Professional Documents
Culture Documents
by Rainer Ender
Executive Summary
• Private equity fund due diligence is the first step in an investment process. The goal of due diligence is
to identify the risk/return profile of a fund offer.
• A well-structured due diligence process contains a top-down macro and a bottom-up manager analysis,
allowing the investor to filter the most promising funds.
• A consistent framework for fund and fund-manager assessment is essential. This assessment must
address quantitative and qualitative aspects, and focus on the manager’s “ingredients for success”.
• At first sight, fund offerings may appear attractive from a pure return perspective. It is crucial that the
investment has an attractive risk/return balance.
Introduction
The term “due diligence” covers a broad range of different due diligence types. These can be grouped
into three major types; financial, legal/tax, and business due diligence. The goal of this article is to shed
light on business due diligence for investing in private equity funds. Due diligence is commonly defined
as “the process of investigation and evaluation, performed by investors, into the details of a potential
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investment, such as an examination of operations and management, the verification of material facts”.
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“It is a requirement for prudent investors and the basis for better investment decisions.” Private equity
fund evaluation faces specific challenges; the private character of the industry makes it inherently difficult
to obtain the relevant information; furthermore, the investment decision reflects a commitment to a fund
manager to finance future investments rather than a straightforward purchase of specific assets. Therefore,
common evaluation techniques used to assess public equity investments are not appropriate within the
private equity asset class.
The private equity market has enjoyed extraordinary growth rates in the past, and private equity investments
showed strong returns, supported by a booming economy and an expanding debt market. The current
financial crisis will have a significant impact on the private equity market; a shake-out of fund managers is
to be expected over the coming years. Managers who can demonstrate how they created value in the past,
beyond just benefiting from favorable market developments, and who are able to make a compelling case for
future value creation will continue to raise capital successfully.
Before investing in a private equity fund, an investor should have sufficient comfort regarding:
• Strategy perspective: the investment strategy of the fund.
• Return perspective: evidence that the manager stands out compared to his/her peer group.
• Risk perspective: assurance that risk is mitigated to the level required by the investor.
The relative youth of the private equity industry, data paucity, as well as benchmarking difficulties within and
across asset classes are just a few elements that indicate why the investor has to rely on qualitative aspects
and judgment during the due diligence process of private equity funds.
Case Study
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Fund Due Diligence for the MCAP Fund
MCAP is a newly formed, European, first-time fund manager launching a €250 million fund specialized in
development capital and small buyout investments in a single industry. The key person for the fund has deep
industry experience. He successfully founded and grew a company operationally superior to more mature,
competitive companies. Subsequently, the company was acquired by an international corporation, where he
then became the CEO. After stepping down, he formed MCAP. Besides him, there are two other partners
who also left their high caliber jobs to launch MCAP. The additional team members previously worked
together in various positions; however, none of them has a track record as an investment professional.
A standard due diligence process focused mainly on the historic performance of the fund would pass on this
fund after the first screening. The risk-return framework has a different approach:
• The industry targeted by the fund is not covered by existing fund managers. The industry appears to be
attractive for backing small, flexible, and dynamic companies with high technological and operational
excellence. MCAP could, therefore, be a promising complementary investment.
• The fund manager’s ingredients for success from a deal-sourcing and value-creation perspective are
in place through the extensive networks of MCAP’s partners, and their in-depth industry expertize. Exit
capability has only been proven in the sale to the international corporation; there is neither a proven
track record, nor an established competitor. Nevertheless, the risk return assessment framework can
be applied to benchmark this new fund against other funds with a single industry focus. Reference calls
are important sources for validating the reputation and the competency of MCP’s team.
• Risk mitigation for the investor is the most challenging aspect of the due diligence in this case. The
management firm is in formation, and the concept is to operate like an industry holding company,
managing five investments with deep operational involvement. It is evident that the fund operation
will be loss-making, and that the partners are pre-financing this initiative substantially. They are well
aligned with the investors in the fund. Close interaction with the manager, and legal terms allowing
intervention by investors, should MCAP drift off course, are prerequisites for reaching the level of
comfort needed to make a fund commitment.
Conclusion
Private equity fund due diligence is a work-intensive undertaking. It requires a clear top-down assessment of
investment segments and geographies that, based on fundamental drivers, appear attractive for investment.
For the bottom-up fund manager evaluation, a proper due diligence process with clear milestones must be
established. This process must be supported by tools that allow a structured assessment of a fund offering,
and ensure comparability of different funds. When working in a broad team, special attention is also needed
to make certain that all professionals apply the same framework, and that evaluations by different people
lead to comparable results.
Finally, it must be emphasized that, while there appear to be many promising investment opportunities, the
most important element for due diligence is to identify the risk behind each opportunity.
More Info
Books:
• Mayer, T., and Mathonet P.-Y. Beyond the J-Curve: Managing a Portfolio of Venture Capital and
Private Equity Funds. Chichester, UK: Wiley, 2005.
• Probitas Partners. The Guide to Private Equity Investment Due Diligence. London: PEI Media, 2005.
Report:
• Kreuter, B., and O. Gottschalg. “Quantitative private equity fund due diligence: Possible selection
criteria and their efficiency.” Paris: HEC, 2006.
Notes
1 Sood, V. “Investment strategies in private equity.” Journal of Private Equity (Summer 2003).
2 Mayer and Mathonet (2005).
3 Fictitious fund example, based on actual cases.