This article outlines the five key areas that form the basis of institutional private equity fund diligence: track record, investment strategy, investment team, deal sourcing, and value creation.
The dispersion of private equity fund performance is much wider than it is for other asset classes due to several factors, chief among them is manager skill. Private equity provides an opportunity to significantly enhance portfolio returns, but only if investors select the right managers. This article outlines the elements of a private fund investment opportunity that should be carefully researched and considered before investing.
The institutional investory community, including pension plans, university endowments and insurance companies, has reaped the benefits of investing in private equity for decades. Over the past 20 years, private equity’s share of institutional portfolios has grown significantly, with allocations generally ranging from 10%-20%, due to the potential for superior long-term results vis-à-vis other asset classes (Figure 1). For instance, the 2016 Yale Endowment Update reported that 31% of the university’s $25.4 billion endowment was invested in private equity and venture capital as of June 30, 2016, and that its private equity investments had generated an annualized return of 11.2% over the prior 10-year period (venture capital investments earned an annualized return of 15.9% for the decade). While institutional investors have been enjoying strong returns from private equity (PE) for many years, most high net worth investors have had little or no exposure to the asset class. The reasons for this are straightforward: PE funds require steep investment minimums, typically $5 million or more, and most managers have focused on big ticket institutional investors who understand private equity and do not require any education. In addition, the effort involved in evaluating a PE investment opportunity is significant and usually exceeds the resources available to individual investors. Comprehensive diligence is particularly critical in PE, where the spread between the best and worst performing managers is substantially wider than in other asset classes, making manager selection paramount (Figure 2). Conducting due diligence on private equity funds is an extensive and detailed process designed to uncover the strengths and weaknesses that can affect performance. The following five areas collectively form the core of private equity fund diligence and can be enhanced with additional analyses as appropriate.
One of the most crucial factors in evaluating a PE opportunity is understanding how a manager has created value in their past investments. Value creation is derived primarily from three factors, which are not mutually exclusive: financial engineering, which typically involves increasing a company’s leverage ratio to boost equity returns; multiple expansion, which means the manager sold its portfolio companies at higher multiples than they were acquired for; and operational improvement, usually reflected in increased revenue and/or EBITDA during the hold period. Financial engineering and multiple expansion are often market-related factors and can expose an undisciplined manager when market conditions deteriorate as they did in 2008-2009. In contrast, portfolio companies that consistently show improved financial performance during a manager’s ownership can be strong evidence that the manager is skilled at making the right bets and has real value creation abilities. These managers are often able to implement fundamental business improvements, such as rationalizing costs and making accretive add-on acquisitions that will generate superior returns over time.
Once it has been determined that a fund manager’s returns are the result of sound investment selection and true operational improvement across the portfolio, it becomes important to understand how the manager achieved those results and whether the necessary elements are present or likely to be replicated in the next fund. At the quantitative level, prior fund cash flows can be disaggregated to analyze historical performance by attributes such as sector, equity check size, source of investment, geography, and lead investment professional. This track record analysis reveals qualitative insights such as whether a fund manager’s overall returns were driven by a particular industry or secular trend, whether an individual partner was responsible for sourcing a disproportionate number of past successful investments, and whether the highest performing deals were sourced on a proprietary or non-proprietary basis. These analyses enable investors to ask the right questions, such as whether a particular sector will be more or less of a focus going forward and whether key investment professionals are still with the firm.
A particularly important track record analysis involves digging into the fund manager’s loss ratio and dispersion of returns. Firms that have consistently doubled their money across most of their deals tend to deliver more attractive results in the long term than managers who have a comparable returns, but produced those results with a few homeruns alongside numerous write-downs.
In addition to quantitative factors, investors must assess a manager’s strategy and how it fits with the expected market environment over the investment period of the fund. It is also important to confirm that the go forward strategy is consistent with the past practices; a common concern of institutional investors is "strategy drift," or deviation from the manager’s past investment approach. While opportunistic strategies can be attractive, these should be characterized as such from the outset so investors can make informed decisions about how they are allocating their capital. Because the primary driver of returns in PE is not market beta but rather the manager’s ability to successfully find, improve and exit their investments, it is critical to have a thorough manager diligence process in place.
The capabilities of the team that will be sourcing, negotiating, monitoring and exiting the firm’s investments are clearly a critical determinant of ultimate returns. prospective investors should investigate the backgrounds and experience of the firm’s investment professionals, as well as the team’s continuity and experience working effectively together. The team’s relationships and networks are also crucial in terms of the volume and quality of the manager’s deal flow, as well as the firm’s ability to identify strong management teams. Reference calls, which are a standard component of institutional diligence, are particularly useful in terms of confirming the attribution claims of individual team members and making sure that the professionals responsible for the past successes are still with the firm. Those individuals must also be properly incentivized to remain at the firm. Many PE firms have failed to implement effective succession plans and transition leadership to capable professionals. Relatedly, it is important to assess how the firm’s profits (also known as carried interest) are distributed in order to ensure that the entire investment team is motivated to maximize the fund’s returns, aligning their interests with those of investors.
Finally, investors should assess the size and quality of the current team in the context of the new fund’s size relative to the last fund and to the unrealized portfolio, to ensure that the firm’s resources are sufficient to successfully deploy the new fund’s capital within the investment period. There are many instances of successful PE firms that raised much larger funds and then stumbled because they were under pressure to put too much money to work and, as a result, abandoned prior disciplines.
A manager’s ability to source a large enough volume of high quality investment opportunities is key in today’s increasingly competitive PE landscape. Managers who rely on auctions to find investments are at risk of paying inflated prices for assets in today’s environment. Certain firms maintain cold calling programs to canvas the market for deals, while others rely primarily on the strength of their networks to generate proprietary opportunities. It is critical that a manager has a structured process in place to identify which companies are best positioned for future growth or are the best candidates for a turnaround strategy.
In sum, investors interested in diversification and the potential for higher returns should consider incorporating private equity into their portfolios. However, because the primary driver of returns in PE is not market beta but rather the manager’s ability to successfully find, improve and exit their investments, it is critical to have a thorough manager diligence process in place. Essentially, investors must develop an informed view of whether the manager’s returns are attractive on an absolute and relative basis, how the manager produced those returns, and whether they will be able to replicate those results in the next fund.
These materials are for informational purposes only and are not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security described herein. Any such offer or solicitation shall be made only pursuant to the final confidential offering documents which will contain information about each fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment therein. This material does not take into account the particular investment objectives, restrictions or financial, legal or tax situation of any specific investor.
Past performance is not indicative of future results. All of the products described are private placements that are sold only to qualified clients through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less information than they can access with respect to publicly listed investments. Prospective investors should also note that investments in the products described may involve long lock-ups and do not provide investors with liquidity.
The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein.
iCapital is a registered trademark of Institutional Capital Network, Inc.
Additional information is available upon request.