Limited Partners are the passive investors in a private equity fund, the customers who enable the General Partners to operate the investment strategy. Without LPs, GPs essentially would have no money to invest besides their own. LPs can be very cautious when writing checks, either their own or on behalf of clients for whom they are in the business of mistake avoidance and wealth preservation. Thus LPs perform due diligence on GPs before putting any of their wealth or the wealth of their clients on the line.
We recently attended a conference where LPs were talking about how they evaluate GPs, and the kinds of things that make them inclined to invest in a GP. After speaking with a few LPs, it became clear that there are common themes around which they largely tend to focus.
Who is the management team?
One of the LPs applied the old real estate mantra (“location, location, location”) to private equity, saying the three most important things are, “team, team, team.” Cohesion and years of doing deals together are very important. The team’s experience sourcing opportunities, their network, and ability to drive ROI speak to their ability to continue to do so.
LP’s want to know how many deals the GPs have collectively done, and how long they’ve been working together. Although a firm can have great historical returns, if the team has changed, they will place much less value on those returns. One LP went so far as to say if a key team member is nearing retirement, they are more likely to be more risk averse and might lose their hunger to win deals.
How do you source deals?
Predictability and quality of deal flow are important factors in determining whether or not an investment in a private equity team is a good one. Does the firm have an angle on the deals it is pursuing? Does it have a marketing and sales orientation to its deal sourcing efforts? Best in class firms like TA Associates put enormous emphasis and resources into systems, tools and people for deal sourcing; do you? Since proprietary deal flow is much more difficult to produce predictably, does the GP know how to compete against other buyers in a competitive environment without overpaying?
Marc der Kinderen, Managing Partner with 747 Capital, commented at an Opus Connect Limited Partner conference in September that some firms hang their hat on proprietary deal flow and use it as a strong selling point. “Proprietary deals are not enough,” Marc said. “They exist, but if you want to do multiple deals a year, you won’t get them all from proprietary deal flow. You can maybe do one or two but you’re still left with several bullets.” Anna Dayn of Cardano added, “It isn’t that impressive to hear it was a proprietary deal because that tells me nothing about whether the GP overpaid or not. I’ve never seen stats that show that proprietary deals are more lucrative on the whole… it makes no difference how the deal was sourced, auction process or proprietary…the difference is how attractive the deal was in terms of valuation.”
What is your strategy and how has it worked in the past?
Though past performance is not an indication of future success, it is one of the easiest ways to judge a team. Are you a generalist, a specialist, or a hybrid? Do you have an outlook on the macroeconomy that drives your strategy or are you planning on levering a company up and hoping for the market to boost its multiples? Marc commented that he prefers managers who have sector expertise and who are not simply “financial engineers or market timers.”
Who else is committed to the fund?
The presence of other investors committing substantial capital provides tremendous validation to an investment in a GP. The hardest LP for a GP to acquire is always the first or first handful.
We really like you. Can you just explain that failed deal you did a few years ago?
When LPs ask GPs about a failed past deal, they want GPs to be honest and to demonstrate that they have very thoughtfully analyzed their failures and understand how to avoid those going forward. Moreover, they will use this to test the team; to ensure they aren’t a polarized group blaming each other or, especially, members no longer with the firm. Hearing differing points of view on this subject from different members of the GP is always a red flag.
In almost every case, an LP puts the GP through rigorous due diligence and interviews. An unfavorable answer to any of these questions weakens an LP’s confidence in the GP and hurts the latter’s chances of receiving funding.