What to Ask When Conducting Due Diligence on Private Equity Funds?

In our previous article “What are the specifics of due diligence questionnaires when applied to alternative investment funds”, we concentrated on the specificities of the DDQ for Hedge Funds. In this article, we focus on DDQs for Private Equity Fund Managers.

Investments in Private Equity funds are by nature long-term and illiquid. This puts an additional pressure on institutional investors or LPs (Limited Partners) in order to conduct a thorough due diligence and try to separate luck from skill. Manager selection in this asset class is crucial.

The quantitative side of due diligence of Private Equity Funds and in depth analysis of track records is challenging due to many reasons like: having access to enough detailed cash flow data from GPs (General Partners), the potential dispersion of returns, and the difficulty of comparing a private equity fund’s return to another. The due diligence done on PE funds is often more qualitative with a focus on topics like the management team, the deal sourcing capabilities, the investment thesis, and operations.

Therefore, the process and tasks around it should be well defined, executed, tracked and documented.

Creating a PE due diligence questionnaire, or in a way a checklist related to the asset class specific issues, is one of the fundamental steps towards successful due diligence on a private equity fund.

On top of the general topics that should be covered related to the market opportunity, strategy, the organization, the team and the track record, there some additional important aspects specific to Private Equity Funds due diligence.

Sample questions to private equity fund managers

What is the source of the manager’s deal flow – how unique is it, and is the fund likely to be involved in many positions shared by several other managers? How much does the manager rely on non-public information in selecting companies to invest in? What leverage does the fund anticipate using at the company level and, if applicable, the portfolio level? Does the manager participate in joint ventures or intend to own entire companies? If the manager participates in the financing of a company, how often is he the lead in a round of financing, where he can be most influential in setting the terms? The fund’s investment period can it be lengthened by the manager or only by a vote of the limited partners? When the manager buys a company, how long does he expect to hold it? How does the manager expect to add value to a portfolio company or property? What portion of his investments does the manager sell through IPOs, auctions, and acquisitions by buyers who see synergistic opportunities? How are cash balances invested, and who is authorized to approve transfers of funds between accounts? What is the risk of incurring unrelated business taxable income? In any prior fund, did the manager ever have a clawback situation?

Sample questions to specific types of private equity fund managers

Venture Capital

How many portfolio companies does the fund expect to invest in? What stage ventures does the fund expect to invest in – early stage, late stage, or expansion capital? How strong is the fund’s sourcing network? What has been the manager’s experience with underperformers ?What has been the manager’s hit rate for successful investments? How equipped is the manager to take board seats and help a young venture by advising it on business strategy, staffing, and raising capital?

Buyout Firms

What is the role of leverage? How does the manager plan to finance the leverage, and what will be the terms? What evidence supports the value of the manager’s network with lending sources? How often does the manager replace management when he buys out a company? How equipped is he to do this and does he possess a broad network from which to recruit able management teams?

Mezzanine Capital

How many layers of debt would typically be ahead of the debenture? What is the typical amount of senior debt? Could the senior debt tranches become larger in the time ahead? Is the mezzanine fund captive within a buyout firm? If so, will this bias the diversification or pricing policies of the mezzanine transactions?

Real Estate

What is the diversification of the properties the manager targets for the fund: by geography, by dollar value of properties, by number of properties, and by type of properties. If the fund will invest internationally, what countries will the fund invest in, and what experience does the manager have investing in those countries? In prior funds, how effective has the manager been in adapting as markets have changed? What use of leverage does the manager anticipate and why? How will the fund finance the leverage? What is the risk that the fund might run out of cash at a time when property values fall?

Natural Resources

What competitive advantages does the manager have in target geographies? What risks – legal, sovereign, political, currency and corruption – is the manager willing to take in each geography? What is the manager’s policy regarding bribes or other pay-to-play requirements that may be encountered in some geographies? How does the manager control or enforce this policy, including at investee operator companies?

Energy Funds

What sector and geographic diversification does the strategy call for? What key relationships does the manager have in the targeted sectors? How will the manager assess risks when evaluating opportunities, and through use of what resources, internal or external? For each type and geographic sector, what are the manager’s exit strategies? How has he extracted maximum value from assets in his prior funds?

Conclusion

With the maturation of the asset class and wide variety of its investment styles, Private Equity opportunities for institutional investors increased scientifically. However, the multi years commitment that comes with it leads to a rigorous and detail oriented due diligence process.

Due diligence questionnaires created specifically for alternative asset managers selection should be considered as a framework to the investor team. With a goal of making sure the right questions are asked and avoiding mistakes, such as being seduced by the manager’s exclusivity, falling for marketing prowess, or not giving enough attention to operational or structural concerns.

Selecting the alternative fund manager through the due diligence process is not the end of the road. The due diligence continues with proper monitoring, aiming to be up-to-date with the manager’s performance and changes in the strategy or organization.

Monitoring, evaluating and investing across geographies and through different strategies, requires skill sets and an increasingly efficient use of technology and data.

If you would like information on technology that can help you structure and keep track of your selection and monitoring due diligence processes for Private Equity funds, manage your research and documentation, or create specific PE due diligence questionnaires, get in touch

Dasseti is an award-winning due diligence technology provider with deep expertise in the private equity sector.