When LPs come calling

There's a paradox that goes to the heart of limited partner due diligence on GP groups in today's private equity market. On the one hand, research conducted by the most sophisticated investors has in certain instances reached a level of depth and rigor never contemplated in years past. On the other hand, in light of the unprecedented number of GPs that have hit the fundraising trail over the last year or two, time has become a precious commodity within the LP ranks – such that the ability to conduct the scale of investigation they would like into each GP group is frequently elusive.

It's a situation neatly summed up by Piers Dennison, investor relations director at European buyout house Candover, who says, ?I think LPs in general are doing more due diligence. There's more information to be obtained and there's more work involved in obtaining it than ever before. But when funds are raised as quickly as they have been in 2005 and 2006, GPs have to be smarter about how they provide the information, and LPs have to be smarter about how they use it.?

Dennison talks from experience: in November 2005, Candover wrapped up its latest fund with a hard cap of €3.5 billion ($4.2 billion), having beaten its €3 billion target in just over six months.

Ray Maxwell, managing director of private equity at international money manager Invesco Asset Management and one of Europe's most experienced limited partners, says his firm will normally seek to conduct rigorous due diligence in vital targeted areas such as: measuring performance against benchmarks; attribution analysis (i.e., which members of the team have been doing which deals, and who's been involved in the most successful ones); the decision-making process; and how capable the GP is of originating deals in a competitive market. But, says Maxwell, ?you don't go through that for every group. Some are very easy to do due diligence on and, in any case, we don't have much time.?

In this pressurized environment, one might be tempted to think that conducting on-site visits to private equity firms would be a luxury that hard-pressed LPs could no longer afford. But in fact, the ability to witness life at the hub of an investment operation is generally seen as increasingly valuable. ?For most investors, there's no substitute for being face to face,? says Dennison. ?You have to bear in mind this is very much a relationship business – it always has been, and always will be.?

As such, trawling in solitude through a fat sheaf of marketing documents will never be an entirely adequate substitute for meeting team members in their daily habitats and seeing how the reality matches the spin. Which helps explain why UK midmarket investor ECI Partners saw ?more groups on site than ever before? when raising its £255 million (€370 million; $443 million) eighth fund last year, according to head of investor relations and marketing Janet Brooks. She says existing investors as well as potential newcomers were prepared to spend at least half a day and, in many cases, a whole day, at their premises.

Meet the team
Like ECI, Candover's HQ also became a home away from home for limited partners during its fundraising period. ?During fundraising you expect to see every current and potential investor at least once,? says Dennison. ?Investors want detailed information about your track record and portfolio, and they also want to meet team members.?

This latter requirement is frequently cited as one of the key reasons for conducting on-site visits. Some investors will want to meet the whole team, from the most senior to the most junior members. Others might just want to meet those they see as pivotal members of staff, for example the investment committee. But for all LPs, it seems, some element of interaction with team members is seen as a vital part of the process.

Janet Brooks describes how that process worked when ECI was hosting investors during its recent fundraising. ?The meetings would start with the managing directors, most often on a one-to-one basis; then, senior investment professionals; and then maybe two junior members of the team. It's a matter of understanding whether the culture and strategy of the GP run deep, whether everyone shares the same vision.? Brooks says, in addition, those that worked on particular deals might be singled out in order to get their views on things that went well and not so well during the transaction(s) in question. Deal origination teams are also popular interviewees, and, says Brooks, members of the finance function may also find themselves under the LP spotlight.

The intensity of the interviewing process depends to a large extent on whether or not the GP has an established track record. Says one LP: ?Over time, it becomes self-evident that those firms with the longer track records must have a good process in place. Therefore, we do much more intensive due diligence on the younger firms.?

The process is, of course, at its most intense during fundraising periods. However, the LP/GP dialogue is not restricted to such times. Information gleaned from previous visits may be the subject of follow-up questions, whether posed face to face or remotely. GPs will also normally conduct conference calls with investors at regular periods throughout the year.

Perhaps the most feared form of due diligence is that which might be described as ?informal? – for example, the variety embodied by the LP that just happens to be in town the following week and wonders whether a meeting might be possible. Such unexpected surprises are officially welcomed but unofficially dreaded because of the lack of preparation time they allow. A particularly alarming example of this was provided by one European GP who told Private Equity Manager: ?We once had an existing US investor who just dropped unannounced into our office at 5 pm on a Friday. I did wonder if he was just checking to see whether we were still here or not.? Luckily, most of the team was.

Shock troops
Thankfully perhaps for GPs, not all investors are fans of this approach. ?We won't do that,? says Invesco's Maxwell. ?Everyone's busy and we don't see ourselves as shock troops. We spend a lot of time with teams in order to build an opinion – we don't just rush in. Half of the time, we'd expect them not to be in the office anyway.?

Unflagged visits are not the only way for an LP to put the wind up a fund manager, however. Another method – whether premeditated or completely unwitting – is to outnumber your hosts at meetings. ?We've had anything from one representative of an LP group to six visit us at any one time,? says Dennison. ?In one meeting, there were more from the LP than there were from Candover.?

Perhaps an even more daunting prospect is limited partners besieging portfolio companies. As the popularity of on-site visits to GP groups increases in popularity, so increasingly does the desire to witness the day-to-day operations of the firms that are the ultimate recipients of LP capital. ?I can't recall it happening more than a few times outside fundraising – but it does happen,? says Dennison. ?We' re happy to arrange it so long as it isn't too disruptive to the portfolio company.?

As these examples illustrate, the transparency that needs to be demonstrated by GP groups in their dealings with existing or potential investors today is striking. It could perhaps be argued that the grillings they have to suffer in order to get their hands on LP capital are a useful antidote to a fundraising environment that appears to have swung the balance of power firmly in GPs' favor in many ways.

In the course of seeking views for this feature, one source confidentially related to PEM the tale of an LP informed by a junior member of staff at a GP group that the firm's investment committee comprised a ?bunch of dictators.? Now, that's the sort of information you'd never find in an information memorandum. The knowledge generated by on-site visits can be both enlightening and terrifying – depending which side of the fence you happen to be on.