have a good handle on how things work”.

RED FLAGS
If one or two portfolio companies really drove returns and the dispersion of outcomes is vast, or fund sizes are increasing, these can be potential red flags, New Mexico’s Grabel says. “If it’s a firm that does something well, does it patiently, sticks to their knitting, doesn’t egregiously change terms or fund size, those are all positive aspects: this is a GP worth continuing to partner with.”

If a GP is changing its business model, in any dimension, it can also be a red flag, he adds. “If a GP all of a sudden is raising funds in different asset categories – if they’re a middle market buyout shop, and then all of a sudden they have a venture practice, a leveraged loan practice, a farming franchise, you name it, I think that’s a red flag. We are also wary of firms that change strategies, be it investment, geography or industry vertical. These types of changes introduce new risks to LPs.”

It will come as no surprise that LPs are looking for evidence of operational value creation capabilities in their general partners. When LPs in the survey were asked about their preference for how fund managers add value, operational improvement was more than four times as popular as financial engineering or market timing.

For New Mexico PERA, value creation means all of these things: identifying good sectors, management teams and companies, and making appropriate changes to those companies. These include financial as well as operational changes and hopefully selling the company into a better market than it was acquired from. Grabel adds that with a good team and business model, GPs are able to overcome unstable markets and delays for exit of portfolio companies.

Wagner considers value creation to be about seeking GPs that understand which value creation levers are appropriate for each situation and have the breadth of experience to adapt.

“Given a typical 10-12-year fund cycle, the economic backdrop may favour a growth orientation or fiscal constraint; taking advantage of low interest rates to de-risk equity; or altering the timing of entries and exits to exploit marketplace conditions,” says Wagner. “Ideal teams are comprised of professionals with complementary skill sets enabling them to succeed across economic cycles.”

Wagner also places importance on public market equivalent analysis, something that half of LPs are planning to increase their use of, according to eVestment’s survey.

Gendron agrees: “I think benchmarking for a long time was really centred on peer group analysis, but public market equivalent benchmarking has come into focus a lot over the last several years.”