October 14, 2014
Interviewed by: David Snow
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Are Synthetic Track Records Legitimate?

When new private equity teams are formed, they often raise money based on track records synthesized from different funds, or reconstructed but impeded by uncooperative former employers. Are these synthetic track records legitimate? Are they worth the effort from investors? Three performance experts weigh in.

When new private equity teams are formed, they often raise money based on track records synthesized from different funds, or reconstructed but impeded by uncooperative former employers. Are these synthetic track records legitimate? Are they worth the effort from investors? Three performance experts weigh in.

Are Synthetic Track Records Legitimate?
Private Equity Performance

David Snow, Privcap: Today, we’re joined by Andrea Auerbach of Cambridge Associates, Erick Bronner of the Riverside Company, and John Clark of Performance Equity Management. We’re talking about private equity performance. All of you are performance experts, so I’m thrilled to have you here for this program. I’d like to focus on something that’s happening a lot in fundraising due diligence these days, which looks like it’s going to happen a lot more, and that is the act of reconstructing track records. Or, building synthetic track records from individuals who have been at separate firms and are coming together to launch a fund. There are many other permutations of that. Let’s start with a question for John: in what circumstances would you as an investor need to pull together disparate track records to form an opinion about a GP?

John Clark, Performance Equity Management: Certainly attribution by partner is a critical component to due diligence and, if you’re looking at a first-time fund and these are partners have come from different firms—or maybe there’s two from one and one from another—you need to be able to pull their attribution and history and track record, see how that fits with the strategy of this new firm and make an evaluation and decision. So, it does create some challenges. I’d say the same thing if you’re looking at a Fund 5 and two new partners have joined the firm; you see this both in venture and buyouts. It’s a similar exercise. How do I get access to the track record of these new partners who may be committing 30% or 40% of the next fund, the capital? To us, it’s an important part of the exercise. You have to be a bit more creative to validate the track records of the partners. A lot of times, when partners leave a firm, the firm’s not as friendly about letting the track record go with them.

Snow: You did all the bad deals, right?

Clark: Yes, absolutely.

Erick Bronner, The Riverside Company: Imagine that.

Clark: They’ll claim they didn’t do a bad deal. I only did these great deals, so there are a lot of different ways you have to really vet and validate the track record, and we spend a lot of time doing that. It’s going to the CEOs of the companies or the LPs of the former fund they came from. We have such a long network, a lot of us—you can talk to LPs and they’ll give you their opinions of what happened and what those partners did. Then, you go to the CEOs and who drove the deal. Who was involved in the beginning of the deal? Who drove the value-add during the investment period? You have to do those things to piecemeal a track record to help you make an informed decision.

Bronner: Just to add to that, whenever a group leaves one organization and goes to another, there are questions of who sourced the deals. Who, to John’s part, created the value and, ultimately, who gets the credit for the exit? Those are the three pieces, as you think about what matters for attribution. Then, how do you figure out how the pieces play together? Going to the CEOs and the LPs is probably the best approach in the sense that they’re closest to the levers of where the value was created, and no matter who leaves and who comes from somewhere else, there are two sides to a story. Then, when you hear both stories and there are smart people telling you the story, they all seem valid. So, there’s more work to be done in doing that, but in a world in which people are leaving places and going to other places, my sense is there’s a lot of value to doing that analysis. Once it’s done, those teams can then create real value for investors. But you do need to roll your sleeves up a bit with some of that to get to the right answers.

Andrea Auerbach, Cambridge Associates: We’re talking about looking at lift-outs and spin-outs and reconstructing these track records. That’s all verification of what you’ve done or contributed in the past. If you have a lot of people coming together and combining their track records, you could end up with a Frankenstein firm, right? One arm was really good at this one thing and the leg was good at another, and the head was doing this, but combined they still don’t really have the skill set you want them to have to make money for you going forward. There’s always that risk that you can do all that groundwork in the background to verify, but then what do you have going forward? As these teams mesh together, you may end up with something a bit different, completely different, awesome or disappointing. A large part of the work we’re doing in the background to verify this is also feeling them out and getting a sense for the chemistry of the combined entity going forward as well. That’s really important.

Clark: We always have a GP come in and you passed on their Fund 1 and you may have passed on their Fund 2, and you say, “Man, I wish I would have done Fund 1.” Many times that was a $100-million fund and now they’re back for $750 and you wonder how that works, but there is a startup risk. We look at these great Fund 1’s and think, “I’ve got to get in one of those,” but, to Andrea’s point, there are a lot of firms that don’t work as well and don’t gel and it may take them a fund or two to do that. So, you have to evaluate and see how this new team is coming together. Typically, it’s a smaller team and it’s usually a smaller fund, but sometimes they come in with a bang and you wonder how that is going to work. You have to raise the bar a bit and evaluate some of those intangible factors. How are they going to work together versus having been in a fund for three years? And seeing the team gel and work together. Those are things you have to figure out.

Bronner: I agree and I’d add to both of their points that there’s a difference between startup teams, especially back when I was a placement agent. There were a bunch of these where teams come together from different disciplines. They know each other through some connection. Now, you have to put a track record together that ascribes to what this team can do, and you also have to diligence decision-making. How does their new investment committee work versus a team that’s spun-out of somewhere else whole cloth? So, this track record ascribed to the team as is, and importantly, you don’t understand how this team makes investment decisions. When I was a placement agent, one of the biggest challenges was these people who know each other in one setting, but now they’re in a new setting and they bring these skill sets and track records, but how will they make decisions? What will happen when one person decides this is isn’t a good deal and somebody else does? It’s different from a team that’s actually been making investment decisions together for a period of time, so you don’t have that element of risk with them.

Snow: My question is, if you are comfortable with all the attribution, like you’re comfortable that Harry did this deal, Sally did that deal and there’s a track record assigned to those deals, and you do create a track record of 30% IRR over a certain amount of time—

Auerbach: Tell me more. Who are these Harry and Sally people?

Bronner: That’s right.

Clark: Yes. You passed the screen.

Snow: It’s a fund I’m representing that I’m happy to tell you about. How seriously can that track record be taken? You’re obviously mentioning all these other factors, but if it’s a Fund 3 and it’s the same team from Fund 2, you say, “Oh, okay. It’s 30%, which is in the top quartile; let’s move forward” or whatever you decide. But, if it is a synthetic track record, how seriously should that be taken, even if it is pretty good?

Auerbach: It makes me want to look closer, as I was joking earlier. You want to get a better sense of what the main contributing factors were to that performance to the skill sets of the individuals involved. This Harry and Sally that you speak of—are they going to combine to continue to consistently deliver that kind of performance? How did that performance come in? One other thing we often do is look at performance of combined track records on a calendar-year basis to see if there was any market element contributing maybe to them investing at the right time. Good for them, but they also had a market lift on their exit, which may not be replicable going forward. So, there’s a lot more than just looking further. We definitely look at combined track records but with a big grain of salt. This is not their combined performance; this is just a track record representing individual deals done as individuals at other firms where other people were probably involved. Note to self.

Bronner: You’d also look the team and ask (a) did they work together before or did they spin out? And (b) where did they go? Did they spin out on their own? It truly is what this team is going to do? Or did they spin to another place and does that other place either add or detract from what you thought they did before? But, to answer your baseline question, private equity is a people business so you have to take track records seriously because the folks who built it have a unique capability in that sector. You have to get away from the math at some level and say, “These people bring backgrounds that enable them to create value.” The only question is how much you ascribe to it.

Clark: Most of us who’ve been in the industry for years have had to do deal with this, so it creates a couple of extra hurdles to get there. If it’s not a friendly departure, you have to go to different sources. But, if you see 30% and you see a 3.2 multiple, it may be worth it. That’s certainly taking it to another level of diligence, but it takes a bit longer. You have to be a bit more creative to really get conviction that that’s the real track record and that some things aren’t left out, and that the strategy that drove that track record is going to be consistent with the strategy of this new fund that’s being created.

Auerbach: I do think this trend is on the rise. If you’re very good at lower middle-market private equity, let’s assume you’re not going to over-raise your next vehicle. There may not be a lot of access to potential LPs that like your success, so there’s an increased willingness to look at newly formed firms. This is exactly the question to be asking right now, because there is a lot of it going on and folks are deciding, “I want to be in the lower middle market. I maybe can’t get enough access or exposure to the managers I’d like to add to my portfolio.”  Where is there access? Oh, this person just left a high-quality platform. They’re hanging out a shingle. Let me go have that conversation. So, this is an increasing trend in the private equity arena and a lot of folks are availing themselves of these different approaches.

Bronner: Andrea brings up a great point. Over the last 12 to 15 months, I’ve heard more of this: “I want a hungry group. I want to make sure I’m not investing in a team that’s not necessarily resting on their laurels, but they’ve been doing this for X number of years and how much longer are they going to do that and at what level? And if I could find a team that is aggressive and with the right pedigree and such, maybe that’s a way to look at it, too?” So, I am seeing more discussions as I talk to investors about that.

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