Due Diligence 2.0
One of the most dramatic upshots of the Global Financial Crisis (“GFC”) has been the increase in due diligence and scrutiny that LPs have placed on investment opportunities, including private equity sponsors. It has been particularly challenging to prepare private equity firms that last raised capital in the 2004 to early 2008 time period when the private equity markets were considerably different for the heightened pressure on terms and due diligence that we are seeing today. In the run-up to the GFC there was an abundance of LP capital chasing fewer quality opportunities, so converting introductions into commitments wasn’t nearly the same challenge as it is today. A few indicators of this changing tide were ILPA’s release of its first official term guidelines in September 2009, the proliferation of the secondary market and the spike in co-investment and direct investment interest we have seen more recently. These market shifts show a growing sophistication in the LP community that has now revealed itself most intently in the level and depth of due diligence and negotiation that are often beyond the scope of the public eye. So, how is this happening?
A recent analysis conducted by Sixpoint revealed that an average LP commitment requires 26 individual points of connectivity between LP and GP or Placement Agent and LP. These points of connectivity include meetings, onsites, conference calls, due diligence-related emails and legal negotiations. It is during these extensive back-and-forths that we are witnessing what we have dubbed “due diligence 2.0.” In essence, this is a new generation or form of due diligence that even the most experienced private equity sponsors have not been a party to and are often under-prepared to deal with. The typical response that we hear from GPs at this juncture is “we had [insert consultant’s name] in here and went through their due diligence process, so we know what to expect.” Nobody questions that the top-tier consultants pioneer and implement many of the industry’s best due diligence practices in a rigorous manner, but we’re seeing this become more widespread and some LPs are starting to raise those well-regarded standards even higher.
In terms of portfolio reviews, LPs are looking in three key areas. First, they are assessing the sponsor’s investment thesis and underwriting process. In particular, they are looking to evaluate the controls around the firm’s investment process, take a much deeper dive into the IC memos to validate the implementation of that process and then understand the transaction pre- and post-acquisition. In the case of unrealized transactions, LPs will typically request the sponsor’s underwriting models for each transaction and will then run additional scenarios over those assumptions. Second, LPs are focused very keenly on the area of valuations. Many feel that they have been led astray in the past, so no longer are they satisfied with a Valuation Policy, a Big 4 auditor and a smile. In fact, investors have developed strong views on valuations and how they should be done (on Revenue, EBITDA, RMR, etc.). LPs are also requesting valuations quarter over quarter to assess consistency and conservativeness of marks. As LPs look to assess the detailed projections provided by sponsors they will evaluate that information in the light of their history of exiting companies for at or above the carrying value. This has become the true benchmark of how conservative a GP truly is. Third, and finally, in terms of understanding the projections outlined in a “bridge” or “gap” analysis, LPs are requesting detailed breakouts of where GPs are expecting to create this incremental value. They want to know how much of the projected EBITDA growth will be driven organically, by acquisition and through operational improvements by the sponsor. In short, LPs want details and they want the back-up to the investment process, valuations and projections that sponsors have historically provided to them.
Further evidence of this increased sophistication on the part of LPs has shown up in the often protracted negotiations that LPs are now engaging GPs regarding their commitments. Typically, these types of negotiations were reserved for the large cornerstone investors – who still have the greatest purchasing power of all the LPs – but smaller ticket LPs have joined the fray as the competition over every dollar has increased their bargaining power. The areas in which we see the fiercest negotiation are fees, investor rights and reporting. The battle over management fees has evolved from just wanting to pay less than 2% to wanting to pay differently for invested capital versus committed capital. In terms of investor rights, even smaller LPs are asking for transparency around LPAC discussions by requesting minutes from those calls and meetings. In effect, they are looking for observer rights if membership isn’t available. Lastly, LPs are increasing their requirements for bespoke reporting both in terms of financial reporting on a quarterly basis and in the quality of the information that they see on capital calls and other forms of communication. These forms of communications have often been seen as afterthoughts for many sponsors and increasingly LPs are asking for higher quality and more tailored approaches to each point of connectivity.
Next on 60 Seconds with Sixpoint: Deal sourcing in a frothy market. How are GPs adjusting and how are LPs evaluating the change in methodologies?
Sixpoint Partners, LLC, is a registered broker/dealer, member FINRA (http://www.finra.org) and SIPC (http://www.sipc.org).
