Let the deliberationscommence
While many GPs may be finding fundraising a tough slog – US buyout funds, for example, were taking an average 18 months to raise in H1 2024, up from around 11 months in 2022, according to PitchBook figures – the stretched timeframes are giving investors much more time and breathing space to do their homework on potential commitments.
It’s a welcome development for many LPs that had struggled to keep up with ever-shorter fundraising cycles before the reset that came a couple of years ago. “It takes much longer to raise a fund today than a few years ago,” says Uwe Fleischhauer, Founding Partner and Member of the Executive Board at YIELCO Investments. “That means there is little pressure to make decisions quickly and LPs can be much more selective.”
Strike while the iron is not hot
But what does that mean for LP due diligence processes? And how are LPs taking advantage of the less pressured environment? One of the most positive developments for LPs is improved access to firms that have managed previously oversubscribed funds. “I was recently at a conference in Asia,” says the CIO of a fund investor. “All the meeting rooms were booked out by GPs, many of them managers that I wouldn’t previously have expected to travel to Asia because they didn’t need to. Now they are travelling. It’s really a sign of the times. It’s an especially good time to be a new LP because you need to build your allocation and right now, you can access some of the best managers out there.”
Another plus-point is that LPs are now often able to choose between committing to a fund at first close (and potentially benefit from any early-bird discounts that may be on offer) or delaying the decision until later on when a manager has already made investments, reducing blind pool and fundraising risk. There is a range of arguments for or against either course of action. For some LPs, remuneration may drive decision-making. “If an LP is paid carried interest, which is based on MOIC, it can make more sense to enter a fund at first close,” says the CIO, adding that entering later means paying an equalisation charge that would eat away at carry. “Yet if an LP is paid based on IRR, it can make sense to commit at final close on the basis that if the fund is doing well, the IRR should exceed the equalisation charge.”
Beyond the institutions’ financial incentives, there can be clear benefits to waiting until later or final closes. “The later you come in, the more information you have,” says the CIO. “You have to pay an equalisation charge, so nothing is free, but sometimes it pays to wait, especially if you are not sure whether a manager will reach final close and raise enough to keep the lights on.” Yet, he adds, this is clearly not a course of action to take if there is a chance that the manager raises more quickly than anticipated – despite the difficult conditions, some are achieving this.
Easier choices?
With the days of heady multiple expansion and ready access to leverage firmly behind us, many LPs say that choosing where to spend their time has become an easier task. “Narrowing down the managers you look at has become somewhat more straightforward than three years ago,” says Sven Czermin, Partner at Palladio Partners. “Back then, everyone had a great track record and return dispersion was limited - there wasn’t a big difference between manager performance.”
However, analysing that track record has not necessarily become easier. With fewer exits over the past two years, many managers are sitting on large unrealised portfolios where individual company valuations may or may not accurately reflect the price an asset may achieve when sold. This is why many LPs continue to look at several performance measures during due diligence. “We look at DPI, but also IRR and TVPI,” says Dana Haimoff, Managing Director at J.P. Morgan Asset Management. “They are all relevant, but one thing we would certainly question is if we see a 2016 or 2017 vintage fund and the portfolio is not yet mostly realised. You’d have to ask what is wrong with that, given the experience we had in the market in the back half of 2020, in 2021 and even the first half of 2022.”
Czermin agrees, adding that it’s impossible to rely solely on a single measure. “DPI is important and always has been,” he says. “But if you make it too important, it incentivises GPs to sell or reach for a continuation vehicle for the sake of delivering DPI rather than looking at the fund performance more holistically.”
Yet financial track record is clearly only one dimension of LP analysis. “Track record is a given,” says Haimoff. “It’s the starting point, especially as it has been a great market for many. Now we have to look at how we overlay a more challenging environment. For that, you really have to dig in and figure out what the manager’s operational toolkit is, how the team adds value, how it wins deals – today, you can’t just make money from leverage or by getting into bilateral conversations to win deals. Many private equity groups tick a lot of these boxes in their presentations, but as LPs we really have to substantiate their claims to get comfort that they can deliver.”
Who you gonna call?
An effective way of achieving this is via extensive referencing, says Haimoff. “We spend a lot of time on references,” she explains. “That includes people off-list as well. So, we speak to current and past portfolio company CEOs as well as leavers to really understand the people we are dealing with and what has happened in the past. They might tell you something, they might not and sometimes what they don’t tell you is just as informative. It’s really important to use your network to fill in some of the gaps.”
“Early referencing can really help to narrow down the field,” agrees Enrica Dacomo, Investment Director at Capital Generation Partners. “That could involve your broader network, LPs or perhaps other GPs that may have dealt with the manager so you can get a sense of whether an opportunity is worth spending more time and resources on.”
LPs are also spending time getting to know the whole team in some instances to understand the firm’s dynamics and how it finds points of differentiation in what can be a crowded market. “You do have to understand the drivers of return,” says Dacomo. “But we also want to drill into what makes a transaction a typical deal for a firm. How has it been sourced, how did the firm select a specific sub-sector, how did it differentiate from the competition within that space? Overall, what makes a deal your firm’s deal?”
Overall, LPs are using the breathing space they now have to verify GP claims in fundraising pitches, while also taking time to track managers that are not currently in their portfolios but could potentially make the cut further down the line. And, while the extended timeframes may be frustrating for GPs looking to raise capital, they should be encouraged by the development that most LPs today recognise the importance of vintage year diversification in their private equity portfolios, unlike the last period when fundraising was difficult, the Great Financial Crisis. So, while LPs may be taking longer to reach decisions, they are largely continuing to invest. “No-one wants to miss a specific vintage year these days,” says Fleischhauer. “It’s a lesson that has been learned that is positive for private equity. Some may have put the brakes on their allocations for a short period, but we are now seeing commitment pace picking up again.”
As fundraising processes have lengthened over recent times, LPs now have more time for detailed due diligence than in the period running up to 2022. So where are seasoned investors focusing their efforts when selecting which funds to back?
There is little pressure to make decisions quickly and LPs can be much more selective.
