Structural Set-Up of a Due Diligence Process
The Overall Framework
A solid due diligence framework contains a top-down review as a first step. This review must assess the attractiveness of the various private equity sub-segments and regions. The assessment includes various evaluation criteria, such as investment opportunities in the segment, capital demand and supply, the quality of the fund manager universe, entry and exit prices, and the future development potential of the sub-segments. Furthermore, it is important that the investment strategy of a fund manager is not only attractive on a stand-alone basis, but also within the overall context of the investor’s total portfolio.
Generating a complete overview of the relevant fund manager universe is the second step. Worldwide, there are about 3,000 private equity fund managers to be considered, making the creation of this overview a very demanding task. It is crucial not to assess the managers who provide you with their fund offering passively, but proactively to benchmark all relevant fund managers for a proper peer-group comparison.
The third step of the framework is to ensure that risks related to the potential commitment are mitigated through an in-depth due diligence process. For all identified issues, due diligence steps must be taken in order to clarify the situation. An investment should only be considered if a sufficient level of comfort is achieved on all issues.
Example of a Due Diligence Process
A clear, well-structured due diligence process, which is tailored to the context of the fund manager, with concrete steps and tools, is an important prerequisite for a comprehensive and consistent fund-manager evaluation. Below, we describe a process structure that is the result of continuous improvements over the past 25 years.
The first screening of the fund offering addresses the track record, strategy, team, and fit with the portfolio. This analysis can be performed by junior professionals, but it is important to have an experienced senior professional reviewing the screening and taking the final decision whether to conduct further due diligence. This ensures that the senior has the full picture of the deal flow and the market dynamics.
The prequalification phase starts with a detailed portfolio analysis of all past investments made by the fund manager. Interactions with the fund manager are used to clarify the impact on the value contribution of the manager to past and future investments. Putting these insights into a structured risk–return framework (see next section detailed below), combined with peer-group benchmarking, allows the identification of fund offerings with a promising risk–return potential. It is beneficial broadly to discuss fund offerings within the investment team to identify critical aspects, residual risks, and external referencing possibilities. This knowledge exchange defines questions for the qualification phase.
The qualification phase is divided into four steps:
Dual control: the project worker starts working with an independent devil’s advocate. The goal of this step is to identify all potential weaknesses that could be discovered by a pair of fresh eyes, and to ensure the quality of the process. It also helps specify further tailored action steps that need to be addressed, and to clarify open issues.
The second step is to review the fund manager’s governance structures and processes, with the goal of identifying operational and team dynamic risks.
The third step is the verification of the self-assessment through third-party referencing. Well-prepared reference calls with past and present key people from underlying companies are an extremely helpful resource for verifying your current impression of the fund manager. Reference calls provide the opportunity to check the contribution of the fund manager to the value creation and the investment sourcing. If external referencing confirms the current assessment and does not lead to new questions, the investment opportunity fulfils all three evaluation levels: appealing strategy, return potential, and controlled risk.
The last step is the legal and tax due diligence.
The investment decision and subscription: having a formalized investment approval mechanism, for example through an investment committee, rounds off the due diligence process, which, as a last step, includes the subscription process to the fund.
Thorough monitoring must be put in place once a long-term investment is made. Monitoring is needed to ensure that active measures can be taken where needed, in order to maximize value for the investor. Monitoring is also an integral part of the due diligence for the investment decision regarding the fund manager’s next fund (typically after three to four years). Due diligence represents a deep monitoring effort on prior fund investments.
A clear fund-manager evaluation framework provides consistency among different manager evaluations, and allows for proper benchmarking of managers within a specific peer group. A scoring system that is appropriate for the qualitative and quantitative analyses on a fund manager has proven useful. By constantly applying the system, the scoring becomes well calibrated. Furthermore, it allows for best-practice manager benchmarking across geographies and segments. Due to the qualitative nature of private equity, the focus of the assessment must be on the “ingredients for success” within the future competitive landscape.
In order to enable the ranking of fund managers within a peer group, a quantitative benchmarking that looks at the return and risk aspects helps to put the full due diligence findings into an aggregate picture. We have applied the following framework during the past decade.
|Return assessment criteria||Score||Risk assessment criteria||Score|
||X.XX||Investment strategy risk
||X.XX||Aggregate company financing risk
|Portfolio return considerations
||X.XX||Portfolio return considerations
|Total return score||X.XX||Total return score||X.XX|