September 1, 2012
Interviewed by: David Snow
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Fundraisers Face Invasive Due Diligence

Not long ago, GPs could raise a new fund with little more than a PowerPoint deck and private placement memo. Then, the financial crisis hit and LPs put GPs under the microscope. Today, LPs are digging deeper and demanding more “invasive” transparency.

Your experts on this crucial topic are Matthew Pedley of The Blackstone Group, Pawan Chaturverdi of Altius Associates, and Jennifer Cho Rinehart of MVision Private Equity Advisers. This program is a must-see for any GP hitting the fundraising trail or any LP researching best practices in the due-diligence process.

Not long ago, GPs could raise a new fund with little more than a PowerPoint deck and private placement memo. Then, the financial crisis hit and LPs put GPs under the microscope. Today, LPs are digging deeper and demanding more “invasive” transparency.

Your experts on this crucial topic are Matthew Pedley of The Blackstone Group, Pawan Chaturverdi of Altius Associates, and Jennifer Cho Rinehart of MVision Private Equity Advisers. This program is a must-see for any GP hitting the fundraising trail or any LP researching best practices in the due-diligence process.

<strong>David Snow, Privcap:</strong> Today, we are joined by Matt Pedley of the Blackstone Group, Pawan Chaturvedi of Altius Associates, and Jennifer Rinehart of MVision Private Equity Advisers. Welcome to Privcap today. Thank you for joining us. We are talking all about a bold new era of transparency in private equity. This is changing the interactions between LPs and GPs, and all of you are right in the middle of that transformation, so I”m very interested to hear your analysis of what”s going on.

Of course, increased transparency has great ramifications for someone about to raise a fund. There will be a lot more information requested of GPs who are about to hit the fundraising trail again– something all of you are in the middle of. But maybe we could start with a question for Jennifer, who helps GPs have successful fundraisings. Imagine that the large audience of GPs about to hit the fundraising trail who are watching this. What should they expect from this more transparent, more invasive era of due diligence, and how can they prepare themselves?

<strong>Jennifer Rinehart, MVision:</strong> So I think that the pendulum has swung the other way, in terms of the information required to get a fund closed. As recent as five years ago, we have had good success with GPs, and we know GPs are out there raising funds with as little as a PPM, and a presentation, and maybe some supplementary information, but today I think that would be quite the exception, and GPs should be prepared to make sure that all of their day-to-day workings as a general partner is effectively documented– portfolio company information is well documented– and that”s part of the initial marketing when you go out to fundraise.

<strong>Snow:</strong> Now, Pawan is someone who is reviewing information from the GPs who come through your door. What should a GP expect now in a market that requires much more information?

<strong>Pawan Chaturverdi, Altius:</strong> I think a better way to look at or answer this question is to segment the market in terms of who the investors are. So there”s large institutional investors, and then there”s the smaller institution family offices– sometimes individuals. The larger institutions have always demanded and received pretty detailed in-depth information.

They generally have a lot of resources. They generally need to do a lot more analysis. Their ticket sizes tend to be large. So a lot of our clients who fall in that category, really not much has changed on the due diligence side from an investment perspective. But what”s changed for them really is much more on the compliance, and disclosure, and those types of matters, more thorough background checks, and those types of items.

The smarter institutions I think have changed a substantial amount from three, four, four five years ago. And there, I think, it”s really a broadening of that recognition that you really need to do your homework before you put in money, because once you do, you”re committed for 10 years, plus.

<strong>Snow:</strong> And I do want to dig a bit deeper into the kinds of information, whether it”s compliance or the integrity of the GP, but maybe following on the same theme with Matt that you”re at a very large organization that has many, many LPs around the world, what”s new on the checklist of things that need to be in place before a fundraising happens?

<strong>Matthew Pedley, Blackstone Group:</strong> Well, I really think it”s a follow on of what happened during the financial crisis. And during that period, we and all other GPs saw a massive influx of questions about the nature of the portfolio– LPs digging into a level of detail that heretofore was really not seen. And then what has happened is that really becomes a one-way street. Once you start going down the path of transparency, it”s almost unheard of that you would step backwards, so you keep ratcheting toward more and more transparency.

And then as fundraisings have started since then, LPs are applying that same desire for transparency that they had as a reaction to the financial crisis and the uncertainty about their illiquid portfolio and wanting to get a firm grasp on that. Well, they”re applying that same rubric to their new fund evaluation, and so I think there is at minimum some degree of that going on.

<strong>Snow:</strong> A follow-up question for all of you, maybe starting with Matt– what”s going on in the background at some of these LPs that is leading them to simply feel the need to understand much more about what”s going on in the portfolios. Is it a board level thing? What”s driving this desire for more information?

<strong>Pedley:</strong> Well, certainly, we”ve heard stories of a number of boards putting pressure on their respective investment teams, and asking them a level of detail of questions that had really not been asked before. So that trickles through onto the GP, and the GP provides that information so that the investors at the OP can give more coherent answers to their boards. So the pressure is definitely coming from the boards, and it”s also coming from LPs realizing that their resources are getting more scarce. It”s getting tougher to get approvals.

In many cases, you”ve got LPs that have a host of managers that really just, by sheer quantity, is becoming difficult to manage. And so they”re looking at rationalizing the number of managers that they do business with. And as a result, you”re seeing this dynamic where you”ve got more wood behind the arrow, if you will. They”re in aggregate, making a smaller number of bets with larger amounts of capital and fewer managers.

<strong>Snow:</strong> Is that what you”re seeing, Pawan?

<strong>Chaturverdi:</strong> Exactly. I was going to say, I think a lot of this is being driven by just those points that Matt just raised. The fact that there”s rationalization going on in the industry in terms of number of relationships that investors want, and, consequently, concentration with those managers means resources now are much more focused, which means resources want to understand and have conviction. Because it”s easy to say, well, once you know a little bit, here”s five choices and who are all equally good. But now you”re saying we”re going to go down to two. How are you”re going to make that decision?

<strong>Snow:</strong> Jennifer, when you”re preparing a GP for this, again, more invasive due diligence regime, and they ask you, well, why do I need to share this? What good does this do? Why do the LPs need to know this? What do you say?

<strong>Rinehart:</strong> So I think that we try to share our perspectives on that particular LP”s process. And I do think, picking up on Matt”s point, about how the financial crisis revealed a lot about GPs– the way they underwrite their investment decisions. I think LPs were, as well, reflective of how they were underwriting managers and really stepping back and saying, do we have certain systems and standards in place? Because we had examples at the bottom of the crisis where certain LPs were asked to go back and represent managers they already backed to the investment committee. And they realized that a lot of the things that they should”ve diligenced or should have had more corroborating evidence for, they didn”t.

And so I think we”ve seen, actually, some significant evolution in terms of the way investors actually underwrite the GPs. And we try to share that knowledge and that experience with the GP, as well, so that they get an understanding for where they came from, and how they”re looking at new managers, and how we can help them through that process.

<strong>Snow:</strong> Well, let”s get down into the nitty-gritty of types of information that LPs are requesting that perhaps they didn”t request at all previously or in as much detail. Pawan, you mentioned kind of compliance types of things. Can you talk a bit more about that, and then after Pawan, I”d be interested in hearing the reports from both Matt and Jennifer.

<strong>Chaturverdi:</strong> Sure. So, again, these are non-investment matters. On the investment side, it”s pretty well understood. And most managers who are not raising a first-time fund or who are experienced in private equity know what to expect in terms of providing information. Typically, more detail in the raw form on the portfolio company is where I think the biggest difference is.

The compliance and disclosure area, I think, is the one. The need for information is driven by one primary aspect of fundraising, which is pension funds have become probably more important over the last few years to fundraising than they”ve ever been. Not to say they were not important in the past, but that focus or concentration has really changed. And a lot of them are answerable at many different levels, which require them to ask these compliant and disclosure questions

To give you a couple of specific examples, I think investors want to know if there”s been political contributions made. If there is an issue with the fund, what jurisdiction is it going to be to resolve that. And so those are the types of things that you could say the GPs in the past never really had to think about. And LPs oftentimes did not ask, unless you happened to be one of the 10 or 20 largest funds. Now, that is percolating down to basically public plans of many sizes much smaller than that.

<strong>Snow:</strong> Matt, does this sound familiar to what is being required of you and your team?

<strong>Pedley:</strong> Absolutely. The reporting and diligence requirements, as I mentioned, kind of have grown hand in hand. One of the areas, to get into specifics, that we”ve seen quite a bit of an increased focus on in the last few years has been on the underlying debt and covenant schedules within portfolio companies. Why? Because during the financial crisis, that was exposed as a primary source of risk in the portfolio. You can lose a company if you heavily violate a covenant.

And during the go-go years, if you will, of 2003 to 2008, there wasn”t a real material risk of that because you could refinance so easily. And suddenly, that became a very, very hot topic. So the level of reporting that certainly we”ve taken on internally, we started getting sufficient questions that we just incorporated into or normal quarterly reporting package.

But we got the questions from people doing diligence on successor funds, in addition to people just wanting updates– so displaying the debt maturity schedule by year, by portfolio company, for an entire fund, displaying the covenant status– again, for every single portfolio company– and letting investors know exactly where you stand from a debt perspective. That was one area that, at least in our experience, really jumped out as an area that LPs became very, very focused on.

<strong>Snow:</strong> Without necessarily naming names, and maybe none of you have this exact anecdote, but have there been moments where information has been requested and the GP has kind of had the reaction of, you got to be kidding. How can that possibly be relevant?

<strong>Rinehart:</strong> So I think it”s OK to say no when that boundary is crossed and there should be reasons why the GP is saying no, and hopefully it doesn”t raise more questions than it answers. But I think that there has been sensitivity around precise economics around the GP.

<strong>Snow:</strong> So, the personal wealth of the GP?

<strong>Rinehart:</strong> Exactly. And all the way down to potentially the team”s precise economics, as well. That”s less often the case, but we still continue to see that and investors are respectful of that.

<strong>Snow:</strong> But, actually, what happens when you say no? Sorry, Pawan, I want to hear your view, but have there been instances where the LPs get that–

<strong>Rinehart:</strong> Well, again, if you”re understanding why the LP is asking that question– they want to understand that the economics are distributed broadly among the team. They want to understand that there”s not excessive fees coming out from management fees, and that there”s a surplus coming into certain individuals. And so if you can address that in a way to– and I think we have done– the satisfaction of the LP. I think you don”t necessarily have to get line by line on what each individual person is receiving.

<strong>Chaturverdi:</strong> I think that”s certainly one area where people want more detail. A couple other areas which stick out in that sort of GPs [INAUDIBLE]– one is when you have a firm which has multiple product lines– you might have a perspective on this– where oftentimes these days LPs will ask for details not just on the fund their due diligencing, but also other funds. And some GPs say, well, why are you interested? That”s not the fund.

I think generally what happens though is– to Jennifer”s point– GPs are pretty comfortable providing any information LPs want, as long as it”s not unreasonable, which it rarely is. The instances where they don”t provide information is because simply they just don”t have it, or it”s hard for them to do it. Another area where I think we see some of this happening in [? terms ?] [? of ?] GPs saying, do you really need that, is when there”s requests– I think this is much more common in the legal review, or the side letters, and stuff like that– where an investor may have some peculiarly unique request.

And it”s not broadly, but entirely to be provided. So there”s no exceptions allowed in certain instances of [INAUDIBLE] and such. And that”s where I think we hear more of this reaction of, really? You”ve got to be kidding.

<strong>Pedley:</strong> I”ll echo what Pawan said. In general, we will bend over backwards to accommodate any request from an LP. There”s really only one instance I can think of where we had to say no, and that wasn”t really on the diligence side. It was on the regular reporting side.

This is a very small investor in a very large fund. And they asked us to move from a quarterly to a monthly reporting cycle and publish the same level of detail that we do quarterly, but just do that on a monthly basis. And that was one where it was just a physical impossibility. There”s no way we could get our team to do that level of reporting.

<strong>Snow:</strong> But it would”ve been so much more fun for you, though.

<strong>Pedley:</strong> Yeah, it would have been dandy.

<strong>Expert Q&amp;A With Jennifer Rinehart, Managing Partner, MVision Private Equity Advisers</strong>

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

<strong>Rinehart:</strong> 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.

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

<strong>Rinehart</strong>: 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.

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

<strong>Rinehart:</strong> 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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