Before making an investment, most limited partners (LPs) like to kick the tires on a manager’s back office operations, and make sure that wire transfers and other procedures are up to code. In fact, 87 percent of them do, according to a 2012 survey of approximately 150 LPs worldwide, the most recent of its kind, conducted by Corgentum, an LP provider of due diligence services.
But LPs have historically limited their operational due diligence – which requires time and effort, and maybe the cost of a consultant – to hedge fund managers, which are generally perceived to be riskier than private equity investments. That’s been changing. The Corgentum study found that two out of three LPs who perform operational reviews of hedge funds planned to start assessing private equity shops too.
In recent years, pfm has confirmed the research’s findings. More and more CFOs report a rise in the number of LPs sending due diligence questionnaires, requesting back-office tours and wishing to speak with the firm’s finance and administrative team before committing their capital. What’s more is that these “DDQs are becoming lengthier, and the visits longer,” as time goes on, says Michael Gibbons, CFO of turnaround investor WL Ross & Co.
LPs’ increased attention to operations has escalated the status of people responsible for operations around the firm, as readers of pfm are aware. But while CFOs and COOs have successfully transitioned into this more forward-facing leadership position that involves greater involvement in investor relations, it’s still a relatively new area of responsibility for these “back-office” professionals. Many have told us that they are unsure of what the best practices are when it comes to LP operational due diligence. In response, pfm has been asking CFOs, consultants, LPs and others about what works best when conducting due diligence, what tends not to work, and other “Dos and Don’ts” when it comes to impressing LPs investigating the shop’s operations. Read on.
DO be prepared for the entire process to take months
When asked how long the typical LP due diligence exercise lasts, our sources gave us estimates ranging from a couple of weeks up to two months. For the most part, “the process depends on how fast GPs are able to submit thorough answers to LPs’ due diligence questionnaires,” says Corgentum managing partner Jason Scharfman, who has completed scores of operational due diligence reviews on behalf of LPs. The onsite visit portion of the process, should an LP request an onsite visit, rarely exceeds one business day.
With respect to how long GPs should feel comfortable taking to complete investors’ due diligence questionnaires, Johnny Randel, who completes DDQs and sends his own as CFO and COO of The StepStone Group, an LP advisor and investor, says that “a couple of weeks is fair” but that most GPs try to turn them around within a week.
DON'T create a clear line between portfolio management and operations
When speaking to LPs, it’s easy to think about the firm as being divided into two camps: the people responsible for investing and managing the portfolio, and those who handle the operations and keep the firm a smooth-running ship. But making that distinction is a mistake, at least when talking to prospective investors, warn LP consultants.
“Investment professionals don’t realize they can leave the wrong impression when they finish talking about the portfolio and go, ‘Oh, you have questions about operations? Let me hand you to the CFO’,” says Scharfman. Operations and portfolio management are intimately related, meaning portfolio managers should be able to have a holistic conversation about the two.
Take compliance, for example. An investment professional who is able to speak about SEC registration, or certain elements of AIFMD, with some degree of comfort, provides investors assurance that compliance is taken seriously at a firm-wide level. LPs do not expect dealmakers to demonstrate an intricate understanding of depositary rules or other technical regulations, but do expect all partners at the firm to be able to discuss important regulations and compliance policies at a high-level.
DO have reasons why a function is either outsourced or kept in-house
There is a growing debate in the industry at the moment about whether to outsource certain functions like accounting and compliance. Outsourcing advocates –including of course the service providers themselves –argue that third party oversight provides a necessary level of independent review. Critics counter that keeping operations in-house makes it easier to directly supervise the work being performed.
There are many other arguments fueling the debate, but whatever side a firm lands on, LPs will want to hear the reasons why. Some say that LPs have a preference for managers that outsource, and want the private equity industry to catch up to hedge funds, which outsource far more work. Others say that LPs care less about whether something is outsourced, and are more interested to know how the decision syncs up with the firm’s specific operational needs and requirements. It is against this backdrop that fund managers need to find the right mix of what to outsource and what to manage in-house, and more so now, be able to explain their reasoning and analysis to curious investors.
To that end, managers should also be prepared to discuss why a relationship with a service provider was severed. There can be legitimate reasons for changing fund administrators or auditors, but LPs will want to hear them.
DON'T be blindsided by difficult, probing questions
Tough questions are a predictable outcome of longer, more intense due diligence exercises carried out by LPs, but sources say not all fund managers have been adequately prepared to field some of investors’ more difficult enquiries.
Staffing levels and retention are a good example of the challenge. “One question we often like to ask, but seems to catch people a little off guard, is related to turnover,” says one US-based fund of funds manager, who sometimes requests to speak with individuals who left a firm. Or, if there is little turnover, he asks what the manager attributes to that outcome. Growing firms, too, should be prepared to answer how a culture of integrity is preserved during a period of expansion.
Questions related to compliance or regulatory exams can be another uncomfortable line of questioning, but managers should be able to “candidly discuss things like SEC deficiency letters” to provide investors a sense for how adept the management team is at correcting compliance gaps, the US fund of funds manager said.
What GPs shouldn’t do is dismiss certain compliance concerns by arguing that they are more relevant to hedge fund managers, adds Scharfman. “You can’t say ‘we’re not trading actively so insider trading here isn’t really a risk.’ It’s always a risk when you have responsibility for deal execution.”
DO use ODD reviews as a chance to impress investors
Throughout LPs’ due diligence reviews, managers have countless small opportunities to leave a good impression. For instance, while most firms now use sophisticated online data rooms to share information, GPs that share files with custom watermarks imprinted demonstrate that the “firm takes control of that information very seriously and that document recipients are less likely to get files intended for somebody else,” says Scharfman.
Another emerging best practice is to have LPs sign confidentiality agreements when reviewing sensitive information. Scharfman says that LPs don’t find it a hassle to sign them, and instead view it as the GP “securing their data with an additional layer of protection.”
An often-missed opportunity is including a member of the investor relations (IR) team during onsite meeting with investors, more and more CFOs tell pfm. “A lot of items are discussed during these meetings and it can be easy for the CFO to miss something,” says Jonathan Schwartz, chief financial officer at NewSpring Capital, a private equity firm. “The IR person is there to keep a list of items discussed and then be proactive about following up with any hanging questions.”
Gibbons adds that GPs should also be able to anticipate most of investors’ questions. “For example, you should know that they’re going to ask about valuation, segregation of duties and emerging topics like expense allocations. So we’ve created a presentation that is intended to answer a lot of those questions upfront.” Gibbons says the eight-slide presentation is high-level and intended to allow LPs to take a deeper dive where and when they see fit.
Stepstone’s Randel adds that StepStone’s approach is dynamic and investors should continually evaluate their questionnaires to make sure they are current and that they incorporate developing issues that arise such as the recent focus on cybersecurity and FATCA compliance. At NewSpring, every questionnaire sent by LPs is archived and reviewed ahead of the firm’s next fundraise, says Schwartz. “What we like to do is take some of the hardest questionnaires we get and use them as a resource when updating our own pre-prepared completed questionnaires.”
DON'T fail to follow up with LPs after the tour is completed
After due diligence is completed, many LPs say the process shouldn’t end there: a follow-up phone call, email or informal lunch would go miles in demonstrating their concerns were not only heard but are being addressed.
What’s more is that a CFO or COO proactively engaging investors about the firm’s internal controls can gain a glimpse into how other firms are handling LPs’ questions and concerns. Perhaps after a visit, a GP might think the LP seemed underwhelmed when the CFO explained how its wire transfers were handled. What GPs can do is casually ask for the LP’s thoughts on how they have seen other GPs clear cash. An LP sharing their inspection experiences may reveal the red flags they’ve spotted, and what practices made them confident their money was entrusted in good hands.
In the end, investors want to know their GPs’ internal controls are best-in-class – particularly given uncertain market conditions and an increasingly crowded fundraising trail. Well-oiled operations will never be the reason an LP ultimately invests with a manager – with performance and team stability remaining the two primary considerations – but poor operations have certainly become a reason for LPs not to.
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