One finding from the Private Funds CFO Insights Survey 2022, conducted in partnership with TMF Group, stands out more strongly than almost any other – that LPs are intent on carrying out more stringent due diligence and that they expect managers to account for their performance across a growing range of areas.
The list of questions asked by LPs is long and varied, but according to survey respondents, investors are particularly focused on business continuity, cybersecurity and financial crime compliance. Almost half of survey respondents said LPs ‘always’ ask if the firm has a suitable business continuity policy, and another 38 percent said the question is ‘sometimes’ asked.
Another area that is quickly emerging as a key focus for LPs is ESG. Last year, only 22 percent of respondents said they were ‘always’ asked if the firm has an ESG consultant to advise on responsible investing across the portfolio. This year, the figure grew to 38 percent, with a further 48 percent reporting that they were ‘sometimes’ asked the question.
Joshua Cherry-Seto, CFO at Blue Wolf Capital Partners, says he has seen “a lot more questions around responsible investing and ESG.”
He notes that ESG may be a particular challenge for US firms, which have not been required to focus on the subject before now. “It’s only fairly recently that most people have even started to understand that responsible investing and impact investing are two different things.
“Now you need to not just talk about your ESG program on paper, but how you are operationalizing it. We don’t get just regulatory questions or very basic questions like, ‘Do you have a policy?’ anymore. Now we have real diligence conversations on, ‘What does that mean? How do you measure it? How do you put it into place?’”
“You need to not just talk about your ESG program on paper, but how you are operationalizing it”
Blue Wolf Capital
Few would dispute that the rise in ESG reporting is here to stay. The CFO of a mid-market firm pointed out that LPs’ questions on a firm’s track record were once very basic but have become increasingly detailed over the past 20 years. “ESG is going to take a path like that,” says the CFO. “Now it’s the early stages, but in five or 10 years, people are going to want a lot more data.”
The CFO adds that the large firms are under the most pressure on ESG reporting currently, but that expectations would soon increase at the middle and lower end of the market.
The survey found that US institutional investors are particularly prone to strengthening their due diligence practices. Over four in 10 survey respondents said that US institutional investors had conducted greater due diligence over the previous three years ‘to a great extent’. Even at the other end of the scale, family offices and high-net-worth individuals were seen as conducting greater due diligence at least ‘to a little extent’ by 83 percent and 72 percent of respondents, respectively.
LPs generally expect to see the CFO personally (at least via videoconference) during the due diligence process. Almost 70 percent of survey respondents said LPs ‘sometimes’ demand to meet the CFO, with 17 percent insisting that this is ‘always’ the case. Similar responses have been recorded across the past four editions of the survey.
It is not just the investor due diligence itself that puts pressure on the back office, but the varied and bespoke formats in which investors require firms to report information. One CFO tells us that “each investor request oftentimes requires a bespoke response,” which takes longer and “puts pressure on bandwidth.”
In the survey, we asked firms whether more LPs were requesting data that follow proscribed or standardized LP formats. Almost two-thirds of respondents answered affirmatively, an increase of 8 percent on last year’s survey. “Any standardized format is very onerous in terms of the amount of data the investors are requesting,” says Kwame Lewis, co-head of fund services for North America at TMF Group. Multiple other sources agreed with Lewis that handling LP requests for data in standardized LP formats can be extremely onerous and is a major source of frustration.
On top of this, says Lewis, “Investors want to visualize their data, so just sending over a spreadsheet isn’t enough anymore. It’s much more impressive to put a dashboard in front of a deal department and show them the trends, rather than just present a bunch of numbers.”
Some firms have resorted to strategies that seek to pre-empt LPs’ questions, partly in an effort to avoid having to report similar information in a multitude of different formats. A CFO at a technology investment firm said that his office has prepared its own DDQ that addresses questions that investors tend to ask during operational diligence. “We put that into the data room and say to folks that we’re happy to speak to them, but we prefer that they read the DDQ first as it might answer 90 percent of their questions. You can’t get away from doing investor diligence calls, but we just try to be a lot more efficient in how we do it.”