Han Dieperink: How do you select private equity funds?

June 11, 2024

_{This column was originally written in Dutch. This is an English translation.}

By Han Dieperink, written in a personal capacity

The differences in returns between the best and the worst private equity funds are so great that even the average private equity funds are not good enough. So how do you make a good selection? Start looking for red flags.

To actually realize private equity returns, funds from the top deciles or top quartile must be selected. This is often done through extensive due diligence, endless questionnaires with which one tries to separate the wheat from the chaff. But what works?

One of those questions I came across in the past had an original interpretation. The question was how many people within the organization were allowed to use the title CFA. The more CFAs the better, you would think, but the purpose of this question was to identify the red flag of groupthink. If there are only CFAs active in an organization, then the risk is not only that they operate within that straitjacket, but also that they belong to the same group of people who see each other regularly, even on weekends. This results in lower quality group decisions.

Four red flags in a row

Recently, a private equity party was in the news that wanted to raise a lot of money for its next fund, but it turned out that there was an argument between the board and the partners. That's the first red flag. The argument turned out to be about the pay structure. In private equity, partners are rewarded based on part of the carried interest, a percentage of the profit on sale. The reason why people do not work for McKinsey, for example, but choose private equity, is based on this carry. Cutting back on this (after the fact) ultimately means that cheap turns out to be expensive: the second red flag.

It also appears that several partners have ended up sidetracked as portfolio managers: the third red flag. After all, it means that the next fund will be led by a different team than the previous funds. While consistency is important here, otherwise we are back to square one. Finally, it appears that the founder has also appointed his sons to the board. In private equity there is no place for nepotism: the fourth red flag.

Focus and interpret

For many institutional investors, due diligence is merely a checklist that must be completed before proceeding with the process. It's proof that they did this part. They save the answers, but do not check whether the answers are correct.

Other investors tend to want to analyze everything, but that often results in paying attention to the wrong details. For example, they want to know everything about past deals, but they do not gain insight into the culture of the company, how investment decisions are made, and whether the people and processes are suitable to generate the right returns in the long term. Of course, questions are asked about track record, team, operational experience, et cetera, but the trick is the interpretation of relevant information. A simple check mark is not good enough.

Past results

An important part of due diligence is past results. The idea is that if a private equity house has scored in the top quartile several times, it will succeed the next time. The problem with this is that the funds also know that they have to score in the top quartile to be selected. This can even mean that value-destroying decisions are made just to score within that quartile.

A high IRR is often open to multiple interpretations and can even be manipulated. The track record is often also based on future valuations, an incentive to keep that valuation artificially high. Also pay attention to whether the return development does not follow the normal pattern that is common within private equity: even then, a red flag quickly arises.

Learn from the deviations

Furthermore, it is especially interesting to look at underperforming investments. After all, these investments have also been selected by the same process and the same team that also selected the investments in the top quartile. There is a lot of information in investments that do not fit the story being told. It probably shows what went wrong and what has been done to prevent it in the future. Just ask about the worst investment and what they learned from it.

This also works great when hiring new employees, simply ask about the worst investment of the past year. If someone states that it does not exist, that is by definition a red flag.

Keep it simple

Finally, there are also very simple red flags. Such as companies that are not transparent or that state that you should trust them without providing additional information. Even when there is insufficient communication, things are usually wrong. This also applies to funds that really want to change everything about a company. Why would you want to buy such a company?

What also helps to form a quick judgment is to talk to the competitor. He usually has a judgment ready. Furthermore, companies are increasingly receiving reviews on websites or via social media. Finally, many people will be surprised at what you can bring out in a simple conversation. Start with that and then check whether it matches the other information.

More columns by Han Dieperink