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Due dilgence in private equity

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There is mounting pressure on pension funds to consider investing in private equity. For those that decide private equity has a place in their long-term strategy, there’s the issue of how to they go about selecting a manager. Given the immense growth in the number of private equity funds in Europe, how do pension fund investors – especially those investing for the first time – ensure that they select a ‘winning manager’?
An answer is to choose a fund of funds manager – they have the specialist experience, market knowledge and research processes to identify those private equity managers most likely to deliver returns above the quoted market. Yet, this process of selecting a fund of funds manager, in itself, requires due diligence.
By drawing on specialist manager research programmes, it is possible to evaluate each investment product’s prospects for medium to long-term outperformance, relative to the risk associated with them. Of course, it is not possible to pick winners in advance with absolute certainty. Nor is it sensible to rely solely on analysis of past performance. However, with the aid of thorough due diligence, it is viable to assess the likelihood of an investment product achieving satisfactory investment performance and determine whether it is appropriate for an individual fund’s private equity strategy.

Manager risk
The greatest ‘risk’ of investing in private equity is not necessarily that the underlying investments are in small companies, which fail more readily than quoted companies (though some undoubtedly do, particularly in early stage/start up funds). Rather, it is the risk that investments are committed to the funds of managers that do not have the requisite skills to build, develop and successfully realise a portfolio of companies.
There is clear evidence that many managers cannot achieve above-quoted market returns.
Over the 10 years to the end of December 1999 the performance of all funds raised in the UK ranged from –7% to +47% a year, compared with the FTSE All Share return over the same period of 14.9% a year. Over shorter time periods, the range between 10th and 90th percentile manager tends to be even greater. The chart shows the dispersion between managers across different stages of investment.
Unlike managers of quoted equities, those managing private equity funds do not tend to see their performance move from upper quartile to lower quartile over time (or vice-versa). The range of returns is partly a reflection that the market can be segmented by ability (as well as by stage of investment and vintage year), with some managers in the ‘premier league’ and others in ‘division three’. In time, the underperformers drop out of the market as they are unable to raise successor funds - but then new players come in to replace them. The structure and nature of private equity funds means it can be a long time before bad managers are weeded out.
Manager (or fund) selection is therefore the key risk facing investors, and compounding this risk is the long-term nature of private equity. Due to their limited partnership structure – the most commonly used vehicle, despite associated legislative problems for some pension funds - investors are effectively locked in for the life of the fund; typically, 10 to 12 years (although there is a growing market in ‘secondaries’). There is little ability to ‘hire and fire’ managers as there is in other asset classes.

The role of fund of funds
As their name suggests, these funds invest primarily in private equity funds. The skills, or added value, that the fund of funds manager brings, is the ability to identify those managers with the greatest potential to deliver returns above those available from the quoted market.
The returns achieved by well-established fund of funds managers suggest that they can identify the managers who do outperform. We would expect a high degree of consistency in the names of the managers backed over time. Data is often quoted, showing that a manager’s performance improves with experience – many fund of funds managers avoid ‘first’ funds, unless it is for a team which has emanated from an older manager and is highly regarded within the industry.
Fund of funds may also invest in companies directly. This is almost always a co-investment in companies in which underlying private equity funds already invest and the manager is well-known and respected. The effect is that the fund of fund’s exposure is slightly geared to a particular fund.
A fund of funds not only provides diversification across managers, but also across geography and investment stage (something of particular importance for first-time investors).

How to select a fund of funds manager
When selecting a fund of funds manager, it is vital to understand their investment process, and how decisions are made and implemented. It is also important to understand the experience, track record and abilities of the team. Private equity is a ‘people’ business and the investment professionals involved will be key in determining the return on the fund.
When examining the ownership and organisation history, particular attention should also be paid to how the current team evolved and what succession plans are in place. You should identify who the key people are, how long they have been with the team and how they are remunerated. The interests of the fund managers/investment professionals should be aligned with their investors. Do the fund managers invest in the fund? Where the team is not independent (that is, owned by a parent company), how competitive is the overall remuneration package and what is the split of any carried interest (a performance-related component) between team and parent? In addition, how reasonable and competitive is the incremental fee that is charged by the fund of funds manager to investors?
As part of the due diligence process it is crucial, in turn, to gain an understanding of the fund of fund manager’s due diligence process for investing in a fund. What are their manager selection criteria? What drives their decision whether or not to invest in a fund?
Most good fund of funds managers will have an extensive proprietary database on who is in the market, whether or not they are invested with the manager. They should offer assurance of their ability to recognise new managers in the market and have the resource to research new markets.
The above points outline some areas requiring research when selecting a fund of funds manager - and there are many more. There are practical points to consider, such as who is going to pay for research in an asset class only likely to represent a small proportion of a fund’s assets. Additionally, the extent to which the research be extended so that the manager can be compared to other players in the market. For these reasons, investors need to seek professional advice to help in the selection of fund of funds managers who, in turn, use their expertise to select the ‘grass-roots’ managers.
Returns from private equity have, in the past, provided returns in excess of the quoted markets. However, the range of returns among managers varies enormously. Through due diligence it is possible to select a fund of funds manager who will be able to identify private equity managers with the greatest expectation of being able to deliver returns above those available from the quoted market. Nevertheless, caution should be applied. There is a significant danger that, in the current climate, some investors and managers will be too willing to get involved in this asset class, with the result that they will over pay and therefore diminish the returns that emerge over future periods.
Karen Reilly is senior consultant in the investment consulting practice at William M Mercer in London

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