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Carrying Out Due Diligence on Private Equity Funds

by Rainer Ender

Executive Summary
• Private equity fund due diligence is the first step in an investment process. The goal of due diligence is
to identify the risk/return profile of a fund offer.
• A well-structured due diligence process contains a top-down macro and a bottom-up manager analysis,
allowing the investor to filter the most promising funds.
• A consistent framework for fund and fund-manager assessment is essential. This assessment must
address quantitative and qualitative aspects, and focus on the manager’s “ingredients for success”.
• At first sight, fund offerings may appear attractive from a pure return perspective. It is crucial that the
investment has an attractive risk/return balance.

Introduction
The term “due diligence” covers a broad range of different due diligence types. These can be grouped
into three major types; financial, legal/tax, and business due diligence. The goal of this article is to shed
light on business due diligence for investing in private equity funds. Due diligence is commonly defined
as “the process of investigation and evaluation, performed by investors, into the details of a potential
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investment, such as an examination of operations and management, the verification of material facts”.
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“It is a requirement for prudent investors and the basis for better investment decisions.” Private equity
fund evaluation faces specific challenges; the private character of the industry makes it inherently difficult
to obtain the relevant information; furthermore, the investment decision reflects a commitment to a fund
manager to finance future investments rather than a straightforward purchase of specific assets. Therefore,
common evaluation techniques used to assess public equity investments are not appropriate within the
private equity asset class.
The private equity market has enjoyed extraordinary growth rates in the past, and private equity investments
showed strong returns, supported by a booming economy and an expanding debt market. The current
financial crisis will have a significant impact on the private equity market; a shake-out of fund managers is
to be expected over the coming years. Managers who can demonstrate how they created value in the past,
beyond just benefiting from favorable market developments, and who are able to make a compelling case for
future value creation will continue to raise capital successfully.
Before investing in a private equity fund, an investor should have sufficient comfort regarding:
• Strategy perspective: the investment strategy of the fund.
• Return perspective: evidence that the manager stands out compared to his/her peer group.
• Risk perspective: assurance that risk is mitigated to the level required by the investor.
The relative youth of the private equity industry, data paucity, as well as benchmarking difficulties within and
across asset classes are just a few elements that indicate why the investor has to rely on qualitative aspects
and judgment during the due diligence process of private equity funds.

Structural Set-Up of a Due Diligence Process

The Overall Framework


A solid due diligence framework contains a top-down review as a first step. This review must assess the
attractiveness of the various private equity sub-segments and regions. The assessment includes various
evaluation criteria, such as investment opportunities in the segment, capital demand and supply, the quality
of the fund manager universe, entry and exit prices, and the future development potential of the sub-
segments. Furthermore, it is important that the investment strategy of a fund manager is not only attractive
on a stand-alone basis, but also within the overall context of the investor’s total portfolio.
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Generating a complete overview of the relevant fund manager universe is the second step. Worldwide, there
are about 3,000 private equity fund managers to be considered, making the creation of this overview a very
demanding task. It is crucial not to assess the managers who provide you with their fund offering passively,
but proactively to benchmark all relevant fund managers for a proper peer-group comparison.
The third step of the framework is to ensure that risks related to the potential commitment are mitigated
through an in-depth due diligence process. For all identified issues, due diligence steps must be taken
in order to clarify the situation. An investment should only be considered if a sufficient level of comfort is
achieved on all issues.

Example of a Due Diligence Process


A clear, well-structured due diligence process, which is tailored to the context of the fund manager, with
concrete steps and tools, is an important prerequisite for a comprehensive and consistent fund-manager
evaluation. Below, we describe a process structure that is the result of continuous improvements over the
past 25 years.

Figure 1. Example of a proven due diligence process structure


The first screening of the fund offering addresses the track record, strategy, team, and fit with the portfolio.
This analysis can be performed by junior professionals, but it is important to have an experienced senior
professional reviewing the screening and taking the final decision whether to conduct further due diligence.
This ensures that the senior has the full picture of the deal flow and the market dynamics.
The prequalification phase starts with a detailed portfolio analysis of all past investments made by the fund
manager. Interactions with the fund manager are used to clarify the impact on the value contribution of
the manager to past and future investments. Putting these insights into a structured risk-return framework
(see next section detailed below), combined with peer-group benchmarking, allows the identification of
fund offerings with a promising risk-return potential. It is beneficial broadly to discuss fund offerings within
the investment team to identify critical aspects, residual risks, and external referencing possibilities. This
knowledge exchange defines questions for the qualification phase.
The qualification phase is divided into four steps:
1. Dual control: the project worker starts working with an independent devil’s advocate. The goal of this
step is to identify all potential weaknesses that could be discovered by a pair of fresh eyes, and to
ensure the quality of the process. It also helps specify further tailored action steps that need to be
addressed, and to clarify open issues.
2. The second step is to review the fund manager’s governance structures and processes, with the goal
of identifying operational and team dynamic risks.
3. The third step is the verification of the self-assessment through third-party referencing. Well-prepared
reference calls with past and present key people from underlying companies are an extremely helpful
resource for verifying your current impression of the fund manager. Reference calls provide the
opportunity to check the contribution of the fund manager to the value creation and the investment
sourcing. If external referencing confirms the current assessment and does not lead to new questions,
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the investment opportunity fulfils all three evaluation levels: appealing strategy, return potential, and
controlled risk.
4. The last step is the legal and tax due diligence.
The investment decision and subscription: having a formalized investment approval mechanism, for example
through an investment committee, rounds off the due diligence process, which, as a last step, includes the
subscription process to the fund.
Thorough monitoring must be put in place once a long-term investment is made. Monitoring is needed
to ensure that active measures can be taken where needed, in order to maximize value for the investor.
Monitoring is also an integral part of the due diligence for the investment decision regarding the fund
manager’s next fund (typically after three to four years). Due diligence represents a deep monitoring effort on
prior fund investments.

Risk Return Framework


A clear fund-manager evaluation framework provides consistency among different manager evaluations,
and allows for proper benchmarking of managers within a specific peer group. A scoring system that is
appropriate for the qualitative and quantitative analyses on a fund manager has proven useful. By constantly
applying the system, the scoring becomes well calibrated. Furthermore, it allows for best-practice manager
benchmarking across geographies and segments. Due to the qualitative nature of private equity, the focus of
the assessment must be on the “ingredients for success” within the future competitive landscape.
In order to enable the ranking of fund managers within a peer group, a quantitative benchmarking that looks
at the return and risk aspects helps to put the full due diligence findings into an aggregate picture. We have
applied the following framework during the past decade.
Table 1. Framework for a manager evaluation addressing risk and return aspects with a scoring system

Return assessment Score Risk assessment Score


criteria criteria
Historical performance X.XX Historical performance X.XX
• Quality of past • Quality of past
performance performance
• Aggregate deal • Deal by deal
performance over volatility
time
Deal sourcing X.XX Operations/team risk X.XX
• Quality of deal flow • Governance
• Involvement in deal structure
origination • Process quality
Value creation X.XX Investment strategy risk X.XX
• Operational • Investment
competence discipline
• Level of active • General risk
involvement in elements
deals
Exit capacity X.XX Aggregate company X.XX
financing risk
• Track based on
many deals vs. • Milestone vs.
single hit upfront financing
• Corporate buyers • Quality of
network syndication partners
Portfolio return X.XX Portfolio return X.XX
considerations considerations

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• Common • Common
characteristics characteristics
of individual of individual
companies companies
supporting return supporting risk
potential potential
Total return score X.XX Total return score X.XX

Case Study

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Fund Due Diligence for the MCAP Fund
MCAP is a newly formed, European, first-time fund manager launching a €250 million fund specialized in
development capital and small buyout investments in a single industry. The key person for the fund has deep
industry experience. He successfully founded and grew a company operationally superior to more mature,
competitive companies. Subsequently, the company was acquired by an international corporation, where he
then became the CEO. After stepping down, he formed MCAP. Besides him, there are two other partners
who also left their high caliber jobs to launch MCAP. The additional team members previously worked
together in various positions; however, none of them has a track record as an investment professional.
A standard due diligence process focused mainly on the historic performance of the fund would pass on this
fund after the first screening. The risk-return framework has a different approach:
• The industry targeted by the fund is not covered by existing fund managers. The industry appears to be
attractive for backing small, flexible, and dynamic companies with high technological and operational
excellence. MCAP could, therefore, be a promising complementary investment.
• The fund manager’s ingredients for success from a deal-sourcing and value-creation perspective are
in place through the extensive networks of MCAP’s partners, and their in-depth industry expertize. Exit
capability has only been proven in the sale to the international corporation; there is neither a proven
track record, nor an established competitor. Nevertheless, the risk return assessment framework can
be applied to benchmark this new fund against other funds with a single industry focus. Reference calls
are important sources for validating the reputation and the competency of MCP’s team.
• Risk mitigation for the investor is the most challenging aspect of the due diligence in this case. The
management firm is in formation, and the concept is to operate like an industry holding company,
managing five investments with deep operational involvement. It is evident that the fund operation
will be loss-making, and that the partners are pre-financing this initiative substantially. They are well
aligned with the investors in the fund. Close interaction with the manager, and legal terms allowing
intervention by investors, should MCAP drift off course, are prerequisites for reaching the level of
comfort needed to make a fund commitment.

Conclusion
Private equity fund due diligence is a work-intensive undertaking. It requires a clear top-down assessment of
investment segments and geographies that, based on fundamental drivers, appear attractive for investment.
For the bottom-up fund manager evaluation, a proper due diligence process with clear milestones must be
established. This process must be supported by tools that allow a structured assessment of a fund offering,
and ensure comparability of different funds. When working in a broad team, special attention is also needed
to make certain that all professionals apply the same framework, and that evaluations by different people
lead to comparable results.
Finally, it must be emphasized that, while there appear to be many promising investment opportunities, the
most important element for due diligence is to identify the risk behind each opportunity.

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Making It Happen
The foundation of a successful due diligence process is a structured process, a proven evaluation
framework, and an experienced team. Some valuable aspects are:
• In-depth knowledge of past fund investments, their business and investment performance, and the fund
manager’s value creation is crucial for the evaluation and the understanding of a private equity fund’s
offering.
• Broad sharing of the investment project work among all investment team members ensures the quality
of the due diligence process, and a consistent investment philosophy across the firm.
• Well-prepared reference calls provide an excellent perspective on how a fund manager creates value.
• An experienced senior professional acting as devil’s advocate on an investment project provides
valuable, internal challenging and risk mitigation.

More Info
Books:
• Mayer, T., and Mathonet P.-Y. Beyond the J-Curve: Managing a Portfolio of Venture Capital and
Private Equity Funds. Chichester, UK: Wiley, 2005.
• Probitas Partners. The Guide to Private Equity Investment Due Diligence. London: PEI Media, 2005.

Report:
• Kreuter, B., and O. Gottschalg. “Quantitative private equity fund due diligence: Possible selection
criteria and their efficiency.” Paris: HEC, 2006.

Notes
1 Sood, V. “Investment strategies in private equity.” Journal of Private Equity (Summer 2003).
2 Mayer and Mathonet (2005).
3 Fictitious fund example, based on actual cases.

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