The way that LPs work with GPs has got to change.
The downfall of The Abraaj Group has, since the unravelling began in February, provided much for private equity professionals to ponder. But the most pertinent question has always been: “What does this mean for the wider private equity industry?”
As we have noted before, one reaction must be an enhancement of operational due diligence practices.
In October we got some detailed insight into this very matter from an Abraaj insider. Ahmed Badreldin was until recently a partner and head of the MENA region for Abraaj, a firm which has collapsed under the weight of its debts and amid allegations that investor capital from a number of its funds was misused.
Badreldin wanted to put forward some practical steps that LPs can take to protect themselves when investing in “emerging managers and smaller GPs”. While he is understandably careful not to identify any specific situation, his observations carry weight given what he must have witnessed over the past year.
The former Abraaj exec has some very specific ideas about protecting investors, such as ensuring that the limited partner advisory committee has the power to demand a forensic fund audit and access to the fund’s bank statements. He also recommends that third party fund administrators be empowered to question the GP’s instructions (“lest it become a rubber stamp”), or better still, bear legal liability as directors in the GP as “this increases the focus and attention to detail.”
What comes through loud and clear from Badreldin’s article is that, in what is still regarded as a people business, a huge part of investment due diligence is based on trust and human instinct. If an investment process for an LP takes between six and 12 months, then “emotional investment potentially gets in the way” of the scepticism that is a necessary part of due diligence.
Part of overcoming this involves due diligence methods that are probably already in the wheelhouse of most LPs, whether or not they are currently applied vigorously enough. “Flushing out inconsistencies from one-on-one interviews, historic churn of GP professionals and interviewing the internal auditor (including specifically what has been excluded from the internal audit cycle) are some of the approaches,” he writes. “Bottom line here is: slides may be perfect, but it can’t be all rosy.”
Badreldin’s guidance is required reading for those LPs who are in a position either to push back on LPA terms or to force governance changes to general partnerships. Yes, at times in this market it seems like investors are not in a position to do this, but the Abraaj example gives a compelling reason to try.