Limited partners step up due diligence

The heightened attentiveness of limited partners (LPs) to the track records and capabilities of the private equity (PE) funds they choose to invest with is one of several major themes addressed in Bain & Company’s Global Private Equity Report 2011, our comprehensive analysis of the trends that are shaping PE this year. In our previous post, we discussed LPs’ increased scrutiny of return track records of general partners (GPs). In this installment, we examine three additional criteria that now top LPs’ due diligence process:

GP investment discipline. LPs are examining one aspect of GPs’ past behavior in particular to get a sense of GP discipline and find hints of what they can expect to happen in the future: namely, the actions a GP took in the boom times, through the downturn and during the past year’s recovery. One key indicator of discipline is a GP’s consistent adherence to its investment strategy. In a recent survey, this variable ranked as the most important factor to LPs when conducting due diligence.

Increasingly, in light of the flow and ebb of the PE cycle in recent years, LPs think it is critical that GPs stick to what they know best. The LPs Bain interviewed suggested that GPs should avoid growing too quickly outside of their areas of expertise as occurred during the boom years and avoid chasing hot segments of the market as they did during the downturn.

LPs are also looking to confirm that GPs take a disciplined approach to deal pricing. Many now believe that high prices GPs paid during the PE boom and continued to pay through the downturn and recovery have brought this once underestimated issue to the forefront. Many LPs now recognize that the biggest danger to returns is not that GPs fail to invest capital but that they overpay for what they do buy with it.

Finally, LPs are taking a closer look at how GPs source their deals, and especially whether they relied too much on secondary buyouts over the past two years. LPs value GPs that are able to source deals proactively. They see proactive sourcing as an outgrowth of GPs’ sector specialization that endows them with heightened capabilities for spotting opportunity, and using systematic screening processes and networks of well-connected expert advisers.

GP operational skills. GPs that can demonstrate successful value-creating partnerships with the management teams of their portfolio companies will increasingly win favorable attention from LPs. GPs clearly recognize this new reality, and many have stepped up their involvement in the operations of their portfolio companies since the onset of the economic downturn. They are touting operational expertise as a strength that differentiates them from other GPs and have made these claims a staple of the private-placement memoranda pitching new funds. But as with GPs’ claims of superior returns, LPs are taking nothing at face value. LPs are probing deeper to identify GPs with true operational expertise, the area where their due diligence processes have made the most progress in recent years.

Some LPs also bring analytical rigor to bear on GPs’ past deals in an effort to tease out how much of their returns they can attribute to alpha versus other factors. LPs that Bain interviewed believe that the downturn helps them distinguish GPs whose true operational capability enabled them to manage the crisis well from those that are mere “window dressers.”

GP organizational dynamics and risks. A crucial issue for LPs today is ensuring that the interests of GPs are aligned with their own. Until recently, most LPs were content to judge that by focusing on a fund’s terms and conditions. But for many LPs those contractual arrangements no longer go far enough to ease their concerns.

Most sophisticated LPs are becoming more vigilant about the internal organizational dynamics of the GP as a whole. One top-of-mind concern for LPs is the motivation level of the younger partners at some PE firms, particularly partners whose first fund may have been from a peak market vintage. Because of the high prices paid to build their portfolios and the slow rate of realizations to date, these partners have not yet made much money and may not earn a carry. Nor do they have money of their own to commit to the next fund. Yet they are locked in because they may have borrowed from their firm in order to commit to their first fund.

Other organizational risks and legacy issues raise LPs’ concerns. For instance, they know that GPs invest in firm infrastructure and personnel based on the projected size of their next fund and the management fees they can be expected to generate. But if the GP is unable to realize those projections in a tough fund-raising environment, they may be saddled with too much overhead and weak staff morale. Also, LPs worry that the burden of GPs’ large legacy portfolios may overly tax their deal and operations partners.

This post was written by Graham Elton, Bill Halloran, Hugh MacArthur and Suvir Varma, leaders of Bain & Company’s Private Equity Group.