April 1, 2012 5:28 am

How to assess a private equity fund

Two businessmen talking©Corbis

Managers get a grilling by Private Advisors

An investor’s relationship with a private equity fund typically lasts longer than the eight years of the average US marriage. That makes private equity easier to sell than other alternative investments. “Every three months you have to persuade a pension fund that your hedge fund is a good investment, but with private equity it’s one decision and you’re done”, says a salesman who has pitched both.

Yet it presents a problem for investors, because while the average private equity fund performance just about matches investing in an index of mid-cap companies, after fees, the difference between a good and bad private equity outfit is substantial.

According to a study by academics at Stanford and Maastricht, a US pension fund that was consistently in the top quartile of private equity investors from 1990 to 2010 made 20 per cent a year, on average, while one in the bottom quartile would have received just 2 per cent annually.

Past performance is one signpost, as it persists. Barclays Capital calculates that a private equity fund ranked in the top third of performers has a 58 per cent chance of staying there for the following three years.

Even so, what worked in one year can fall flat as the economy shifts. Small teams of private equity general partners also can change in fundamental ways between one fund and the next if a key person departs. Tensions over compensation or succession that merely simmered before can boil over.

One way to try and pick up on those risks is to treat the entire manager selection process as a job interview in its most methodically ruthless form, as does Private Advisors, an alternative asset manager now owned by New York Life.

Founded in 1997 by Lou Moelchert, the group adopted its particular approach in 2006 after it invited human capital consultants GHSmart in to give its directors a personal six hour grilling, and then talk to everyone in the organisation. The results persuaded them their interrogators might be onto something. “The write ups were so accurate for those who were self-aware,” says Chris Stringer, of Private Advisors.

Now, trained by GHSmart, they subject all the members of a private equity team under consideration to the same sort of close analysis, armed with a scorecard of 21 attributes to look for patterns of behaviour. “Most human beings are going to continue doing what they’ve done in the past”, says Mr Stringer.

The idea is that under sustained questioning, a step by step tour through the accomplishments and failures of the past, the picture of the person begins to emerge. One manager was backed in large part because he had been so disappointed not to get into an Ivy League university: money was just a way of keeping score, meaning he showed no sign of retiring or easing off.

But Mr Stringer has tricks to get at the truth as well, threatening to follow up with former employers. “Now this is a specific thing we find very effective. You sit there and you ask how to spell the [former employer’s] name,” he says, before asking “what would they say about your strengths and weaknesses, if I called them?”

And the group does follow up, running down 30 references or more on the typical private equity partner, preferably in person. Mr Stringer describes travelling to meet one wealthy family, the former investor in a prospective fund. “While they didn’t say anything material, the facial expressions and surprise, there was enough apparent dislike to give us pause.”

Of course, not all private equity managers are prepared to sit through such treatment, particularly if their fund is in demand and they are turning away investors. Private Advisors, which has around $1bn invested in private equity, concentrates on the outfits with teams of five to 20 people who are willing to put up with such treatment.

But it illustrates the central challenge of picking a private equity team, one that makes it increasingly likely that money will continue to concentrate in the hands of those with an existing track record. “It’s more difficult now than it was four or five years ago for sponsors to get up and running,” says Ricardo Hollingsworth, partner at Katten Muchin Rosenman.

And the only real alternative is to trust a track record and pick a private equity discipline that seems likely to succeed. Aaron Gurwitz, chief investment officer for Barclays Capital wealth management, says: “It becomes a question, is this the right strategy for this vintage year, is it a good year for leveraged buyouts, for secondary funds, for distress or for venture?”

This article is subject to a correction and has been amended.

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