087-100_Survey_14 pages 16/5/05 3:24 pm Page 87

SURVEY 87

THE GUIDE TO FUND INVESTMENT DUE DILIGENCE 087-100_Survey_14 pages 16/5/05 3:24 pm Page 88

Due diligence and the Limited Partner

Private Equity International

Introduction • Terms and conditions How important are the terms and conditions of a partner- Chart One: Respondents by institution type With such a wide gap between the returns achieved by the top- ship agreement to the decision of whether or not to invest in

performing and bottom-performing GPs, manager selection in a fund? Have investors declined to invest in funds because of Asset Manager 7% Other 1% private equity is crucial. Being able to select the star performers terms and conditions? What areas of the partnership agree- Government Agency 1% Public Pension Plan 13% in the industry from amongst the herd of average-performing ment cause concern to limited partners? In particular, are Corporate 2% managers can mean the difference between spectacular returns there ‘deal-breaking’ terms and conditions? Corporate that far outweigh anything comparable in other asset classes, and Consultant/ Pension Plan 6% Advisor 11% middling returns that barely exceed (or worse, fall short of) the • GP and portfolio company visits Union Pension public markets. As such, for investors rigorous due diligence on Do investors visit with prospective GPs as part of their due Plan >1% diligence? What about with portfolio companies? potential fund investment opportunities is crucial. Endowment or Foundation 11% 88 Private Equity International, alongside Probitas Partners, has • Use of questionnaires undertaken an extensive survey of limited partners in private Do investors expect GPs to complete detailed due diligence questionnaires? What value is placed on these? equity funds in order to ascertain the due diligence procedures 10% that investors are undertaking when considering private equity • Analysing track record Manager 28% and fund investment opportunities. The survey Bank 4% asked for respondents’ views, attitudes and opinions in several Do investors require track record data in electronic format Company 6% areas: for analysis?

• Scope of investment activity • Due diligence on first time funds What fund types, geographies and investment activities are What are investors’ attitudes towards committing to first investors undertaking? Which fund types and geographies time funds? What are the most important issues to investors are the most popular amongst limited partners? when conducting due diligence on such vehicles?

• Most important factors in due diligence • Sponsored funds What are the most important factors to limited partners What are limited partners’ attitudes towards committing to when conducting due diligence on a fund? Is track record sponsored vehicles? What are the most important issues to the most important consideration? What about ‘softer’ investors when conducting due diligence on such funds? issues? Respondents were contacted between December 2004 and February 2005 via an online survey. In order to secure a large

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enough volume of responses, and to respect privacy, all respon- the sample is large enough to enable the drawing of broad trends Chart Two: Respondents by geographic location dents were guaranteed anonymity and the results here are pre- as to which areas of private equity investment are most attractive sented in aggregate format only. Invitations to take part in the to investors at the current time. survey were sent to major institutional investors in private equi- Rest of World 3% ty funds from around the world. In total, 313 separate institu- It would seem that the majority of LPs are keen to build a diver- tions responded to the survey. Charts One and Two analyse the sified private equity fund portfolio. As illustrated by Chart Four, Western Europe (outside UK) 21% survey respondents in terms of institution type (Chart One) and all of the major private equity fund types (buyouts, both large geographic location (Chart Two). Respondents represented all and mid-cap; venture, both early- and late-stage; and growth types of investors in private equity funds, with fund of funds capital) are part of the investment activity of investors, with managers, public pension plans, consultant/advisors, founda- more than three quarters of respondents indicating they invest in tions and endowments, and family offices the most prevalent. each of these categories. North North American-based institutions represented the largest pro- United America 70% Kingdom 6% portion of respondents (70%), with those from Western Europe Perhaps somewhat surprisingly, Chart Four shows that a very (excluding the UK) accounting for a further 21%. United high proportion of institutions are investing in venture capital Kingdom-based respondents made up 6% of total respondents, funds. Almost 85% of respondents indicated that they make with investors from elsewhere in the world accounting for the commitments to seed/early stage venture capital vehicles, the remaining 3%. second highest proportion of any fund type, while almost 80% said they invest in later-stage venture capital funds. These might Respondents were, in the main, experienced investors in private be considered surprisingly high percentages, given the bursting equity and venture capital funds, with more than 70% of the of the technology bubble, well-publicised troubles in the venture 89 survey sample having been investing in the asset class for more space since the latter half of 2000 and the fact that many than five years (see Chart Three). Indeed, the largest proportion investors were badly burnt by their exposure to venture capital. Chart Three: Respondents by length of time of respondents (43%) reported that they had been investing in It may be a reflection, however, of the fact that respondents to investing in private equity private equity for more than 10 years. This relatively high level our survey are largely experienced, sophisticated investors. As of experience is most probably a reflection of the large number such, they will have experience of the substantial returns that a Less than 2 years 4% of North American-based institutions in our sample, given that well-built venture capital portfolio can bring, along with a institutions from this region have, in general, a longer history recognition that it is this sub-segment of the asset class (in the with the private equity asset class than their counterparts else- US at least) that, while certainly the riskiest and arguably the where in the world. hardest to execute well, is the best performing area of the mar- 2 to 5 years 23% ket. We might also be seeing a ‘Google factor’ here. The highly Scope of investment activity successful IPO of the search engine company, and resultant home run win for its venture capital backers, will have been Greater than 10 years 43% The purpose of our survey was to elicit investors’ attitudes and noticed by institutional investors. Many will be keen to ensure opinions on the issue of fund investment due diligence. It was they don’t miss out on a similar opportunity in the future. not intended to provide the definitive survey of where institu- tional capital earmarked for private equity investment is going to Mid-market buyout funds are the most popular fund type cate- be deployed. Nonetheless, the large number of respondents gory with institutional investors, with 90% of respondents indi- means that it is worth analysing the answers given relating to cating that they invest in such vehicles. The mid-market has cer- 5 to 10 years 30% investment activity. While certainly not enough to state with tainly been flavour of the month with investors for some time, certainty that this is where investors’ dollars and euros will go, with country-focused funds in particular attracting substantial

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levels of interest from limited partners. Mid-market funds are (see Chart Five). Almost 85% of limited partners are also invest- Chart Four: Types of private equity and seen by investors to have a number of advantages over large buy- ing in Western European funds, with the same proportion also venture capital funds invested in out funds. Crucially, the mid-market is seen by many to be less backing UK vehicles. This is a strong indication that Western efficient than the large buyout market. A comparative lack of European markets on the Continent have reached a substantial 100 auctioned deals not only means that prices are often lower, but level of maturity. 90 also gives GPs managing mid-cap vehicles a better chance of 80 70

securing proprietary deal flow. As such, they are seen to offer Other markets see less activity, with the most substantial being s t n

better returns prospects. the Asia Pacific region. Fully half of all respondents state they de 60 n o p s 50 have appetite for Asian Pacific private equity and venture capi- e R f

While many of these arguments are valid, one can question tal funds, a reflection of the current strong interest in this part o 40 % whether investors’ faith in the mid-market sector is misplaced. of the world. Many private equity houses view Japan and China 30 The ‘mid-market’ is an increasingly crowded space, with seem- in particular as interesting opportunities and this is clearly 20 ingly every other GP keen to ensure it is seen as a mid-market translating into LP interest in backing funds investing in the 10 player. It is also becoming a much more efficient segment of the region. And interest will certainly have been boosted by the 0 l l s t e s b n d er out ita ita out e i n tate h ture p p n u s ture t private equity market, with deals increasingly conducted by huge returns made by the Ripplewood-led syndicate from the n a a darie D a E c e n F O V C C o ed zz f l tru e h e Buy c ss ea s ket Buy g t g e Me d o R ra investment banks and other advisors via auctions. As such, the listing of Japanese bank Shinsei, a transaction that has been ta w ture ar S tre n f S n L s u In ro e i F -Mar ly G V D e idea of ‘proprietary deal flow’ may be something of a myth. This described as amongst the most lucrative private equity deals of ar g Mid /E sta eed is particularly the case in mature markets like the US and United all time. S ater L Kingdom, which have heavily competitive markets where auc- tions are commonplace. In such an environment pricing pres- 55% of limited partners report that they purchase fund interests 90 sures may be as acute as in the larger buyout segment of the mar- on the secondary market (see Chart Six), while 47% indicate ket. And of course, if every is keen to invest that they undertake direct investment in unquoted companies, in the mid-market, it stands to reason that not all can get into either directly themselves or as co-investments alongside investee Chart Five: Geographical regions invested in the top-performing funds. funds.

Less than 80% of respondents indicated that they invest in large The fact that more than half of investors are actively purchasing Other Emerging Markets buyout funds. It is likely that this lower percentage reflects con- interests on the secondaries market (and presumably also selling cerns over whether such vehicles can be amongst the best per- interests as well) is a strong indicator of how much the institu- Latin America

formers in the industry, given the sheer size of the transactions tional market has matured in recent years. Interest in secondary Central & Eastern Europe they are undertaking and the fact they are operating in a highly funds managed by the likes of Landmark Partners, Coller competitive, structured and auction- and process-driven seg- Capital and Greenpark Capital has been extremely strong in Israel

ment of the market. It may also reflect concerns over fee sizes, recent years. Furthermore, investors are now beginning to use Asia Pacific both management and transactional. Finally, the sheer size of the secondary markets to actively manage their private equity such vehicles means access can become an issue for some portfolios, focusing the number of GP relationships they have Western Europe (excl. UK)

investors, as a result of minimum commitment levels being on a smaller number of better-performing managers and gaining United Kingdom pegged too high for them to reach. exposure to earlier year vintage funds managed by such groups. This shows a level of understanding, sophistication and experi- North America Unsurprisingly, it is North America where the largest proportion ence of private equity that one would not have expected from 0 20 40 60 80 100 of limited partners are making fund commitments, with 96% of such a large proportion of the limited partner community but a % of Respondents respondents stating that they invest in North American vehicles few short years ago.

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Most important factors in due diligence capital or private equity fund, investors are taking a bet on the Chart Six: Directs/co-investments and secondaries ability of the individuals at the GP to source, manage and exit In order to ascertain which factors are deemed the most impor- compelling unquoted investments and thereby produce superior tant by limited partners when conducting due diligence on pri- returns for them. Ideally, investors will want to see a substantial 100 vate equity fund investment opportunities, respondents to our history of working together as a team at the GP. While groups 90 survey were asked to select the ten most important factors to without a history as an investment team can be successful when 80 them from a broad list of 18, ranging from the length of time fundraising (recent successes by the likes of Altor Equity 70 s the GP has worked together as a team, to benchmarking the GP Partners in Europe and Shasta Ventures in the US illustrate that nt

e 60

nd No o vs. public sector returns. The results are displayed in tabular for- this is the case), these are unusual and even in such cases the p 50

es Yes R principals at the GP usually have a significant related history f mat in Chart Seven.

o 40

% (albeit not as one investment team). 30 As pointed out by a number of respondents there are clearly lim- 20 its to this exercise. In particular, several pointed to the fact that Of more importance to limited partners than a history together, 10 all of the 18 factors are of importance, so selecting just ten was however, is the stability of the GP team. Whether the GP in 0 Undertake Directs\ Undertake a difficult exercise. Others pointed out, quite rightly, that differ- question has a stable investment team goes a long way to help- Co-investments Secondaries ent factors might be more important dependent on the particu- ing an investor understand the dynamics at the group. lar fund opportunity under consideration. Due diligence on a Questions relating to the ‘chemistry’ at a GP (what is the atmos- first time fund, for example, will focus on different factors than phere like at the GP; how do the investment team get on with diligence on a sixth or seventh vehicle from an established GP each other etc.) are by definition qualitative in nature and per- with which an investor already has a relationship. At the end of haps the hardest part of the due diligence process. However, an 91 the day, due diligence is more of an art than a science, with ‘gut’ assessment of these factors is crucial to understanding whether a feeling as important as more quantitative factors. Nonetheless, particular GP is a good investment or not. The best-performing the results do provide an interesting overview of which factors teams are often those that have a long-established, stable work- are given most weight by limited partners when undertaking due ing relationship and where the personal chemistry is strong. By Chart Seven: Most important factors diligence. the same token, a strong track record may not be replicable when conducting due diligence where something has happened to wreck the chemistry at the Factor % of Respondents A cursory glance at Chart Seven shows that the most important GP, such as a key member leaving in possibly acrimonious cir- GP team stability 92 factors to LPs when conducting due diligence concern issues cumstances. A less than stable team, with a number of key defec- Consistent investment strategy 91 Historical multiple of return 80 relating to the GP’s stability and consistency of strategy; track tions, should be a warning flag for limited partners. Terms and conditions of the fund 79 record; and terms and conditions of the fund in question. Positive references 77 Checking that the GP has followed a consistent investment Length of time GP has worked together as a team 75 Historical internal rate of return (IRR) 72 GP team stability and consistency of investment strategy were strategy is seen by limited partners as a critical factor in the due Benchmarking GP vs. vintage year comparisons 59 both chosen as among the ten most important factors when con- diligence process. GP focus when it comes to investment strate- Strong operating background amongst GP team 57 Carry sharing arrangements amongst GP team 53 ducting due diligence by more than 90% of respondents to our gy can be crucial to success. Investors will be keen that GPs focus Proprietary deal flow 51 survey. Related to team stability, the length of time the execu- their efforts where their expertise lies. Many limited partners will Whether GP is independent, captive or semi-captive 45 Rapport with the GP team 31 tives at the GP have worked together is also seen as important, have been burnt by the excesses of the dot-com era, when, chas- Historical investment pace 19 ranked amongst the top ten by 75% of respondents. ing the high returns seemingly available, some GPs strayed from Number of boards senior professionals serving on 16 their stated strategies and pursued investments in the internet Presence of cornerstone financial investor 10 Benchmarking GP vs. public sector returns 7 Stability and longevity amongst the GP team can be expected to and telecoms sectors. Many, if not the bulk, of such investments Presence of a star investment professional 7 be of concern to limited partners. By committing to a venture were ill conceived and resulted in failure. Limited partners will

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be keen to ensure that such ‘style drift’ does not happen again ship between GP and LPs are going to be of obvious concern to and that their GPs ‘stick to their knitting’. For many, only evi- anyone considering a fund commitment. A number of areas will dence that the GP under question did not undertake any such exercise the minds of limited partners, with management fee lev- style drift in the first place will be satisfactory. els and structure, provisions governing distribution of fund prof- its (carried interest percentage, distribution mechanisms, water- Analysis of track record is seen by limited partners as an impor- falls, clawbacks etc.), sharing of transaction fee income and key- tant factor in due diligence, a fact that will not surprise many. man provisions likely to top the list. Tax and structuring issues After all, the object of investing in the private equity asset class will also be of prime importance, as all types of limited partners is to achieve superior returns that outperform other asset classes. will be keen to ensure they are not exposed to any unnecessary To do so limited partners have to invest with the best-perform- tax liability. Issues relating to terms and conditions and legal due ing managers, a fact made all the more vital given the extremely diligence are explored in more depth in the next section (see wide dispersion of returns between the best-performing and ‘Legal due diligence: fund terms and conditions’ below). worst-performing GPs. The aim is to invest with those GPs that are top quartile, or even top decile. As such, investors will be Reference checking is seen by limited partners as important, looking for a compelling track record and will be keen to put with 77% of respondents placing positive references amongst this record to the test: how has it been produced; which indi- the ten most important factors in due diligence. Limited part- viduals are responsible (and are they still at the GP); are there ners will often approach the managers of companies that form significant differences between the realised and unrealised por- part of a GP’s portfolio and seek confidential feedback on the tions of the portfolio; is the track record net of fees and, if not, GP. Similarly, they may approach groups that the GP has what does taking account of fees do to it? worked with in the past, such as corporate financiers, syndicate 92 partners, debt providers or legal advisors. The fact that track record (both the GP’s historical multiple of return on capital and its historical internal rate of return (IRR)) Arguably feedback from the managers of companies in the GP’s was considered one of the ten most important factors in due portfolio is the most important. Some respondents stated that diligence by a lower proportion of respondents than GP team they have turned a deal down after receiving feedback at this stability and consistency of investment strategy points to the stage, as managers of portfolio companies have highlighted defi- fact that investors acknowledge that track record is not the be- ciencies in a GP and it’s approach. all-and-end-all of due diligence and should be treated with some caution. Private equity is notorious for almost all GPs Respondents also highlighted the fact that when seeking feed- claiming to be top quartile, and as a result the raw figures pro- back on a GP from groups it has worked with in the past, the vided by the GP are only part of the equation. The key for particular relationship between the referee and the GP should be investors is to take the track record as provided and perform kept in mind. Other groups may have underlying motivations their own analysis on it, with the aim of discovering how the for giving the feedback on a GP they do. Investors should bear track record has been created and (crucially) whether or not it this in mind and treat the feedback given with some caution. is replicable going forward. This is particularly the case with the feedback received from individuals that are on a GP’s reference list, as they would pre- Limited partners also view terms and conditions as an important sumably not be on the list if they were going to say negative consideration when undertaking due diligence, with almost things about the GP! Therefore, investors should try to seek 80% including them as one of the ten most important factors. feedback from groups that have worked with the GP in the past The terms in the partnership agreement governing the relation- but that are not on its list.

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Chart Eight: Importance of terms and Other factors were considered to be less crucial in the due dili- Terms and conditions conditions in due diligence gence process. 57% of investors responding to our survey placed whether the GP has a strong operating background as We have already seen that limited partners consider terms and

3% being amongst the top ten factors when undertaking due dili- conditions to be an important factor when performing due dili- gence. The importance of an operating background at the GP gence on private equity fund investment opportunities. They 46% can, however, vary with the particular circumstances of the are, however, just one part of the overall due diligence process They are vital and must be fund and manager being considered. Operational expertise and and other factors can be given more weight. This view is con- exactly to our liking experience may, for example, be of much more relevance for a firmed by the results of Chart Eight. Only 3% of respondents They are very important and venture capital or industry-focused vehicle. Similarly, ‘propri- we may refuse to invest if stated that terms and conditions are vital and have to be exactly they were not to our liking etary deal flow’ was rated amongst the top ten factors by a rel- to their liking. The remaining 97% felt that terms and condi- They are somewhat important atively low proportion of respondents (51%), possibly reflect- tions are either very important or somewhat important, with a but as long as close to market other factors are more important ing acceptance amongst investors that truly proprietary deal slightly higher proportion holding to the former view. flow is extremely hard to come by and claims by GPs to have 51% access to same should be taken with an extremely large pinch of Terms and conditions can turn a ‘yes’ investment decision into a salt. ‘no’. The vast majority of investors reported that they have declined to invest in a private equity fund that they otherwise The presence of a cornerstone financial investor is not given would have committed to because of the vehicle’s terms and con- much weight by limited partners, with only 10% of respondents ditions (see Chart Nine). In general, however, investors tend to rating it amongst the ten most important factors to due dili- consider terms and conditions in aggregate and in the context of gence. Whether the GP is independent, captive or semi-captive the overall investment opportunity in front of them. ‘Bad’ terms 93 is seen as more important, being rated amongst the top ten by alone might not be enough to warrant a no decision, if the fund 45% of respondents. These issues are explored in more depth and manager in question is an attractive opportunity. Likewise, later in this chapter (see ‘Sponsored funds’ below). ‘good’ terms cannot make a poor investment into a compelling Chart Nine: Have you ever declined to invest in a one. For many investors the old adage that it is better to be in a fund you would otherwise have done so because One surprising result was the relatively low proportion (53%) of top-performing fund on slightly less than optimal terms, than in of the vehicle’s terms and conditions respondents placing carry sharing arrangements at the GP a poorly performing vehicle on excellent terms, holds true. amongst the ten most important factors to due diligence. How No 21% carried interest is shared amongst the various executives at the Furthermore, many respondents pointed out that terms and GP, particularly the junior members, can be an important factor conditions are investment-specific. Certain terms are more for team stability and individual motivation, both issues that important, and more likely to be a deal-breaker, in some fund limited partners claim to be much exercised about. After all, a types than in others. A good example is the issue of transaction desire for a greater share in the carried interest is almost always fee income sharing. This can be a big issue with buyout funds, a factor when junior executives leave an established GP to set up where such fee income can be considerable and has the potential their own firm. Perhaps limited partners view carry sharing to misalign the interests of GP and LPs. Investors will be con- arrangements amongst individuals executives as an internal mat- cerned that buyout fund partnership agreements provide for the ter for the GP itself, with their interest confined to the ‘big pic- sharing of transaction fee income; negotiations will revolve ture’ i.e. how much carry the GP will receive in total; how car- around the exact proportions in which income is shared. By con- ried interest payments to the GP are to be structured etc.? While trast, venture capital investments rarely generate much in the Yes 79% such a view is perhaps understandable, it does seem a little short- way of transaction fee income. Investors may be prepared, there- sighted. fore, to see the GP keep the bulk, or even all, of any income that

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is generated. Investors may also be prepared to give way on terms could be a deal breaker. Investors are keen that GPs put ‘skin in if the GP in question is top tier. The most well established and the game’ by committing their own capital to the funds they are Chart Ten: Deal breaking terms and conditions best-performing managers are usually able to extract more seeking to raise. Low GP contribution levels are increasingly favourable terms, due to their historical performance and the being seen as an important screening issue for investors. As well No Hurdle strong demand for their vehicles. A first time or emerging man- as serving to further align the interests of the management team ager, by contrast, would likely find investors much more robust at the GP with that of LPs, it is also an indication of confidence No No-Fault Divorce Provisions when it comes to negotiating terms. on the part of the GP as to its strategy and performance expec- Not Sharing tations. Most if not all investors would be extremely reluctant to Tr ansaction Fee Income

Terms must also be considered in aggregate rather than individ- commit to a vehicle if the GP wasn’t prepared to ‘put its money Deal-By-Deal ually. As an example, an investor may be willing to agree to the where its mouth is’ and risk its own capital. Furthermore, such Carried Interest

non-existence of a keyman clause if the partnership agreement commitment should be meaningful given the circumstances of No Claw Back Provision contains a robust no-fault divorce provision. At the end of the the GP group in question. While 1% to 2% is often seen as a day, if an investor declines to commit to a fund due to terms, it ‘market standard’ for GP contribution levels, this amount might No Keyman Provisions

is usually because of the terms and conditions of the vehicle as a be excessive for a newly formed group raising its first fund. By No GP Contribution whole, rather than because of any one clause. contrast, for the executives at a GP on their fifth or sixth fund to the fund

that have already made substantial sums from previous vehicles, 0 10 20 30 40 50 60 70 80 90 Nonetheless, some areas of the partnership agreement are given such a figure might not represent much of a burden in terms of % of Respondents more weight by investors and are often the subject of intense nego- their personal net wealth. tiation between GP and LPs. And for some investors, certain terms will be sacrosanct, with either their absence (or presence in some GP and portfolio company visits 94 cases), or the fact that they are not structured to the investor’s lik- ing, enough to cause the institution to walk away. Three areas in Limited partners clearly see substantial value in visiting the GPs particular can be seen as ‘deal breakers’: the lack of a clawback; the with which they are considering investing. Over 70% of lack of keyman clauses; and the absence of a GP contribution to the respondents always visit the offices of GPs as part of their due Chart Eleven: Do you visit the offices of GPs fund (see Chart Ten). The following were also offered by investors diligence process. A further 20% often undertake such visits. A as part of your due diligence process? as potentially deal-breaking issues in addition to those illustrated in mere 8% and 1% respectively only rarely visit or never visit (see Chart Ten: excessive transaction fee retention (one respondent indi- Chart Eleven). Rarely Visit 8% Never Visit 1% cated it had declined to invest in a fund due to this issue); excessive management fees; a failure to net transaction fee income off against By visiting the office(s) of a GP, investors get to see the manag- management fee; ‘cherry picking’, or special treatment to particular er in its natural environment (as it were), allowing them to get a Often Visit 20% LPs; transfer provisions; and overly restrictive FOIA-related terms, greater handle on how the GP interacts as a team; what the such that confidentiality clauses in the partnership agreement are working dynamics are like and so on. In particular, it offers LPs overly binding. The latter is especially an issue for US public pen- a chance to meet with and interview junior members of the GP’s sion plan sponsors and possibly also for their counterparts across the team, an important consideration given the fact such individu- Atlantic, now that the UK has its own Freedom of Information leg- als will rarely be part of a pitch given by the GP. Many investors islation (although it seems the effect of such legislation may be less put such store in the value of visiting with a GP at it’s office that pronounced in the UK than in the US). they make multiple visits and/or endeavour to visit all the offices the manager maintains. Clearly there is no substitute for press-

The main issue for investors seems to be the GP contribution, ing the flesh and, for many investors in private equity funds, no Always Visit 71% with more than 80% of respondents stating that a lack of same visit means no investment.

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Chart Twelve: Do you visit portfolio companies as The main constraint on undertaking GP visits is resource – a indicated that they would like to visit with portfolio compa- part of you due diligence process? lack of time, money and (crucially) personnel. Investors are, nies more than they do, but cannot due to a lack of both staff however, generally looking to overcome these constraints and and time. For smaller investors, with perhaps only two or

Always Visit Selected undertake GP visits, regardless of the resource issues. Several three staff dealing with the whole of an investment program, Active Portfolio Companies 9% Never Visit Selected respondents indicated that, while they have rarely visited GP it is simply not possible. Larger investors, while they may have Portfolio Companies 24% offices in the past, they were keen to make more such visits in less resource pressures than their smaller counterparts, will the future, recognising their value to the due diligence often find it as impracticable to visit portfolio companies as Often Visit Selected Active process. One option for some looking to overcome resource part of their due diligence. This is due to the large number of Portfolio issues may be to have their private equity consultants conduct fund commitments such institutions make each year, and thus Companies 20% team visits for them, a practice that several respondents said the large number of existing portfolio companies to visit. The they were already undertaking or were looking to do in the numbers involved in such circumstances make it impractica- future. ble for even those groups with big staffs to visit portfolio com- panies in anything but a relatively superficial way. A number of respondents pointed out that they are effective- ly being forced to ramp up the amount of GP office visits Rather than visiting with companies directly, investors instead they undertake. In many cases, a GP will nowadays only visit make extensive telephone calls to CEOs to take reference a potential investor for the initial pitch meeting. It is rare for checks and seek feedback on the GP. Almost all respondents Rarely Visit Selected a GP to follow this with a further visit from a larger propor- indicated that, while they may not visit with portfolio com- Active Portfolio Companies 47% tion of its team. This may be an area where GPs and their panies directly, they always make such calls over the tele- advisors (in particular placement agents) could help to phone. As well as seeking feedback from portfolio company 95 improve the due diligence process for investors. LPs would CEOs, investors will also approach groups that the GP has clearly welcome a significant (i.e. bringing the majority of the worked with in the past, such as corporate financiers, syndi- team) visit to their office. The logistics of conducting an cate partners, debt providers, legal advisors and other LPs. office visit to every potential LP on a target list, however, Such feedback can be a valuable part of the due diligence makes this unlikely, especially when there is no guarantee process, highlighting deficiencies in the GP and its approach that the time and effort expended with such a visit will trans- to matters ‘on the ground’, which can often be difficult to late into a commitment. unearth elsewhere in the due diligence process.

Visits to active portfolio companies are seen to have less value However, a number of respondents pointed out that when to the due diligence process. A mere 9% of respondents seeking feedback on a GP from groups it has worked with in reported that they always visit selected active portfolio com- the past, investors should always keep in mind the nature of panies, while only a further 20% often undertake such visits. the relationship between the referee and the GP in question. The majority – 47% - only rarely visit portfolio companies, As discussed already, particular groups may have underlying while almost one-quarter of investors never do so (see Chart motivations for giving the feedback they do. Investors should Eleven). especially treat the feedback given by groups on a GP’s refer- ence list with some caution, as it is unlikely the GP would More properly, it is not the case that investors see less intrin- have put forward a name if the individual concerned were sic value in visiting with portfolio companies as opposed to going to say anything overly negative. As such, investors visiting the GP, but more that resource constraints dictate that should endeavour to speak to groups the GP has worked with such activity often cannot be undertaken. Many respondents that are ‘off list’.

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Use of questionnaires (often in electronic format for ease of analysis), portfolio compa- Chart Thirteen: In addition to receiving the private ny information, further background on the executives at the GP, placement memorandum (PPM), do you require the Requiring GPs to complete a detailed due diligence question- and so on. If well constructed, GPs can anticipate a lot of the naire is by no means a universal practice amongst limited part- questions that investors may ask in a standard questionnaire. completion of a detailed due diligence questionnaire? ners, although their use is more likely than not. One third of investors state that they always require the completion of a due Those investors requiring the completion of a questionnaire may Never 19% find it helps to speed up their due diligence process, as well as diligence questionnaire in addition to receiving a PPM, with a Yes, Always 32% further 30% indicating they do so in the majority of cases (see helping to ensure that information is available in a consistent Chart Thirteen). 19% of respondents rarely require the comple- format. However, it is unlikely that any one standard question- tion of due diligence questionnaires, with the same proportion naire will be able to address every area of the due diligence never asking GPs to do so. process. Indeed, several respondents pointed out that their use of questionnaires varied from GP to GP (with their use more like- Rarely 19% It is worth noting that a number of respondents pointed out ly when considering a group with which the investor is not that, while they may not require GPs to fill in a questionnaire, familiar, and the opposite with those GPs where a pre-existing they often receive completed questionnaires anyway as they have relationship exists). Further, the actual content of the question- been filled in for other LPs. Investors will often request that if naire can also vary from case to case, with a number of respon- the GP has filled in a questionnaire for another potential LP that dents adamant that a ‘standard’ questionnaire does not exist and they be sent a copy, and many GPs appear to have responded to is in any event undesirable. In the Majority of Cases 30% this by sending completed questionnaires to all potential investors as a matter of course. Analysing track record 96 Consultants also come into play here, with some investors, par- Clearly an investor mulling a commitment to a private equity ticularly smaller and/or less experienced groups, outsourcing the fund will want to analyse the GP’s track record. But do investors issuing and collation of questionnaires. Constructing question- require that track record data be presented to them in electron- naires, customising them for the particular fund investment ic format in order to help with ease of analysis? opportunity under review, and managing their collection and Chart Fourteen: In addition to receiving the (PPM), analysis is an area of value-add that consultants can bring to The vast majority of investors prefer to obtain track record data do you require track record data their clients. in electronic format. 50% of respondents always require it, with in electronic format? a further 29% stating that they want to see it in the majority of Many investors will turn to the materials provided by the GP cases (see Chart Fourteen). While some investors stated that they (including the PPM and other marketing materials) in the first would input data themselves from hard copies, others took the instance when conducting their due diligence, supplementing opposite view, reporting that all data should be electronic and Yes, Always 50% In the Majority with further questions (sometimes in the form of a structured displaying a desire to see all due diligence materials in electron- of Cases 29%

questionnaire, sometimes with specific written questions, or even ic format. Rarely 13%

via a telephone interview) where they feel there are gaps. Never 7% Nowadays, many GPs will prepare, with the help of their place- Electronic data has a number of benefits for investors. Not only ment agents, a detailed due diligence pack for potential investors. is it more convenient and saves the re-keying of data, it also These materials will go beyond a mere PPM, and may include allows investors to run their own analysis on track record, detailed reference lists and/or actual reference interviews under- import data into their own benchmarking models and so on. 0% 20% 40% 60% 80% 100% taken by the placement agent, detailed track record analysis LPs want to be able to calculate their own IRR and multiple fig-

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Chart Fifteen: Which option best characterises your ures, as well as being able to slice track record data and perform bemoan an increasingly crowded middle market and the recy- position on investment in first time funds? detailed attribution analysis. They are also interested in model- cling of their capital in big ticket sponsor-to-sponsor transac- ling net cashflows to LPs, as well as the gross performance of tions, first time funds are now being classified as a fertile fron-

Our Investment Policy Prohibits portfolio companies and the fund. Receiving data in electronic tier of untapped potential. Investment in First Time Funds 5% format makes this sort of analysis easier. It would seem that limited partners have a healthy appetite for We have an Active Emerging Manager Analysis of track record data is another area where consultants first time fund or emerging manager opportunities. Almost one Program or Mandate 22% are active, with several respondents indicating that their advisors quarter of respondents said they have an active emerging man- handle this part of due diligence for them. Specialist private ager program or mandate, with a further 73% indicating that equity consultants will have built up experience in performing their investment guidelines allow them to invest in first time sophisticated modelling on private equity track records. They are funds and they do so, albeit rarely. Only 5% of respondents stat- also likely to have built databases of fund and portfolio compa- ed that their investment policy prohibits such activity (see Chart ny performance data against which they can benchmark an indi- Fifteen). A number of respondents pointed out that their atti- vidual GP’s track record. Many investors, especially smaller tude to first time funds fell somewhat outside these three cate- groups or those with a relatively minor exposure to private equi- gories, as they invest in such vehicles regularly but fall short of ty, will not be able match such analysis skills. As a result, out- having an active program or mandate. sourcing this area of due diligence may be of benefit. Respondents also pointed out the problem of defining what is We can Invest in First Time Funds but Rarely do so 73% Due diligence on first time funds meant by a ‘first time fund’ or an ‘emerging manager’. These can run the gamut from a highly experienced team spinning out an 97 Making commitments to first time or emerging managers is established GP, a formerly captive investment team raising its often part of the private equity investment programs of sophis- first third party vehicle, experienced investment executives from ticated institutional investors. A significant number of investors, different groups coming together to form a new GP, to complete particularly large US public pension plan sponsors, have devel- novices new to the private equity asset class. While such defini- oped specific emerging manager programmes. Large US pension tional issues certainly exist, and the language used does not help funds that already have, or are in the process of building, emerg- (first time funds, spin-outs, emerging managers and debut funds ing manager programmes include CalPERS, CalSTRS, the state are all used to describe essentially the same situation), investors’ treasuries of North Carolina and Connecticut, the Los Angeles attitudes are clear. They can be summed up thus: first time County , the New York State Teachers Retirement funds, yes; first time managers, no. Fund, MassPRIM, the retirement associations of Colorado and New Mexico, and the Texas Teachers Retirement System. Essentially, investors will commit to a first time fund only where the executives managing the vehicle have experience of the pri- Motivations for making commitments to first time funds can vate equity asset class and thus there is a verifiable track record. vary, from accessing early stage venture capital funds (existing In practice, this often translates into an investor having to know funds in the sector, particularly those managed by top-perform- the principals at the new team from their previous positions, or ing GPs, are often closed to new investors), identifying attractive at the very least know of them. LPs prefer that an emerging man- opportunities in the small and middle markets, to basically ager is comprised of individuals that have a history of working accessing the stars of tomorrow – ‘finding the next KKR’. Many together (see Chart Sixteen), although this does not preclude the LPs are keenly interested in first time/emerging managers as success of a group made up of individuals coming together from there is an expectation they may be top performers. As LPs different previous employers. A distinctive investment strategy is

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also seen as a bonus for an emerging manager (see Chart Sponsored funds Chart Sixteen: Most important factors when conducting Sixteen). due diligence on a first time fund It is not unusual, particularly in Europe, for private equity or

Individuals or teams spinning-out from established GP groups venture capital funds to have either sponsors or cornerstone Investment Professionals have and raising their first vehicle, captive investment teams raising investors. Amongst such vehicles are funds managed by semi- a History of Working Together Distinctive their first third party fund, newly formed GP groups made up of captive fund managers, where the parent organisation will spon- Investment Strategy individuals from several established GPs – all would be consid- sor the vehicle, as well as usually being the largest investor in the Positive References ered and can make compelling investment opportunities. Recent fund. Also included in the category of sponsored funds would be from other Investors

fundraising successes by the likes of Exponent Private Equity vehicles managed by independent GPs that have convinced one Letter of Attribution from Previous Manager(s) and Altor Equity Partners in Europe, and Shasta Ventures in the or more limited partners to act as the main sponsor(s) of the Verifying Track Record US, illustrate this point. A group of individuals completely new fund, as well as to commit a substantial sum of capital to the Demonstrates Proprietary Deal Flow to private equity would be highly unlikely to get a look-in from vehicle. In both cases the sponsoring organisation may also own Team Members with a investors, however, unless they had an extremely compelling a proportion of the GP management company. Strong Operating Background story and had skills and/or experience that could translate to Positive References from success in the asset class. Geography can also be a consideration, For the GP, such an arrangement can mean that not only does it Company CEOs with several respondents pointing out that they invest in first receive a substantial tranche of capital with which to kick off Presence of One or More Star Lead Investors time funds only in their domestic markets. fundraising, but that it is able to use the sponsor’s brand name during fundraising. Having one or more well-known institu- 0 10 20 30 40 50 60 70 80 While LPs may want to be investing in first time funds, due dili- tion’s commit to a fund can been a great boon for a GP, as it is % of Respondents gence on such vehicles can be even more demanding than on a a public vote of confidence in the manager and may give other 98 successor vehicle from an established group. As such, many investors the confidence to make their own commitment. In investors may find that, while they can perform due diligence on addition, the sponsoring organisation may also help by intro- established managers internally, they lack the skill set to both ducing new potential LPs to the fund, as well as by marketing adequately scour the market for emerging manager opportuni- the vehicle to its clients. ties and perform due diligence on those they find. Large institu- tions face a further problem, in that if they want to deploy large It might be thought, therefore, that LPs would have a preference chunks of capital, investing in small, first time funds is a rela- for sponsored or cornerstoned funds. However, our survey sug- tively inefficient use of time and effort. gests that investors are in general wary of such vehicles. While only 5% of respondents have investment policies that prohibit Instead, investors may look to funds of funds as a route to access- investment in sponsored funds, the vast majority – almost 90% ing this area of the market. As an example, CalSTRS has recent- - indicate that they rarely invest in sponsored funds (see Chart ly tapped New York- and London-based INVESCO Private Seventeen). Capital for a $100 million mandate to invest in new and next generation managers. Similarly, the New York City Retirement Investors are wary of sponsored funds largely because of the System has committed $175 million to JP Morgan and Fairview potential for conflicts of interest between the sponsoring organ- Capital for a similar investment strategy. Other fund of funds isation and that of other LPs and the GP. The concern is that the managers with emerging manager-focused vehicles or expertise sponsor may have undue influence upon the GP, with invest- include: Parish Capital Advisors; Flag Capital Management; ments made for non-financial reasons. As an example, several Muller & Monroe Asset Management; Private Advisors LLC; respondents pointed to the danger that in an investment bank- Progress Investment Management; and LGT Capital Partners. sponsored fund, investments made be made with one eye on the

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Chart Seventeen: Which option best characterises your ancillary advisory and debt work that the parent bank can obtain position on investment in sponsored funds? from the investee company. This concern will be the greater where the sponsoring organisation has a strong presence on the fund’s investment committee Often Invest in Sponsored Funds Investment Policy Prohibits and/or Act as a Sponsor 8% Investment in Sponsored Funds 5% Not all investors share these concerns about sponsored funds. There can certainly be structures put in place to help mitigate against conflicts, such as the sponsor not sitting on, or having a very limited role in, the investment committee, and Chinese walls being erected between the GP and the sponsor organisa- tion’s advisory or leverage teams. Much will depend on the nature of the sponsoring organisation (a non-bank sponsor may be viewed with less suspicion, for example), its level of commit- ment, motivations for sponsoring the GP and the benefits the sponsor gets in return for its patronage.

In particular, other investors will want to understand the terms Can Invest But Rarely Do So 87% upon which the sponsor is backing the GP, and whether it has any special treatment not given to other investors or economic benefits above being a limited partner in the fund. Often a GP 99 will have to sacrifice some of its carried interest to the sponsor. This share is in addition to the slice of the fund’s profits the sponsor would be entitled to as a limited partner. The sponsor may also benefit from more favourable terms and conditions than other LPs, including taking a slice of the fee income earned by the fund (including management fee) over and above what might go to it as a limited partner.

Such arrangements can act to misalign interests between the GP and LPs and have a disincentive effect on the executives at the GP. Investors will, therefore, be keen to ensure that such arrangements are not excessive before making a commitment to a sponsored fund.

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