By Solomon Owayda, founding partner, Mozaic Capital Advisors
It is said that hindsight is 20/20. Wouldn’t it be great if one could look back at a private equity portfolio and have the chance to double down on the good investments and undo the bad ones?
I have been investing in PE for the past 29 years, with my first commitment to a fund made in 1988 while I was head of private equity at California State Teachers’ Retirement System. At the time the industry was in its infancy and in fact had not yet gotten the PE name; it was still known as “alternative investments.” I remember having a conversation with my colleagues when the total amount of U.S. funds raised in 1990 exceeded $10 billion, and we thought that doom and gloom would ensue and that high returns were a thing of the past.
As one can imagine, I have seen (and invested with) the good, the bad and the ugly. I always think about what I should have done differently if I had known then what I know now. Many investors build models to project winners and losers, but most of these models are backward-looking.
In the early ’90s, a handful of LPs, myself included, started meeting in Chicago to address PE-related issues, and these meetings morphed into the Institutional Limited Partners Association, of which I was chairman until I left the pension fund in 1997. This original group came up with a simple yet effective way to analyze and conduct due diligence on PE funds. I called it the “5 Ps of Private Equity.” If I adhered to this methodology early on, I am sure I would have declined some of the groups with whom I invested and now wish I had not committed to.
People: No matter what financial models one prepares and deploys, PE is still a people’s business. At the end of the day, you are NOT investing in a product; rather, LPs are investing with people. One needs to be able to look at a fund’s general partners in the eye, and the GPs need to pass the smell test. It is important to know — really know — who the GPs are, their backgrounds, their experiences and their levels of involvement, and I am not talking about only education and experience. No financial model can help pick these partners; rather, it is the experience of making the mistakes, assessing the scars left after investing with the wrong groups, and, one hopes, not repeating the mistakes.
Performance: Although analysis of past performance is backward-looking, it is the second most important criterion to analyze when investing in PE funds. It is critical and vital to see what the GPs have invested in and what their returns are. Performance can be analyzed in several ways: Some LPs look at IRR, while others look at multiples. I am one of those who like to look at both. We all have heard the adage “you cannot take the IRR to the bank,” but it is an important tool. What’s good is a fund that has a 3x return but it took the GP 15 years to do so. But what about a fund that had one or two early winners and lost money on the remaining portfolio, yet still shows a high IRR? It is also important to see who owns the track record. Is a new team taking credit for the performance of partners who are no longer involved?
Process: Another important criterion to analyze is the process that the GPs follow to make money: in other words, how they source, how they analyze, how they buy, how they add value, and how they exit their deals. Sourcing deals and the amount of deal flow a GP looks at is very critical; in general, a robust pipeline usually translates to strong deal activity and a healthy return. Of course, the process of sifting such a deal flow is as important. If a GP wants to institutionalize its investor base, they cannot invest by the seat of their pants; having a process to source, analyze, buy, and sell (and repeat it) becomes very critical.
Product: Private equity is not homogeneous; it comes in many shapes, forms and flavors. When looking at a fund, one must be able to understand what one is investing in. Is it a buyout fund, venture, small/middle market or megabuyout, mezzanine and debt or equity? This criterion is important for return comparisons; when analyzing performance, one must compare funds of similar vintages and similar styles.
Price: The last criterion to consider is the terms of the partnership — but I did not want to call this analysis the 4 Ps and a T, hence I changed it to Price. It is important to look at the terms of the LP agreement and see how LP-friendly it is. The ILPA published key terms and conditions that it believes are fair to both, and many look at these terms as a guide rather than the ultimate terms to be followed. Management fees should be paid to cover the operating expenses of a partnership and the carried interest is the incentive. Of course there are many other terms to look at, but these two seem to take the bulk of the consideration.
When one analyzes a potential investment in a particular PE fund, these criteria might appear to be just common sense. Well, they are — and are meant to be that way. They are intended to be broad categories that each investor can then customize to fit their needs, policies and procedures.
LPs should note that applying these criteria does not guarantee a high rate of return; rather, when followed with attentive care, these 5 Ps will help LPs avoid investing in the ugly funds that many wish to avoid.
(Correction: Solomon Owayda is founding partner of Mozaic Capital Advisors; the original version of this article gave an incorrect name for the firm.)