Research Roundtable Publication
A thoughtful process is an important part of any investment approach, but it is especially crucial with private investing, given the illiquid nature of the investments, the multi-year commitment required, and the limited rights and transparency often afforded investors (Limited Partners – LPs) in a private investment fund.
Private investment due diligence questionnaires (DDQs) have been developed for institutional investors, but they are often long and quite technical.
As a supplement to detailed institutional DDQs, the following is a summary of questions to consider when investing in private investment funds or companies, which we developed with the help of both Private Investment academics and professional Private Equity investors and allocators (see the Special Thank You section at the bottom).
The list may still seem long, highlighting the unique nature of private investing, but hopefully the sections outlining various issues to keep in mind, and our attempt to simplify language, will increase transparency and be a useful template for both advisors and investors.
Links to more information can also be found at the end of this paper following our Conclusions under Related Reading and Resources.
General Overview and Firm Structure
- What is the organization structure of the firm and fund?
- How many professionals are full time and what is their experience?
- How many professionals are part time and how is work outsourced?
- What members of the firm have been responsible for each type of deal and what is their specific experience related to focus of the new fund?
- What are succession plans for the firm’s leadership and do key-person clauses or provisions for a no-fault divorce exist?
- Does any third party have an ownership interest in the firm (is the firm publicly owned, has another firm taken a stake in the GP, etc.)?
- What is the composition and role of boards and advisory committees?
- How involved are boards or advisory committees?
- Do they have influence or votes on investment decisions?
- Are they involved in valuations?
- What conflict of interest policies and procedures exist?
- How much money are General Partners (GPs), board members, and other affiliates contributing to the new fund and how much do they have in all funds as a percentage of their net worth
- How are incentive fees – carry allocated inside the firm?
- What is the firm’s investment philosophy, process, and investment edge?
- What is the firm’s competitive advantage and what sets them apart from competing GPs?
- What is the structure of the idea generation, investment analysis, and investment decision making process?
- Is the GP a leader in the space the new fund is focusing on?
- What is the source of the manager’s deal flow and how unique is it?
- Who and how many competitors does the manager typically bid against for deals?
- What has been the manager’s hit rate for successful investments and what are examples of wipeout investments (what are loss ratios)?
- How much remains to be invested in prior funds?
- What is the size of the fund and timing of the fundraising period?
- What is the fund minimum and how many LPs does the fund expect to have?
- Will there be multiple closings for the fund?
- When is the final close date?
- How is the fund being sold and, if placement fees exist, who pays these fees?
Investment and Portfolio Structure
- How many investments does the fund expect make and what stages and types of companies does the fund expect to invest in?
- Does the firm target seed investments, early stage, late stage, expansion, etc.
- What sector, industry type, geography, etc. will the fund focus on
- What are the size of anticipated investments and do deal minimums or maximums exist?
- What parts of the capital structure is the fund focused on (mezzanine, etc.)?
- Where will investments be located?
- How will the fund be geographically diversified?
- What resources and unique networks does the firm have related to investments that are outside the region or country where the firm’s investment team is located?
- What is the manager’s target investment hold period?
- How does the manager expect to exit investments?
- What portion of the manager’s exits are expected to be IPOs, auctions, or acquisitions by strategic buyers?
- Does the manager participate in joint ventures or intend to own entire companies?
Capital Call and Cash Management
- What is the fund’s projected investment and capital allocation period?
- Have prior funds been able to efficiently deploy capital (see other references to remaining funds to be invested from prior funds – power dry)?
- What is the anticipated timing of capital calls and what triggers calls?
- Does the manager hold cash or only call capital on an as-needed basis?
- What notice period do LPs receive on capital calls (10-day notices can be common but they can be shorter)?
- Are subscription lines of credit (SLCs) used to control the timing of capital calls and cash flows (see addition questions below on SLCs related to performance evaluation)?
- What leverage does the fund anticipate using at the company level and, if applicable, the portfolio level?
- How will leverage be obtained?
- Does the GP participate in the financing of companies in funds?
- Can the manager reapply any income or realized gains, or must these by paid directly to investors?
Governance and Conflict Management
- Does the manager have policies that state how the manager will allocate opportunities between the funds, other LPs, the GP, and other affiliated firms or individuals (board members, etc.)?
- Will the fund have priority on every opportunity that would be appropriate to consider for the fund, ahead of any subsequent fund or separate account?
- Can GPs or affiliates co-invest in deals?
- If so, do potential conflicts and risks of cherry-picking exist?
- Are GPs and LPs offered the same deals and terms?
- Are cross-fund transactions allowed?
- If so, how are transaction prices established?
- What is the priority of GP and LP distributions (waterfall provisions)?
- Has the GP ever had a claw back situation and, if so, how was it handled?
Private fund managers hold assets that can be difficult to value, and reported valuations tend to be limited and can include many subjective inputs.
Managers often provide multiple forms of performance metrics that can be difficult to evaluate and compare to other types of investments. Examples include, but are not limited to, realized and total fund MOICs, TVPIs, DPIs, and IRRs, which can be influenced the timing of cash flows and lines of credit. Accordingly, a multi-dimensional analysis of performance is prudent.
The following are a list of additional issues to consider:
- Has the performance of any prior funds been competitive with other asset classes and have prior funds met the manager’s stated return targets?
- What is the fund’s return target and what are key assumptions?
- Does the manager provide KS-PMEs, TYPIs, DPIs, and IRRs?
- Do subscription lines of credit exist, and if so, what are their impact on IRRs?
- Were results in prior funds dominated by one or two home runs?
- Is the track record long enough to predictive value?
- What is the frequency and transparency of reporting?
- Has performance been calculated by independent valuation firms and audited?
- What is the focus and size of the new fund related to previous funds?
- Is the manager moving into a new strategy, for which results on prior funds may have less predictive value?
- If the new fund is substantially larger, is the investment team properly resourced to replicate any past success (also note time needed for prior funds and powder dry – refer back to investment process and edge questions)?
- Have any changes taken place among the management, investment team, advisors or decision makers at the firm?
- What individuals inside the firm have been driving investments and what are the track records of partners, analysts, and key advisors?
- Based on the focus of the new fund, and the individuals involved, are prior track records applicable?
- Has the market changed sufficiently to impact the predictive value of the performance of any previous funds?
- Are any changes in the competitive landscape likely to impact the firm’s ability to replicate any past success?
Terms and Fees
Private investment fund documents, disclosures, and terms can be complex and it is important to understand manager incentives.
Below are a list of questions related to the evaluation of management fees, expenses, and other costs.
- What are management fees based on (invested funds, committed capital, etc.)?
- Does the fund pay for travel, investment due diligence, deal costs, or any portfolio company fees and expenses?
- If so, how are these disclosed?
- Are caps set and are they deducted from management fees?
- Do net performance figures include all expenses and other costs?
- How are incentive fees calculated?
- Is the fee calculated on the whole fund or on an asset-by-asset basis?
- Are they based on IRRs?
- Are management fees and incentive fees the only source of income for GPs and other key professionals?
- What is the stated time period for the full life of the fund?
- Can the firm extend the life of the fund and, if so, for how long (note previous questions related to target investment hold and capital allocation periods)?
Fund Document Review List
- Offering memorandum and subscription agreement (PPM, etc.)
- Governing documents, and regulatory and audit filings
- Partnership agreement
- Conflict of interest documents
- Audited financial statements and SAS 70 report
- SEC Form ADV (Parts I and II)
- 13F and 13D filings
- SEC examination findings
- List of legal, tax, and third party administrators
- Marketing materials and investor communications
- Monthly, quarterly, and annual reports
- Policies, procedures, and references
- Compliance or equivalent policies and procedures manuals
- Employee manuals
- Code of ethics, conflict of interest documents, and personal trading policies
- Risk management and cyber security policies
- Valuation and pricing policies
- Business continuity and disaster recovery plan
- Vendor management policy
- List of references (current and previous LPs, service providers, and vendors)
Additional Considerations for Funds of Funds
- What is the composition of the fund-of-funds by investment style, sector, geography, and size of each sub-fund?
- Does any overlap exist with other investments the investor holds?
- Do any firm professionals, board members, advisors, or affiliates have any interests in or affiliations with any sub-fund or its affiliates?
- If so, how are potential conflicts managed?
- What are all the fees, costs, and expenses of the funds of funds and what are the total estimated costs to investors taking into account all fees, costs, and expenses of all sub-funds?
- How many different sub-funds are included in the fund of funds?
- How much transparency does the fund of funds manager provide into underlying sub-managers?
- What are the minimum and maximum allocations to any individual sub-fund?
- How long of a track record must a sub-fund have in order for the manager to consider adding it to the portfolio?
- What proportion of the sub-funds are closed to individual new investors?
- What has been the turnover of sub-funds and why?
- What are the criteria for termination?
- What are the redemption provisions of each of the sub-funds?
- How likely are any sub-fund liquidity issues to impact the liquidity or performance of the fund of funds?
Additional Document List and Considerations for Direct Private Investments
- Overview of business strategy, product(s), and market expectations
- Product market fit and competitive landscape analysis
- Current stage of product or business development
- Understanding of business structure (LLC, C-Corp, etc.) with all incorporation documents, bylaws, and governance documents
- Documentation of any patents, copyrights, trade secrets, and other IP
- Understanding of lease and property agreements, collateral pledges, security agreements, indentures, and mortgages
- Governmental licenses and permits with any associated regulatory analysis
- Understanding of any environmental risks and any impact studies
- List of existing banking relationships
- Cash flow, line of credit, and burn rate analysis (3 years or more)
- Balance sheets and income statements (3 years or more)
- Projected revenue, expense, and margin analysis with all assumptions (3 years or more)
- Cap table and lists of all advisors and board members
- Audit procedures and all safety and risk manuals and processes
- Identity of legal and tax counsel
Conclusions and Summary
No due diligence questionnaire can cover all issues or produce a definitive yes or no answer for an investment opportunity.
Beyond the considerations and questions listed above, it is also important to step back and balance any analysis with the emotion involved in any investment decision, keeping these thoughts in mind:
Is the desire to do a deal, or any prior connections with the individuals associated with the fund, potentially influencing anything uncovered during your due diligence process?
Have you taken enough time for due diligence?
Are you prepared to be a long-term partner with private fund managers (remember – time frames can be 10 or more years)?
Related to the last point, having a good understanding of who you are investing with, what makes them different, and what is driving them is important. The following are a few additional questions to consider along these lines, which we touched on to some extent, but want to emphasize:
Are the senior leaders of the fund solely focused on their funds with significant skin in the game in terms of time and treasure?
What is the culture and reputation of the firm – are they considered to be partners by other GPs and industry leaders?
Ultimately, due diligence is in part an emotional and human exercise, which can be based on limited information. It also does not end with the initial investment. Once an investor has committed to a private investment fund, it is only the beginning.
Many good private investment opportunities exist but they are not easy to find at the correct time. To increase the probability of success, it is important to have a good team, a thoughtful process, constantly examine assumptions, and to maintain a disciplined, diversified, long-term plan.
Special Thank You:
A special thank you to Victoria Ivashina, the Harvard Business School, Lovett-Learner Professor of Business Administration Head, Finance, who provided important edits and was especially generous with her time. Professor Ivahina’s book is first on our Related Reading and Resources list below for a reason. If you would like a copy of the book let us know and we will send you one.
Also, thank you to Brent Beshore, the CEO and Founder of Permanent Equity, Jim Kane, CFA, CAIA, CIPM, a Senior Pension Fund Specialist at the National Education Association, and Jeremy Heer, CFA, CAIA, a Senior Portfolio Manager at the University of Chicago Endowment. They offered valuable insights and contributed to our list of questions based on their industry experience.
Next, appreciation goes to Ludovic Phalippou, the head of the FAME Group at Said Business School at the University of Oxford, who was kind enough to spend time reviewing this piece. A link to his book on the subject can be found under Related Reading and Resources.
Finally, a continued thank you to members of our Research Roundtable, who always provide good insights and are valued partners.
Related Reading and Resources:
Patient Capital: The Challenges and Promises of Long-Term Investing – Ivashina and Lerner
Private Investment Due Diligence Questionnaire – ILPA
Private Capital Investing Keys – Commonfund
Alternative Investment Due Diligence Questionnaires – AIMA
Key Drivers for Alternative Manager Selection – CAIA
The Variant Perception – Victoria Ivashina, Jason Zweig, and Michael Mauboussin
Private Equity Laid Bare – Ludovic Phalippou