Due diligence guide: Importance of portfolio monitoring

When establishing a new fund relationship, limited partners (LPs) generally move from a position of having little to no knowledge of the general partner (GP) or fund manager to making a formal commitment over the course of a few months to a year. During this time, an LP will follow a standard due diligence process, which generally includes but is not limited to an examination of the GP’s investment strategy and past performance; an in-depth evaluation of the team through site visits, reference calls and other meetings; and a review of internal and external GP documents including investment memos and due diligence materials, capital call and distribution notices, and reports to LPs.

Conducting due diligence on a re-up investment with an existing GP relationship follows a similar process as many of the same issues are reexamined by the LP after a number of years, but with the benefit of having had regular interaction with the GP by virtue of the established investment relationship. While the formal part of the due diligence exercise will take place in the months leading up to the re-up decision, in many respects the informal due diligence begins when the initial commitment was made – at the beginning of the ongoing fund monitoring process by the LP. Effective monitoring practices by LPs can lead to a more efficient due diligence exercise prior to a re-up decision by focusing on confirming satisfactory performance in specific areas or by concentrating on certain key elements of the GP’s performance.

A thorough monitoring process includes many components. Most notably, these components include regularly reviewing the portfolio via quarterly and annual reports; attending annual meetings and maintaining regular contact with the manager for updates; administrative monitoring which includes monitoring of capital calls and distributions; and ensuring that actions undertaken by the manager are in compliance with the limited partnership agreement. Certain LPs may undertake additional monitoring activities by way of participation on the advisory board of a fund or through coinvestments with a GP.

Annual meetings
A fund’s annual general meeting (AGM) can prove to be an effective monitoring tool for LPs in a number of ways if they plan and use their time at the AGM in an effective manner. There is certainly informational value in attending AGMs: obtaining updates on the portfolio, the GP’s view of the private equity industry and the general economic outlook, as well as viewing presentations from portfolio company executives. It is, however, important to remember that this information is all planned and presented by the GP according to what they want to share since there is very limited interaction at formal sessions. Effective use of the AGM as a monitoring and diligence tool requires further effort on the part of the LP.

Outside of the formal presentations, an AGM offers an LP attendee a number of opportunities to interact with members of the GP, nearly all of whom will be in attendance. An efficient approach is to spend time during scheduled breaks, dinners, social hours and breakout sessions talking one-on-one or in a small group with investment team members with who the LP does not regularly interact. Since regular communication with a GP is usually handled by one or two professionals, an LP can use the AGM as an opportunity to get to know other members of the investment and operations team, including mid-level and junior professionals and those who spend most of their time dealing with portfolio company operations.

While the conversations will not take on the formal tone of a due diligence session, an LP can still gain a better understanding of what roles different professionals play within the general partnership. Also important is observing interactions between different members of the investment team in an informal setting in order to develop a better opinion on the team dynamic.

Often in a formal on-site due diligence setting participants from the GP are coached on how to interact; this tends not to be the case in social gatherings outside of the presentation sessions at an AGM. These interactions can be especially instructive with GPs that are dealing with succession issues in trying to determine how the process is perceived across the organisation.

Evaluation of team dynamics should also focus on the range of participation of GP team members in the formal sessions of the AGM. An LP should look for the level of involvement of members below the senior partner level as an indication of both the contribution of these professionals and how they are viewed within their own firm. For example, an AGM where most of the formal presentations and discussions are handled by a small number of senior partners may be an indication that the firm is somewhat autocratic in nature, while a GP that allows many members to play key roles in presentations is likely one that exhibits a high degree of confidence in the team. Often these outward appearances can be a reflection of the internal workings of the GP on a day-to-day basis. Such observations can be noted by an LP as indications of issues that may arise later in due diligence when examining succession or key man issues.

An AGM is also one of the best networking opportunities for an LP in terms of making contacts with other LPs. In addition to sharing thoughts on the GP hosting the particular AGM (think of this as a mid-fund reference check, similar to what might be undertaken during formal due diligence), LPs can build their contact network and increase their potential list of diligence calls for other managers comparable to the one whose AGM they are attending.

This partial chapter is one of 19 in The Definitive Guide to Private Equity Fund Investment Due Diligence:  Perfecting your due diligence ability for top-quartile returns, a new book from PEI Media.