LPs double down on due diligence

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LPs continue to place great import on team size and investment capacity when performing due diligence. Indeed, beyond track record, this forms a major part of the process for 88 percent of investors, according to Private Debt Investor’s LP Perspectives 2023 Study. This has changed little from last year’s findings (91 percent). Higher market volatility in 2022 has meant LPs are spending longer evaluating team capabilities, as successor funds grow larger and some GPs add new strategies.

“An upper mid-market GP might be adding a new fund targeting the lower mid-market, resulting in more workload; especially when the exit environment is less robust,” says Helen Lais, managing director and head of US primaries at Capital Dynamics.

“When markets are more volatile, there could be supply-chain issues or other incremental challenges that portfolio companies are facing. Experience always matters in these markets.”

Some investors believe that current economic headwinds make it even more important for the team to have bandwidth to add value across many fronts.

“In this current cycle, we think companies are going to remain in portfolios for longer. Some GPs may therefore end up with larger portfolios versus the prior cycle and will have to commit more time as a result,” says Jean-François Le Ruyet, partner, private equity funds and co-investments at Quilvest Capital Partners.

Another key aspect of fund due diligence is seeking assurances that the right level of specialisation is in place. In verticals such as technology and healthcare, LPs are focusing on the amount of operating capability and operating experience that GPs have in-house to support portfolio companies.

Paul Buckley, managing partner at FIRSTavenue, says that assessing the value-creation team has become a bigger priority: “GP team size and investment capacity has reduced materially in due diligence – I would say less than 30 percent – while evidence of value creation and a replicable investment process has increased materially.”

The good, the bad and the ugly

Succession and retention plans are becoming a priority item for LPs as they ask more questions on team promotions and how GPs are plugging departure gaps.

“We’ve seen ‘the good, the bad and the ugly’ in terms of succession planning,” says Le Ruyet. “Managers are starting to learn their lessons and realise its importance.”

Meanwhile, the proportion of investors that consider ESG during due diligence is roughly in line with last year at around nine in 10, but fewer investors say it forms a major part of the process (35 percent) compared with the 2022 study (57 percent).

Similarly, evidence of diversity, equity and inclusion at the GP level plays a major part in due diligence for 18 percent of LP respondents in the latest study, down from 28 percent the previous year. Under a fifth do not take DE&I into account at all.

Buckley believes the two issues are interlinked and have far more importance today. “My expectation is there will be a dramatic rebalancing on the S in ESG over the next year as investors ask whether you are creating employment through your activities and hiring the right people,” he says.

While the weight that investors give to different considerations during fund due diligence may shift, the process itself continues to place the highest demand on busy investors’ time (58 percent), closely followed by portfolio monitoring (51 percent).

However, as GPs adopt technology into their investment process, this is aiding LPs.

“Before the pandemic, LPs only received formal, verbal portfolio updates generally once a year,” says Lais. “Now we are receiving verbal updates quarterly (over Zoom), in addition to the standard written reports. Our ability to understand what’s going on in the portfolio and engage with managers has really improved. In this down market, GPs have embraced providing more real-time updates.”

Last year’s survey revealed that management fees were the biggest source of disagreement when it came to limited partnership agreement terms, cited by 50 percent of respondents. This year, that figure has fallen to 38 percent, with carry distribution waterfall structures (40 percent) and clawback provisions (38 percent) eliciting a similar response.

Le Ruyet notes that with distribution waterfalls, “sometimes you have ‘super carry’, with a higher carried rate above certain higher performance thresholds. That’s what drives the gross to net returns and the alignment between GPs and LPs.”

Warren Hibbert, founder and managing partner at Asante Capital Group, points out that management fees tend to be a rationally determined outcome “relative to fund size”.

He says: “Sub-$1 billion [fund] fees still retain 2 percent, but above that it starts to trend towards 1.75 to 1.5 percent. The cost of investment is always something that LPs are sensitive to and most GPs aren’t going out with off-market terms, particularly in this environment.”

One anonymous investor cited a recent disagreement when a GP moved to more GP-friendly terms for its new fund: “To us, any movement in that direction in this economic environment is surprising. On balance, GPs are either not changing anything, or making an LP-friendly change. It felt like an aggressive position to take.”

According to the latest study, the main cause for disagreement is a lack of or an unsatisfactory key-man clause, although the proportion of LPs citing this as one of the top three bones of contention with GPs has fallen from 49 percent to 41 percent year-on-year.

In Buckley’s opinion, as the market consolidates around the biggest fiduciaries, LPs acknowledge that “GPs with fantastic track records have managed to generate results, irrespective of any one individual. There’s a war for talent going on and investors are becoming less sensitised to the key-man clause”.