15 Dec Private Equity Due Diligence: An Art and a Science
“There is an art to science, and a science in art: the two are not enemies, but different aspects of the whole.” —Isaac Asimov
“Rely on the ordinary virtues that intelligent, balanced human beings have relied on for centuries: common sense, thrift, realistic expectations, patience, and perseverance.” — John C. Bogle
“Never buy anything from someone who is out of breath.” —Burton Malkiel
Patrick Nolan, CAIA, Portfolio Manager – Private Markets — At Gratus Capital, my role includes sourcing and screening investments, conducting due diligence, negotiating investment terms and monitoring performance of private investment opportunities. In this post, I want to describe the process I use and share some interesting experiences I have encountered along the way.
Sourcing, Screening and Due Diligence
Due diligence is the research and analysis of a company or organization done in preparation for a business transaction [i]. Of the “investable universe,” select firms are identified as potential investment candidates. Of these, fewer make it through a preliminary screening and are reviewed more deeply. From the firms selected for review, only a small portion are selected for a full due diligence review.
I introduce this process to demonstrate that conducting due diligence according to a standard requires considerable effort. After sourcing and screening, I use metrics to disqualify managers and judge the best from the rest. I developed this due diligence process from my experience in institutional-level timberland and apartment investing. In addition to my experience, I rely heavily on the Institutional Limited Partners Association’s (ILPA) [ii] sample Due Diligence Questionnaire and Chartered Alternative Investment Analyst Association publications.
According to Brown, Fraser and Liang, the cost of due diligence depends on a series of factors, including the time spent, the level of thoroughness and whether accounting firms, law firms, third-party service providers and consulting firms are used. These authors assume “a conservative cost of due diligence of $50,000 to $100,000 [per single institutional hedge fund allocation]” but contend that effective due diligence of funds in the selection of fund managers can generate alpha for an investor’s portfolio [iii].
I’ve heard that there is an art and a science behind any worthwhile endeavor. Gratus’s due diligence process has a solid foundation in the “science” of private investing. Having proper procedures in place is critical, but so is a focus on the spirit of the task. Procedure must not cloud the goal of judging the worthiness of a manager and the overall attractiveness of an opportunity. To demonstrate the two sides of due diligence, I’ll list some of the questions behind the “science” and then share the more interesting anecdotes that make up the “art”.
The “Science” of Due Diligence
Below are a few of the ILPA’s recommended BASIC questions for Limited Partners to present to Investment Managers:
- Will Placement Agents be used during the fundraising process?
- Were there any carry clawback situations in any of the Firm’s prior funds?
- Are any investments in the Firm’s track record excluded from provided materials?
And a sampling of recommended DETAILED questions to an Investment Manager:
- Describe any significant staff departures that are expected to occur between now and the end of the Fund’s investment period.
- How will investment opportunities be allocated between active funds? Discuss any funds and/or separate accounts with potential allocation considerations.
- During deal structuring, what is the process for integrating ESG-related consideration into the deal documentation and/ or the post-investment action plan? (ESG: Environmental, Social and corporate Governance)
In addition to 15 pages of similar questions, the ILPA goes on to provide multi-page templates for reporting portfolio investments, funds, professional references and team member biographies. To top it all off, the ILPA ends with a list of 33 requested documents including Firm budgets, a list of LP secondary sales, and annual meeting presentations for the last 2 years! Lastly, third-party auditors, custodians, accountants and investigators are suggested in order to triangulate and verify the subject’s response. The result is a pile of information that may be erroneous or even fraudulent. The process may create value, but it may also only create a false sense of security.
The “Art” of Due Diligence
Clearly the ILPA provides a road map for thorough institutional private investment due diligence. The inclusion of third-parties to verify facts creates another layer of confidence. But at what cost? What resources are required of both the interviewer and interviewee to conduct such a review? What great opportunities are missed if the ILPA is followed too closely? Clearly there is a role for these questions if the investor is a public institution that is highly sensitive to any type of headline risk. But many investors are not political targets with a large public presence. Additionally, most investments only carry a small portion of the possible risks covered by the ILPA. Common sense is in order. Relying too heavily on the ILPA would be counterproductive for some investors’ task at hand. This is where I value the “art” rather than the “science” of due diligence. Below I’ve categorized some examples that capture the subtleties of properly evaluating a manager and a potential private investment.
Lack of Professionalism
- What should you do when a manager is unreliable during the due diligence process? Do they say they will do things and not follow through? Can you responsibly trust a manager to conduct themselves professionally after they’ve been awarded your money if they are unreliable before they’ve received your money? Better to pass on the relationship.
- How should you approach an opportunity with incomplete information? Many popular managers request verbal commitments prior to having finalized legal documents. This tells me a few things: either they are well-seasoned and have numerous relationships or they are trying to pressure investors into a deal while withholding details. Verbal commitments with pre-existing managers is one thing, but making first-time investments with a manager that requires commitments prior to providing complete information is a bad idea. Lastly, this may reveal that the manager’s clients have become complacent and are relying on the persistence of past performance. These are signs of a mature and well-worn strategy that may be better to avoid [iv].
- Sloppy marketing materials are a sign that the manager is likely sloppy in other facets of their business and possibly in their investment underwriting. When I find marketing materials that specifically contradict or do not mesh with corresponding legal documents, I penalize accordingly. While these mistakes are likely careless, they may also be purposefully misleading. I don’t want to deal with a manager that is guilty of either.
- I’ve come across managers that sell a popular trend, even when it isn’t entirely accurate. For example, one office manager suggested that a property was in the currently en vogue market of Nashville, TN. Technically the property was a part of the greater metro-area, but it was 17 miles from downtown. Not exactly an honest description.
- I often see project-level returns in marketing materials. This is clearly misleading, because clients will receive the performance net of fees and expenses.
- Optimism is not a strategy. I often see deals where the entire strategy is the assumption that past performance will persist or that there will be increased demand for the product in the future. For me to become comfortable with a deal, I want to see a model with flat or decreasing demand, a.k.a. cap rate expansion.
- “Cash-On-Cash” return. What if you gave me $10 today and I gave you $1 each year for 10 years. Does that sound like 10% “Cash-on-Cash” return? Or even worse, an average of 12.9% “Cash-On-Cash” return? There are more realistic examples, but I see this line of reasoning often when managers quote “Cash-On-Cash” return. The confusion stems from unreported losses, return of capital that is not income, or a reduction of capital account balance. Distributions are meaningless if you don’t know whether they represent income or return of capital. Often, one cannot be certain until the asset is sold and fully realized. Solution: Ask for equity multiples and IRR returns.
- Conflicts of interest are sometimes unavoidable. If they are small and are properly transparent, then conflicts of interest will not disqualify a deal. Three conflicts that I recently found were unnecessary and were a somewhat dubious effort to sneak additional fees out of the deal.
- Fees based on Potential Rent. Why not compensate on actual rent? Potential rent can be set by the manager as a benchmark. ‘Fees based on Potential Rent’ is synonymous with giving the manager a blank check.
- Acquisition fees based on purchase price. This is pervasive in real estate, but I think it should be challenged more often. Once a manager has client capital secured, they are actually incentivized to pay more for a property! I don’t see this going away, but I also like to bring it up with managers and let them know that I do not like this form of compensation. A better solution might be a percentage of equity, as this would incentivize the manager to balance the proper mix of debt and equity.
- Fees on construction costs. This is another perverse misalignment of interests, and managers should be pressured to seek compensation elsewhere [v].
- Catch-up clauses. I will try not to get lost in the details here, but catch-up clauses on carried interest are an additional layer of fees that managers often use. I suspect that many investors do not fully realize the hidden expense of a catch-up clause. Put simply, think of a catch-up clause as retroactively removing the performance hurdle after it has been achieved. This is sometimes referred to as a soft hurdle (catch-up) or a hard hurdle (no catch-up). Consider a 20% carried interest (often called the ‘promote’) and an 8% hurdle (often called the ‘preferred return’). If there is a 13% return after management fees and expenses, then with no catch-up, the manger would receive 1% (20% of the return above 8%). With a catch-up, the manager would receive every dollar from 8% to 10% in order to ensure that they receive 20% of all profits, and then 20% of profits from 10% to 13%. This catch-up comes to 2.6%. This equates to a 10.4% return for the LP investor instead of 12%. This also means that the manager has less incentive after a gross return of 10%, because they’ve received most of their compensation already.
- Lastly, how long do you want to be invested in a deal? Managers say they will be out of a deal in 5 years, but when you ask for it in writing in the documents, sometimes they won’t agree. If a manager will not put a 10-year maximum term on a 5-year business plan, then I have less trust in their business plan. Managers often want full flexibility to hold a property and avoid selling into a poor market. I’ve worked around this problem by agreeing on buy-out clauses. In short, a manager’s legal documents should reflect the business plan.
In all, I hope this description relays my view of both the art and the science of private investment due diligence. The science is certainly an important and necessary step in reviewing an opportunity, but thinking creatively is also important when seeking the best possible managers and investments. As an alternative asset manager, we will continue to strive to bring both aspects of the process together for the long-term benefit of our clients.
The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. As with any investments, past performance is not a guarantee of future results. In illiquid alternative investments, returns will be reduced by investment management fees and fund expenses. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.
[i] Merriam Webster Dictionary defines due diligence as: research and analysis of a company or organization done in preparation for a business transaction.
[ii] “The ILPA is the only global, member-driven organization dedicated exclusively to advancing the interests of private equity Limited Partners through industry-leading education programs, independent research, best practices, networking opportunities and global collaborations. Initially founded as an informal networking group, the ILPA is a voluntary association funded by its members. The ILPA membership has grown to include over 400 member organizations from around the world representing over US $1 trillion of private assets globally.” https://ilpa.org/
[iii] Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy https://ilpa.org/wp-content/uploads/2016/09/ILPA_Due_Diligence_Questionnaire_v1.1.pdf
[iv] I have noticed this behavior in many apartment community investments.
[v] I often see these fees on projects sponsored by vertically integrated operators.