Fund and Manager Due Diligence
For most LPs, fund portfolios represent exposure to a small fraction of the total universe of funds. Even if we exclude areas of the market which fall outside of regional and strategic preferences, as a proportion of the total universe a typical active LP commits to well under 1% of available funds during any given year.
When narrowing down such a big pool, what proportion of opportunities should an LP and its consultants be reviewing in order to achieve best-practice and fulfill their fiduciary duty?
One LP recently described their fund sourcing activity as a ‘triage’ – incoming opportunities are either rejected outright, placed in a pile to review before moving to a deeper dive, or immediately receive attention due to a pre-existing relationship and knowledge of the fund manager. Re-ups are also a key consideration and are often subject to their own evaluation process. With some major LPs looking to reduce their number of GP relationships, just getting an LP to review a fund is a major challenge for most firms in fundraising mode.
A lot of today’s fund marketing activity is planned around this dynamic. But as we move into an environment where LPs may well be making fewer investments, favoring experienced managers and allocating more capital to re-ups, this will leave the fundraising market in a hyper-competitive state.
In a ‘buyers’ market’ fundraising environment, the onus tends to fall on fund managers to adapt and prepare for a demanding and extended process. But what about LPs? After all, almost all LPs have a fiduciary responsibility to their stakeholders to engage in a best-practice fund sourcing process. As the ratio of available funds to planned commitments gets ever-larger, LPs should consider how their processes must evolve if they are to retain confidence in their ability to select the best funds.
Increasing Capacity – High Level Filtering
This week I demoed Preqin’s new Fund Series Analyzer, a high-level due diligence tool which allows LPs to access market data to analyze metrics such as performance, fundraising history, split of investments by type, LP commitments and more across a GP’s fund series. Nobody is likely to commit on the basis of this analysis alone, but it does help LPs to increase their capacity to conduct high level analysis and filter incoming opportunities more quickly with greater confidence.
PE Stack’s Pricing and Sample Client database shows that 35% of major institutional investors where we track a complete product portfolio are already using Preqin or Pitchbook. Bloomberg, which has the highest penetration of all data and analytics platforms (85%), also offers a private equity module which can accomplish many of the analyses required for high-level filtering. Users of these platforms should ensure that they are maximizing the potential for these tools to add value to fund screening, and any LP evaluating a market data platform should be asking for a demonstration of how the platform can satisfy this specific use case.
Such databases can also provide details of funds in market which an LP may not be aware of that fall within their stated area of focus. As capacity to review increases, more LPs will take a proactive approach to source the best opportunities, with the potential for some institutions to fall behind if they cannot form relationships with the most in-demand managers.
Increasing Capacity – Deep Due Diligence
For deeper due diligence, market data alone is insufficient. LPs and their consultants require access to portfolio level data and financials, plus details for key professionals. The key to increasing capacity here lies with the use of analytics platforms built specifically for LP due diligence. eVestment’s TopQ+ platform is among the best-established tools in the space, with users also benefiting from the wider ecosystem of eVestment market data and analytics. If and when the eVestment and Solovis products integrate more closely, this also opens the door to seamless ‘what-if’ analysis which would allow LPs to view the theoretical impact of a manager’s past funds on their portfolio. I also like Betterfront, which was launched by an ex-investor who was frustrated by the due diligence bottleneck and built a tool to allow deeper analysis across more funds in less time than his old Excel-based process.
The presence of such tools begs the question why LPs can’t simply review all opportunities on this level. On the one hand LPs are busy, investor relations professionals are persistent, and LPs don’t want to get bombarded with follow-ups. Another factor is data ingestion, which inevitably takes time and resource, even if the onus is mostly on the GP to get this right. As due diligence platforms grow and more data is already available on platform, this too can become less of a bottleneck. Cepres’ Digital Data Hub is well positioned here with an existing database of cashflow data at the fund and firm level from 7,000 funds, plus portfolio company level operating data, which can be released to potential LPs.
As tools of this nature and the associated networking effect of LP/GP engagement grows, LPs reliant on Excel alone to conduct due diligence will have to consider if they are still fulfilling their fiduciary duty if the volume of funds they are able to take a deep-dive on represents an ever-smaller proportion of the market.
Collaboration
So far, we’ve focused on data and analytics as the core considerations in widening the bottlenecks, but there is a third factor which is equally important – collaboration and research management. In terms of collaboration, the most forward-looking LPs see this as both an internal and external activity. Lenox Park’s RoundTables platform allows LPs to collaborate and share ideas on their investment management processes and access investment opportunities, increasing users’ confidence that they are engaging in a best-practice process aligned with their forward-looking peers.
For managing internal processes, there has been an explosion of RMS (Research Management System) tools entering the market to help front-office teams effectively manage research, collaboration and the associated document management. By moving toward a focused platform and away from email and generic tools like DropBox, users can gain better insights and more efficiency in managing the pipeline of opportunities. Tools such as MackeyRMS, BipSync, DiligenceVault and Diligend are predominately or entirely devoted to RMS, while the majority of larger suite providers are also investing to improve their RMS functionality.
A Buyers’ Market isn’t Just a Problem for the Sell-Side
The problem of an over-supply of new funds in a congested fundraising market is not just a GP problem; LPs have a fiduciary duty to ensure they are engaging in a best practice fund assessment process. The technology is there to facilitate vastly increased capacity to review funds and make allocation decisions more confidently with better accountability. Committing to new funds is understandably not a priority for many institutions right now, but when the time comes for decisions to be made, LPs must be ready to deal with the challenges which this fundraising market will undoubtedly bring.
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