Investment Due Diligence – the main stage of the process of selecting private capital funds

04.02.2023

 

 

- Hello, Kuanysh. Before we discuss the process of choosing private equity funds, can you please briefly tell our readers what investment due diligence is?

 

Hello, dear readers. The term "Due diligence" in other words "a comprehensive legal evaluation", became part of the generally accepted practice after the adoption of the US Securities Act of 1933 (US Securities Act of 1933). Due diligence is a comprehensive audit of the financial condition of the acquired asset or business, along with a comprehensive study of the company's activities and an assessment of possible legal and investment risks. With regard to investing in private capital funds, investment due diligence can be described as a process of checking and evaluating the effectiveness of investment managers' activities in order to make an informed investment decision. The future profitability of the investment portfolio depends on how carefully and in detail the investment due diligence is carried out.

 

- Which division of the NIC conducts investment due diligence of private equity funds?

 

Investment due diligence is carried out by the division of the front office responsible for investing in private capital - the Department of Alternative Investments. As with any front office division, our activity is not only to analyze, compare and select private equity funds, but also to create and maintain long-term relationships with fund managers, as well as sovereign funds, institutional investors and other similar organizations.

 

- Why do sovereign wealth funds and other investors prefer to invest in private equity funds?

 

Investments in private equity funds are long-term and require investments from the investor during the investment period of the fund (usually up to 5 years), followed by a holding period with a gradual return on investment, which limits investors' access to liquidity. In theory, the risks and potential additional costs associated with investing in illiquid assets should be offset by a higher average return. Indeed, according to a study by Robert S. Harris, Tim Jenkinson and Stephen N. Kaplan (2014)1, historically, over a long period of time, the annual return on venture capital and investments in private equity funds, minus commissions, exceeded the return on public equity indices by an average of more than 3%. The purpose of sovereign funds is to stabilize the national budget, increase and transfer funds, as a rule, from the export of natural resources to the next generations. Due to the long-term investment horizon and, as a result, the relatively high tolerance for illiquidity, sovereign funds and institutional investors have the opportunity to invest in private equity funds and thus diversify their portfolio.

 

- Please tell us how the process of choosing private equity funds begins?

 

Even before the start of the whole process, taking into account the portfolio diversification targets, the region and the strategy for which the selection will be carried out, are determined. Further, screening selection of funds in the market that meet the minimum requirements regarding the size of private capital funds, manager's experience, geographical focus, etc. is carried out. After the screening stage, our department conducts scoring, which identifies the best funds for further analysis. At this stage, the main criterion is the size of funds and the profitability of managers, which is expressed in terms of the internal rate of return (IRR) of funds and the ratio of distributed capital to invested (DPI). The scoring is followed by due diligence of funds selected from the list, in which our team conducts a more in-depth analysis and comparison of managers.

 

- What do you pay attention at during the investment due diligence?

 

During the investment due diligence, we pay special attention at the experience, organizational structure, composition of the manager's investment team, the process of selecting companies and creating added value. Benchmarking is also carried out – a comparison of the historical profitability of the manager's funds with the funds of other managers of a similar strategy. The conditions for investing in the fund are also important, since, for example, a high management fee can offset the potential super-profitability of the manager. Also, an important factor is the analysis of potential conflicts of interest and how the manager minimizes such risks. To get the full picture, meetings and calls are held with representatives of various departments of the manager, at which we ask more specific questions of interest to us. It is also a good practice to conduct reference calls with other investors who have already invested in the funds of this manager.

 

- As you said earlier, the profitability indicators of previous funds play an important role in making the final decision. However, by the time the process of raising capital begins, significant changes may occur in the strategy and the manager's team. How do you take these changes into account during the investment due diligence?

 

Indeed, it is very important to determine whether the manager is able to demonstrate future returns similar to those of previous funds. For example, if the current composition of the investment team differs significantly from the composition responsible for previous funds, then it is necessary to determine how much of a role the employees who left the company played in concluding and implementing transactions. If the manager's team has been left by key employees who were responsible for the majority of successful transactions in the past, then it is highly likely that the manager will not go through the following stages when making an investment decision. The same applies to significant changes in the size of investments, sectoral and geographical focus, and other factors.

 

- What usually completes the process of choosing private equity funds?

 

After the investment decision is made, an agreement is signed between the General Partner represented by the private capital fund manager and the Limited Partner represented by the investor. This is followed by a stage of systematic monitoring, which can also be described separately.

 

- Kuanysh, thank you for your time and for describing the process of choosing private equity funds in detail.

 

Thank you for your questions, too. Due diligence is a very important process in any investment activity and I hope that this information will be useful for our readers

 

¹ Harris, Robert S., Jenkinson, Tim., Kaplan, Steven N. 2014. “Private Equity Performance: What Do We Know?” The Journal of Finance, 69(5).

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