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Experienced private equity investors and advisers attach significant importance to out-performing the market. Research has shown that only through such out-performance can investors be confident of exceeding the returns of their quoted portfolios – a key justification for having a private equity programme.
However, consistently investing in superior private equity funds requires having an advantage over the market, be it through better knowledge of which funds are likely to perform best, or better access to those funds – or both.
Without a doubt there are some legendary stars among private equity managers whose funds have produced stellar returns for their investors. The chances of these managers’ successor funds
continuing to out-perform the
market are significant. Indeed it would be relatively straightforward to create a portfolio from a wish-list of such managers that would very likely outperform the market.
Unfortunately, lack of access is perhaps the key (or possibly most frustrating) issue in fund investing today. Many of these elite funds will simply not be part of the investable universe for the vast majority of limited partners (LPs).
That said, the top quartile is a big place. Most of the occupants will be less legendary funds which are not as quite as coveted, mostly because their history is not so exalted or their attractions are less obvious. It is in assessing and selecting these funds that an LP’s superior knowledge and analysis can be critical.
A decade ago the proportion of non-specialist investors in private equity funds was much higher than today. It has been said, perhaps unfairly, that many of these investors chose opportunities on a “dim-sum basis” – not surveying the universe of available funds or having a benchmark to guide them, but picking one or two funds from a small selection (usually limited to managers or placement agents who were tenacious enough to identify and pursue them as a potential source of capital).
At that time, the relatively few specialists in fund investing had a significant informational advantage over a large part of the market. By observing a larger universe of funds, they were more easily able to conclude which managers were really doing something different or special. However, over time the industry has become significantly more professional and the large majority of the capital available for private equity funds is now managed or advised by private equity specialists.
The natural result is that the low hanging fruit – the very top managers that “check all the boxes” – will be known to much of the market and will offer limited or no opportunity for new investors to back them. It is therefore increasingly necessary for investors to dig down further to find the hidden gems through their own research.
Even among specialists there is not a consensus on whether a particular fund is desirable. Different experts will assess the various ‘success’ factors in different ways. More importantly, they may weight the significance of these factors differently. As a placement agent we see the areas on which various LPs focus their due diligence processes, and both the common concerns as well as the differing issues they raise on any fund that we present to them.
It is clear that the due diligence data requirement of most LPs has increased substantially over the past five years. Past performance is still king, but investors are seeking increasingly detailed information in order to assess this. A headline IRR number for a manager might
be almost entirely based on
investments done a decade before, of a different size, in a different
sector and in a different market environment – perhaps even with different personnel.
Certainly investors want to know if a manager has performed well in the past, but increasingly they also try to assess how relevant and how sustainable this performance is.
To this end they will focus on the attribution of investments in the track record to individuals within the manager, analyse the risk profile at both the investment and the portfolio level and the way in which equity growth in portfolio companies has been achieved, and interpret these findings in light of their own view of the evolving market and competitive environment in which the fund operates.
Investors also scrutinise the
unrealised portfolio increasingly closely in order to form a view about its potential performance, well before such returns are
crystallised. Benchmarking prior fund performance against a private equity database such as Venture Economics is fairly routine.
However, the limitations of such anonymous databases are not well understood by all. Many investors now maintain their own databases of deal returns and fund returns in order to benchmark funds (and their underlying investments) with known comparables.

There is no doubt that some investors are better at judging funds than others and have earned long-term fund investing track records that reflect this expertise. Most investors will take some degree of comfort from the endorsement of, and by extension the due diligence of, other investors (particularly those regarded as leaders in thought or thoroughness).
However, investors who, either by unstated policy or simple practice, wait until others have completed their due diligence are more likely to find that they lose out in an oversubscription situation and are unable to participate.
Identifying potential high-performing funds is only one way of gaining an advantage over the market. Another primary way is by having a better chance than others of being accepted as an investor in targeted funds. Whenever too much capital targets a particular fund then some investors will be disappointed, either because they are cut out or scaled back by the manager.
First priority typically goes to existing investors who are rewarded for their support when the firm was getting started, or was not so sought after in its own
proving years. Existing investors will also usually have a lower due diligence requirement as a result
of the body of knowledge on the manager that they have already built up. This makes them additionally attractive to managers who don’t want to spend too much time on the fundraising side of the business. The cruel irony is that the very best way for investors to get access to successful managers is to have backed them before they became successful.
Various pieces of research have provided reasonable evidence that the returns of a predecessor fund and its successor are correlated. This is why investors spend so much effort breaking down a
manager’s track record in order to better understand it.
However, evidence of prior fund performance will frequently arrive too late to be of use, firstly, because a decision on ‘fund two’ will typically need to be made before the final outcome of ‘fund one’ has become clear; and secondly, by delaying backing a manager until the outcome of ‘fund one’ has become clear an investor excludes itself from the only group with near guaranteed access to ‘fund two’ – the existing LPs. Awaiting clear evidence of exceptional performance of a prior fund before committing to a new relationship may result in access problems. Investors need to remember that they too are in the business of taking risks to generate rewards.
In all but the most highly sought-after funds, there will typically be additional capacity in a successor fund; the fund size will probably have increased and some existing LPs may be unable to re-commit for reasons outside their control, such as changes in policy, or lack of money. To the extent that this gap cannot be filled by other existing investors increasing their commitment, the next priority will go to desirable new investors.
There is a broad spectrum of LP desirability and different managers will have different views. However, it is clear that the investable universe for some investors is considerably greater than for others on the grounds of their desirability as investors. Some managers favour LPs who can add value to the fund. The majority of managers prefer passive LPs who, as long as the manager performs respectably, will be reliable sources of capital into the future.
Indicators of reliability might include the LP having long-term access to capital, a stable private equity programme over a number of years, low staff turnover and a track record of backing managers over a number of funds – including through trying times when stamina and steadiness were required to stay the course.

Managers also have views on how troublesome an LP may be – from their due diligence requirements to their reputation in negotiating terms and conditions and even their litigiousness.
More recently, considerations about the impact of freedom of information legislation have caused access problems for some US public institutions. However, managers also favour LPs who have a strong reputation in the market – so-called “thought leaders” whose endorsement can add momentum to a fundraising process even though the corollary might be a higher due diligence requirement or even pressure on terms and conditions.
In some respects LPs can make themselves more attractive to managers in order to increase their investable universe and this is an increasing aspect of the industry. However, to the extent that it involves compromising their due diligence process or capitulating on terms it is a delicate path to tread. Other LPs are simply structurally more attractive to managers as long-term sources of capital.
What is clear is that better knowledge and better access are linked – investors who are quickest to appreciate the attractiveness of an opportunity are less likely to encounter oversubscription situations and more likely to be at the front of the queue when they do. Many members of the top quartile may appear to have come out of nowhere and, certainly, less
established players will be harder to evaluate. However, this is where the specialist’s experience in
assessing character and seeing past situations can be applied – where more conventional number crunching cannot.
Assessing who among the less obvious players will succeed will tap fund selection expertise, secure positions in the next generation of stars early, and generate outsized rewards for risk. As the LP universe becomes more professional, a key way that the most experienced and brightest LPs can maintain their edge is to flexibly employ their market-leading processes, fine minds and their imaginations to unearth the hidden gems of emerging, or previously tarnished managers and markets.
Laurence Zage is head of research at Helix Associates in London

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