Fund-level due diligence: More than ticking boxes

How many private equity professionals does it take to change a light bulb?
a) A syndicate of 10 private equity firms, 100 investment bankers and 100 lawyers
b) Not applicable. My deals never fail and my light bulbs never fail
c) Don't know. But the LPs pay for our light bulbs somewhere in the numbers.

Why did the PE executive cross the road? Why is your firm targeting an IPO despite claiming that a company benefits from private ownership?

All of these questions should be put to private equity managers before an LP decides to invest with them, argues Veryan Allen, adviser to high-net-worth individuals, family offices and pension funds who specializes in emerging and frontier markets.

There's little doubt that Allen - who made the observations on his blog - was writing in jest. However, the subject of fund-level due diligence is something investors shouldn't take lightly.

"For proper due diligence - particularly in emerging markets - you really have to drill down to the portfolio company level to understand the true value-add the GP brings to the portfolio management team - the CEO and CFO," explains Richard Tan, Hong Kong-based senior private markets consultant at Towers Watson, a major gatekeeper to institutional investors like pension funds.

"You need to make sure that the downside protections are examined carefully and are enshrined if possible in the legal documentation."

Doug Coulter, head of Asia Pacific private equity at LGT Capital Partners, goes one step further. "There are a number of portfolios where you have mediocre companies, no exits and GPs who haven't raised any more money or aren't going to raise any more money," he says."Maybe if people had done better due diligence, qualitative and quantitative, before committing capital, they wouldn't be in these positions."

Surface skimming

Anecdotal evidence suggests that the due diligence conducted by many LPs active in Asia is still insufficient. Yet given the dominance of minority deals in the region, which means the investor has less influence over the portfolio company, choosing the right GP is arguably more important here than anywhere else.

Numerous LPs, particularly smaller firms located in far-flung locations, have been known to make do with merely skimming the surface of a private equity firm's investment thesis or just having a conversation with a couple of its senior professionals.

The problem with this approach is that few firms have skeletons in their closets that can be exposed with a peripheral glance. According to Violet Ho, head of the Beijing office for Kroll, the private intelligence agency, LPs investing in China should be concerned that various investigations and background checks on private equity firms have revealed unscrupulous behavior.

"Some founders of GPs, who made their money as entrepreneurs, have gone on to present investment opportunities to their funds without revealing previous personal involvement in these companies," Ho tells AVCJ. "Then they tell their family or friends that they can achieve a valuation for the company that's higher than what it's worth. They do it because they get some sort of personal pay-off when they secure and finish the transaction."

Another source is aware of an LP that invested with a firm, only to discover the main manager of the fund had lied about his educational background. Ironically, the returns from the fund were healthy, and so the LP continued to invest in any case, but the situation nevertheless acts as a cautionary tale for those investors that believe they can take GPs at face value.

Challenges at sea

Potential corruption, physical distance between an LP and a prospective GP, and the size of the LP's team, aren't the only challenges that present themselves during the due diligence process. Investors need to adopt a two-tiered approach to their analysis of a PE firm - examining both the fund manager and the underlying portfolio companies - but the companies aren't always entirely willing to participate.

Furthermore, many Asian companies aren't properly or credibly audited, so getting high-quality financial information can be difficult.

"Portfolio companies don't always understand what's happening," says Ian O'Donnell,a partner in the venture capital practice at US and China-focused law firm Cooley. "It can be difficult to ask them to deal with 30-40 calls from LPs. One solution is to bring some standardization into the process, which funds are trying to do because it avoids having LPs contact their companies too many times."

The bulk of institutional investors already use a standardized questionnaire as part of due diligence - although Towers Watson's Tan emphasizes that this doesn't capture the nuances of the contrasting emerging markets across Asia and that investors ought to make further inquiries to obtain the necessary level of detail.

This is even more important in the case of first-time funds. According to data from Prequin, at 46% of the total, "Asia and rest of the world" account for the largest proportion of private equity vehicles raised by first-time managers, which globally are targeting an aggregate of $72 billion at present.

Though around half of all Asia-focused LPs are thought to have a policy prohibiting investment with new managers, the remaining 50% have their work cut out to make sense of a firm that has yet to build up a track record.

First-time fund managers rarely have their documentation and investment procedures honed to the same standard as more experienced counterparts, so LPs are obliged to conduct research on a more informal basis. If the individuals behind the fund made investments before the formation of the GP, investors can accumulate valuable information by talking to people who invested alongside them.

Global fund-of-funds manager Pantheon rarely takes this chance though, and will only invest in a first-time fund if it is a spin-out from a larger institution or has a pre-existing relationship of 2-3 years with the firm.

Among funds that do have predecessors, a strong track record remains one of the top three criteria for LPs. Perhaps surprisingly, though, this doesn't mean that it's game over for firms with one or two catastrophic deals in their wake. On the contrary, LPs may view past blow-ups as a positive, arguing that they don't want their capital to be used as the tuition fees for the GP to learn on the job. If a team can take past experiences and apply what was learnt intelligently in future transactions, it generally isn't a problem.

"If a company goes bankrupt, though, then something's seriously wrong," says a partner at a global fund-of-funds. "It's a pretty big mistake if something goes bust 2-3 years after your investment, so we would take that seriously. We would prefer the loss ratio of the overall fund to be under 20%."

Affinity Equity Partners lost its principal when Australian Colorado Group went under last year, but this $298 million buyout is unlikely to cast a shadow over the GP as it enters the market with its fourth fund, targeting $3.5 billion. The prospects for Advantage Partners, however, are uncertain. The Japanese private equity firm acquired Tokyo Star Bank for $2.2 billion in 2007 - by far the GP's largest investment - only to see it fall into the hands of creditors four years later after failing to meet debt payments.

An element of track record that appears to generate disagreement among LPs is the need for consistency of strategy. On the one hand, the consensus is that if it's marketed correctly, and there are good reasons for the change, a shift in direction is justifiable. An example would be a fund manager that decided to move away from investing in healthcare in China because it deemed the margins insufficiently high to continue to operate in the space. Provided the decision was explained in adequate detail, many LPs would accept it.

On the other hand, despite the need for flexibility in the rapidly changing Asian market, there is the argument that a lack of consistency renders a track record useless and may cause an investor to question a GP's judgment. "In general, we prefer people to be consistent in terms of strategies where they've made money in the past," is how one LP puts it.

Team equality

Another prime consideration when conducting due diligence is the quality of a GP's team and a cohesive decision-making structure. What LPs don't like to see are situations in which one or two fund managers drive the entire investment process. If a fund says it has 4-5 managing partners, they want to see equanimity in terms of remuneration between those individuals.

An exception to this are so-called "personality funds," where much of the marketing revolves around a particular person. Hony Capital and Primavera Capital, run by John Zhao and Fred Hu, respectively, arguably fall into this category.

In such scenarios, investors typically view it as defensible if the most prominent individual(s) earn 60% of the carried interest, due to the benefits these quasi-celebrities confer on the fund when convincing entrepreneurs to take capital, for example.

"I don't think anyone wants a firm that is just driven by one individual, so you can't be happy about that, but you have to play with the cards you're dealt and in China you can't always find those solid teams of people who are just carving themselves out of a firm or a bank," adds Ben Wootliff, who heads the Hong Kong office of the business risk consulting firm Control Risks Group.

Others point out that in China, in particular, the media frenzy surrounding private equity and venture capital means that it's very difficult for anyone who has encountered success in this field to remain low-profile, even if they wanted to.

Thus on balance LPs appear willing to accept the disproportionate number of entities in Asia riding on the backs of high-profile individuals for a while longer. What has changed with regards to due diligence on firms is that - although many LPs in Asia still have a way to go to bring background checks up to the global standard - they are spending longer on their investigations than ever before.

Even firms with prominent figureheads face more sophisticated and relevant lines of questioning than in the past.

"Before, it tended to be that when we were asked to look at a firm, we were asked to look at the founder," says Kroll's Ho. "Now a lot of LPs are asking questions about the whole deal team - their composition, their stability, do they get along? They're asking a lot more about the culture and values of the firm, which is a very positive sign."

 

SIDEBAR: Diligence - USD vs RMB

It seems counterintuitive that a fund would ask for an investment from an LP and then fail to provide enough information about itself. However, such circumstances aren't unheard of in Asia, especially in China, where a discrepancy has been noticed between the level of data provided by renminbi- and US dollar-denominated funds.

Offshore funds that raise in both currencies simultaneously typically share information based on a template established over years of experience in LP reporting. It's unusual for renminbi funds raised by Chinese GPs to have this depth of background, so many of them fall down on this point. The exception tends to be firms that recruit external advisers to assist with English language-versions of the PPM and due diligence materials or even with creating an LP reporting template.

"They will without doubt improve over the course of time, but some of the Chinese GPs that are thinking of raising for the first time may not be that equipped at the early stages of their fund life," says Richard Tan, Hong Kong-based senior private markets consultant at gatekeeper Towers Watson.

Not all LPs see this lack of familiarity with due diligence and reporting procedures as a disadvantage in any case. Some take it as a given that in cases where PE firms have perhaps only raised one prior fund in a relatively kind market the ability to pre-package due diligence and create a robust data room for investors will not be as advanced. LPs can use this to their benefit, though.

"If you have a truly local team that's fluent in Mandarin and has done due diligence on dozens of managers, it's in your DNA to meet directly with the management teams of companies who might not speak English to check if the lights are on on Friday night, that they're running multiple shifts, and actually need the capex that they're expressing," says Alex Wilmerding, principal with global fund investor Pantheon's Asian investment team.

"It's natural to sift through the accounts and diligence information that is only provided in the local language."

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