Track record and a GP’s team size and investment capacity continue to represent the most significant areas of due diligence. However, Private Debt Investor’s LP Perspectives 2021 Study indicates ESG considerations are becoming an increasing priority. Close to 40 percent of investors state that ESG now forms a major part of their due diligence process, and evidence of diversity and inclusion at the GP level now forms either a minor or major part of the process for 80 percent of LPs.

“More LPs are asking questions about a manager’s ESG policies and posing questions about not only the diversity of the team, but also the steps that a GP is taking to enhance diversity within their organisations,” says Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association. “These are not gating questions, per se. Rather, LPs are trying to establish a baseline against which they can measure progress over the life of the partnership, and as a way to probe on questions of culture and values. With ESG, it can also be a matter of judging a GP’s foresight – the ability to look around the corner and anticipate the range of issues that can impact the performance of the underlying portfolio.”

Gabrielle Joseph, head of due diligence and client development at Rede Partners, adds: “It is quite clear that many GPs did not take gender diversity seriously before they started being asked questions by LPs. Now there are enough questions that GPs are starting to consider whether they have a problem before they even go fundraising. That is a positive development for the industry and, in particular, we are seeing emerging managers deliberately seeking to build in diversity from the start.”

An orderly transition

The study also reveals a heightened focus on succession issues and retention plans in due diligence. This may be compounded by concerns around a possible surge in retirements in the wake of the coronavirus pandemic.

“I think periods of uncertainty often lead to people revaluating life’s priorities and whether they wish to roll the dice again for a new fund,” says Peter Linthwaite, head of private equity at Royal London Asset Management. “Senior retirements are not a new phenomenon in times such as this. We have seen it before in 2001 and 2008.”

In light of this wave of potential people moves, inadequate key person clauses were cited as one of the most contentious areas of fund documentation, with half of investors saying this leads to the most disagreement with GPs during due diligence.

But Choi points out that the trend is towards increasingly broadly drafted key person provisions that name groups of individuals, such that as long as someone fills the title, the key person provision will not be triggered. “LPs have to balance the need that GPs have for flexibility in managing these leadership transitions with the governance risks posed by material turnover within the firm’s leadership,” she says.

Merrick McKay, head of European private equity at Aberdeen Standard Investments, adds that an overly restrictive key person clause can have unintended consequences. “It can give certain individuals too much power and that can work against you,” he says.

“Key man clauses are by nature very case specific and there needs to be a balance between giving the LPs comfort that talent will remain versus giving certain individuals too much leverage internally within the GP,” says Mikael Huldt, head of alternative investments at AFA Insurance.

Fees and expenses

Management fees also continue to be a source of friction, with 47 percent of LPs sharing this sentiment. “Generally, management fees have stayed fairly stable as a percentage, but funds have generally increased in size more than management teams have grown their headcount and there has been a growing trend to allocate costs and expenses away from being borne by management fees and instead to being included in the fund expenses borne by LPs,” says Huldt. “You just have to make sure that you have the full picture and then decide whether or not the economics are fair.”

Linthwaite adds: “It has always been a source of some amazement to me how little change there has been in basic pricing and terms in private equity, and GPs continue to do a fine job in dividing and ruling their investor base at the time of fundraising. But then they would argue that the results justify it.”

However, as the fundraising market becomes increasingly bifurcated in the covid-19 environment, some GPs are lowering management fees in order to get their fund over the line. Paul Newsome, a partner and head of investment solutions in Unigestion’s private equity team, says GPs are also making concessions in other areas, including offering guaranteed co-invest and tiered carried interest models. “Where managers are having difficulties, they are coming under pressure to offer more LP-friendly terms,” he says.

LPs have other bones of contention, meanwhile. Linthwaite would like to see more frequent and timely portfolio valuations and greater detail and transparency in how valuations are derived, as he believes institutional investors will come under greater regulatory pressure to show they have fully reviewed and challenged the valuations they receive and use in their reporting.

“I also think the legal profession needs to get a grip on documentation. I am currently reading a 100-page LPA and a 50-page subscription agreement. Perhaps a radical review of precedent documents is needed to avoid the temptation to just keep adding to an old document,” Linthwaite adds.

“The same radical overhaul of KYC reviews could assist,” he says. “In the modern age it seems crazy for an LP to go through the same laborious process and after the usual pushbacks supply the same documents one gave to another administrator in the same jurisdiction only last month. There should be some form of passport for large, regulated entities like banks and insurers to avoid this KYC dance.”