Unwritten rules

Investment committees make or break returns but tend to be as idiosyncratic as the individual partners who serve on them. By David Snow

Of all the challenges that a GP group can face on the fundraising trail, one of the most heartbreaking is the curse of the one-hit wonder. A private equity firm that has met with spectacular success in a single deal and middling to non-success in other deals will be greeted with skepticism by sophisticated LPs, who, contrary to an old saying, actually believe it is better to be smart than lucky.

Lucky, in the investment-fund sense, means stumbling into a deal just before all the factors sufficient for a huge exit come into play. Not surprisingly, such lucky GPs will typically argue that a blowout deal was the result of careful analysis, shrewd negotiation and structuring, followed by the adding of value.

Austin Long, a partner at Austin, Texas-based private equity consultant Alignment Capital Group, says he seeks to separate one-hit wonder firms from investment teams that stand a chance at repeatable success. Repeatability, he says, resides chiefly in the prowess of the investment committee – the collection of people responsible for approving deals from a particular fund. ?We' re looking for tangible evidence that decisions are made in a way that is disciplined, documented and dependable,? Long says.

In conducting due diligence on a private equity firm, Long says he and his partners are impressed when GPs not only know the details of a particular deal, but also all agree on how the decision came about to approve the transaction.

Investment committees are highly idiosyncratic based on the various personalities that make them up. But most fall within three broad models with regard to group decision making: unanimity, consensus, and what Long refers to as the ?Hugo Chavez model? – an ostensible democracy where a Great Man nevertheless has the final word.

Long says he prefers the unanimity model – by which no investment is approved unless every member of the investment committee votes for it – in part because this model is more likely to stop a bad deal (when, for example, a solitary, stubborn committee member won't back an otherwise popular deal). ?Avoiding bad deals is really the essence of consistency in this market,? says Long.

Smaller private equity firms are most likely to adopt a unanimity approach to the deal approval process. Larger firms are more likely to find this model to be too restrictive and unwieldy. Instead, most firms describe their investment committee as adhering to a ?consensus? model – where a deal moves forward based on tacit agreement among most committee members. The rules of consensus-model investment committees are seldom detailed in any partnership or subscription agreements. Indeed, Long notes an important reason why larger GP groups avoid formal unanimity models – these can present liabilities.

?Let's say a firm does a deal and it turns out to have been mispriced,? says Long. ?So the advisory committee is agitating for answers and a junior guy on the investment committee comes forward to say, ?I told them it was too expensive.? The LPs then say, ?Hold on, I thought it was a unanimous system?? ?

Several steps beyond the fog of consensus is the Hugo Chavez investment committee, or perhaps one with a small plutocracy of decision makers surrounded by trusted junior partners who advise but do not have veto power. Long notes that in its unreconstructed days, Dallas buyout firm Hicks Muse Tate & Furstpresented itself as a ?benevolent dictatorship? with cofounder Tom Hicks at the top.

Many benevolent dictatorships continue to exist in private equity, albeit many are under the guise of the consensus model. Superior investment judgment is such a rare thing that investment committees often take a long time to mimic in organizational process what the firm's founder accomplished through solitary cognition, if such a process is ever developed.

Still, process is a sign of institutionalization and an indication that a firm's ability to consistently outperform will outlast the tenure of the founders. Kohlberg Kravis Roberts, for example, in the late 1990s moved from a decision making process controlled by Henry Kravis and George Roberts to a six-person investment committee. In a recent interview with the Financial Times, Johannes Huth, the head of KKR's European operation, noted that the introduction of an investment committee represented a ?massive change in our culture? The business is becoming more formalized and more institutionalized. We are trying to identify what makes a good transaction and replicate that across the firm.?

Every private equity firm has attempted to structure its investment committee(s) such that success is replicated. Below is a sampling of investment committee structures and cultures across six very different firms.

The Carlyle Group: ?übercommittee? control
It is hard to think of a better Petri dish of private equity organizational complexity than The Carlyle Group. The Washington DC-based global investment behemoth currently manages 37 funds, each with its own investment committee. The firm has not, however, promulgated a formal set of rules for decision making across all of these bodies, according to Carlyle spokesman Chris Ullman. Instead, quality control is maintained primarily by the involvement of the firm's three founders across almost every fund.

Each Carlyle fund – including, for example, the mammoth new $7.85 billion US buyout fund – has one or more partners in charge of the vehicle. These lead partners may kill a deal at any time, but for a deal to receive final approval, it is passed up to what the firm informally refers to as the ?übercommittee? – an investment committee that typically includes the fund heads and one or more of the senior-most partners at Carlyle – cofounders David Rubenstein, Daniel D'Aniello and William Conway; and chairman Louis Gerstner.

The senior partners tend to divide up investment committee responsibilities based on areas of relative expertise, but here again there are no hard rules. D'Aniello, for example, sits on the investment committees of all Carlyle energy and real estate funds.

The übercommittee maintains constant contact with the deal teams and with each other, but when it comes time to make a decision, there are no formal operating procedures. ?If you tried to codify it, you would have difficulty,? says Ullman.

Responding to a question about whether famed dealmaker Conway has an outsized influence over which buyout deals get done, Ullman says: ?It's not that simple. Among the three founders, the majority rules, unless the third person doesn't want it to.?

Adds Ullman: ?They've known each other for 20 years. They know the difference between, ?I don't like it,? and ?Over my dead body. ? ?

Carlyle continues to draw heavily on the experience of its founders for investment judgment, while keeping an eye on the day the founders are no longer available. The firm has created a separate committee specifically to explore the best ways to devolve power from the founders. Among the topics receiving ongoing scrutiny is how to best structure investment committees for consistent success without the omnipresence of Carlyle's old guard.

Graphite Capital: all hands on deck
As a mid-market UK private equity boutique, Graphite Capital is not shy about broadcasting one of its key strengths, which is smallness. The London firm, which closed its most recent fund on £375 million ($650 million; €550 million), notes in its marketing materials that it operates out of a single office, and has an edge in ?rapid decision-making.?

David Williams, a partner at Graphite, says his firm's size and single location means all its partners enjoy great intimacy with the deals that get done every year. ?It's not as if the investment committee is going to get a piece of paper with a company they've never heard of,? says Williams, who is one of five Graphite investment committee members.

He likens deal approval to a series of small hurdles, as opposed to a huge wall at the end of a due diligence cycle. ?We' re almost a rolling committee,? Williams says. ?The process goes through three or four iterations. We discuss what we bid, what the bid should be, what are the provisos, what are the additional due diligence requirements? I tend to focus on a few points that are of interest to me, but not wait until the end to learn what the answers are.?

Williams says that in conducting their own due diligence, Graphite's LPs often inquire about the firm's investment committee with the assumption that it follows a more formal procedure. To the contrary, says Williams, ?I don't think we've ever had a vote. But I've never known a deal get approved where it's been against the views of someone on the committee.?

Graphite has resisted the idea of having people external to the firm sit on the investment committee. ?We've taken the view that if you have an external member, all they're going to do is turn investments down,? says Williams. ?It's our track record. We don't want to be in a position where deals that we would have liked to have done end up getting turned down by third parties.?

Graphite feels this informal and frequent interaction translates into rapid and informed decision making. He says he's sure other UK mid-market firms also have a similarly unregimented structure, but describe a more formal process for LPs because ?they think it's what LPs want to hear.?

Advent International: global standard
Boston-based Advent International was among the earliest private equity firms to embrace the global approach to investing. The firm currently manages a $3.3 billion global fund for the US, Western Europe and Asia; a $375 million Latin American fund; and a $400 million Central European fund.

David Mussafer, a managing director in Advent's Boston office, notes that when the firm was founded in the mid-1980s, it was originally conceived as an affiliate model, with regional offices given autonomy to execute deals. ?The problem with the affiliate model was that you had variable investment standards,? says Mussafer. ?We ended up deciding that Advent needed to have our own employees on the ground in local markets to be able to establish consistent performance.?

In 1989, Advent began setting up offices in Europe and other regions and created a set of standard memoranda to be used by regional investment committees. While the process of bringing a deal through to completion involves many steps and updates (all of which must be submitted in English), Adventmandates that three principal documents be used by the committees.

The introductory brief outlines the merits, rationale and overall value creation opportunity of a potential deal. If a deal moves forward, the next document submitted is a deal qualification memo, which is longer and outlines in greater detail the proposed deal structure, due diligence status, risks and opportunities.

Next is the Adventinvestment memorandum, which encompasses all the due diligence findings and addresses any concerns raised at the deal-qualification-memo stage. At this point, the investment committee may have discussed the details of a deal as many as 15 times, says Mussafer, and so the final approval is anything but a rubber stamp.

To better ensure shared culture and standards, regional investment committees have overlapping membership from other regions. For example, Steven Tadler, who chairs the European investment committee, also sits on the North American committee. ?If you meet someone from our Frankfurt office, we want you to feel that Advent is a German firm. We don't want our people to say, ?I've got to go back to Boston or London on this.? So by establishing regional investment committees, we make people feel that there's more of a local presence for decision making, with the checks and balances of having senior people from other regions sit on the committees.?

Mussafer declines to define specifically how Advent investment committees arrive at group decisions. ?There's not a judicial process where it's five votes to four,? he says.

Each deal gives rise to ?vigorous discussion? among committee members, and after more than 500 Advent investments, Mussafer says his firm has seen ?almost every iteration you can imagine? in arriving at a decision. However, ?If a senior member of the team has strong reservations, it's difficult for a deal to move forward.?

Allied Capital: pre-screening is key
Allied Capital is a publicly traded business development company, and so the firm is committed to disclosure, systems and clearly defined best practices, according to William Walton, the chief executive officer of the company.

This systematic approach is applied to Allied's investment committee, which is made up of 12 people and serves as a constant sounding board for investment ideas at Washington, DC-based Allied Capital.

Walton says that his firm has a very clear, predefined screening process that excludes most companies from Allied Capital's radar. Those that do make it to the Allied investment committee have several mandatory attributes – they must have highly predictable revenue, be in ?less cyclical? industries and feature high returns on capital. Walton adds that Allied Capital's relatively low cost of capital allows it to focus on ?hitting singles and doubles? as opposed to seeking out higher risk investments.

By the time a company with all these prescribed attributes makes it to a final investment committee meeting, the remaining discussion tends to center on how Allied might add value to the business, and then on a due diligence process that seeks to confirm that the business really does have the attributes necessary to get past the Allied screen.

The investment committee's role is to ?measure companies versus the criteria we have,? says Walton. ?We can make a decision pretty early on if a company meets the criteria.?

The Allied Capital investment committee has no formal voting rules, pursuing instead a consensus on moving a deal forward. However, as CEO, Walton has the final say on this most crucial matter.