Private Equity Fund

Investment Due Diligence

Second Edition
Perfecting your due diligence ability for top-quartile returns

Edited by Kelly DePonte, Probitas Partners

Published in October 2010 by

PEI Media Ltd
Second Floor
Sycamore House
Sycamore Street
London EC1Y 0SG
United Kingdom
Telephone: +44 (0)20 7566 5444
www.peimedia.com
2010 PEI Media Ltd.
ISBN 978-1-904-696-81-0
This publication is not included in the CLA Licence so you must not copy any portion of it without the
permission of the publisher.
All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or transmitted
in any form or by any means including electronic, mechanical, photocopy, recording or otherwise, without
written permission of the publisher.
The views and opinions expressed in the book are solely those of the authors and need not reflect those of
their employing institutions.
Although every reasonable effort has been made to ensure the accuracy of this publication, the publisher
accepts no responsibility for any errors or omissions within this publication or for any expense or other loss
alleged to have arisen in any way in connection with a readers use of this publication.

PEI Media editor: Wanching Leong

Production editor: Julie Foster
Cover design: Joshua Chong
Printed in the UK by: Hobbs the Printers (www.hobbs.uk.com)
Cover image: Courtesy of iStockphoto

iii

Contents
Figures and tables

vii

Foreword and appreciation

xi

Chapter three
Emerging managers: How to
analyse a first-time fund

19

By Kelly DePonte, Probitas Partners

Introduction
19
Key points in the analysis of emerging managers 20
Conclusion
26

SECTION I:
IN-DEPTH, INCISIVE CHAPTERS

Chapter one
Private equity fund manager due
diligence and selection

By Helen Steers, Pantheon

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
Challenging times adjusting the due diligence
process in the wake of the credit crunch
Conclusion

Chapter two
Track-record analysis as the
foundation of due diligence

Chapter four
Legal due diligence:
The ILPA Principles
3
3
4
4
4
8
8

By Kelly DePonte, Probitas Partners

Introduction
Other efforts

29

29
30

Chapter five
Legal due diligence: a Q&A session

31

Introduction
The experts
The questions

31
31
31

Chapter six
Private equity benchmarks:
Methods and meaning

45

11

By Atsushi Urushitani, Seiichi Saito and Melissa

Banila, Alternative Investment Capital Limited
Introduction
11
Analysis at fund level
11
Analysis of portfolio companies
15
Analysis of realised investments
15
Analysis of unrealised investments
16
Other factors affecting consistency
of track-record performance
17

By Jesse Reyes, QuartileOne, LLC and

Austin Long, Alignment Capital Group, LLC
What is a benchmark?
Opportunity cost and benchmarking
Can private equity truly be benchmarked?
Peer group benchmarks are not enough
Searching for alpha
Navigating the benchmark forest

45
45
47
51
54
54

The Definitive Guide to Private Equity Fund Investment Due Diligence

iv

CONTENTS

The need for additional benchmarks

Public market equivalents
Summary of PME methods
Conclusion

61
61
69
71

Chapter ten
Venture capital due diligence:
Issues of analysis

97

By Janet Cheston, Lisa Edgar and

David York, Paul Capital Investments

Chapter seven
Doing due diligence on the
next fund: The importance of
portfolio monitoring

73

By Kelly Chaplin, British Columbia Investment

Management Corporation
Introduction
73
Annual meetings
73
Other meetings
74
Advisory board participation
75
Co-investments
76
Conclusion
78

Chapter eight
Regional due diligence:
A European perspective
By Katharina Lichtner, Capital Dynamics
Introduction
Team
Strategy and market
Processes
Quantitative analysis
Conclusion

Chapter nine
Due diligence in emerging private
equity markets
By Ernest J.F. Lambers, EMAlternatives, LLC
Introduction
The rise of the emerging markets
Key elements in the selection of
private equity managers
Conclusion

79

79
80
84
84
85
88

89

89
89
90
96

Introduction
Differences between venture capital and
private equity manager evaluation
Selection criteria and evaluation processes
Investment performance
Team
Investment strategy
Investment process
Portfolio management
Governance
Conclusion

Chapter eleven
Mezzanine funds: Risk, return
and the equity mix
By Matthias Unser
Overview of the mezzanine market
Different strategies of mezzanine funds
Risk and return of mezzanine investments
Due diligence for mezzanine fund managers
Conclusion and outlook

Chapter twelve
Sector-focused funds: Special
considerations on due diligence
By Jeffrey Mansukhani,
Cambridge Associates LLC
Introduction
Team
Strategy
Performance
Considerations for private equity industry
sector funds

The Definitive Guide to Private Equity Fund Investment Due Diligence

97
98
98
99
100
101
102
103
104
105

107

107
110
114
117
126

129

129
129
130
131
134

CONTENTS

Other sector fund strategies

Conclusion

136
138

Chapter thirteen
Co-investment due diligence

139

By Kenneth Van Heel,

The Dow Chemical Company
Introduction
Why establish a co-investment programme?
Issues to consider when developing a
co-investment strategy
Co-investment due diligence
Conclusion

Chapter fourteen
Private equity real estate:
Factors of analysis
By Hawkeye Partners, LP
Introduction
Real estate fund due diligence
Legal fund terms
Conclusion

Chapter fifteen
Infrastructure fund investing
By Nancy Duff Mangraviti and Scott Sinha,
RBC Global Asset Management
Introduction
Infrastructure fund diligence: Beware the
traps for the unwary
Back to basics: portfolio construction
Evaluating a managers infrastructure
investment strategy
First-time funds/emerging teams
Fund terms and structure warranting
special focus
Conclusion

139
139
140
143
148

149

149
152
152
157

159

159
159
160
160
163
164
165

Chapter sixteen
Secondary private equity
fund pricing

167

By Ian Charles and Charlie Tingue,

Landmark Partners
Introduction
Benefits of buying secondaries
Secondary underwriting introduction
and information needs
Secondary DCF model set-up
Public company projections
Private company projections
Future capital calls and unfunded
capital return
Converting gross cash flows to a
purchase price
Sensitivity analysis
Conclusion

167
169

Chapter seventeen
Publicly traded private equity
vehicles: A different kind of model

179

By Adam Goldman, Red Rocks Capital LLC

Accessing private equity: an overview
What is listed private equity?
Listed private equity vehicle structures
Drawbacks
What drives pricing?

Chapter eighteen
Investing in fund management
companies
By Andrew L. Turner, Northern Lights
Capital Group
Introduction
Asset management as a pure intellectual
capital activity
Evaluating investment fund managers and
investment strategies

170
171
171
174
176
176
177
177

179
180
181
183
185

189

189
189
191

The Definitive Guide to Private Equity Fund Investment Due Diligence

vi

CONTENTS

Converting investment success into

business success
Creating the environment for success
Conclusion

Chapter nineteen
Staffing for success: The human
capital factor
By Erik Hirsch, Hamilton Lane,
with contributions from Michael Koenig
and Grant Saul
Introduction
Sourcing
Due diligence
Legal
Back office/reporting
Monitoring
Globalisation and private equity
Models for deploying human capital to
private equity
Advisory model
Separate account model
Fund of funds model
Hub-and-spoke model
Conclusion

193
194
196

197

210
213
216
217
219
220
221

SECTION III:
APPENDICES
197
197
197
198
200
201
201
201
202
202
203
204
205

SECTION II:
2010 PEI/PROBITAS PARTNERS
PRIVATE EQUITY FUND INVESTMENT
DUE DILIGENCE SURVEY
Conducted June/July 2010

Private equity fund investment

due diligence: A survey of
institutional investors

Scope of investment activity

Most important due diligence factors
Terms and conditions
Other key elements of the due
diligence process
Due diligence on first-time funds
Due diligence on sponsored funds
Summary

209

Survey devised and conducted by

PEI Media and Probitas Partners; Analysis by
Nicole Warren, Probitas Partners
Introduction
209
Profile of survey respondents
209

Appendix I
225
Private Equity Investors Association
Recommended Due Diligence
Questionnaire

Appendix II
241
Private Equity Investors Association
Legal Due Diligence Checklist

SECTION IV:
FROM THE PEI ARCHIVES

Journalistic coverage of
due diligence
Year of the extension
Planes, trains and due diligence
Changing the equation
Tales from the fraudulent frontline
Who cares?
The winds of change
Lots of appetite, little follow-through
Manager selection key for Asian PE

249
250
252
253
257
258
259
263

About PEI Media

268

The Definitive Guide to Private Equity Fund Investment Due Diligence

vii

Figures and tables

Figures
Figure 1.1:
Figure 1.2:
Figure 2.1:
Figure 2.2:
Figure 4.1:
Figure 6.1:
Figure 6.2:
Figure 6.3:
Figure 6.4:
Figure 6.5:
Figure 8.1:
Figure 8.2:
Figure 8.3:
Figure 8.4:
Figure 8.5:
Figure 8.6:
Figure 9.1:
Figure 9.2:
Figure 10.1:
Figure 10.2:
Figure 11.1:
Figure 11.2:
Figure 11.3:
Figure 11.4:
Figure 11.5:
Figure 11.6:
Figure 12.1:
Figure 12.2:
Figure 12.3:
Figure 12.4:
Figure 12.5:
Figure 12.6:
Figure 14.1:
Figure 14.2:
Figure 15.1:
Figure 16.1:
Figure 17.1:

US and Europe private equity returns, 19692009

Private equity fund investment process
Example of investments with different multiples but same IRR (20%)
Example of investments with different IRRs with same multiple (2.5x)
Attitude towards the ILPA Private Equity Principles
Four potential sources of private equity benchmarks
Since-inception IRR timeline
Time-weighted rate of return timeline
Investment-horizon IRR timeline
Time-zero IRR timeline
Due diligence selection framework
Example of an analysis of team development
Example of a geographic analysis
Example of a portfolio analysis
Example of a performance benchmarking analysis
Example of a value-creation analysis of individual components in a leveraged buyout investment
Private equity fundraising in the emerging markets
Private equity investments in the emerging markets
US venture capital sectors of investment ($ invested)
Venture capital fund selection process
Basics of mezzanine financing
Strategic profiles in the US and Europe
Comparison of returns for US and European mezzanine loans
Regional differences in risk (as of 31 December 2009)
Sponsored vs. non-sponsored transactions (as of 31 December 2009)
Due diligence process for mezzanine funds
Financial services-focused private equity funds and total commitments, 200009
Dispersion of cash-on-cash multiples for healthcare-focused and generalist funds, 200009
Returns of US private equity-backed companies vs. relevant public indexes by sector
Returns of media companies vs. US private equity and public equity
Spectrum of private energy partnerships
Returns on private distressed investments vs. US private equity and the S&P 500
Index of US commercial real estate values from 1978 to first half 2010
Historical quarterly total returns for the NCREIF Townsend Fund Index
Considerations when mapping an infrastructure portfolio
Example of a private equity J-curve
LPE companies premiums and discounts
The Definitive Guide to Private Equity Fund Investment Due Diligence

viii

F I G U R E S A N D TA B L E S

Figure
Figure
Figure
Figure

17.2:
19.1:
19.2:
19.3:

Secondary LP pricing vs. LPE discounts

Dispersion of returns for public equity vs. private equity
Due diligence process
Hypothetical hub-and-spoke model

Survey figures
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure
Figure

1:
2:
3:
4:
5:
6:
7:
8:
9:
10:
11:
12:
13:
14:
15:
16:
17:
18:
19:
20:
21:

Profile of respondents
Respondent firm headquarters
Private equity investment experience
Primary investment sector focus
Primary investment geographic focus
Interest in the secondary market
Interest in directs and co-investments
Due diligence staffing
Key factors in due diligence
Fund performance benchmarks utilised
Attitude towards terms and conditions
Attitude towards the ILPA Private Equity Principles
Terms and conditions deal-breakers
Due diligence on-site GP visits
Due diligence on-site selected portfolio company visits
Require the completion of a detailed due diligence questionnaire
Require track-record data in electronic format
Attitude towards first-time funds
Key factors with first-time funds
Attitude towards sponsored funds
Position on sponsored funds

Tables
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table

2.1:
3.1:
3.2:
6.1:
6.2:
6.3:
6.4:
6.5:
6.6:
6.7:
6.8:
6.9:

Example of an attribution analysis

First-time private equity funds as % of market
Average private equity fund sizes
Example of a benchmark selection for a fund of funds
Example of averaging IRRs vs. calculating a pooled-average IRR
Comparison of benchmarks against BRT criteria
Example of an original ICM PME calculation
Example of an original ICM PME calculation resulting in a negative terminal value
Example of an AICM PME calculation with a negative IRR
Example of an AICM PME calculation with a positive IRR
Example of a PME+ calculation
Example of a PME+ calculation from a more successful investment

The Definitive Guide to Private Equity Fund Investment Due Diligence

F I G U R E S A N D TA B L E S

Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table
Table

6.10:
6.11:
6.12:
11.1:
11.2:
11.3:
12.1:
14.1:
15.1:
15.2:
16.1:
16.2:
16.3:
16.4:
17.1:
19.1:
19.2:

Example of a K&S PME calculation

Example of a K&S PME calculation from a more successful investment
Summary of PME methods
A short history of mezzanine financing
Risk and return comparison among mezzanine deals by size
Important factors for any due diligence
Energy private equity performance compared to public indices
Real estate fund due diligence checklist
Infrastructure sectors
Key considerations in evaluating risk in an infrastructure strategy
Information required for secondary fund due diligence
Common terms and attributes in secondary fund transactions
Public company classification example
Forward-looking operation projections
Comparison of private equity vehicles
Expected annual legal costs
Cumulative reporting and cash flow administration cost of a private equity programme

The Definitive Guide to Private Equity Fund Investment Due Diligence

ix

xi

Foreword and appreciation

When the first edition of The Guide to Private
Equity Fund Investment Due Diligence was published in 2005 we were at the beginning of a
great bull market for publicly traded stocks and
private equity. The bull market rapidly changed private, greatly expanding the market in size, in sectors covered and geography, in many cases
moving private equity from the financial pages to
the front pages. From 2005 through 2007, access
to rapidly growing fund managers perceived to be
top of the class became a focus for many
investors, especially for those funds that raised
money rapidly.
Though the importance of proper due diligence
never totally faded, the retrenchment in the industry that came with the global financial crisis has
focused much more attention on the area. Many
investors are limited in the amount of capital they
can deploy, and manager selection is key in
deploying those relatively scarce resources.
Intensive due diligence is, of course, the basis of
the selection process.

Though the fundamentals of fund due diligence

have not changed, the expansion of the market
have made things more complex. This second edition includes a number of entirely new chapters,
including sections on sector-focused funds, secondary investing, infrastructure and real estate.
Other chapters have been updated to ensure that
they reflect current market practice, including an
entirely new survey of institutional investors on
key areas of due diligence focus.
With a topic as complex as this, we have been fortunate to attract a group of distinguished industry
practitioners to author the chapters of this book.
Most of the material here has been written by individuals who have devoted their spare time in spite
of busy professional schedules to share their knowledge of the market. This book would not be possible
without their contributions, and the editors wish to
express their profound thanks to all the authors.
Kelly DePonte, Probitas Partners
Wanching Leong, PEI Media

The Definitive Guide to Private Equity Fund Investment Due Diligence

CHAPTER ONE

Private equity fund manager due diligence

and selection
By Helen Steers, Pantheon

Introduction
This chapter tackles the subject of private equity
fund manager due diligence and is divided into
three parts. First of all, we examine why manager
selection is so critical in private equity. We go on
to describe the challenges of conducting due diligence and constructing a well-diversified private
equity portfolio, and discuss a typical due diligence
process. Finally, we highlight the changes in this
process over the past five years, since the first edition of this guide was published, and in the aftermath of the credit crunch.

The importance of private

equity manager selection
Unlike the hire-and-fire world of public equity

manager selection, the choice of a private equity

fund manager means making an investment decision that will endure for 10 years, and even longer.
After making a commitment, an investor is unable
to exit from a fund until it is completely liquidated,
except under extremely unusual circumstances or
unless it elects to dispose of the position in a secondary sale.
Much more is at stake in the initial manager selection decision in private equity, hence the importance of getting it right on day one. What is more,
the consequences of getting it wrong in private
equity are much more important than in the public
markets. Dispersion in performance of private
equity fund managers is significantly greater than
between public equity managers. In fact, according
to data from Thomson Reuters VentureXpert, the
dispersion between the top-performing private

Figure 1.1: US and Europe private equity returns, 19692009

20
Upper: 17.0%

Net IRR (%)

15

Upper: 14.5%

10
5

Median:
3.6%

0
-5

Upper: 15.0%

Median:
6.6%

Median:
6.2%
Upper: 3.3%

Lower: -0.4%

Median:
-2.2%
Lower: -2.7%

Lower: -3.1%
Lower: -8.0%

-10
US venture

US buyout

Europe venture

Europe buyout

Source: Thomson Reuters VentureXpert to 31 December 2009, captured 19 May 2010.

The Definitive Guide to Private Equity Fund Investment Due Diligence

SECTION I: IN-DEPTH, INCISIVE CHAPTERS

equity managers and the bottom can be close to

20 percent, as shown in Figure 1.1.
The dispersion of returns between managers
emphasises the importance of comprehensive due
diligence in identifying the top-quartile managers.

The challenges of private equity

manager due diligence
Another difference between the public and private
investment worlds is that there is much less publicly available data to assist in private equity fund
manager selection. Generally, the investor either
has to build their own database or rely on outside
sources that may be limited in nature. The investor
has to ask for detailed information on each fund on
which they conduct due diligence there are no
rating agencies to help, no standard documentation and no comprehensive published measures of
individual funds performance. There are also no
investable private equity indices, so an investor
cannot track a standard portfolio of managers. As
such, active asset allocation and active choice of
managers are the only options in private equity.
In addition, the investor finds that there is much less
quantitative data available than in public manager
selection, hence the importance of qualitative methods and informal networks in assessing private
managers (for example, reference checking takes on
even greater significance). Even the quantitative
data that is available may be open to interpretation
and based on underlying valuation assumptions that
the investor will need to question. The process of
winnowing out the prospective finalists is also complicated by the fact that there are restricted open-tobuy periods with private equity funds and inherent
problems accessing the best managers.
Finally, investors have to compare a private equity
fund offering not only with other, similar funds currently on offer, but also with funds that may be

organised in the future by comparable managers,

operating in the same sub-asset category, some of
which may be very difficult to identify. This is clearly not the case in the public equity world.

Private equity portfolio

construction
There are over 4,000 private equity fund managers
in the world and typically more than 500 funds
which are open to buy at any one time. Typically,
an investor will choose to build a diversified portfolio consisting of around 25 to 45 funds over a
three to five year period drawn from a number of
sub-asset categories. The exact number of funds
will depend upon the investors geographic remit,
target asset allocation and desired level of diversification. For example, one investor may be satisfied
with a handful of managers covering Europe on a
pan-European basis, as part of a small but globally
diversified private equity portfolio, while another
may build separate US, European and Asian portfolios, diversified by geography, stage and vintage.
Having decided upon their investment strategy and
level of diversification, an investor needs to map
the universe of private equity managers thoroughly, to ensure that they are selecting funds from the
broadest possible offering and not just restricting
the choice to available managers (that is, those
that are readily accessible or have funds that are
currently open). The investor must then categorise
each manager, rating it against its peers in a rigorous manner, according to a range of criteria.

The typical due diligence process

Every private equity investor develops his or her
own methodology for selecting managers and has
to comply with his or her own investment approval
process. This can vary and may be more or less
formalised, depending upon the investor. However,

The Definitive Guide to Private Equity Fund Investment Due Diligence

P R I V AT E E Q U I T Y F U N D M A N A G E R D U E D I L I G E N C E A N D S E L E C T I O N

Figure 1.2: Private equity fund investment process

Private equity funds available in the market

Industry
relationships

Research

Intermediaries

Fund
relationships

Monitor and
oversight

Exit and
distribution
management

Deal sourcing

Preliminary
analysis

Does not fit

criteria

Due diligence

Investment
committee
approval

Negotiation and
legal review

Commitment

Source: Pantheon.

the decision-making flow chart shown in Figure 1.2

details the typical stages in a private equity fund
investment process.
The process starts with the sourcing of the fund
opportunity. Typically, an investor will either be
approached directly or indirectly (through a

placement agent) by the fund manager or will

adopt a more proactive stance, targeting a manager because of an existing relationship or as a result
of research and industry networks.
Preliminary analysis usually involves a relatively
high-level review of the essential elements of the

The Definitive Guide to Private Equity Fund Investment Due Diligence

CHAPTER FIVE

31

Legal due diligence: a Q&A session

venture capital funds and all types of investors in
such vehicles. They are:

Introduction
A thorough review of the terms and conditions of
the partnership agreement is a vital part of the
due diligence that any investor considering investing in a private equity or venture capital fund
should undertake. As the financial crisis has
slowed down the fundraising process and limited
the amount of capital available for investment, the
due diligence process has become more important as investors re-evaluate relationships and
reconsider investment programmes. Examining
the details of the partnership agreement, and
negotiating with the general partner (GP) where
necessary, is as much a step in the due diligence
process as analysing the GPs track record or taking references.
In order to examine the area of legal due diligence
in depth, PEI Media asked a group of distinguished
fund formation experts to comment on a number
of issues, ranging from whether investors were
paying more attention to legal due diligence,
through whether there are substantial differences
between different classes of investors, to those
areas that are causing concern to limited partners
(LPs). Their responses are included below in a
Q&A format.

The experts
Our group consists of leading legal private equity
and venture capital fund formation attorneys from
the US, the UK, Germany and Asia. Between
them, they have many years of experience in
structuring funds and drafting terms and conditions
in limited partnership agreements globally. Their
experience relates to all types of private equity and

Uwe Brenz and Tarek Mardini of P+P Pllath

+ Partners, Berlin
Dean Collins and Lawrence Sussman of
OMelveny & Myers, Singapore and Beijing,
respectively
Craig Dauchy of Cooley LLP, Palo Alto
Robin Painter of Proskauer Rose LLP, Boston
Duncan Woollard of SJ Berwin, London

The questions
Given the turmoil of the last couple of
years, are investors in general paying
more attention to legal due diligence?
Have they become more sophisticated in
this arena?
Uwe Brenz (UB) and Tarek Mardini (TM): Yes,
investors (even smaller investors such as family
offices) have become more sophisticated over the
last few years and spend more time and energy on
analysing and negotiating legal terms as part of
their increased overall due diligence. This is both a
result and sign of the fact that private equity has
matured as an asset class. While it is true that
investor-friendly legal terms do not automatically
make successful fund investments, the financial
crisis has made investors aware that good fund
governance is important as a downside protection
of investors assets and can help prevent an
unsuccessful investment from becoming a catastrophic one.
Dean Collins (DC) and Larry Sussman (LS): There
has undoubtedly been a greater emphasis among
institutional investors on risk management generally

The Definitive Guide to Private Equity Fund Investment Due Diligence

32

SECTION I: IN-DEPTH, INCISIVE CHAPTERS

and this has led to increased legal due diligence for

investors into Asia funds. This has been particularly
marked among investors with a shorter history of
making allocations to the asset class, including
many Asia-based investors, who have increasingly
started engaging external legal counsel to assist
their fund reviews, although some such investors
even significant ones still do not negotiate on
terms. Large investors from the US and Europe
already had fairly robust processes in place, and the
failures in their portfolios were largely driven by
market forces or insufficient commercial due diligence rather than legal issues.

Craig Dauchy (CD): Without a doubt, investors

and their counsel have generally become more
sophisticated on legal due diligence. In light of the
economic climate over the last couple of years,
investors are placing a high priority on legal due
diligence and many investors are conducting more
extensive due diligence than ever before. Many
institutional investors have become more aggressive in commenting on fund partnership agreements and these agreements are often heavily
negotiated. In addition, LPs are participating in
multiple diligence meetings with fund management teams and are placing great importance on
diligence on track records and references.
Robin Painter (RP): The turmoil and the subsequent regulatory activity has led to an increased
understanding of the legal and regulatory environment, such as for instance diligence by public pension plans concerning the use of placement
agents. However, in my experience the focus of an
investor is linked to the maturity of an investors
portfolio, as well as the investors overall strategy
in building that portfolio. An investor with a mature
portfolio might only refine its approach slightly in
light of recent flux in the market, while a new
entrant to an asset class will be brought to consider a broader range of diligence issues as it develops its own investment strategy from a blank
slate. It is therefore often more a question of

adapting the legal diligence to a particular investment model.

Duncan Woollard (DW): Investors are certainly

paying more attention to legal due diligence than
ever before. All investors will now undertake a
legal review of a fund whereas as little as two
years ago many investors would simply follow the
larger and more sophisticated investors. We are
also finding that the extent of the legal review has
increased greatly. Investors are going into a lot
more detail on the terms and conditions of funds
and examining exactly how they work, rather than
simply following a box-ticking exercise. This has
tended to make the closing process a far more
drawn out and difficult affair and dealing with each
investors requests with due consideration has
become crucial as many investors are quite prepared to walk away from the investment if the key
terms do not match their expectations. With
respect to investors sophistication, LPs certainly
have a greater understanding of the terms of fund
documentation than in the past and what affect
these terms might have in the future. Many LPs
do not feel obliged to follow market terms where
they think these do not provide them with sufficient protection and many pursue their own agenda on core issues, born from their own experience
and previous mistakes.

The ILPA Private Equity Principles were

released in September of 2009. Have
they had a major impact in the
structuring of funds going to market or
in current limited partnership agreement
(LPA) negotiations?
DC/LS: The ILPA Principles are a manifestation of a
change in the balance of power between GPs and
investors, and it is this change, rather than the
principles per se, that is having the real effect.
Indeed, in an Asia context, the Principles, which
are commonly regarded as having been created in
response to the excesses of the large global

The Definitive Guide to Private Equity Fund Investment Due Diligence

CHAPTER SIX

45

Private equity benchmarks:

Methods and meaning
By Jesse Reyes, QuartileOne, LLC and Austin Long, Alignment Capital Group, LLC

This chapter examines private equity benchmarking

by evaluating the methods in current use,
analysing some of their shortcomings, providing
guidance on their proper use and surveying new
methods that have been developed to provide
additional benchmarks.

What is a benchmark?
Before the advent of modern power tools, craftsmen resorted to tradecraft to precisely build furniture. At the time, without accurate rulers or
measuring tapes, they used trade tools such as
story sticks and for measurement would make
marks on their workbenches as points of reference. For example, these benchmarks might be
used to make sure that all legs for a table were
the same length.
Thus, a benchmark is a point of reference.
In investments the term has evolved to mean
the use of indexes and other return statistics
to evaluate the performance of financial securities. There is a large body of knowledge regarding
the use of indexes as benchmarks in the
public securities markets and an entire performance measurement industry has evolved for
the express purpose of creating and using a
bewildering variety of benchmarks. Benchmarks
range from the trivial (for example, what was
the return last year or I want a 10 percent
real return) to the extremely complicated (for
example, a set of heuristics and algorithms that
can be used to evaluate a complicated investment structure).

Opportunity cost and

benchmarking
The choice of a benchmark would seem to be trivial. After all, in the public markets there are stock
indices derived from a seemingly endless supply
of composites. However, the choice of a benchmark is actually quite complicated in that a true
benchmark should be chosen on the basis of the
investment decision being evaluated, whether the
benchmark is intended for direct comparison or for
what we call an opportunity cost comparison.
Take the case of the nave manager. Assume an
investment manager has a choice of two securities, A and B. The manager can choose any proportion of investment in these two securities, for
example, 70 percent A:30 percent B, 20 percent
A:80 percent B, 0 percent A:100 percent B and so
forth. Without superior knowledge, the nave (passive) manager would have no basis for a decision
between the two investments and would therefore
select a 50:50 weighting. The investment weighting decision that the active manager actually
makes should be superior to the returns of this
nave manager decision.
Given even a simple investment portfolio, there
are myriad potential decisions to evaluate. For
example, a portfolio manager might make a decision to invest in private equity versus another
asset class; a decision to invest 30 percent in venture and 70 percent in buyouts; or a decision to
invest in 2003 vintage year funds but not 2004. In
each case a benchmark should be appropriate to
the decision being evaluated.

The Definitive Guide to Private Equity Fund Investment Due Diligence

46

SECTION I: IN-DEPTH, INCISIVE CHAPTERS

For a relevant example in the private equity industry, take a buyout fund of funds manager who
must make two critical investment decisions:
which vintage years to invest in (a temporal allocation decision); and, within those vintage years,
which buyout managers to invest in (a series of
manager selection decisions).
This manager forms a buyout fund of funds in
2001 and invests in underlying funds with vintage
years 2001, 2003, 2004 and 2006. Note that the
manager chose not to invest in 2002 and 2005.
There are two different benchmarks for these two
different decisions. The first benchmark would
exactly mirror the managers temporal allocation
decision by using return data from the exact same
vintage years in which the manager chose to
invest. The only difference between the managers
series of investment selection decisions and the
benchmark would be the relative performance of
the funds the manager selected versus the performance of the funds in the benchmark. This
direct comparison benchmark would measure only
the managers selection prowess.
Alternatively, the manager could select a composite
benchmark made up of all the vintage years in the
investment period, from 2001 through 2006. The
managers decision not to invest in 2002 and 2005
should provide superior results when compared to

the benchmark that includes those vintages. In this

second benchmark there are two potential differences between the managers investments and the
benchmark: the vintage years selected and the
managers selected within each vintage year. This
benchmark thus evaluates both the vintage year
timing decision and the series of manager selection
decisions as well. This second benchmark comparison is what we call an opportunity cost benchmark
the manager had the opportunity to invest in all
five years but did not do so, a decision the outcome of which should be measured against the
benchmark and either rewarded or penalised. The
investment decisions incorporated into this simple
illustration are summarised in Table 6.1.
Although many investment professionals believe
the direct comparison benchmark that is, one that
exactly mirrors the managers actual investments
is the only viable benchmark, our example makes it
clear that a direct comparison benchmark only evaluates one dimension of the investment decision.
Just as in the public markets, which frequently use
benchmarks involving a broad stock market index, a
private equity benchmark should reflect what the
manager did decide to invest in as well as what the
manager did not decide to invest in.
Of course, in addition to comparing returns to a
private equity universe, the buyout fund of funds

Table 6.1: Example of a benchmark selection for a fund of funds

Vintage
2001

Fund of funds managers portfolio

Direct benchmark

Opportunity benchmark

X
X

2002
2003

2004

X
X

2005
2006

The Definitive Guide to Private Equity Fund Investment Due Diligence