How LPs Select a GP – The 4 Ps
22nd May 2018 1905 - Article - Knowledge Library
The private equity industry has remained largely unchanged for many years – until recently it has broadly been unaffected by digitalisation like most other industries. However, we are now seeing a shift in the ecosystem, with a greatly increased level of due diligence undertaken by the Limited Partner (LP) when selecting a General Partner (GP) to invest with. Within this article we will take a close look at four particular areas of review; people, performance, process, and price.
Many LPs live by the mantra that the three most important things when selecting a GP are ‘people, people, people.’ In that vein, there are likely to be a number of important questions related to people. Top of the list is usually who is in the management team of the GP, what are their backgrounds, competencies, specific areas of expertise, and so on. It is typical to be able to view profiles of the team. It is also important that the GP feels they can work with the LP, so getting a view on personalities and business culture as a whole are absolutely key in that discovery phase.
Whilst it may not be possible to find this detail out in full, a common query is which other LPs the GP works with. That information may be given at a high level. Team cohesion, years of experience, their network, and ability to deliver ROI are all important aspects to delve into. It will be indicative of their ability to continue delivering.
LPs will be particularly interested in which team make ups delivered which deals, particularly if there are positive historical returns of note. If these were delivered by team members who have left, there may be a question over the GPs ability to deliver in the same way – the same is true if a key team member is nearing retirement.
LPs are very mindful of the fact that they are primarily investing in people, and not products. Unfortunately there is no financial model out there that can help a private equity firm to pick a GP. Some of it will come down to asking the right questions, but most of it will be down to the gut feel the LP has about the individuals they will be working with.
Unsurprisingly LPs want to take a close look at the past performance of the GP. This is likely to be at a very granular level – what investments have been made, when on average exit has occurred, what has ROI been, and so on. Whilst this information is backward looking, it is probably the most important set of data the LP can access and also double check for validity.
Successful deals are important but failed deals are also important because they can tell the LP a lot about the GP. Why did they make the mistake in the first place? Did they do anything to mitigate their losses? How did they keep the LPs informed? And most importantly, did they learn from their mistakes? If there was another similar failure event thereafter, it should be sounding the alarm bells.
Moreover when an LP really gets into the detail with the GP, they can begin to get a sense of the culture of the team. Are they all singing from the same hymn sheet? Or is there an evident blame culture – blaming each other, or trying to pin it on someone who has left the firm. A common view on the analysis of the failure is important, as is a clear strategy implemented to avoid it happening again in the future.
When we talk about process we are really interested in how the GP works – how do they run their private equity business. Top of the list is how they source deals. Deal flow predictability and quality are important factors. Also, does the GP typically have an angle on the deals they find – are they at the front or the back of the queue? How does the GP compete against other buyers in a competitive environment, without overpaying? There are lots of systems, tools, and of course people available to undertake deal sourcing. The key is to get to the bottom of how it is done and importantly how the GP evolves that process as the profile of the best available deals changes.
We know that looking at past performance does not guarantee future success, although it is a very useful indicator. What you are looking for is a GP who puts time and effort into producing a short, mid and long term strategy and can demonstrate how it was constructed, and how they track progress against it.
At this high level you basically want to know what process the GPs follow to make money – how they source, how they analyse potential deals, how they buy, how value is added, and how they decide when to exit deals. The type of GP you want to work with will not just be doing this on a wing and a prayer, they will of course use a level of intuition and gut instinct, but they should be operating within a governance structure that sets parameters.
One of the big complaints LPs traditionally had about GPs was that they did not receive enough communication. Over the years a lot of GPs have heard this concern and the pendulum has swung the other way with an abundance of information being shared with LPs – and often too much. Getting communication and information exchange at the right level has to be agreed between both parties. The LP should be asking the GP how they typically communicate with their LPs – frequency, media, etc. This will provide a good indication of whether there is common ground to work from to produce a framework that would be well suited to the expectations of the LP.
At a basic level most GPs charge a management fee which broadly covers the operating expenses of the engagement. On top of that there is usually a performance fee which is a percentage of the return on investment. There are other commercial models that are more complex but it is advisable from an LP perspective to keep it simple and make sure the GP is incentivised to work hard. This means that it would not be worthwhile trying to drive down the performance fee too substantially as that may ultimately have a negative net benefit. Therefore the key in this particular area is to find a balance.
Private equity is a traditional industry that has been largely based on relationships between the GPs and LPs. Partly fuelled by technology, we are now witnessing LPs conducting far more intensive due diligence of GPs in 4 key areas – People, Performance, Process and Price. Within this article we have examined the specific areas of focus within these areas that we are typically seeing LPs focus on.
GP Selection and Due Diligence Program
Lawson Conner are well positioned to assist institutional investors, including pension funds, sovereign wealth funds and other investor financial institutions, in their potential GP evaluation, selection and onboarding. Read more about our GP Selection and Due Diligence Program (PDF).