With more GPs striking out on their own, LPs face the daunting task of evaluating deal-makers’ track records.
In private equity, success has many fathers, while failure is an orphan. That’s how one GP described the challenging art of portraying and confirming track record when landing a new job, spinning out a new firm or winning an LP.
Private equity presents unique challenges on this front, at a time of much activity around new firm formation, strong fundraising and churn in personnel from the lower middle market up to behemoth players.
“It’s often a negotiated topic when people leave or join a firm, and a major consideration in those talks, with no easy answers,” said Sean Hill, partner and co-head of the Private Investment Funds Group at law firm Proskauer.
By contrast, if you run a public equities mutual fund, for example, your fund performance during your employment pretty much speaks for itself by the stocks you picked and the returns they delivered. Likewise, a hedge fund manager may simply point to the IRR of a fund she ran to prove her mettle.
But with private equity funds, different people may work on various parts of a deal from sourcing to finding a buyer. Operating partners provide guidance, too. Plus, most major decisions about buying and selling go through a multi-person investment committee. It’s often a question of whether the overall firm or an individual at the firm really deserves high marks for a fund’s performance or a deal.
If an investment performs well and a person claims credit for it, it’s hard to say who takes the blame if it sours once that person leaves the firm. Venture capital fund managers may face similar challenges of proving their role for a deal or fund performance when so many people take part in the overall process.
“Ten or 15 years ago, most LPs thought one guy found the deal and they sold it,” said Peter Martenson, a partner at Eaton Partners, a placement agent that works with many first-time funds. “Now it’s a real team effort, even with outside consultants involved as well.”
In one move to get a handle on all this, the Small Business Administration includes 20 designations for track record in its application for an SBIC license to run a lending fund for small businesses with support from the U.S. government.
Attribution terms the SBA looks at range from deal lead before the investment, to a discussion of post-investment roles. One key element in the application is the deal team leader that “took ownership” of the deal, doing all the work to develop the investment, a GP said.
Portable track records
With our without the SBA process, private equity track records remain subject to conflicting rules around confidentially and disclosure, said Proskauer’s Hill. For the most part, track record remains with the firm. In some cases, firms that don’t plan to raise another fund may provide deal-record attribution letters, but only at their discretion.
Hill sees an “inherent tension” between the Investment Advisers Act’s rules over portability of track record versus U.S. securities laws on full disclosure.
“The Advisers Act, in essence, says that track record isn’t easily portable,” Hill said. “But you could have someone with a terrible track record that starts a new firm and ‘sheds his skin,’ in that he can’t really disclose track record because it’s not portable anyway under the relevant circumstances, but he doesn’t want to disclose it anyway.”
It’s possible an investor may have a securities claim against a manager for failing to disclose a bad track record, but he may be following the Investment Advisors Act by not disclosing it.
“At a minimum, an employee wants to say what boards they were on, what duties they had for an employer, and other non-performance factual information,” Hill said. “That should be considered resume material as opposed to a track record, but that is not entirely clear under the Advisers Act.”
Outright legal disputes over track records remain rare, but instead, departing members of a team and their former bosses often “maintain a deep-seated hatred that festers for many years,” Alex Abel, a principal at RCP Advisors, said at Buyouts Insider’s PartnerConnect West conference in Half Moon Bay, California, on October 13.
Abel took part in a panel called “LP Due Diligence Best Practices: Red Flags In the Evaluation of a GP’s Team,” along with Julia Winterson, a director for the University of California Regents, and Sarah Kim, director of private equity and venture capital for Stanford Management Co.
Winterson said she has seen cases of mediation over track record, but didn’t mention any lawsuits. “It’s often complicated when people separate,” she said. “Sometimes they bring in brokered help.”
For her part, Kim said she bases track record assessments on reference calls with portfolio company CEOs. When she sees track record parsed out in percentages of input on a deal, she usually doesn’t place much weight on it.
Confirmation requires hard work
Although track record claims typically fall into a gray area, new funds continue to be raised and people get hired all the time. But not without a lot of hard work by investors and employers.
Eaton Partners’ Martenson said about 20 people on his firm’s team of at least 60 focus on shoring up track record claims by GPs in first-time and other funds by calling CEOs, talking to consultants, and reading press releases and news reports. It’s akin to trying to figure out a Major League baseball player’s batting average almost from scratch.
“Our job is to corroborate that,” Martenson said. “We ask the executives, ‘You say you did these deals. How can we triangulate that? Is there a CEO of a portfolio company that will say, ‘Yes, you led the deal?’”
Before raising a fund, Eaton Partners also checks whether track records leave out underperforming deals. “It’s a little bit of a forensic exercise,” Martenson said.
When executives leave firms, it’s usually not totally amicable, Martenson said. Some executives negotiate terms of their exit, which may include a break of a year or two before they start their own fundraising effort or agreeing to continue managing a fund they worked on for a certain period of time.
Building a mosaic
LPs often spend significant resources checking out individuals even before they review their track records. Some hire private investigators at a cost of tens of thousands of dollars. While it’s expensive, it’s a fraction of the tens or hundreds of millions of dollars that may be committed to a fund.
“It’s like putting a mosaic together,” said Brian Gallagher, partner at Twin Bridge Capital Partners. “You have all these pieces of information that you have to fit together to see the larger picture. Our business is very much both art and science. But the ultimate art is being able to form conclusions and apply judgment based off this mosaic you have created.”
Sometimes weak firm performance may not be an indicator of how a spin-off firm will fare. “A lot of firms have gone away because their performance started to trend down, but we have seen one or two spinout shops emerge that have performed quite well,” Gallagher said. “That makes you scratch your head.”
LPs work to compensate for the natural human inclination of presenting their best work and diminishing their roles in any mistakes. The LP community is tightknit, with LPs from farflung geographies connecting at networking events and conferences and comparing notes on GPs. Part of an LP’s due diligence on a new manager usually includes a chat with one or more of the manager’s previous investors, LPs have said in past interviews.
Gallagher focuses on knowing the players in the fund first, followed by an analysis of the firm’s positioning and focus, before scouring track record claims.
“When you invest in a fund it’s about people, strategy and track record,” Gallagher said. “You start with the people and ask: Am I investing in good, smart, hard-working people? Then you move to the strategy. The last is track record. But if you don’t clear the first two, then you never get to track record.”
SIDEBAR: Can you make the cut?
Do you have what LPs are looking for in a fundraiser? “The first step is to evaluate your team and strategy relative to the SBIC Program’s general management qualification guidelines,” said law firm Locke Lord LLC in a presentation about Small Business Investment Companies. Locke Lord said the SBA is looking for:
* Private equity investing experience and strong “deal flow” of the same type that the proposed fund would perform.
* At least two general partners who have five or more years of “decision-making” experience as a principal in a private equity fund (rather than as an agent such as consultant, investment banker, broker, etc.)
* Realized track record of superior returns, placing a fund in the upper half of performance for venture funds of the same vintage year and style.
* Managerial, operational or technical experience that can add value at the portfolio company level.
* Cohesive management team, with complementary skills and history of working together.