Institutional investors are taking a closer look at the back-office operations of fund managers in what appears to be a new normal for GP-LP relations. Service providers are circling
In the investment industry, as in any area of study, trends prove subject to redirection and expiration when the drivers behind them are fickle or few. But when virtually every macro force at play is advancing the same effect, a sense of irreversibility begins to cement.
Perhaps no aspect of private equity reflects this observation more than LPs’ intensifying approach to operational due diligence (ODD) on GPs. The motivators are as ubiquitous as they are implacable: regulators are stepping up requirements around governance and fiduciary duty compliance; technological advancements are facilitating more sophisticated analyses; and concerns about an impending global economic downturn are translating into conservatism around partnership and transaction commitments.
Most LPs are now said to have either formally or informally embraced strategies to reduce their GP relationships. At the same time, disappointing returns in various asset classes have rechanneled more money into PE, ramping up pressure to get those investment decisions right. LPs accustomed to ODD principles and procedures in domains such as hedge funds are now bringing those practices to private equity. That shift has now been unfolding for long enough that PE-specific benchmarking is more possible, further accelerating its progress.
“Investors are looking much deeper into the infrastructure and operations of firms,” explains Michael Henningsen, a partner with placement agent First Avenue. “You get these ODD questionnaires that run to hundreds of questions and cover everything from how you approach the regulatory environment, your tax planning, the way you run your investment process and document the process, cash flow management, cash flow approvals, even how many people need to approve which levels of cash outflow.”
The industry consensus is that the number of questions in this process and the amount of time it takes to come to a fund commitment decision has more than doubled in the past 10 years. In addition to the regulatory, tax, and cash handling considerations typically associated with back-office operations, LPs are digging deeper into valuation calculations, conflict-of-interest prevention protocols, hiring strategy, individual background checks, signals about team culture, and how all these data points can be regularly monitored.
More recently emerging factors relate to cybersecurity and how it touches on access, auditing and dispersal processes for transferred funds. Likewise, a general trend toward tech-enhanced interconnectivity in GP operations has prompted more investigation into how financial due diligence metrics can be relevant to ODD. The most controversial points usually involve skin in the game in terms of verifying the extent of GP fund commitments and improving transparency in the gamesmanship around management fee offset.
The concern here is that seemingly in-house team members such as operating partners may be classified as external to the GP and therefore the financial responsibility of LPs under standard fee agreements. Such disputes can be exaggerated in venture capital, where the likes of venture partners and advisors often outnumber regular staff by a wide margin. Pushback on both sides is palpable, especially among the largest and most confident players, but this may help bring the limits of feasible resistance into focus.
Daniel Strachman, co-founder of the US-based Investment Management Due Diligence Association (IMDDA), acknowledges LPs are under a lot of pressure to deploy but sees this as poor justification for cutting corners or glossing over details. Primary capital providers in this view are ultimately responsible for performance results and therefore obliged to conduct the manager assessment process in the most informed way possible.
“There’s a lot of fear of missing out, which is total nonsense. You can’t lose what you don’t invest,” Strachman says. “A lot of LPs are afraid to ask questions because there’s this feeling that the investor is not as smart as the manager, so the manager is going to get offended if you ask about cash controls or how investments are made. People say they can just read the pitchbook and understand, but a pitchbook is a marketing thing. It’s no different than a sales sheet at a car dealer.”
One of the main challenges with questionnaires for fund managers is that they tend to become a check-box exercise, whereby LPs simply confirm that the third-party service providers appointed to handle accounting, banking, IT or other back-office operations are credible. This is seen as an especially hazardous pitfall for LPs overanxious to achieve sufficient comfort to follow through with parallel plans around separate managed accounts, co-investment or advisory committee seats.
LPs must therefore understand how to analyze ODD information themselves, but also what questions to ask in the first place. In developing markets where many investors are new to PE, there is a tendency to address too many unnecessary data points in noise-filled questionnaires that can complicate negotiations. This is often worsened by an instinct to respond to developments in the news about issues like cybercrime or fraud. The risk is that too much focus in certain areas can be as detrimental as relying on light, high-level review.
“There are core ODD items that have become industry expected best practice, but beyond that, a lot of it is driven by recent events and media, which is a bad model because it’s backward looking,” says Jason Scharfman, a managing partner at Corgentum Consulting. “You have to cast a broad, multidisciplinary net across a lot of operational areas because you can’t predict where the next problem is going to be. You might really want to kick the tires on valuations but then a compliance issue may trip you up.”
US-based Corgentum offers risk reports to hedge and PE fund managers and is tracking increased demand from Asia. The firm has some 100 relationships in the region, about 40 of which receive ongoing compliance and reporting support. ODD services in this vein are seen as especially needed in markets where fewer GPs employ fund administrators, LPs have fewer resources for ODD work, and PE experience is generally thinner on the ground.
Much of Asian demand for ODD services to date has focused on small funds, VC and impact investors. This is partially attributed to the idea that strategies of this kind are typically subject to lower levels of regulatory scrutiny. But there is also recognition that because players in these domains are usually less established, they are less likely to dispute the questionnaires that come their way.
When disputes do arise, third-party can be useful in brokering difficulties around issues such as the sharing of sensitive data. Corgentum, for example, proposes compromise in the form of confidentiality agreements with the manager. The use of consultants may also appeal to the GP perspective because it effectively gives the LPs the comfort they want at their own expense.
Some industry participants advise, however, that LPs should engage consultants only to realize a first cut on the ODD to see if a given fund is a good fit. They must then step back and do an internal review, getting more directly involved in the process.
For LPs, the key risk in too much reliance on third parties is in receiving insufficiently tailored service, especially considering a few large firms tend to dominate the ODD space. Mercer, Cambridge Associates, NEPC, and Albourne are among the most commonly cited names globally.
“A lot of investment advisors and consultants told large institutional investors that they were creating customized portfolios but what their clients realized during the global financial crisis was that they all owned the same things,” says IMDDA’s Strachman. “I’m sure the due diligence was done, but they found out these so-called customized portfolios weren’t really so customized.”
Nevertheless, almost two-thirds of LPs in a 2019 global survey by EMPEA were found to use questionnaires unique to their institutions. This has in turn been seen as creating difficulties for small teams struggling to keep up with growing information demands.
Wider adoption of standardized ODD templates from organizations such as the Institutional Limited Partners Association (ILPA) could ease this burden on GPs while also allowing LPS to channel more resources into the discovery of potential operational issues or the verification of reporting through interviews or on-site visits. Application of this approach may be all the more essential in markets with higher relative populations of first-time managers.
“LPs may favor larger GPs with the resources to build out dedicated internal ESG [environmental, social and governance] teams and hire best-in-class external administrators and advisors, which might come at the expense of allocating to smaller fund managers operating in the middle market,” says Jeff Schlapinski, senior director of research at EMPEA. “The irony is that there is less competition and potentially more scope for value creation and implementing international best practices in this segment.”
An ODD-driven flight to quality could have a number of knock-on effects in the industry, including an acceleration of the consolidation of GP relationships into fewer but larger fund commitments. It may also promote fund specialization since managers will be eager to showcase strategic virtues that offset their ODD shortcomings or raise smaller funds that can achieve their targets with support from less professional and demanding LPs.
“We’re seeing more sector funds because LPs that really want to have capital at work in a specific sector have a shorter list of GPs to choose from, which leads them to make some consolations,” says Johanne Dessard, global practice director in Bain & Company’s PE practice. “The downside for GPs is that they won’t have access to the same number of LPs. For the smaller and newer funds, it will be far trickier, and they’re the ones that will be paying the consequences most of the time.”
The tech effect
This effect could be tempered, however, by the gradual democratization of PE through a combination of overall industry growth and technological innovations around access. At the moment, it is really only the largest institutional investors that demand transparency on ODD issues. But as a broader LP base gets exposure to the asset class, more universal norms around due diligence, including ILPA-consistent questionnaires, are likely to become either generally expected or formally enforced.
“There’s a lot more money flowing into private equity, and it is becoming more accessible to the affluent classes, rather than just ultra high net worth individuals and institutional investors,” says Aisling Keane, head of alternative investment solutions for Asia Pacific at State Street. “If this distribution channel continues to grow and mature, the investors are not going to be asking all these operational due diligence questions – there will need to be a higher level of comfort in regulation, standardization, and even automation.”
Automation may ultimately have its biggest impact on ODD uptake by making the whole exercise easier and more effective. Digitized questionnaires, for example, can quicken a process that takes up to 12 months by nearly 50% when they are used by large LPs with the extensive GP relationships. For smaller LPs, time savings of 30% could be achieved. In theory, this gives LPs better insights and more time for analyzing potential fund commitments, as well as improved flexibility in monitoring ODD issues in existing GP relationships.
Indeed, the digitization of questionnaires is not just a way of discovering ODD hang-ups, it’s a way of addressing them on both sides of the GP-LP partnership. The key objective is to streamline a procedure of defining the structure of a questionnaire, distributing it, sending reminders to managers, compiling and analyzing responses in different formats one by one, then sharing the information internally and creating a report on shortlisted interviewees.
Wissem Souissi, founder and CEO of fund manager due diligence technology provider Diligend, estimates, however, that more than 90% of LPs in private markets continue to use “archaic” processes for data exchange and ODD. This includes the manual sharing of PDF files and Word documents via email and data warehouses, the latter of which requires sorting through hundreds of variously formatted pieces of information.
“The big GPs would love to continue to dictate to the small to medium-sized LPs the way they share data,” says Souissi. “The easiest way for GPs is just generating PDF files and putting them in a virtual data room and that’s it. But if GPs would like to get the money quicker, maybe they should help the LPs make the decision quicker with the new tools that they would like to use. It’s in the interest of all parties to look for ways to change this practice.”