I was both delighted and chagrined to see an announcement that the first ever conference on private equity funds due diligence will be held December 7, 2006.
Doesn’t it seem way overdue that people start building a more robust understanding of what it takes to do due diligence on private equity funds? There are only about 3,000 funds with about $150 billion under management, and expectations for 2007 are in the $200 million range for additional money going into private equity funds. Private equity funds have only been around since the early 80s.
A few random due diligence points:
Of course fund management is the first place to look. Unfortunately there are no shortcuts here. To perform proper due diligence on a fund’s management team is a long, grueling and difficult process. It’s easy to run a few background checks and call a few people. This is not good due diligence, although I have seen this all too many times. I wouldn’t even call it due diligence. This is barely basic investigation. To really check out a management team, you have to dig into every fund ever managed by each person. You have to talk to people above and below them. You have to run every claim made by each person. If you can do this (it is often impossible, since people sometimes move around a lot, and funds start and stop every day, changing hands, etc., etc.) then you are beginning to see the character of the team.
You then have to look into some much more complicated issues. For instance, how many of the team benefited personally by co-investing alongside the fund? What happened at the end of the funds this team managed?
What kind of actual business plan does the team have? (you will be shocked by the shameful lack of business plans!) If they do have a plan, how thorough did they really get? Is there a complete plan for succession in the event of untimely events?
Moving on, what are the management fees, pay schedules (and expenses!), transactions fees, incentives, offsets, finder’s fees, and on and on? Are the fees paid when earned or does the team get paid no matter what? Do the management fees ratchet downward as the fund grows older and there is less work to be done? Remember, the management fees are not the big hit for the team, that comes from their carried interest.
Who are the real control persons? What are all the “related parties” relationships and transactions?
Dig into each and every disclosure document. It is sometimes amazing to see tons of details in required government filings that somehow never make it to the more readily available documentation that they are happy to share with you. In other words, are they transparent, translucent or opaque?
Have they even tried to build any sort of secondary market liquidity?
Do they have a hard budget process that they rigorously follow?
If they have international aspects, how smart are they about the myriad minefields (political risk, government restrictions, different accounting, legal and tax issues…..) For instance, the European market is currently starting to be a bit overheated.
What kind of clawback provisions exist?
Do they have the typical 20% carried interest, or do they have more, say 25% or even 30%, and if so, why do they deserve a bigger percentage?
As you can obviously see, this is a very sophisticated place, and is not for the faint of heart. If you want to play in this game, you better remember a few things. Stick to your portfolio diversification allocation for high risk, and don’t go above the percentage you originally set! If you have never played any where near this level, then don’t. This is really the place for the institutionals. Of course it’s a shame that many of these don’t seem to have any common sense either. So what else is new?
Charles F. Bacon, CEO & Keeper of the Vision
charlesbacon(at) superdiligence (dot) com
Due Diligence, Inc.
www. superdiligence (dot)com
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