Due diligence & psychology: Internal audit

Behavioral finance psychology is a well understood field and regarded as elemental in both the art and science of investment, but its core teachings are not widely put into practice. That is a severely negligent misstep in every asset class but perhaps none more so than private equity.

The exceptionally complex web of relationships that define PE ensures that communication, motive, personality, and other human factors are more decisive variables than contractual or business-level specifics. The industry chestnut that PE is a people business is often associated with firm handshakes, outgoing attitudes, networking and, increasingly, diversity. But with rising competition, a deeper understanding of this mantra is now required.  

More GPs are leveraging the same financial models, databases and educational backgrounds with support from the same service providers. There is less room than ever to credibly claim an edge over the pack and an increasing need for realism about the diminishing opportunity to exploit information asymmetry. This rapidly leveling landscape has piled pressure on LPs to review their approach to industry intangibles.

Much of this effort will involve recognizing vulnerabilities around cognitive bias and the idea that, as investment industry theorist Benjamin Graham said, "the investor's chief problem – even his worst enemy – is likely to be himself." Among the most common pitfalls here are availability heuristics, which lead to value judgments based on minor, personally relevant inputs that have been over-weighted in the decision-making process. This phenomenon makes real dangers of chasing recent trends and excessively focusing on past performance.

Availability heuristics also encourage investors to overreact to both good and bad news, inspiring greed in a boom and panic in a bust. Overcoming this tendency and thinking independently when the market heaves in various directions has more to do with EQ than IQ because decisions are made for emotional rather than logical reasons. This point is relevant to every counterparty in all aspects of private equity, including hiring, team mechanics, fund formation, portfolio management, deployment, and exit.

Robin Harris, a Hong Kong-based managing director for UK family office Capricorn Capital and formerly of senior vice president at Macquarie Private Capital Markets, stands firm by this philosophy. He identifies emotional temperament as a more critical consideration in manager selection than track record and flags personal experience where investments that seemed to tick all the diligence boxes were sunk by a lack of insight into the psyche of a chairman or founder.

"When I look at businesses, 99.9% of the due diligence is around the individual that I'm partnering with and investing with. Maybe that's extreme, but the businesses we buy don't have assets," Harris says. "There's no property, plants and equipment to wrap my arms around. When you buy a services business, you're really buying people, in the form of staff, customers, clients and intermediaries. All the value is in the individuals, and that starts with the management or the owner."

States of denial

These are the most difficult assessments to make in the investment game, and in private equity they must be made from multiple vantage points. Best-practice processes to date emphasize an understanding of the key limiting factors, including a lack of information about the person on the other side of the negotiating table and the human impulse to reject inconvenient truths when they are revealed.

PE professionals skilled in analysis and logical extrapolation are well equipped to hobble themselves with this kind of cognitive dissonance, easily finding ways to recalibrate benchmarks or develop novel rationales for holding onto incorrect assumptions.

Among GPs, this behavior is most commonly associated with a swaggering type-A personality, confident enough to take chances while others play to avoid mistakes. For LPs, negativity bias appears to be the mental quicksand at play. The risk here is in developing an aversion to handicaps so strong that many imperfect but viable opportunities will be discounted in favor of a mediocre middle.   

Most of the thought leadership on these issues comes from the homogenous confines of Wall Street. Building an Asian playbook for this kind of qualitative due diligence will therefore demand a greater focus on multiculturalism. But embracing that challenge is going to be complicated for several reasons.

Firstly, cross-cultural communication breakdowns in Asia are only part of a broader trust issue across the region. The concern is that resumes, supporting data, and track records are often said to be manufactured, and the only way to get the goods on someone is to directly engage with their closest personal contacts. Second, important subtleties around guilt, pride or shame can be lost in translation, while trivial foibles and idiosyncrasies are magnified.   

Furthermore, business cultures across the region are traditionally recognized as being fundamentally relationship-based rather than contract-based. This creates more of a buyer-beware than a seller-beware environment that is harder for outsiders to navigate, no matter how well acclimated they are. 

Scott Peterman, a private equity and M&A-focused partner at Orrick in Hong Kong, cites the work of renowned cultural anthropologist Clifford Geertz as part of his training in dealing with these issues. Having worked in Asia since the 1980s, he sees the miscommunications related to the region's cultural complexity as a barrier even for bi-cultural professionals and locally born returnees, perhaps especially in China.   

"It's very difficult to get past your own personal prejudices or cultural inferences to evaluate and understand what motivates another person from a different background," Peterman says. "There's lots of room to get it wrong with the issue of trust, especially in this part of the world. Part of that is because there's not much recourse for people who've been cheated. And that's compounded by a predilection to not invest time in longstanding relationships but instead get as much as you can from the opportunity in front of you."

Trust issues

There are no shortcuts to building trust, but understanding the discrete perspectives involved can prove helpful. In the investment process, trust difficulties are predominantly grounded in reluctance among founders to give up control. In fundraising, an institutional investor's instinct to be suspicious is amplified by the sheer scope of their fiduciary responsibility, while a high net worth individual is simply reluctant to trust external parties managing their wealth.

Meanwhile, all these viewpoints are churning in an increasingly opaque macro context. The onset of the digital age has brought with it a new landscape of leaks, espionage, break-ins, and whistleblowing. This has been aggravated by mounting pressure to put capital to work in unfamiliar markets.

One of the most resonant cases of broken trust in recent months is The Abraaj Group, which became the world's largest insolvent developing markets PE firm in 2018 due to a still-unfolding drama around allegations of misuse of funds and unpaid debt. The meltdown is most often framed as a matter of LPs being seduced by the charm of the people around the firm while ignoring more nuanced transparency and character profile concerns.

The lessons learned suggest character-focused diligence is a pre-deal or pre-hire consideration, but this is by no means the case. For example, some GPs that already conduct psychological profiles on potential recruits now likewise quiz their existing teams. LPs have not yet begun to ask for access to these reports, but that could be the next evolution in standard practice.

At the portfolio level, post-investment monitoring benefits from an added dimension of intimacy but faces challenges around having to adapt to changing dynamics in a relationship. Kyle Shaw, founder and managing partner at Shaw Kwei & Partners, has more 30 years' experience investing asset heavy businesses in Asia and sees character assessments as an ongoing exercise.   

"I've found that getting to know someone's family is a good way to find out what motivates them and take the pulse of that person. But you must remember that due diligence is a three to nine-month process interacting with many service providers, so you don't get that much of a chance to really get to know somebody," he says. "You get to know them a lot better after the investment when you're actually working with them. That can be when things that seemed benign during the background check start to come up, and you connect the dots."

Background checks are the most common formalization of personality reviews and help demonstrate how a mix of factual confirmations and careful questioning can impart meaningful clues about temperament. Although culture and psychology-based questions are all but unknown in standard due diligence questionnaires, GPs and LPs alike are beginning to experiment with combination strategies on this front.

One investor tells AVCJ that his firm ran a standard questionnaire process with the entire team at a portfolio company and all the employees checked out as satisfactory. But when a psychological questionnaire was layered on top, it identified the CFO as someone who would struggle with a larger customer base and generally lacking the personality to grow the business further. The CFO was replaced.

Reference checks

The bulk of background checking takes place at the GP-LP level, however, especially with a view to uncovering financial skeletons in the closet such as unpaid taxes or debts. GPs typically provide the LP or third-party investigator with a menu of contacts, which could host clues to personality style and motive. Most LPs will also speak with people not on the list. They will either request the contacts from the GP or follow up independently, or both.

Best-practice approaches in reference calls maintain a consciousness that any commentary will be colored by the preoccupations of the related parties. Much of the information will come in the form of remarks that are either unprovable or impossible to disprove. Rumors in these instances will often represent stronger evidence than one-off allegations, since they suggest unanimity and a reputational risk.

"A reference call is a call with another individual to secure genuine feedback noting that the individual may have their own views or biases, so you are taking into account the comments of the person you are speaking with while keeping in mind the context of their position or perspective," explains Thomas Swain, a director with Credit Suisse's private fund group. "Ultimately, what we think is key is to get a consensus from a number of people in the market to understand empirically how people behave as partners."

Technology is having a significant impact on this part of the industry, especially in social media, which have proven divulging but difficult interpret. Many of the red flags include online rants about seemingly innocuous topics such as sports team, which can have a sensitive subtext.

Some LPs have assembled "bad news committees" to sift through the data. In a recent survey of hedge fund and PE managers by Corgentum Consulting, 62% of LPs began searching social media within the past year as part of the pre-investment background investigation process. Like many service providers, Corgentum's use of technology has accelerated rapidly in recent years, and it now has access to the same systems police use to find missing children.

Jason Scharfman, a managing partner at the firm describes one investigation where a fund manager lied about education details on his resume, which resulted in the LP redeeming its commitment to the fund and the GP firing the offending investor. While it is still rare for an LP to pull out because of a revelation that comes up about an individual in a background check, advances in automation could lead to more cases in this vein.  

"If they don't tell us about it, and we find something, then it really doesn't matter what we find, the severity of it increases because they tried to conceal it," says Scharfman. "At that point, there's a multiplier effect, particularly when it relates to anything financial. The question becomes, ‘Did the GP investigate anybody on its team before hiring?' One seemingly small thing isolated to one person suddenly has consequences across the whole firm and you have a lot more questions."

Team dynamics

Investigating an entire firm is not practical, but it should be possible to determine group psychology through a limited number of priority engagements. For example, when conducting due diligence on a fund manager, this usually means looking into anyone with key person status and keeping an eye on how the exclusion of other senior partners from this distinction influences esprit de corps. 

In both investment firms and operating businesses, this work will sometimes involve analyzing the dynamics in the room when several people are together, then following up by individually interviewing them and triangulating the inputs to create a more complete picture. A typical result from this process is the identification of one or two strong leaders surrounded by a weak or somehow marginalized team. Investors are advised to check how team members are incentivized in such cases, if possible.

One LP recounted a scenario where a junior partner at a GP was interacting confidently over lunch until his managing partner entered and he began to stutter. This raised alarm bells for the LP about morale and staff harmony. An investigation was duly launched, but it turned out to be a harmless coincidence.

The takeaway in this case is twofold. First, behavioral minutia is now being formally documented, which could have long-term knock-on effects in terms of how investors and entrepreneurs plan meetings. Second, investigators must remember that any given observation or referee soundbite is merely one datapoint of little relevance on its own. Investors should therefore develop methods for maximizing the value of these bits of information such as collecting them in targeted areas of interest.

"I want to understand how a GP has dealt with a failure and maybe talk to other investors to hear how they perceived that GP act in tough situations. I'm always leaning toward GPs who have experienced problems because that's where the true psychology comes out," says Eric Marchand, an investment director at Unigestion. "With GPs that have always been very successful and haven't faced adversity, that's a piece of the puzzle you don't have. Either you're happy to live with that or you're not, but you really want to understand it."

Crisis management capabilities are clear personality indicators that any investor would want to explore. But the more readily available signals of a person's dependability such as lifestyle habits or minor legal transgressions can be troublesome to evaluate as risks, even for specialists. As a result, a school of thought has persisted that character flaws not directly connectable to financial performance are best written off as immaterial.

"The big advisory shops do not have better insights into GPs than LPs. Any LP can do the work and get the information, but by putting that advisory layer between the LP and the GP, they've got plausible deniability," says Daniel Strachman, co-founder of the Investment Management Due Diligence Association. "There are many sophisticated LPs that don't want to know because they don't want to have to go back to a board and say, ‘We can't invest in the GP because we heard he was caught drunk driving.'" 

Look deeper

Goldman Sachs is not one of these LPs. The US investment bank claims to have established an intricate personality profiling program, including a system for measuring team chemistry by scoring factors such as discipline, motivation, rivalry, self-awareness, and humility.

Chris Kojima, a partner and managing director at the firm, refers to these ingredients as "managerial alpha" and says LPs must think of GPs as "living organisms." This work emphasizes avoiding lines of questioning that reinforce LPs' natural biases as well as shifting attention toward fundamental psychological drivers and away from the fundraising pitch. 

"We can't listen to the manager that is presenting to us – we have to look at that manager as a helpful source of information," Kojima told the AVCJ Japan Forum in June, noting that LPs generally depend on managers to interpret diligence data points in a narrative that frames the GP in a positive light. "LPs need to try to resist storytelling as the primary form of evaluation and instead identify factors that are important to your organization."

If this philosophy catches on, it could shake up the arguably lazy "flight to quality" trends that cyclically reshape the PE industry. More creative and investigative explorations of any given counterparty will, in theory, reveal hidden gems and result in more diversified portfolios among GPs and LPs alike. This in turn would diminish the tendency for investors to ignore serious EQ warnings when the dubious evidence of a good track record suggests an opportunity that cannot be missed.   

Perhaps most importantly, it could also inject a balancing dose of modesty into an industry known for being guided by big egos. Cognitive bias errors are common precisely because soft data is more difficult to detect and interpret, both in one's own mind and in the minds of others. In an industry where complexity of strategy is used to imply unique value, there's a good chance this style of investing could go mainstream. But then again, there are few historical precedents for logical moves en masse.  

"If I'm a capital allocator and it's my job to create a portfolio of active managers, what ability do I think I have to identify those unique one-in-a-hundred skillsets and character traits in others early enough," says Capricorn's Harris. "The odds of finding them are so small, I don't think it's even prudent to try. But people continue to try to do it for the same reason that people put money in a lottery when they know the odds are horrendous. It's just how our brains are hardwired."

 

SIDEBAR: Background checks – PE gets personal

The trend toward more background investigations in private equity has created a fair amount of frustration among all parties concerned, principally due to the financial costs of doing deeper reviews of individuals, the longer timelines that come from incorporating those reviews into a diligence process, and the inevitable learning curve inefficiencies that go with adopting new protocols. The most intense grievances, however, are associated with the idea that some of this work may be pointless and even disrespectful.  

Many inquiries are highly personal, especially those seeking to sidestep reputational risks around social concerns. The irony is that the struggle to stay clean has become rather messy. The most contentious personal issue on the agenda is marriage – an institution often compared to private equity because it is also based on a long-term relationship involving shared financial interests. Support for questioning about marital status contends that it is part of a holistic approach to confirming whether the targeted person is predisposed to ignore commitments or be self-servingly opportunistic.

"I want to know if a manager cheats on their spouse. In some cultures, it's more accepted – I get that you must know your market. But it gives you important insights into character and ethics and morals. It's not all about numbers, not anymore," says Daniel Strachman, co-founder of the Investment Management Due Diligence Association. "If you're divorced, how often do you see your kids? Is your spouse an investor in the fund? If you're in the middle of a divorce and you have to pay your spouse out, will you take money out of the fund?"

Strachman adds that managers going through a divorce should be transparent about the process, proactively flagging it with LPs. Counterarguments to this view see disclosures about home life as not only invasive but irrelevant. The logic here is that answering honestly about one's bad luck on personal issues can incorrectly imply a character flaw. Allegations about spousal abuse, whether verified or not, are typically deal breakers. But marital problems as signs of potential stress or distraction create a more nuanced challenge for LPs looking to be thorough yet discreet.

"Our clients are really only interested in issues of a personal nature to the extent that something could impact the stability of the individual. They're not interested in getting into background for background's sake," says Dane Chamorro, a senior partner in Control Risks, which does background checks on behalf of a range of institutional LPs. "Where these issues typically come up is where there are already rumors or speculation about marital discord affecting performance. There are certainly examples of things like that, and quite often it's habits such as gaming or a high-flying lifestyle."

Even if LPs try to take the high road on this issue, they will still likely be forced to make judgments with vague information and a sense of conflict about which option best reflects their fiduciary duty. The classic dilemma is the divorced investor who legally left his wife with nothing. Should he be regarded as a shrewd steward of money during a period of instability or a ruthless public relations time bomb? As one investor puts it: "The psychology thing, especially when it comes to personal questions, really opens it up to interpretation more than fact."

 

SIDEBAR: VC partnerships – Mind games

In private equity, cross-cultural miscommunication and sheer bravado are the most commonly cited reasons for personal friction derailing what might have been a fruitful relationship. But in venture capital, some of the biggest psychological pitfalls stem from a lack of familiarity with the asset class itself.

Michael Joseph, a managing director and co-CEO at Ion Pacific claims unique visibility on the issue, given his firm's non-traditional approach to VC. Ion Pacific works closely with LPs and other GPs when it takes secondary positions in funds. As a hybrid debt and equity investor, it also often seeks highly aligned advisory relationships with individual entrepreneurs ­– rather than whole companies – by keeping the same class of shares as the founder.     

Joseph sees the explosion of interest in VC in recent years as a challenge of understanding between these counterparties that is made more personal by the fact that so much of the activity revolves around impassioned entrepreneurs and high net worth individuals (HNWIs). It is hard to find reliable numbers on what percentage of first-time VC investors are HNWIs, but the consensus view is that this group represents the basis of the boom from a financial perspective, especially in Asia. 

The problem is that an increasingly competitive environment characterized by rushed fundraises and dazzling headlines about start-up success has created thousands of 10-year partnerships where people don't see eye to eye. This is not only a story about HNWIs being surprised by the timelines and dilution issues of VC. Fund managers are getting gummed down in frustrations as well.

"There needs to be an education process," says Joseph. "GPs may feel that potential investors know what they're doing and know the risks, and it's not the GP's job to educate them, which is fair. But the last thing you want as a GP is to be answering emails from an LP who made a $1 million commitment to your $150 million fund, hitting you every quarter and asking how the portfolio is doing."

Good chemistry in VC may be even more important in the GP-founder relationship, given how closely they must work together. From the investor perspective, this starts with realizing that individual founders are replaceable and that it is therefore essential to maintain a workable rapport with all the top leadership in the start-up.

While the ability to attract the best start-ups remains mostly a question of the imprimatur of a VC's brand, psyche appears to be playing a larger role as the industry swells. That's because winning personality traits around grit and tenacity are now confronting a larger opportunity set with fewer realist voices coaching restraint.      

Joseph describes a typical scenario in which a visionary entrepreneur with a survivor's instinct plans to grow a company to a value of $150 million with VC support. Things go well, the company takes off, and the agreed exit is in view. Then the VC industry's hype machine kicks in, and alignment of vision is lost. 

"They continue to attract more praise from the market and more attention from investors until they start saying, ‘Maybe this isn't a $150 million company, maybe this is the next unicorn,'" Joseph explains. "Sometimes they're right, but a lot of times, that's not the case. You need to make sure the founder has a level enough head to make good commercial decisions versus growing a company for the wrong reasons."

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• Topics
• GPs
• LPs
• Advisory
• Asia
• Shaw Kwei & Partners
• Credit Suisse Private Equity Asia
• Unigestion
• Goldman Sachs