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Private Equity Due Diligence

April 23, 2024.

It’s possible to invest directly in privately-owned companies. Unfortunately, most investors lack the relationships, expertise, and resources necessary. Even those with access may be unable to source attractive investments, conduct due diligence, or negotiate and structure the transaction, and monitoring a private equity investment can be challenging.

Because of these inherent challenges, most investors gain exposure to private equity through a fund. Private equity funds allow investors to invest directly into private companies while outsourcing much of the process to the managers of the fund.

Investments in Private Equity funds are by nature long-term and illiquid. This puts an additional pressure on institutional investors or LPs (Limited Partners) in order to conduct a thorough due diligence and try to separate luck from skill. Manager selection in this asset class is crucial.

The quantitative side of due diligence of Private Equity Funds and in depth analysis of track records is challenging due to many reasons (such as having access to enough detailed cash flow data from GPs (General Partners), the potential dispersion of returns, and the difficulty of comparing a private equity fund’s return to another). Due to this, the due diligence done on PE funds is often more qualitative with a focus on topics like the management team, the deal sourcing capabilities, the investment thesis, and operations.

Creating a PE due diligence questionnaire (or checklist) is a fundamental step in evaluating any potential private equity investment.

Before you begin investigating private equity funds, make sure a private equity investment is appropriate for you – ask yourself the following questions:

  1. WHAT’S MY TIME HORIZON?

Private market investments take years to mature. It takes time to identify and source the right deals, time to improve the underlying investment, and time to successfully exit the investment. Investors looking to fund obligations years down the road (e.g., retirement, charitable giving, or passing wealth on to younger generations) may find private market opportunities attractive. However, those looking for short-term, tactical allocations may find that other investments are better suited to their purposes.

  1. CAN I AFFORD ILLIQUIDITY?

By their nature, private market investments are illiquid – they are difficult to buy and sell. The long-time horizon previously discussed may enhance the potential for return, but it is also a key consideration for investors with liquidity needs. Most private market funds have 10-year terms and a classic J-curve profile, and may not suit the needs of investors requiring liquidity.

  1. WHERE DOES AN INVESTMENT FIT IN MY OVERALL PORTFOLIO?

An allocation to private markets may provide a variety of benefits to a portfolio: higher return potential, lower correlation to the public markets, and diversification. Some investors may add a private market investment as part of their overall equity strategy for its potential to deliver outsized returns. Others may find it an attractive counterbalance to publicly traded investments or highly correlated assets in their portfolio. Regardless of the size of the allocation or its role in the portfolio, investors should ask themselves what they are looking to achieve with a private markets allocation, and how it may affect the performance of your overall portfolio as a whole.

  1. AM I COMFORTABLE WITH LESS TRANSPARENCY INTO PERFORMANCE?

Consistent reassurance about performance via daily price quotes or frequent reporting, as is the custom in the public markets, is not made available for private market investments. While private market fund managers report returns and significant portfolio developments to their investors (typically on a quarterly basis), private market investment holdings are inherently difficult to value, and it can be hard to quantify the impact a manager has had on underlying investments until those investments are sold. With a private market investment, investors are placing their faith in the manager to create value over a long period of time, with results that are difficult to appraise until the latter half of the fund’s life. This is an important reason why thorough due diligence is key prior to investing.

Items to Assess in private equity due diligence

  1. Assess the fund’s strategy in relation to your investment goals. Assess how the investment thesis and methodology aligns with your requirements like desired returns, cash yield preferences, geographic exposures, asset class synergies, and ESG priorities. Confirm the GP’s time horizons, projected holding periods, and position sizing match your liquidity needs and risk temperament. Understanding the fund’s strategic framework provides the context to judge whether consistency seems likely based on current cycle conditions and team capabilities.
  2. Assess how the fund addresses risk management. Private equity investing involves substantial risk not only in individual portfolio companies, but also at the fund structure and operations levels. It’s crucial to assess how portfolio company risks will be managed post-investment.  Review how the fund insulates against macroeconomic cycles, global events, supply chain crises or other outside shocks that affect returns. The resilience processes differentiate veterans with experience across decades of ups and downs from first-time funds.
  3. How has the fund manager created value with past opportunities? There are three primary “value creation” drivers – and they are not mutually exclusive:
    1. Financial Engineering: increasing a company’s leverage ratio or otherwise adjusting the capital structure to boost equity returns;
    2. Multiple Expansion: selling portfolio companies at higher multiples than those at which they were acquired; and
    3. Operational Improvement: implementing strategies to increase revenue and/or EBITDA during the investment holding period.

Once you determine the source of a fund manager’s returns, you must consider whether they are coherent and repeatable. Will the same investment professionals that led the last fund also lead its successor?

  1. Assess the private equity management team: Who are the key people behind the fund?
    1. It’s said that you don’t just invest in a fund but rather the GP running it. So, gather in-depth background on the key decision makers – what are their qualifications, area expertise, track records, and alignment incentives?
    2. Leverage networks to get candid insight on GP reputation from peers and shareholders in previous funds. Ask probing questions directly to test experience as well as discover personality fit – will communication styles mesh well?
    3. Evaluate personnel continuity at the firm, any churn, and mitigating succession plans. Understanding the human leadership element is vital for truly gauging capabilities to handle economic environments.
    4. Meet with the fund partners in person can clarify commitment levels or reveal disconnects between spokespeople and actual managers. Also, verify GPs and affiliates co-invest a minimum of 1% in their own funds. Skin-in-the-game ensures managers have personal capital risk at stake. Enquire if later funds will recycle proceeds from high-performing early funds – indicating confidence putting personal wealth back for employees beside third-party money.
  2. Ask them difficult questions:
    1. What has been the manager’s experience with underperformers? What has been the manager’s hit rate for successful investments?
    2. Ask them about a failed company, and what they learned from the investment.
    3. Do they highlight their losers over their winners?
  3. Assess the compensation structure of the private equity fund: What are all the associated fees and expenses?
    1. Private equity sticker fees have a well-known structure of ~2% management fees and 20% carried interest. But you must take the time to quantify total costs since expenses can rapidly eat away projected net returns.
    2. Request the latest audited financials from the GP entity to inspect operating expenses, fund setup costs, and overhead allocations across funds. Factor in advisor fees, consultancy costs, broken deal expenses and ask if these are capped at a deal or overall fund level to avoid overruns.
    3. Evaluate fee tiering – does the fee rate decline as fund size increases? Is carry subject to a preferred return or recoup investment costs first? Fee terms can align investor-GP outcomes while complex waterfalls may enable over-earn by management.
    4. Run earnings scenarios adjusting for total estimated expenses. Allocators targeting 17-20% IRR net to investors see over 70% of that eaten away solely by the classic 2 & 20 fee load. Thus baseline projections must support the fees.
    5. Research compensation structures – are bonuses adequately tied to fund performance versus raw asset gathering?
  4. What is their deal sourcing and evaluation approach?
    1. The source of a private equity fund’s deals is hugely influential on ultimate returns. Many GPs find acquisitions through auction processes – where a target company or asset is openly put up for sale. However, winning competitive auctions often demands paying higher purchase prices that cut into profits.
    2. An alternative is proactively sourcing proprietary deals through intensive outreach efforts to potential sellers who have not formally put companies on the market. While more time and research intensive, directly contacting owners can access deals other funds miss, supporting lower acquisition costs and unique upside if valuations rise after securing a strategic yet little shopped asset. Evaluate how wide the net is cast when sourcing acquisitions and investments. More pipelines allow being selective for quality.
    3. Question how many annual opportunities are reviewed and in what ways proprietary models, data, or connections provide advantages over other firms when securing high quality assets.
    4. Review the decision making and due diligence roadmap leading up to acquisitions or investments. Is approval consensus-driven or autocratic? The depth of sourcing networks, investment analytical expertise, and leadership team dynamics indicate an ability to repeatedly uncover and accurately assess deal prospects most others overlook or misevaluate in the market.

Conclusion

Those committing to private equity investments based solely on marketing pitches or assumptions around headline performance metrics too often regret the outcomes years later when private equity returns are realized.

Conducting intensive due diligence in opaque private markets requires asking detailed strategic questions that reveal underlying risks and confirm alignment between investor’s investment goals and complex fund vehicles.

By incorporating key due diligence questions into your evaluation process when considering new private capital commitments, you can cut through obscurity and make sound allocation decisions that are aligned with your portfolio objectives.

Have Questions?  Contact Us!

References

Veronis, Nick.  “6 Things to Consider When Selecting a Private Equity Investment”.  6 Things to Consider When Selecting a Private Equity Investment – Financial Poise.  April 15, 2022.

Charanas, Joan.  Essential Due Diligence Checklist for Private Market Investments: The 6 Questions Every Investor Should Ask.  LP Investor Due Diligence Checklist: Top 6 questions to ask (vyzer.co).  November 30, 2023.

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