September 20, 2012
Interviewed by: David Snow
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Deep Diligence in the Portfolio

In today’s market, fundraising means hundreds of reference calls between LPs and portfolio company executives. How do you prepare busy executives for an exasperating level of due diligence? In the third segment of this essential thought-leadership series, Pawan Chaturverdi of Altius Associates, Matthew Pedley of The Blackstone Group, and Jennifer Cho Rinhert of MVision Private Equity Advisers share best practices in portfolio-level due diligence. The segment includes an expert Q&A with Rinehart of MVision, the sponsor of this series.

In today’s market, fundraising means hundreds of reference calls between LPs and portfolio company executives. How do you prepare busy executives for an exasperating level of due diligence? In the third segment of this essential thought-leadership series, Pawan Chaturverdi of Altius Associates, Matthew Pedley of The Blackstone Group, and Jennifer Cho Rinhert of MVision Private Equity Advisers share best practices in portfolio-level due diligence. The segment includes an expert Q&A with Rinehart of MVision, the sponsor of this series.

David Snow, Privcap: Today we are joined by Matthew Pedley of the Blackstone Group, Pawan Chaturvedi of Altius Associates, and Jennifer Cho Rinehart of MVision Private Equity Advisers. Welcome to Privcap today. Thanks for being here.

So today we are talking about the bold new era of transparency in private equity. You’re all very aware of this, you’re on the front lines of due diligence transparency reporting. What I’d like to dig into today is a very important part of the due diligence process. And that is the LPs learning about what’s going on right at the portfolio level. And so I’m going to guess it’s a lot of work not only to prepare the people and the information about the portfolio, but to actually connect it them with the LPs, and sometimes in extensive due diligence calls.

Matt, at the Blackstone Group, I would imagine that with all of your portfolio company executives, there’s a lot of information to prepare. And can you talk a bit about what exactly are you getting to the LPs and their advisers so they can independently verify the story that’s coming out of Blackstone.

Matthew Pedley, Blackstone Group: When we are preparing for a fundraise, we generate a standard due diligence package. And one of the elements in that package is a list of references. And that is a pretty multifaceted list. It includes industry contacts, portfolio, company CEOs, advisers with whom we work closely. And this list is multiple pages of names and respective contact information. And we hand that to any investor that requests a standard diligence package.

Snow: And do you simply give it to them and say, knock yourself out, call these people if you’d like? Or do you arrange for calls to take place?

Pedley: We will happily arrange calls if that’s what the LP prefers. By and large, they or their respective gatekeepers will manage that process for them.

Snow: And Pawan, as someone who conducts due diligence into GPs on behalf of clients, is that what you’re looking for? Do you want access right down to the portfolio level to be able to speak to the executives?

Pawan Chatuverdi, Altius Associates: Yeah, absolutely. It’s part of standard due diligence for us. I think there’s two ways, especially when you have larger firms, like your firms, where the standard information, financials, operating performance of some companies is often covered in group calls. Still sort of make it streamlined. And that’s the basic information. But regardless, we like to do one-on-ones. But those are not so focused on these broader issues, they are more specific on companies or what we are most interested in, and what may not be appropriate to be discussed in a group setting. But yeah, every single fund we look at and recommend to our clients or invest in for ourselves, we have to and we will always do portfolio company references.

Snow: I’m going to follow-up with you about the part about what’s not appropriate to be discussed in a group setting. But first, we’ll start with Jennifer. As an adviser to GPs on the fundraising trail or preparing for the fundraising trail, what kind of work are you doing with the portfolio company executives to help them get ready for the due diligence that lies ahead?

Jennifer Cho Rinehart, MVision: Yeah, so you can’t really coach the CEOs. They’re going to say what they’re going to say. But we do make all of the calls in advance in terms of understanding what dynamics come out. Maybe there are certain CEO calls that are better than others. We do actively manage that. So we don’t provide a blanket list of CEOs, we manage who’s calling who. And we also try to stage those calls so that the investors are doing it late in their process where they’re excited about the group, they’re heading towards a commitment or towards an investment committee approval and they need to make these reference calls. And there may be certain companies that are more interesting because it’s outperforming, underperforming. And so we try to track who’s calling them and make sure the CEO themselves are not getting overwhelmed by too many calls in a short period of time.

Snow: Do the LPs have an opinion about whether your team is on the call or do they sometimes say, look, I just want it to be me and the CEO, and nobody else can listen?

Rinhart: No, so we’re never– we’re rarely on the call. I think it’s been exceptional when that’s been the case. But it’s usually a one-on-one with the investor and the CEO. But we’re scheduling the calls on behalf of the GP, so that we know the CEO isn’t getting deluged with these types of requests.

Snow: And Pawan, you mentioned, obviously joining in the group calls that are arranged, but then you have an appetite for more specific questions, sometimes they’re fairly sensitive. Can you talk about what types of more sensitive questions you would be asking?

Chaturverdi: Yeah, what I was referring to is some questions just aren’t efficient to be discussed in a group setting. It could be issues like, are they personally investing in a deal or in the fund? Could be that we have some questions about a specific partner or a firm that is an investor in that company. And we want to know more about specifically what that person or firm was dealing with that company.

Generally, the way the group calls, at least we find them useful is to get a view of the business, of the management and their sort of financial and operating background. It’s not so much to dig into the more personal human aspects of the reference that we would like to get into.

Snow: What about in situations where, as Jennifer alluded to, things aren’t going that well? Is that a more challenging conversation?

Chatuverdi: I think it’s OK to ask, if these are fair, reasonable questions on the financial or operating parts of the company in a reference call. Generally, the way you’d want to do it, and it’s obviously a little bit of an art you learn over time. I’ve goofed up probably more than anyone else in the world, but you learn that you have to ask them delicately. These people are very senior, very important people, and they have a lot of things that are going on. So once you figure that out, I think there’s always ways to get the information without being offensive, even if the company’s not doing well. 

Snow: And there’s been a reference here to deluging– is that a word– CEOs of companies with too many calls. Matt, how do you avoid or mitigate the possibility that hundreds of LPs are going to be individually requesting calls with specific CEOs?

Pedley: It’s difficult to prevent that. But particularly with a standard reference list, like the one that we publish, so we really just– we work with those individuals prior and prepare them for the fact that they may be getting a multitude of calls. But these people are selected because they are believers in what we do. And they want to be supportive to us.

Chaturverdi: How do you deal with smaller investors if they want same access to portfolio company CEOs? I mean, someone putting in $5 million into a multi-billion dollar fund.

Pedley: It’s rare that we have people at that size, though it does happen. What we found anecdotally is that people committing at that level generally are not–

Chaturverdi: Making calls?

Pedley: They’re not performing the same degree and duration of diligence process that a large state pension would, for example.

Snow: Is there the risk that certain CEOs or certain personalities might have a sense of humor failure at the idea of being called so many times by so many different investors? Without naming names, has that ever come up as a challenge? And whether from your perspective or your perspective in preparing these executives for due diligence.

Rinehart: Oh, yeah. I mean, I think we’ve gotten requests for CEOs to say, just take me off the list for the next three months because I’m doing something big at the portfolio company. And so we’ll abide by that and we’ll only use them if there’s a giant investor that’s looking to go to finalize seed at that time. Otherwise we’ll defer.

We found that investors are spending a lot of time on the references. And even the smaller guys as well as a larger guys. And so that proactive, rotating CEOs in and out, not giving everyone the full list but hoping to address their questions with two or three portfolio company CEOs has been a way to effectively manage that.

Snow: Slightly different topic and it has to do with valuation policy. I wonder, number one, to what extent are LPs interested in, hey, GP tell me what your policy is for valuing all of these portfolio companies? And then, what the right way is to present that? And maybe starting with Matt. Have you seen a progression in the ways across private equity that the valuation policy has become an area of interest?

Pedley: Absolutely, without question. It’s gotten to the point where whether it’s for diligence on a new fund or successor fund that we’re offering, or just LPs coming in for an update, we’ve gotten specific requests for an outline of our valuation– an overview of our valuation process. So we actually have a standard presentation at this point that is very well honed that walks step by step through our process, which is a pretty robust process, as you can imagine. So we have key members of our finance team that actually manage that process themselves, will come and meet with interested LPs and spend 30 to 60 minutes walking through the valuation process in detail, and field questions, show them sample quarterly reports if they aren’t investors already. And we’ve found that people who are interested in that level of detail will walk away from those meetings very impressed. So–

Snow: Wishing they never went in?

Pedley: No. But to the degree that that is a diligence item on their list, we feel pretty comfortable that that is going to be given a check plus after they’re done with that.

Snow: Pawan, is there a wrong way to present a valuation policy? Or have you found certain presentations of the policy to be deficient from what they should be?

Chaturverdi: I think for us it’s more than just policy, it’s company by company. We look for the metrics on the performance of each unrealized company. And to us, actually quite honestly, we do a lot of that on our own, where we look at what multiples are these being carried at. Why are they up or down? What are the basis for valuation, those types of things. So it’s really not just a policy that engages our investment committee the most. It’s much more of a company by company.

And in many ways, it’s a process of negative affirmation if there’s such a term. If we see something where it’s carried at what seems like an unreasonable multiple or valuation, that’s what leads to the questions. It’s rare that somebody will say, well, why is it only carried at two times EBITDA, or whatever it is. But I think we go a little bit beyond variation policy. And most GPs who are experienced, and we have that information, the raw information that we can do our own analysis on.

Rinehart: Have you seen, Pawan, that the same asset is being carried at different valuations by GPs?

Chaturverdi: We have. It’s not actually– I wouldn’t say it’s the norm, but it’s certainly not an exception either. It happens fairly often with the fair market valuations and so on. It’s not uncommon to see– and this happens more in smaller funds. Sometimes it does happen in larger funds, too. And certainly happens in venture funds as well, where there’s an insider round and some people are valuing it a certain way and so on.

Rinhart: No. So we see that a lot and we struggled because are you being too conservative or aggressive? And you don’t want to be too much or too little, you want to be just right. And I think that the context– so we advise our clients the context of what are the operating metrics and how is it performing relative to the underwriting plan is more important than maybe where you’re holding it that exact quarter.

Snow: And, of course, o top of all this, on top of the interest from LPs and better understanding valuations, we’ve got increased regulatory requirements that performance must be presented in a certain way. So I would imagine that’s placing an even finer point on getting it right?

Rinehart: Yeah. And I think they are, the GPs that we work with are consultative with their advisory board, their LPs, and so everyone has an understanding of how they’re coming to those valuations. But you still have competitors out there that have higher marks on their books or lower marks, and you’re constantly, I think, checking with what’s going on in the market.

Chaturverdi: Yeah, we actually check even internally within our own databases to see if someone else has invested in that company, and if they’re carrying it at the same or lower or higher valuation.

Snow: Matt, again, without naming any names, is it frustrating when– if Blackstone goes through a laborious process to come up with what they feel is the appropriate value and they see someone else carrying either the same or similar asset at a very different value? Are there challenging conversations that take place because of that?

Pedley: We certainly will receive calls from LPs who may be invested in multiple funds that are in the same underlying portfolio company when there are discrepancies in the valuation. And really, what we do is just provide the next layer of detail on how we derive the valuation. All we can do is give the most detailed explanation possible for the rationale behind our valuation. And then the LP can have a similar conversation, hopefully, with the other managers that may be in that company.

Snow: One final topic, and it’s a bit more forward looking. To what extent are investors interested in the path to liquidity, what lies ahead, making projections? Again, not an exact science, but I’m interested in how much information GPs are being asked to give up about that. Jennifer?

Rinehart: I think in the situations where there is a fair amount in the unrealized portfolio, investors have to not only take the valuations as one metric, but really understand how that portfolio is going to be monetized. So there is a lot of attention being spent on that by the investors. And thus, by the GPs. And really, trying to lay out some of the key milestones that they need to achieve to get to a sale event. And where we’re being responsive to investors without being aggressive in terms of projections. But if these things happen, we expect that the returns will be in this type of range.

But again, you have to be careful with what you say given the regulatory environment. But I think investors are spending a lot of time on that.

Pedley: I would echo that. Particularly again, since the financial crisis, the scrutiny on that sort of thing, and investors, and particularly larger investors, are maintaining their own models of their portfolio. So we will often get asked for guidance at both the portfolio company and the fund level on our expectations for how that investment’s going to perform.

Snow: And, I mean, it is somewhat sensitive. How do you manage to paint an accurate picture without appearing to hype or be overly optimistic about a portfolio company?

Pedley: Well, for starters, if it’s a publicly held company, we obviously can’t– we can’t really discuss that. For privately held companies, we can offer our projections for performance in the near term. And then, it’s actually a fairly simple derivation exercise once you have the primary metrics in place. So those require assumptions and we caveat that they are just that.

Snow: All right. Pawan, are you interested in that? I mean, what level of detail do you want about what might lie ahead.

Chaturverdi: You always want to have that. The question is, can anyone answer these questions in a meaningful way? And there’s two parts to that, I think. One is timeline and one is, what are you expecting in that timeline? I think the operating performance projections are a little bit easier and more factual, and that’s what we probably are most interested in. The near-term exits are always something we talk about when we are looking at a fund. What’s going to happen in terms of liquidity in the next 12, 18 months?

The reality is, with fair market valuations, unless you are grossly under over overvaluing the company on the books, I mean the outcomes aren’t going to be that different if they’re going to happen in the next 6 to 12 months from what’s on the books. So that’s why I said you always want to know what’s going to happen in the future. But only if you can know that. And it’s a hard question to answer.

Snow: Well, this has been, again, fascinating to hear about the deep level of analysis that LPs are requesting about what’s happening at the portfolio level. There’s a lot more to talk about, but I think we can pause for now. I hope that the next time we talk about transparency and due diligence on Privcap, I can have you all back.

Expert Q&A With Jennifer Rinehart, Managing Partner, MVision Private Equity Advisers

Privcap: Almost half of MVision’s clients have been first-time funds. Why?

Rinehart: When we were starting out, I think that we were looking for high return opportunities, and whether it was an existing fund or a new fund, we were indifferent. We thought we knew which investors we could bring on board to those types of opportunities.

I think as we’ve been growing our business in the US, those types of opportunities happen to be a little bit more prevalent. You see the next generation of leaders coming through in the private equity firms. There’s a natural inflection point. So we’ve seen a lot of opportunities on that front.

Privcap: What kinds of questions do LPs tend to have about first-time funds?

Rinehart: I think they’re looking for seasoned teams. Experienced teams that have been executing on a strategy for a long period of time. They want to see that that type of strategy is something that they can repeat outside of that parent company or the platform that were previously investing at.

But I think if you can align all of those elements, and that you can show that the opportunity’s an exciting one, so it’s not just another plain vanilla middle market buy-out fund, but there’s something about the way they buy or what they buy that’s differentiated. I think there is a whole universe of investors that can get very excited about that.

I think the converse is true as well. There’s a whole universe of investors, no matter how good the experience or track record or strategy is, will never do a first time fund. So part of the knowledge that we bring to the table is that historical knowledge of which investors would be more inclined.

Privcap: What level of due diligence does MVision perform on its own potential GP clients? 

Rinehart: So we would run the GP through our own due diligence process, which is very similar to that of your traditional LP. And I think we’re going through the strategy, making sure everything is internally consistent, spending time with the entire team, and really understanding where potential weaknesses may be

So let’s not hope and pretend these issues won’t arise during the fundraising. Let’s be very cognizant about it, and try to be offensive in the way we handle those issues, and build it into maybe our materials, our marketing, the PPM, as opposed to being caught on the back foot as you’re fundraising.

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