First-time fund foundations

Over the last few years, private equity investors have shown increasing interest in emerging managers, or those GPs raising their inaugural funds. As evidenced by many of today's established, brand name firms, private equity firms tend to generate their best returns early in their life. Emerging managers tend to manage smaller sized funds and target smaller sized companies, which is a less competitive and more inefficient segment of the market for investors. There are also more opportunities to improve smaller sized companies, which creates equity value and can translate to higher returns. Last, and perhaps most important, emerging fund managers tend to be hungry and highly incentivized to generate attractive returns in their first or second funds.

For these reasons, investing with emerging managers can be an attractive prospect, either through formalized investment programs or opportunistic approaches. But, from a potential limited partner's perspective, the risks are greater with emerging managers. After all, newly formed GPs tend to have more limited track records, teams with less experience working together and yet to be proven access to a steady stream of high quality investment opportunities, in comparison to their more established counterparts.

To mitigate these risks, most investors know they should dedicate extra time and effort to interviewing the investment team members, conducting reference checks and examining investment experience in detail. Beyond the investment due diligence, however, investors should also devote resources to conducting operational due diligence when considering investing with emerging managers.

Operational due diligence is an area to which investors may not always direct enough scrutiny. Within established GPs, various elements of operating infrastructure are often taken for granted by private equity professionals. But as more new GPs with convincing stories arise, investors are becoming more aware that, aside from experience and good track records, it is also critical to make sure that these GPs have institutional-quality processes and procedures in place to manage the fund.

We conduct a separate operational due diligence process for emerging managers that includes a separate questionnaire and checklist of items to review in each of four key areas: firm infrastructure, organization, investment process and reporting and administration.

Firm infrastructure
Diligencing a GP's infrastructure involves an examination of several areas of general operation, including technology, facilities, insurance and third-party service providers. To begin, we typically request to review a firm's operations and compliance manuals and a three year operating budget. The budget allows us to determine if the fees that will be generated by the fund are sufficient to cover the manager's operating expenses.

Technology is critical because it supports a manager's investment process and back office operation, as well as both internal and external communication. In evaluating a firm's technology resources, we ascertain what is conducted inhouse versus outsourced to a consultant. We check the firm's technology platform, including file and email servers, and also inquire about the firm's telecommunications systems. To assess the firm's facilities, we tour the manager's office(s) to assess if office space is sufficient to accommodate the current team plus any planned growth. If not, we discuss the manager's plans for relocating in the future and how this will be managed. For insurance, managers should have sufficient policies in place for errors and omissions as well as professional liability. We have helped several firms by referring third party insurance brokers to assist in purchasing the necessary policies. Lastly, we request a reference list of all third party services providers in the areas of legal, accounting and audit and any other outsourced service.

Organization
Organizational risks primarily involve a firm's team. Questions we typically ask regarding the firm's organization include:

When looking at a firm's organizational risks, the key things to look for are whether a formal structure is in place and if there are procedures for managing the firm and the team. We also want to ensure that the firm's key professionals are tied to the firm. For example, a New York based buyout firm that had historically managed family wealth was raising its first fund with third party capital. In discussing the firm's organizational structure, we discovered that ownership of the management company was concentrated with one key partner, who happened to be a member of the wealthy family. After completing our investment due diligence, we worked with the manager and its legal advisors to restructure ownership of the management company to ensure the team's long term objectives were better aligned with the investors.

From a more qualitative perspective, we also try to understand the culture of the GP from all levels of the firm's professionals. In the interview process, we observe whether team members have consistent views on investing and firm vision, whether certain members are domineering in conversations and general body language, among other factors. Our objective in assessing the culture is to determine if the firm is an enjoyable place to work, which will be key in retaining existing employees and attracting new ones.

Investment process
For investment process, we want to ensure formalized procedures are in place for sourcing, analysis and execution, and monitoring. We begin by requesting a firm's investment or due diligence manual. Some of the questions we ask during this process include:

Many emerging managers are comprised of talented investors who have never had to think through these types of procedural questions. Without a formalized process for investing, the leap that institutional investors have to take with emerging managers becomes even greater. There have been numerous situations where we have helped promising firms institutionalize their process or adopt valuation policies that are common in the industry.

Reporting and administration
While many GPs handle their fund reporting and administration internally, for emerging managers, our general preference is to outsource, since this function is critical for institutional investors and not a core competency of most emerging managers. We made this case to a California-based venture capital GP comprised of three partners, which was planning to devote a portion of a partner's time to overseeing fund reporting. We convinced them that the reporting function was better served by outsourcing to a third party, which would also free the partner's time to focus on his core competency – investing.

Whether in-house or outsourced, we like to see a formal reporting manual, documenting procedures for quarterly and annual reporting, as well as administering the cash flow activity for the fund. We request sample cash flow notices and quarterly reports from managers. We like to see sufficient descriptions of investments, including a portfolio company's attributes, so we can ensure a fund is investing in a manner consistent with the underlying investment strategy. We have mock cash flow notices that we often share with emerging firms to help them develop cash flow notices containing sufficient data. Lastly, we conduct a review of the manager's portfolio accounting system. We have experience with a variety of systems commonly employed in the industry and have helped several managers think through the functionality they will need in managing a fund.

We believe the trend of LP commitments to emerging managers is positive for the private equity industry. As the industry continues to evolve and established firms grow larger, emerging managers provide investors with the opportunity to develop relationships with talented firms while they are still small and to grow with them. However, to attract institutional investors, it is important for emerging managers to understand that being a great investor is not enough when striking out on one's own. By taking the time to build high quality firm infrastructure and to develop comprehensive processes and procedures for investing and administering the fund, GPs can demonstrate awareness of the higher operational risk inherent in emerging firms and help prospective investors in gaining comfort with these risks.

Jim McGovern is a managing director and investment committee member of Philadelphia-based investment advisor Franklin Park LLC.