Guide to PE Due Diligence

THE GUIDE TO PRIVATE EQUITY FUND INVESTMENT DUE DILIGENCE

THE GUIDE TO PRIVATE EQUITY FUNDINVESTMENT DUE DILIGENCE

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IntroductionKelly DePonte, Partner, Probitas Partners

Private equity fund manager duediligence and selectionHelen Steers, Partner, Pantheon Ventures Limited

• Introduction• The importance of private equity manager selection• The challenges of private equity manager due diligence• Private equity portfolio construction• The typical due diligence process

Towards a standard private equity due diligencequestionnaireNeil Rue, Principal, Pension Consulting Alliance, Inc.

• Background• A due diligence questionnaire is still essential• Final thoughts

Track records: analysing unrealised returnsPeter Martenson, Former Director, Pacific Corporate Group LLC and

Chris Hanrahan, Principal, Key Capital Corporation

• Introduction• Understand the GP’s original investment thesis• Evaluate the GP’s value creation• Understand valuation comparables• Financial model of the portfolio• Some final steps• Conclusion

Emerging managers: how to analysea first time fundKelly DePonte, Partner, Probitas Partners

• Key points in the analysis of emerging managers• Summary

Due diligence in emerging private equity marketsErnest J.F. Lambers, AlpInvest Partners N.V.

• Introduction• Investing in developing markets• Key elements in the selection of private equity managers• Past performance• Strategy• Team• Terms and governance• Concluding remarks

Mezzanine funds: risk, return and the equity mixDr. Matthias Unser, VCM Venture Capital Management GmbH

• Overview of the mezzanine market• Different strategies of mezzanine funds• Risk and return of mezzanine investments• Due diligence on mezzanine fund managers• Conclusion and outlook

Contents

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Legal due diligence: a Q&A sessionBenjamin Aller, Partner, SJ Berwin, Craig Dauchy, Partner, Cooley

Godward LLP, Robin Painter, Partner, Proskauer Rose LLP, Duncan

Woollard, Assistant Solicitor, SJ Berwin

• The panel• Contributor biographies

Benchmarking and performance measurementMark Weisdorf, Mark Weisdorf Associates Ltd.

and Janet Rabovsky, Watson Wyatt & Company

• Private equity – the redux• Having the right mindset• Short-term performance measures: qualitative assess-

ment of performance• Longer term measures: quantitative performance meas-

urement and benchmarks• No one measure or benchmark is sufficient• The requirement for a balanced scorecard

Co-investment due diligenceGuido van Drunen, Kenneth Van Heel and David Julier,

The Dow Employees’ Pension Plan

• Introduction• Why establish a co-investment program?• Issues to consider when developing a co-investment

strategy• Due diligence• Conclusion

SURVEY

Due diligence and the Limited PartnerPrivate Equity International

• Introduction• Scope of investment activity• Most important factors in due diligence

• Terms and conditions• GP and portfolio company visits• Use of questionnaires• Analysing track record• Due diligence on first time funds• Sponsored funds

DIRECTORY OF INVESTMENTADVISORS AND CONSULTANTS

CONTRIBUTOR BIOGRAPHIES

APPENDIXES

Appendix One: Private Equity Investors Association Recommended Due Diligence

Questionnaire

Appendix Two: Pension Consulting Alliance, Inc. Due Diligence Questionnaire

Appendix Three: Private Equity International on fund investment due diligence

Appendix Four: Private Equity Manager on fund investment due diligence

Appendix Five: About Private Equity International

Appendix Six: About Private Equity International Research Publications

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and the organisation and ensure that there are no obvious ‘deal-breakers’. If the investor is satisfied that the fund meets its pre-liminary criteria, full due diligence begins.

People frequently ask how long a ‘typical’ fund due diligenceprocess takes. Unfortunately the answer is that the length of thedue diligence phase varies wildly, since it depends upon the com-plexity of the fund, its geographic remit, the size of the manag-er’s organisation and the availability and quality of the informa-tion supplied by the manager. In addition, investors have vary-ing levels of sophistication and knowledge, and often focus moreon certain elements of the process than on others. In general,investors have to evaluate a basket of both quantitative and qual-

itative factors, which can be grouped together under the follow-ing areas and assessed using the techniques described below.

People:Assessment of the manager’s team, organisation, individuals’ experi-ence, remuneration structure• Multiple face-to-face meetings, including visits to the fund

manager’s offices.• Interviews with investment professionals, alone, and in

groups, formally and informally.• Organisational, ownership and remuneration analysis.• Detailed reference checks with portfolio company manage-

ment, other private equity professionals, bankers, account-ants, lawyers, investors, and previous colleagues.

Process:Assessment of the manager’s deal sourcing, due diligence, monitor-ing and exit process• Complete portfolio review.• Assessment of the manager’s previous due diligence work,

including checks on portfolio company files and monitoringsystems.

• Interviews with portfolio company managers.

Philosophy and investment strategy:Assessment of the consistency and suitability of the manager’sstrategy, and its execution• Understanding of the market within which the fund manag-

er operates.• Comparison of strategy and positioning with private equity

managers targeting the same or similar markets (whether ornot they are currently in the market with a new fund).

• Analysis of trends in previous portfolios of the fund manag-er to test for ‘strategy drift’ (departure from a stated strategy).

• Evaluation of the manager’s ability to carry out the fund’sstated strategy.

Performance:Assessment of the manager’s track record, areas of value-add andrepeatability

Chart Three: Private Equity Fund Investment Decision-Making Flow Chart

Private Equity FundsAvailable in the Market

IndustryRelationshps

Research

Deal Sourcing

PreliminaryAnalysis

Due Diligence

InvestmentCommittee Approval

Negotiation andLegal Review

Commitment

Intermediaries

Does NotFit Criteria

Monitor andOversight

Exit and DistributionManagement

Fund Relationship

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both where the company is in reference to initial expectationsand also the GP’s projected exit method, exit valuation and pro-jected timing. This provides a relatively unbiased assessment ofwhether the portfolio company is tracking on the originalunderwriting projections proposed by the GP. Incidentally, thisdata also should provide additional guidance regarding theappropriateness of the current carrying value.

A prospective LP should attempt to place himself in the shoes ofthe GP in order to evaluate whether, at a macro level, the port-folio company presented a compelling investment opportunity.Investors should consider the characteristics of the businessmodel that make the company an attractive investment, such asbarriers to entry (e.g. brand/switching costs/scale economies)and potential substitutes, the nature and degree of competitionin the company’s markets and the company’s respective posi-tioning, the power of suppliers and buyers (e.g. the Wal*Martfactor) and the strength of the management team (includingwhether the management team is comprised of repeat, success-ful entrepreneurs). Additional considerations in the case of anLBO investment should include, among other factors: the com-pany’s ability to generate steady free cashflow; low capital expen-diture requirements; financeability; consistent operating mar-gins; and relative cyclicality. When evaluating a venture invest-ment, one should additionally assess the market opportunityand whether competing VCs have financed companies in a sim-ilar space.

The following questions illustrate the types of considerationsthat can facilitate an investor’s analysis of the initial investmentthesis. Did the GP expect to grow the company organically, byacquisition, or a combination of both? If the GP projected topline (revenue) growth for the company, how realistic were theseprojections? What are the operating margins of comparablecompanies? If the leading company in the industry boasts oper-ating margins of 30%, is it reasonable to expect the GP toachieve margins in excess of that benchmark? How did the GPplan to finance the company’s growth, and was the companycapitalised in a manner appropriate to the thesis? Several of theseissues are discussed in more depth in ‘Evaluate the portfolio

company ‘value added’ of the GP’ below.

Finally, in considering the GP’s original investment thesis, oneshould remain cognisant of macroeconomic trends and cyclesand how they, in turn, impact the IPO and merger and acquisi-tion markets. These macro trends can dramatically affect com-pany performance, exit valuations, and exit timing. In fact, thereis such a high degree of correlation with macroeconomic trendsthat a rule of thumb has arisen, which states that ‘on average,recession vintage years outperform for buyout funds, while non-recession vintage years outperform for venture capital funds’.

Evaluate the GP’s value creation

An outgrowth of understanding the GP’s initial investment the-sis is discerning how the GP has added value since investment.Of course the type of value creation that is most importantvaries by the type of portfolio company investment and by theGP’s original investment thesis. In general, investors need toascertain the source(s) of value creation for a particular invest-ment opportunity: operational improvements (leading toincreased growth, profitability or both), debt paydown, and/ormultiple expansion. However, some basic areas to focus oninclude the following:

• Increase/decrease of revenue and EBITDA• improvement/deterioration of margins

• Increase/decrease in debt• prudent/imprudent leverage

• Management team changes• anticipated/un-planned management changes

• Strategic direction• planned/unplanned changes in strategy such as

expanding/contracting product lines, customers;marketing, etc.

• prudent development milestones

VC focus

Venture-backed companies carry some unique considerations relevant to

assessing the original investment thesis. First, one must assess the pre- and

post-money valuation at which the GP made the investment. One can,

through Venture Economics or other databases, assess the reasonableness of

that valuation relative to its peers. When a security software company is

financed at a $50 million post-money valuation at its ‘A’ round and is pre-

product and pre-revenue, the robustness of the valuation may inhibit

prospects for future out-performance because most venture realisations and

exits average between $70 and $100 million while loss ratios of 50% are not

uncommon.

Second, one should also assess the cash burn rate and anticipated future

cash needs of the company as well as the strength of its investing syndi-

cate. This is necessary to assess future financing risk for the company and

may provide insight as to the probability of an imminent writedown or

writeoff. If a company has three months of cash left, has sought follow-on

financing for a year, and has consistently missed its investment mile-

stones, its prospects of attracting follow-on financing are limited – cer-

tainly at its current valuation.

Third, one must assess the status of the market that the start-up is tar-

geting – whether it develops as expected, or more slowly than expected,

will impact the company’s financing needs, runway, willingness of VCs to

continue funding, size of the company and its ultimate success. Consider

whether the market is crowded or out-of-favour in the context of a com-

pany’s probable exit timing. If the company is maturing, the robustness of

the exit environment via M&A and/or IPO for companies in its space is crit-

ical.

Fourth and more generally, one needs to assess whether the company is

hitting its milestones in product development, sales, management team

build out, etc., as a failure to achieve these on plan will impact future val-

uations. Likewise, one should note whether the company has been able to

attract strategic investment because the presence of strategic money may

provide insight into the relative attractiveness of the market and com-

mercialisation potential.

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agers who have a demonstrated history of success as private equi-ty investors. For fund managers, having individuals with signifi-cant attributable private equity track records as part of the team iscrucial. Of course, a group that has a combination of private equi-ty, operational, technical and investment banking skills is attrac-tive, but the lack of a successful private equity track record –including realisations – makes an emerging manager much lesscredible.

Even with some sort of track record in place, the most difficultissue to diligence is the team dynamic and its impact on stability.For true first-time funds – where the team is coming together forthe first time – this is especially key. Any fund of institutional size– roughly larger than $100 million or €100 million – is difficultto manage with a single person. A team of three or more seniorinvestors is usually preferred. If the team does not work welltogether – if it in fact is not a cohesive team – it can fracture andput the fund and investors at risk.

Evaluating the team dynamic and potential team stability is an artrather than a science. It requires the experience of having per-formed due diligence on a large number of managers in the past.Key process items and areas of focus include:

• Group and individual interviewsThere is no substitute for meeting with the team exten-sively in order to develop a feeling for how well they willwork together. How they interact with each other whilebeing questioned on their investment strategy, theirinvestment process and their personal relationships is akey check on how well they have considered these issuesinternally before starting the fund marketing process.Importantly, time needs to be spent both in group meet-ings and on a one-on-one basis with senior team mem-bers. Group sessions are important not only for what issaid but also for body language – how they react to whatthe other is saying. This is important to help determinewhether they agree on important issues, respect oneanother, and like one another – all important factors inweathering difficult times. One-on-one sessions are also

key in determining whether they still espouse the basictenets of the team when they are not presenting as part ofthe group and that the corporate culture of the team istruly engrained in its senior members.

• Previous working relationships within the teamBesides interviews, of course, a review of previous work-ing relationships amongst the team members is impor-tant. If the team is assembling for the first time, it isimportant to determine if they’ve worked together before– either on individual transactions while at other firms oreven in other businesses before becoming involved in pri-vate equity. Personal social ties can also be important,though it must be noted that the tenor of those relation-ships is likely to be different from that in a high-pressureworking environment. Last, it needs to be noted that evenfor team spinouts, drilling down in this area is important,especially if only a part of a group of investment profes-sionals has left another organisation to form an emergingmanager. Teams are not just collections of individuals, butrather a social grouping whose members play various rolesdynamically interacting with other members of the group.When a subset of a group breaks off, the team dynamiccan change dramatically – sometimes for better, some-times for worse.

• Internal firm economicsThe internal division of carried interest and ownershipshares of the fund management company are alwaysimportant in determining team stability, whether with anestablished or an emerging manager. A large disparity inthe distribution of carry amongst senior investment pro-fessionals often leads to dissension and turnover – and thestructure of most private equity funds is not usuallygeared toward a single individual dominating the invest-ment and company oversight process in a diverse portfo-lio of investments. Ownership positions in the manage-ment company not only drive certain economics, but alsoaffect the ability of individuals to share in the direction ofthe firm, helping to build commitment to the team.

Emerging managers: a definition

There is no one definition of an emerging manager. Different investors

apply different criteria. However, the four classifications below broadly

cover the sector:

• First time fund, first time investors

In this case, a group of professionals looks to form an investment vehi-

cle with a senior team that does not include a single individual with

significant private equity experience. Fundraising for these groups is

often very difficult; and often these groups actually fail to raise a fund.

• First time fund, experienced investor team

In this case, a group of professionals who individually have extensive

private equity experience, but have limited experience working togeth-

er, form a fund. Groups like this would include the first funds of Fox

Paine and Shasta Ventures.

• Team spinouts

In this instance, a team of professionals who have worked together

within a fund manager decide to spin out and form a separate firm.

Examples include: Triton Partners spinning out from Doughty Hanson;

Alta Partners, Alta Communications and Polaris all spinning out of Burr,

Egan, Deleage; the recent creation of Diamond Castle by senior profes-

sionals from DLJ Merchant Banking; and the founding of Exponent by

senior team members from 3i.

• First institutional fund

Since the process of raising a first time fund is very difficult, many fund

managers start the process differently – by raising money on a deal-by-

deal basis or creating a fund with significant support from government

programs (such as the SBIC program in the US) or financial institution

sponsors. These groups then approach the broader institutional market

with a follow-on fund, but have at that point had a chance to prove

their investment ability, their access to quality deal flow, and their

strength as a cohesive team. Fund managers who started in this man-

ner include Littlejohn & Company, W Capital and KRG.

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accord and have already started to triage their portfolios. Thishas limited the availability of senior debt and boosted demandfor mezzanine.

Going forward the picture for independent mezzanine fundswith a focus on small and medium sized companies is a goodone, even if activity levels amongst the banks picks up. Sponsorsoften favour independents over banks for supplying mezzaninefor a number of reasons. If a bank holds both senior and mezza-nine debt on its balance sheet it will usually favour the senior ifsomething goes wrong. Companies and sponsors therefore seebanks as less flexible than independent mezzanine players andwithout the same interest in maintaining equity value. In awind-down situation, a bank would rather liquidate the assets

instead of viewing the company as a going concern.

Market dynamics are quite different, however, for large trans-actions. This end of the market has seen unforeseen inflows ofcapital from structured vehicles, hedge funds and other insti-tutional investors recently. With pricing for mezzanine undersevere pressure, it is very hard for independent mezzaninefunds to maintain their previous position at the forefront oftransactions.

Different strategies of mezzanine funds

There are six dimensions along which mezzanine fund managerscan define their strategies:

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Chart Three: Different strategic profiles in the US and Europe

Strategies in the Market

Europe

US

Strategic Choices

• Equity orientation

• Background of transaction

• Size of investee companies

• Degree of independence

• Industry focus

• Fund structure

• Geographical focus

with warrants1 sponsored2

large caps3

diversified5 independent4

leveraged6

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One of the most important strategic choices of a mezzaninefund manager is the one between sponsored and non-sponsoredtransactions. While there are still many funds that follow bothroutes, it seems that fund managers are increasingly focusing onone or the other strategy as the market matures. Consequently,in Europe most fund managers still tend to do both sponsoredand non-sponsored transactions, while in the US many fundmanagers started with the same approach a couple of years agobut now focus on one of these two strategies.

Chart Six illustrates that, while they carry higher risk, non-spon-sored transactions deliver higher returns. Not only are the lossrates for non-sponsored transactions higher than those for spon-sored transactions (8.9 per cent vs. 7.3 per cent) but also theequity cushion is lower (28.3 per cent for non-sponsored deals

vs. 34.1 per cent for sponsored deals). Finally, the higher riskalso stems from a higher percentage of invested capital that isinvested in common or preferred stock (17.4 per cent for non-sponsored vs. 5.3 per cent for sponsored deals).

What is the effect of being a captive fund on the risk and returnof mezzanine transactions? Does getting the first look at a dealreally produce higher returns? We distinguish between inde-pendent funds and funds that are affiliates of either a privateequity firm or a bank or an insurance company. The resultsshown in Chart Seven are somewhat mixed. While independentfunds achieve higher gross IRRs than captive funds their multi-ple is lower. The explanation for this embarrassing result is thatcaptive funds invest a higher percentage in the equity (whichtypically is paid back only after several years with no current

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Chart Seven: Captive vs. independent funds

PE captive

independent 18.7%

70.7%

Distribution of deals in CEPRES

Gross IRR

18.1%

14.1%15%

20%

Multiple

1.37

1.45

1.4

1.5

1.3

1.6

Loss rate

7.2%

8.5%

6%

9%

7%

8%

10.8%

bank/insurance captive

16.1%1.44

7.0%


shift strategy and enter a market segment where it expectsmore favourable competitive conditions, the fund managermust be in a position to execute this new strategy success-fully. For example, a mezzanine manager that focussed onsponsored deals in the past and now wants to do more non-sponsored deals needs access to new sources of deal flow.This requires that a new network of deal sources has to bebuilt, as the manager can no longer rely on equity sponsorsand banks as providers of attractive deals.

• Quality of deal flowMezzanine funds generally compete not on the basis ofprice, but on the basis of relationships and the flexibility andreliability they can offer. Therefore, it is important to haveestablished relationships with equity sponsors, banks and

financial intermediaries. Proprietary deal flow is relevant toavoid auctions in which pricing is highly competitive.

Management team• Quality of team

For a mezzanine investor it is important to have both a cred-itor’s and an equity holder’s perspective on transactions.While the economic, financial and legal risks associated withleverage are of primary importance, there is also an interestin the upside potential of the company that has to be accu-rately assessed. Especially important is that the team mem-bers have worked in a relevant space. For example, for a mid-market mezzanine fund it is vital to have bankers that wereactive in mid-market lending, leveraged finance or M&A.For a non-sponsored fund a background in private equity is

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Chart Ten: Proprietary rating system

ExpectedReturnRating

Expected RiskRating

Fund BFund A

Fund C

Fund D

A

B

C

D

A B C D

Category Return factors

Ø Deal flow sourcesØ Due diligenceØ CovenantsØ Monitoring and risk

managementØ Proportion of recapsØ Investor structure

Ø LeadershipØ ConsistencyØ Quality of

deal flow

InvestmentStrategy

Risk factors

Ø ContinuityØ Carry splitØ Performance

attributionØ Team structure and

succession plans

Ø Standard deviationØ Loss rateØ Contractual returnsØ LeverageØ Equity risk

Manage-ment Team

Ø Team qualityØ CommitmentØ Value added

TrackRecord

Ø IRRØ Multiple


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best determine how to measure it’s performance. This is espe-cially true during the early years, when the J-curve seems to gen-erate a drag on returns – the short-term price for a longer-termilliquidity premium. As we will demonstrate, fiduciaries (boards,trustees, CIOs and portfolio managers alike) can be comfortablewith the challenges associated with measuring the performanceof a private equity portfolio, particularly in the early years, if per-formance is measured within the proper context.

Having the right mindset

Private equity funds tend to involve commitments of up to 10-12 years (and up to as much as 15 years for funds of funds). Suchfunds typically provide the investment manager (known as thegeneral partner or GP) five to six years to find attractive invest-ments (in private companies) in which to deploy the capital, andanother five to six years to add value to portfolio companies soas to maximise their exit value. The result is that private equityfunds have a typical weighted average life of between 7 and 8years. For pension plans, endowments and foundations, thelong-term nature of private equity investment is often a closermatch to the duration of their liabilities and obligations thanmost other asset classes.

Success in private equity is dependent on internal portfolio man-agers, private equity fund of funds, consultants, ‘gatekeepers’ oradvisors (collectively known as limited partners or LPs) selectingexternal managers (GPs) who can deliver superior returns. Giventhe wide dispersion of possible returns, and long investmenttime horizon, fiduciaries require a robust and extensive due dili-gence, assessment and selection process. Industry data illustratesthat median returns for private equity funds, after costs, over tenyear periods, are often below that of investing in public equityindices. Other studies have noted that top quartile managershave continued to deliver top quartile returns – in other words,there is a persistency of success.2

Since cash return to investors over the 10 to 15 years of a fund’s

life is the only true measure of the GP’s performance, quantita-tive measures during the first five years, and arguably prior to theseventh or eighth year of a fund’s life, can be challenging.

Of course, fiduciaries have a responsibility to monitor invest-ment performance and oversee managers in the short term aswell as the long term, and portfolio managers must have somebasis for deciding whether to invest in a GP’s subsequent privateequity fund prior to the maturity of the current vehicle.Therefore, appropriate measurement tools need to be deter-mined and utilised over both the short and longer term.

Short-term performance measures: qualitativeassessment of performance

During the first five years of a private equity program, prior tomaterial cash returns from exits and subsequent distributions,performance of the portfolio, individual GPs and investmentteams must by necessity involve more qualitative assessment.The following outlines a number of criteria that can be moni-tored and included in an assessment of interim performance.

Investment thesis• Is the GP disciplined in staying within the original invest-

ment thesis and strategy, to the extent it remains relevant,and within the fund’s area of competence or competitiveadvantage (e.g. geographic, sectoral)?

• How informative and timely is the manager in communi-cating to investors with respect to the investment environ-ment, emerging themes, and planned adjustments to strate-gy and tactics?

• Are the tactics employed by the GP responsive to changes inthe economic and capital market environment, and givencompetitive and other dynamics in the industries in whichthe fund invests?

Pace of investment• What percentage of total capital committed to the fund has

2Steve Kaplan and Antoinette Schoar, ‘Private Equity Performance: Returns, Persistence and Capital Flows’ University of Chicago Graduate School of Business, June 11, 2003.

What are you trying to measure?

An important consideration prior to determining which performance

measures should be utilised is what exactly is one trying to measure?

Possibilities include:

• The performance of the private equity portfolio relative to one or

more of:

• a targeted or required rate of return (nominal, real or risk-adjusted)

• public equity

• the universe of private equity funds

• the private equity portfolios of peer groups

• The performance of the GP relative to its stated investment thesis and

objectives.

• The performance of the GP relative to its peer group (e.g. leveraged

buyouts, venture capital, mezzanine debt, etc.).

• The performance of underlying portfolio companies.

• The skill of the investment team in selecting superior funds and GPs.

• The skill of the investment team in deciding to overweight or under-

weight certain styles, geographies, and strategies at various times

during economic and capital market cycles.

All of the above are useful things to measure and it is for fiduciaries to

determine their relative importance and priority. Clarity with respect to

what different measures of performance actually measure is also helpful

in performing attribution analysis, i.e. assessing the various components

of performance, outperformance and underperformance.

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trying to answer are whether or not the technology, product orservice does what it is purported to do, and if not, why; andwhat will drive adoption of the product or service? In establishedcompanies, it is important to understand the market and com-petitive conditions driving the company’s revenue and marginprojections, and to identify risks associated with the operatingplan. This may be a section of the due diligence process wherean institution is more reliant on the GP, third-party consultantor industry expert. However, with some guidance, an institutionshould be able to clarify the company’s value proposition anddetermine if its success is predicated on factors outside of thecontrol of the company, such as the creation or development ofanother technology or market, or the establishment of analliance with a complementary company.

Financials: records and projections

Once the product/service and value of a company have beenjudged, those managing an institution’s co-investment programwill want to review the financial records and management pro-jections of the portfolio company in an attempt to assess its fis-cal health and the feasibility of achieving the value creation. Theonly thing we are sure about is that financial projections arerarely correct and often optimistic or inflated. Although GPswill typically have a company’s financial statements audited by athird party, the institution must review and understand thefinancial statements of the company. This review will help theinstitution ascertain if company management is fiscally respon-sible and focused on the value-creating milestones and operatingplan. One will also want to stress-test the financials of the pro-jected operating plan. This would allow the institution to deter-mine if the company would have the capacity to remain eco-nomically viable given an extended downside scenario, and thekey sensitivities driving success.

When reviewing a company’s financial statements, special atten-tion should be paid to historical and forecasted revenues. Thosemanaging the co-investment program should have a goodunderstanding of how the company’s management impartsinformation regarding revenue and how that translates into the

overall quality of those revenues. One must also be cognisant ofthe potential and propensity for a company’s managementand/or the sellers to use unrealistic revenue projections. It is pru-dent for a co-investment manager to discount these projectionsconsidering expected market conditions and management’s trackrecord of meeting stated revenue targets. Customer referencecalls can be helpful in verifying future revenue ranges, thougheven these data points must be considered in context.

Another financial issue that an institution must consider is howmuch capital has already been injected into the company andhow much is expected to be raised. This issue is especiallyimportant when considering management’s use of capital andtheir ability to meet business objectives. An institution maywant to avoid companies that have consumed financial resourcesin excess of comparable companies at similar stages of growth.

Within the realm of conducting due diligence on the financialsof a proposed investment, particularly in non control co-invest-ments, it is important for an institution to evaluate the compa-ny’s capitalisation (CAP) table and determine the company’sownership structure on a fully-diluted basis. This will provideinsight as to the investor base that has effective control over thecompany and its direction. In order to ensure alignment ofinterest, an institution should also carefully consider the man-agement and employee ownership and option pool (containedwithin the CAP table). The appropriateness of issued optionswill be dependent on several factors, including the stage andtype of company, quality of management, and management’sability to achieve business objectives. A typical allocation formanagement and employees is 10-20% depending on the stageof the company, not including founder’s shares. In certain typesof transactions, investors may also require that managementinvest or maintain a certain level of ownership in the company.

Market and industry

Most likely prepared in parallel to the assessment of a company’svalue proposition and revenue projections, the managers of theco-investment program should conduct a study of the industry

"Show me the money!"

Cuba Gooding, Jr.

in ‘Jerry McGuire’

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levels of interest from limited partners. Mid-market funds areseen by investors to have a number of advantages over large buy-out funds. Crucially, the mid-market is seen by many to be lessefficient than the large buyout market. A comparative lack ofauctioned deals not only means that prices are often lower, butalso gives GPs managing mid-cap vehicles a better chance ofsecuring proprietary deal flow. As such, they are seen to offerbetter returns prospects.

While many of these arguments are valid, one can questionwhether investors’ faith in the mid-market sector is misplaced.The ‘mid-market’ is an increasingly crowded space, with seem-ingly every other GP keen to ensure it is seen as a mid-marketplayer. It is also becoming a much more efficient segment of theprivate equity market, with deals increasingly conducted byinvestment banks and other advisors via auctions. As such, theidea of ‘proprietary deal flow’ may be something of a myth. Thisis particularly the case in mature markets like the US and UnitedKingdom, which have heavily competitive markets where auc-tions are commonplace. In such an environment pricing pres-sures may be as acute as in the larger buyout segment of the mar-ket. And of course, if every institutional investor is keen to investin the mid-market, it stands to reason that not all can get intothe top-performing funds.

Less than 80% of respondents indicated that they invest in largebuyout funds. It is likely that this lower percentage reflects con-cerns over whether such vehicles can be amongst the best per-formers in the industry, given the sheer size of the transactionsthey are undertaking and the fact they are operating in a highlycompetitive, structured and auction- and process-driven seg-ment of the market. It may also reflect concerns over fee sizes,both management and transactional. Finally, the sheer size ofsuch vehicles means access can become an issue for someinvestors, as a result of minimum commitment levels beingpegged too high for them to reach.

Unsurprisingly, it is North America where the largest proportionof limited partners are making fund commitments, with 96% ofrespondents stating that they invest in North American vehicles

(see Chart Five). Almost 85% of limited partners are also invest-ing in Western European funds, with the same proportion alsobacking UK vehicles. This is a strong indication that WesternEuropean markets on the Continent have reached a substantiallevel of maturity.

Other markets see less activity, with the most substantial beingthe Asia Pacific region. Fully half of all respondents state theyhave appetite for Asian Pacific private equity and venture capi-tal funds, a reflection of the current strong interest in this partof the world. Many private equity houses view Japan and Chinain particular as interesting opportunities and this is clearlytranslating into LP interest in backing funds investing in theregion. And interest will certainly have been boosted by thehuge returns made by the Ripplewood-led syndicate from thelisting of Japanese bank Shinsei, a transaction that has beendescribed as amongst the most lucrative private equity deals ofall time.

55% of limited partners report that they purchase fund interestson the secondary market (see Chart Six), while 47% indicatethat they undertake direct investment in unquoted companies,either directly themselves or as co-investments alongside investeefunds.

The fact that more than half of investors are actively purchasinginterests on the secondaries market (and presumably also sellinginterests as well) is a strong indicator of how much the institu-tional market has matured in recent years. Interest in secondaryfunds managed by the likes of Landmark Partners, CollerCapital and Greenpark Capital has been extremely strong inrecent years. Furthermore, investors are now beginning to usethe secondary markets to actively manage their private equityportfolios, focusing the number of GP relationships they haveon a smaller number of better-performing managers and gainingexposure to earlier year vintage funds managed by such groups.This shows a level of understanding, sophistication and experi-ence of private equity that one would not have expected fromsuch a large proportion of the limited partner community but afew short years ago.

Chart Four: Types of private equity and

venture capital funds invested in

0

10

20

30

40

50

60

70

80

90

100

Mid

-Mark

et Buy

out

Seed

/Ear

ly St

age V

entu

reGro

wthCap

ital

Later

stag

e Ven

ture

Capita

lLa

rge B

uyou

tSe

cond

aries

Dist

ressed

Deb

tM

ezza

nine

Fund

of F

unds

Real E

state

Infra

struc

ture

Oth

er

% o

fRes

pond

ents

Chart Five: Geographical regions invested in

0 20 40 60 80 100

Other Emerging Markets

Latin America

Central & Eastern Europe

Israel

Asia Pacific

Western Europe (excl. UK)

United Kingdom

North America

% of Respondents

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is generated. Investors may also be prepared to give way on termsif the GP in question is top tier. The most well established andbest-performing managers are usually able to extract morefavourable terms, due to their historical performance and thestrong demand for their vehicles. A first time or emerging man-ager, by contrast, would likely find investors much more robustwhen it comes to negotiating terms.

Terms must also be considered in aggregate rather than individ-ually. As an example, an investor may be willing to agree to thenon-existence of a keyman clause if the partnership agreementcontains a robust no-fault divorce provision. At the end of theday, if an investor declines to commit to a fund due to terms, itis usually because of the terms and conditions of the vehicle as awhole, rather than because of any one clause.

Nonetheless, some areas of the partnership agreement are givenmore weight by investors and are often the subject of intense nego-tiation between GP and LPs. And for some investors, certain termswill be sacrosanct, with either their absence (or presence in somecases), or the fact that they are not structured to the investor’s lik-ing, enough to cause the institution to walk away. Three areas inparticular can be seen as ‘deal breakers’: the lack of a clawback; thelack of keyman clauses; and the absence of a GP contribution to thefund (see Chart Ten). The following were also offered by investorsas potentially deal-breaking issues in addition to those illustrated inChart Ten: excessive transaction fee retention (one respondent indi-cated it had declined to invest in a fund due to this issue); excessivemanagement fees; a failure to net transaction fee income off againstmanagement fee; ‘cherry picking’, or special treatment to particularLPs; transfer provisions; and overly restrictive FOIA-related terms,such that confidentiality clauses in the partnership agreement areoverly binding. The latter is especially an issue for US public pen-sion plan sponsors and possibly also for their counterparts across theAtlantic, now that the UK has its own Freedom of Information leg-islation (although it seems the effect of such legislation may be lesspronounced in the UK than in the US).

The main issue for investors seems to be the GP contribution,with more than 80% of respondents stating that a lack of same

could be a deal breaker. Investors are keen that GPs put ‘skin inthe game’ by committing their own capital to the funds they areseeking to raise. Low GP contribution levels are increasinglybeing seen as an important screening issue for investors. As wellas serving to further align the interests of the management teamat the GP with that of LPs, it is also an indication of confidenceon the part of the GP as to its strategy and performance expec-tations. Most if not all investors would be extremely reluctant tocommit to a vehicle if the GP wasn’t prepared to ‘put its moneywhere its mouth is’ and risk its own capital. Furthermore, suchcommitment should be meaningful given the circumstances ofthe GP group in question. While 1% to 2% is often seen as a‘market standard’ for GP contribution levels, this amount mightbe excessive for a newly formed group raising its first fund. Bycontrast, for the executives at a GP on their fifth or sixth fundthat have already made substantial sums from previous vehicles,such a figure might not represent much of a burden in terms oftheir personal net wealth.

GP and portfolio company visits

Limited partners clearly see substantial value in visiting the GPswith which they are considering investing. Over 70% ofrespondents always visit the offices of GPs as part of their duediligence process. A further 20% often undertake such visits. Amere 8% and 1% respectively only rarely visit or never visit (seeChart Eleven).

By visiting the office(s) of a GP, investors get to see the manag-er in its natural environment (as it were), allowing them to get agreater handle on how the GP interacts as a team; what theworking dynamics are like and so on. In particular, it offers LPsa chance to meet with and interview junior members of the GP’steam, an important consideration given the fact such individu-als will rarely be part of a pitch given by the GP. Many investorsput such store in the value of visiting with a GP at it’s office thatthey make multiple visits and/or endeavour to visit all the officesthe manager maintains. Clearly there is no substitute for press-ing the flesh and, for many investors in private equity funds, novisit means no investment.

Chart Ten: Deal breaking terms and conditions

0 10 20 30 40 50 60 70 80 90

No Hurdle

No No-Fault Divorce Provisions

Not SharingTransaction Fee Income

Deal-By-DealCarried Interest

No Claw Back Provision

No Keyman Provisions

No GP Contributionto the fund

% of Respondents

Chart Eleven: Do you visit the offices of GPs

as part of your due diligence process?

Always Visit 71%

Rarely Visit 8%

Often Visit 20%

Never Visit 1%

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Bear Stearns Asset Management, Inc.

Address: Private Equity Division, 383 Madison Avenue, New York, NY 10179, United States of AmericaPhone: +1 212 272 9062Fax:Other office locations:Website: www.bearstearns.comEmail:

Callan Associates Inc.

Address: 101 California Street, Suite 3500, San Francisco, CA 94111, United States of AmericaPhone: +1 415 974 5060Fax: +1 415 512 0524Other office locations: Atlanta, Chicago, Denver, New JerseyWebsite: www.callan.comEmail: [email protected]

CAM Private Equity Consulting & Verwaltungs GmbH

Address: Zeppelinstr. 4-8, Cologne, D-50667, GermanyPhone: +49 22 1937 0850Fax: +49 22 1937 085 19Other office locations:Website: www.cam-pe.comEmail:

Cambridge Associates LLC

Address: 100 Summer Street, Boston, MA 02110-2112, United States of AmericaPhone: +1 617 457 7500 Fax: +1 617 457 7501Other office locations: London, Menlo Park, Singapore, Washington DCWebsite: www.cambridgeassociates.comEmail:

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Private Equity Investors Association (PEIA) was formed in 2002in order to promote the interests of institutional investors in pri-vate equity partnerships. It aims to achieve this by providing (1)a focal point for raising standards and promoting best practice,(2) a forum for communicating both nationally and interna-tionally with general partners and other interested bodies, and(3) a means for exchanging knowledge, information and experi-ence. Members are drawn from the world of investors in privateequity and represent pension funds, charities, family offices andinsurance companies. At present, the Association can claim torepresent many of the leading independent private equityinvestors in the UK.

As part of its programme to promote best practice, the PEIAformed a working party to develop a standardised questionnairefor limited partners to use in their due diligence process. It ishoped that it will be adopted by both limited and general part-ners and thereby improve the quality and quantity of the infor-mation presented in due diligence memoranda. It is recognisedthat the questionnaire does not cover all the needs of all limitedpartners and that some limited partners will request additionalinformation.

Please note that the PEIA recognises that this is the first publi-cation of this questionnaire and is subject to change. If anyinterested parties have suggestions or recommendations thenthese will be carefully considered by the PEIA and may be incor-porated in later versions. Any such comments should be made toRobert Baird, a director of the PEIA. He can be contacted on+44 (0) 1689 826837 or by e-mail at:[email protected].

PART I - Initial Due Diligence Material

1. General Fund Information

a. Full legal name and address of Fund.

b. Legal and tax structure of Fund (diagram if available).

c. Jurisdiction of Fund.

d. Full legal name and address of General Partner/Manager.

e. Primary Fund contact person and contact details (phone, faxand e-mail).

f. Brief overview of history of organization including informa-tion on when and how founded, funds under managementcurrently and an overview of all investing activities carriedout by the firm.

2. Placement Agents

a. Name all placement agents and advisors, including contactnames, addresses, e-mail addresses, telephone and fax numbers.

b. Describe the placement agreements, including compensa-tion structure. Please indicate who will be responsible forpayment of placement agent compensation, and how andwhen compensation will be paid.

c. Nature of any affiliations between placement agent(s) andGeneral Partner.

3. Fundraising and Corporate Governance

a. Target Fund size including maximum (hard cap) and mini-mum target sizes, together with minimum and maximumsize of individual LP commitments.

b. Total commitments received to date and, if available, thenames, contact details and amount committed by eachinvestor.

c. Actual or anticipated first closing date.

d. If applicable, details of investments made to date.

e. Expected total number of closings and date of anticipatedfinal closing. Details of provisions regarding the admissionof additional investors after first closing.

f. General Partners’ commitment to the Fund.

g. Executive commitment to Fund.

h. Describe the Fund’s policy for making distributions in cashor in specie and the method for calculating the carried inter-est for in specie distributions. Please state the prior history ofin specie distributions.

i. Describe the Fund’s policy regarding the reinvestment ofpreviously distributed amounts. If permitted, describe thetime constraints.

j. Describe the Fund’s policy regarding the reinvestment of

Appendix One:Private Equity Investors AssociationRecommended Due Diligence Questionnaire

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3. Please discuss how interests will be aligned between theGeneral and Limited Partners.

4. Please provide your pro forma annual budgets for theGeneral Partner/management companies for all funds youcurrently manage (including the proposed new fund). Notethe duration of the investment/commitment periods foreach fund.

5. Please quantify the following financial information on theindividual principals of the General Partner:

6. For each principal in the partnership, please complete thefollowing carried interest schedule for all prior partnershipsthe individual has an interest in:

7. Please use the table to the top right to provide full details ofyour planned management fee structure.

8. Using the table to the bottom right please highlight what dis-tributions take place before profit sharing (i.e., carried inter-est) takes place:

Also, please provide full details (or a copy of ) your planned dis-tribution procedures.

9. For all principals involved with the Partnership, please com-plete the table titled ‘Current Board Responsibilities’ on thenext page. Include all Board responsibilities (e.g. portfoliocompany boards, public company boards, non-profitboards, other boards).

10. Please provide copies of all side letter agreements with anyinvestors, including but not limited to all Limited Partnersand General Partners.

11. Under the proposed partnership agreement is the GeneralPartner allowed to coinvest alongside the Limited Partnersoutside the Limited Partnership?

12. Please identify all principals and/or affiliates of the GeneralPartner that will be coinvesting.

13. Will an advisory board give final approval to distributions?Who will be the members?

14. What steps have you taken to ensure that the Limited

Partners will not be liable for any issues beyond the term ofthe partnership?

15. Identify and discuss any actual or potential conflicts of inter-est with respect to the General Partner and professionalsinvolved with the fund.

16. Please describe ‘for cause’ and general termination rightsproposed in the Limited Partnership agreement.

Principal Name Expected Carry Points Total Annual Expected Total Annual Expected Carried Interest Capital Compensation From Compensation From Compensation IfContribution This Fund Other Sources Fund Meets Objective

(see Section 1, Ques. 1c)

Joe Smith $2,500,000 5

Total All Principals $8,500,000 17

Affiliate 1 1,000,000 2

Affiliate 2 500,000 1

Total Principals

and Affiliates 10,000,000 20

Initial Base Fee %

Initial Capital Base: Check one that applies

Committed Capital

Contributed Capital

Other Capital Base (please describe)

Fee Reversion Features Check all that apply

New Asset Base when CommitmentPeriod Terminates

Sliding Fee Reduction over Time

Other Features: Check all that apply

Fee Scaled on Capital Raised

Advisory Fee Offsets

Other Features (please describe)

Principal or Affiliate Name Allocated Carried Amount of Allocated Amount of Allocated CarriedInterest Carried Interest Distributed Interest Vested

Joe Smith $7,482,000 $1,243,000 $6,239,000

Total All Principals and Affiliates 45,257,000 $6,722,000 $38,535,000

Type of Distribution Occur beforeProfit Sharing?

Return of LP’s invested capitalin individualinvestment

Return of LP’s management fees associatedwith individual investment

Return of LP’s share of writedowns associatedwith other investments

LP’s Preferred return on capital invested inindividual investment

Return of LP’s share of management feesassociated with all partnership investments

LP’s preferred return on all of a LimitedPartner’s contributed capital

Other

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Schedule I – Performance Summary for ABC Partnership, L.P.

Company Level Performance - Gross of FeesPre Carry After Carry

Fully Distributed Investments Yr. Of First Yr. Of Contributed Distributed Distr./Contr. Distributed Distr./Contr.Investment Exit Capital* Capital Multiple IRR Capital Multiple IRR

Company A XXXX XXXX $ $ x.xX % $ x.xX %Company BCompany CCompany DCompany ECompany FCompany G

Aggregate of Fully Distributed Investments $ $ x.xX % $ x.xX %

Partially Distributed Investments ‘Cash-On-Cash’ - Using Adjusted Terminal Values (ATV) Using Unrealized Values (UV)

Pre Carry After CarryPre After

Yr. Of First Contributed Terminal Distributed Distr./Contr. Distributed Distr./Contr. Terminal Carry CarryInvestment Capital Value Capital Multiple IRR Capital Multiple IRR Value IRR IRR

Company H XXXX $ $ $ x.xX % $ x.xX % $ % %Company ICompany JCompany KCompany LCompany MCompany NCompany OCompany PCompany QCompany RCompany SCompany T

Aggregate of Partially Distributed Investments $ $ $ x.xX % $ x.xX % $ % %

Total Fund Performance - Gross of Fees $ $ $ x.xX % $ x.xX % % % %

Management Fees (before advisory fee rebates) $less: advisory fee rebates $

Net Management Fees $

Total Fund Performance - Net of Fees $ $ $ x.xX % $ x.xX % % % %

Notes:If investment history is less than one year, then IRR is ‘NM’ - Not MeaningfulShow negative IRRs, do not insert alternative explanations or acronyms

A

E

K L

G H I

J

J M N O

FP Q

R

S

C

D

B

T

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So far the argument has only taken into consideration venturefunds. Does the same logic apply to all private equity funds?Data in Venture Economics for non-venture funds is relativelysparse, but what’s there is suggestive. Chart 3 looks at how longit takes for top-quartile funds in aggregate to pay back con-tributed capital, for vintage years 1986-1996.

This shows that top-quartile venture funds and top-quartilenon-venture funds (buyouts, distressed, and so on) have surpris-ingly similar payback statistics. Out of 11 vintage years in thisarbitrary sample, the non-venture top quartile paid back fasterin four cases, the venture top quartile paid back faster in sixcases, and there was one tie (4.25 years for aggregate top-quar-tile venture and non-venture funds formed in 1993). And it isworth bearing in mind that this sample period includes theextraordinary years for venture funds of 1995 and 1996. As aresult, the results discussed above apply just as well to non-ven-ture funds as to venture funds, and a diversified portfolio is morelikely to give the best cashflow over time than a portfolio thatconcentrates on one sector alone.

This analysis provides some guidance on how one might con-struct the best private equity portfolio, for both IRR and pay-back rate. First, pick strong managers of all kinds – don’t justconcentrate on the strategies currently in fashion. Next, build awell-diversified portfolio of perhaps 15-25 funds from amongthese managers. Over the long term, we believe such a portfoliois the best bet, whether measured in terms of IRR or time tobreak even.

Barry Griffiths is a Vice President at Goldman Sachs and Head of

Quantitative Research for the Private Equity Group (PEG), which man-

ages approximately $11 billion in capital commitments across primary

partnership, co-investments, and secondary partnership investments. He

can be reached at [email protected].

This material is provided for educational purposes only. In the event any of

the assumptions used in this material do not prove to be true, results are

likely to vary substantially from those shown herein. Opinions expressed

are current opinions as of the date appearing in this material only.

Why does this happen? As Chart 2 reveals, cash returns in theventure universe are right-skewed. That is to say, the best fundsare farther above the median than the median is above the worstfunds. As a result, the best funds in a portfolio speed up thereturn of capital more than the worst funds slow it down.

This observation – that a portfolio of funds will generally returncapital faster than the median fund in the universe the portfoliois drawn from – applies just as much to top-quartile venturefunds as it does to the venture universe as a whole. It’s easy tosee that the top quartile has some funds that return capital veryquickly, but no funds that return capital very slowly. In otherwords, the top quartile is itself right-skewed. Therefore a portfo-lio of top-quartile funds will usually return capital faster thanthe median top-quartile fund.

Chart Two: Ratio of distributed to contributed capital

for venture fund quartile boundaries, as of June 2003

Top QuartileMedianBottom QuartileBreakeven

Mul

tipl

e

5

4

3

2

1

0

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Vintage Year

(Source: Thomson Venture Economics)Source: Thomson Venture Economics

Chart Three: Breakdown times for top-quartile

vintage-year aggregates, 1986-1996

Metric Venture Non-venture

Mean time to breakeven 5.4 5.6

Fastest time to breakeven 2.5 3.5

Slowest time to breakeven 10.0 7.8

Number of years faster 6.5 4.5

Source: Thomson Venture Economics

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Now, from an ex-ante perspective the expected return on the pri-vate equity investment depends on the expectation with respectto the benchmark return and the PME. Specifically, the expect-ed returns can be written as follows:

Taking into account that y and x defines the standard devi-ation of the random variables x and y, the expectation of theyearly compounded rate of return is defined as follows:

Of course, one may not only be interested in making an assess-ment of the future return of investment strategy 1, but also inthe riskiness implied by this strategy. This can be expressed interms of variability of the final wealth generated by the invest-ment strategy or, what is equivalent, in terms of the variance ofthe yearly rates of return. Under the assumption that x and y areidentically and independently distributed (iid) it follows:

From this it follows that the variance of the periodic yearlyreturns is calculated as follows:

Finally, it should be noted that under this approach the correla-tion coefficient of the continuously compounded yearly returnsof the private equity investment and the benchmark investmentis defined as follows:

Now, if this approach is used for making an inference on thereturn characteristics of the private equity industry as a whole, itshould be emphasised that the distributional parameters of thePME cannot be estimated on the basis of table 3. There, the dis-tribution of the PME on the basis of all sample funds is report-ed, i.e. a pooled distribution. However, strategy 1 implies that anLP invests in all the funds available at a given point in time, i.e.

in all the funds with a given vintage year. Therefore, the relevantPME distribution of such a strategy has to be derived on thebasis of all the vintage year portfolios available in our sample.Basically, this is the time-series distribution of the PME. In sam-ple 1, 20 of these vintage year portfolios can be constructed lead-ing to the results presented in table 4. As one would expect, itturns out that the PME volatility of several funds portfolios islower than the PME volatility of the single funds. Moreover, itturns out that this time-series approach leads to considerablyhigher average PMEs.

Now, the results of table 4 can be used for estimating the distri-

Liquidated Funds

AverageMedian75th Percentile25th PercentileStdevvalue-weighed PME

Sample I

AverageMedian75th Percentile25th PercentileStdev value-weighed PME

Sample II

AverageMedian75th Percentile25th PercentileStdev value-weighed PME

VC

0.82%0.68%0.97%0.33%1.01%

0.98%0.75%1.17%0.40%1.15%

1.01%0.76%1.22%0.44%1.15%

BO

0.90%0.89%1.24%

-0.51%0.53%

0.94%0.86%1.24%0.59%0.51%

1.06%0.92%1.35%0.61%0.70%

TOTAL

0.86%0.80%1.10%0.42%0.81% 0.94%

0.96%0.82%1.23%0.51%0.89%1.04%

1.03%0.88%1.27%0.55%0.95% 1.16%

VC

1.11%0.81%1.38%0.54%1.51%

1.14%1.06%1.44%0.66%1.02%

1.25%0.99%1.27%0.60%1.38%

BO

1.07%1.09%1.37%0.64%0.60%

1.24%1.02%1.43%0.63%0.59%

1.06%1.13%1.42%0.77%0.74%

TOTAL

1.09%0.99%1.38%0.58%1.14% 1.21%

1.20%1.03%1.43%0.66%1.11% 1.27%

1.23%1.07%1.45%0.66%1.10% 1.30%

Table 3: Pooled sample distribution of PE Funds’ PMEs

PME (MSCI Europe) BME (JPM European Govt. Bond)


179


Our analysis reveals that the payback percentage and perioddepend both on the regional focus and the investment stage offunds. Table 1 indicates that US buyout funds are the most suc-cessful in paying back drawn capital. Of all liquidated US buy-out funds, 80 percent managed to return the full amount of cap-ital drawn from investors. While US venture (77 percent) andEurope buyout (75 percent) show similar payback percentages,investors have to be especially careful when selecting Europeanventure funds – historically, 44 percent (24 of the 55 liquidatedEuropean venture funds in our sample) did not break even.

For liquidated funds that did break even, what were the averageand median payback periods? Table 1 shows that for buyoutfunds, the average payback period is approximately seven years,whereas venture funds took more than eight years on average,with European venture funds showing the longest payback peri-od. Note that the average and the median payback period arevery similar.

Is capital being returned faster?

It is important to consider how the payback characteristicsdescribed above might develop over various vintage years. Inparticular, can one observe trends in either the payback percent-age or the payback period? In other words, is the industry pay-ing back faster than it used to?

In order to investigate the behavior of the payback characteris-tics over time, we analyse a larger sample of 1,057 funds in thedataset that were raised in the time period from 1983 to 1994.It should be noted that when we investigate payback character-istics of non-liquidated funds per vintage year, the results arenaturally biased downwards: assuming that the funds in thedataset do not change, every fund that reaches break-even afterDecember 2003 (the date of our data sample) will increase boththe payback percentage (more funds pay back) and the averagepayback period (payback periods of funds reaching breakevenfor any given vintage year are longer than the current average).We choose 1994 as a cut-off point to reduce the bias introducedthrough funds that are still active but have not yet reachedbreak-even.

Chart 2 shows that the payback percentage of US private equityfunds has proven to be surprisingly stable across vintage years.Generally 75 to 80 percent of US buyout funds paid back alldrawn capital with only the 1990, 1991 and 1994 vintagesshowing a failure rate over 40 percent. For US venture, oneobserves that approximately 70 to 75 percent of all funds paidback all drawn capital. These figures coincide with the averagepayback percentage of all liquidated funds (see Table 1).

Interestingly, while vintage 1993 and 1994 venture funds mightstill manage to pay back their drawn capital, many of these fundswere apparently not able to benefit from the excellent exit envi-ronment of the late 1990s. A comparable study of Europeanbuyout and venture funds shows similar results.

As already mentioned, the average payback period of the sampleunderestimates the final payback period for the vintages 1983 to1994 (downward bias). Nevertheless, trends and cycles in theaverage payback period of private equity funds are clearlyobservable. Chart 3 illustrates what most investors realised whenmonitoring their portfolios; the 90s vintages paid back muchfaster than the 80s vintages.

In contrast to the relatively stable payback percentages describedabove, the average US venture payback period has fallen fromabove eight years for vintages in the mid-eighties to approxi-mately five years for the 1993 vintage year, as can be seen fromChart 3. Given the relative lack of venture capital exits during2000-2003, we expect this trend to reverse for late 1990s vintageventure funds that did not benefit from the TMT bubble.Average payback periods for such funds should rise toward the

Chart Two: Payback percentage per

vintage year USAPAYBACK PERCENTAGE PER VINTAGE YEAR USA

Size

Payb

ack

Perc

enta

ge

US VC US BO

100%

80%

60%

40%

20%

0%1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Chart Three: Average payback periodAVERAGE PAYBACK PERIOD

Vintage Years

Ave

rage

Payb

ack

Peri

od

US VC US BO

14

12

10

8

6

4

2

01983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Payback percentages by vintage year for US funds raised between1983 and 1994.

Table 1: Payback percentage and payback period of liquidated funds asof Q4 2003.

Average payback period per vintage year for US funds raisedbetween 1983 and 1994.

Payback US US EU EUcharacteristic venture buyout venture buyout

Paybackpercentage

77% 80% 56% 75%

Average paybackperiod

8.1 6.8 8.7 7.1

Median paybackperiod

8.0 6.9 9.0 7.1


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In November 2001 a management team bought out their businessfrom major financial publishing group, Euromoney InstitutionalInvestor PLC. This business was centred on private equityand venture capital, and included the websitePrivateEquityOnline.com – already one of the most heavily usedprivate equity news sites around – as well as plans for a major newmagazine dedicated to the asset class. That magazine was launchedin December 2001 and is called Private Equity International.

Since then, that same group of managers plus a growing team ofseasoned journalists and other publishing professionals, havebeen busy developing a range of publications and other mediathat are all centred on private equity and venture capital. Thecompany now has offices in both London and New York and isable to track all aspects of the industry across all time zones. Weare genuinely global in our approach.

Today, the company offers the following publications andproducts:

Private Equity International: the global magazine for privateequity. One of the most widely read and recognised monthlymagazine on private equity and venture capital. Written by oneof the most highly regarded editorial teams with over thirty yearscombined experience of the industry. PEI delivers fresh newsand insight on how the asset class is developing worldwide.

Private Equity Manager: the first monthly journal written forthose involved in running the modern private equity firm:CFOs, COOs, Heads of IR, Human Resources – as well as themanaging partners. Launched in June 2004, PEM delivers sub-stantive commentary and guidance on all aspects of operationalbest practice for the private equity and venture firm.

PrivateEquityOnline.com: probably the best known websitededicated to private equity and venture capital. Launched inApril 2000, its daily news coverage from around the world isnow read by 40,000 registered users. Journalists in both Londonand New York are posting stories on PEO throughout the dayon the people, the deals and the firms shaping the industry.Private Equity International conferences: in order to provide pri-vate equity professionals with a small number of focused eventsthat make full use of the company’s knowledge of the privateequity industry, PEI is now hosting a series of conferences inEurope, North America and elsewhere. Our Private EquityCOO & CFO meetings in both London and New York, forexample, have already established a significant following.

Private Equity International research publications: a growingseries of market reports, research guides and directories are beingwritten, edited and compiled by members of the team to providein-depth information and analysis for various industry partici-pants, including GPs, LPs, financiers and other advisers. Thesetitles address the current absence in the market of in-depthproducts that cover the issues and trends shaping the asset classon a global basis.

To find out more about any of these products just call either ourLondon [+44 20 7566 5444] or New York [+1 212 645 1919]offices.

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Private Equity International’s research publications address thecurrent absence in the market of in-depth products that coverthe issues and trends shaping the asset class on a global basis.Leveraging its expert knowledge, along with its contacts andclient base, Private Equity International’s range of marketreports, research guides and directories offer private equity pro-fessionals, investors in the asset class, the advisory communityand others involved in private equity the quality, in-depthresearch, analysis and comment they need.

Market Reports

Cover specific topics of relevance to private equity in a conciseand focused manner. These highly specialised and targetedreports are aimed at covering technical issues or particular areasof the private equity industry in an incisive manner, providingreaders with a valuable primer on these issues.

Research Guides

Cover the broader issues, themes and trends that are helping toshape the development of the private equity asset class.Consisting of in-depth analysis and comment, along with theresults of surveys into the attitudes and opinions of private equi-ty professionals and investors, these research-rich, multi-con-tributor studies provide readers with some of the most authori-tative and substantive comment available on private equity.

Directories

Private Equity International will also be publishing a range ofdirectories for use as work tools by private equity professionals,

advisors, investors and others involved in the asset class. Thesepractically orientated, comprehensive and detailed directorieswill profile investors in the asset class, advisors, service providersand private equity firms.

The following research publications have already been published:

• Placement Agents Market ReportThe definitive guide to private equity placement agents, this120-page Market Report combines in-depth editorial with aglobal directory of agents and the results from surveyingboth LPs and GPs about their views on the role and contri-bution of agents in the fundraising process. The book isfilled with information and comment relevant to anyoneinvolved with private equity funds and fundraising.

• Routes to LiquidityA detailed study of how liquidity is being brought to theasset class. This 224-page Research Guide includes contri-butions from leading players in the liquidity field, combin-ing in-depth editorial with a global directory of secondarybuyers and advisors, along with the results of a unique sur-vey into the attitudes towards the secondary market of buy-ers, sellers and GPs.

Contributors include Camelot Group, Campbell Lutyens,Capital Dynamics, Cogent Partners, Coller Capital,Debevoise & Plimpton, Deutsche Bank, Goldman Sachs,Greenpark Capital, Landmark Partners, Lexington Partners,LGT Capital Partners, London Business School, New YorkPrivate Placement Network, Pantheon Ventures, Partners

Group, Paul Capital Partners, Pomona Capital, ProbitasPartners, Schroder Ventures International Investment Trust,SJ Berwin, Standard & Poor’s and Vision Capital.

• Private Equity Technology: Assessing the AlternativesAn assessment of technology solutions and how they applyto private equity firms. This 222-page Market Report coversthe importance and risks of technology, how technologyspecifically applies to the modern private equity firm andincludes a detailed analysis of the technology solutions cur-rently available to private equity firms. The guide is sup-ported by a survey of investors’ use of and attitudes towardstechnology, along with a unique directory of private equitytechnology providers and their products / services. Thisguide is essential reading for anyone involved in developinga private equity firm’s technology infrastructure.

• The UK LBO ManualA practical guide to structuring private equity-backedbuyouts in the United Kingdom. Written and researched byleading international law firm Ashurst, this is the first in aseries of country-specific guides that address all aspects ofprivate equity-backed buyouts. Topics covered include: thedevelopment of the UK buyout market; the structure ofleveraged buyouts; documentation; taking equity; debt andsecurity; taxation aspects of LBOs; the impact of EC andUK merger control and anti-trust rules; public to privates;structuring equity incentives for management; insolvency;and more. This 156-page report is an essential resource forall those involved in UK private equity buyouts.

Appendix Six:About Private Equity International Research Publications

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into the dynamics and future of the fund of funds marketundertaken with fund of funds managers, placement agentsand LPs. Also contains the most comprehensive directory offund of funds managers available, profiling more than 150managers from around the globe, including contact details,investment remits and previous funds backed. This report isan essential purchase for anyone interested in understandingand raising capital from this increasingly important area ofthe private equity market.

Contributors include Adams Street Partners, LondonBusiness School, Mowbray Capital LLP, O’Melveny &Myers LLP, Partners Group, Probitas Partners, SCMStrategic Capital Management, Standard Life Investments(Private Equity) Ltd.

If you have any queries about Private Equity International’s cur-rent and forthcoming research publications please contact:

Nick GordonHead of Research PublicationsPrivate Equity InternationalSecond FloorSycamore HouseSycamore StreetLondon EC1Y 0SGUnited Kingdom+44 (0)20 7566 [email protected]

• The Private Equity International Global Limited PartnersDirectoryThe most comprehensive international guide to investors inprivate equity funds. This 990-page directory providesdetailed, in-depth profiles of the private equity investmentprograms of over 870 institutional investors and advisorsfrom around the globe. Built from the ground-up by a teamof multi-lingual researchers, this directory is the most com-prehensive, extensive and user friendly guide to current andactive investors in the asset class available. An indispensablefundraising tool for those raising and marketing privateequity and venture capital funds.

• The Guide to Private Equity Fund Investment DueDiligenceA detailed study into performing due diligence on privateequity and venture capital funds and managers designed toassist institutional investors in making investment selectionsin this inefficient asset class. This 212-page Research Guideincludes contributions from leading institutional investorsin private equity funds, placement agents, fund managersand investment consultants and advisors. It combines in-depth editorial with a global directory of consultants pro-viding specialised private equity advice to institutions, alongwith the results of a survey into limited partner attitudestowards fund investment due diligence.

Contributors include AlpInvest Partners N.V., CooleyGodward LLP, Dow Employees’ Pension Plan, Key CapitalCorporation, Mark Weisdorf Associates Ltd., PacificCorporate Group LLC, Pantheon Ventures, PensionConsulting Alliance Inc., Probitas Partners, Proskauer RoseLLP, SJ Berwin, VCM Venture Capital ManagementGmbH, Watson Wyatt & Company.

• A Guide to Private Equity Fund of Funds ManagersThe definitive guide to the global private equity fund offunds market. This 276-page Market Report consists of in-depth editorial from leading fund of funds managers, place-ment agents and advisors, along with the results of a survey

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Documents

Transcript of Guide to PE Due Diligence