5 minutes with… Travers Smith
The latest instalment of our ‘5 minutes with…’ series; a brief catch-up with private equity operational professionals and service providers to learn about their work and views on current trends.
From technology to talent, regulatory compliance, ESG and public image, operational strategies are fast becoming front of mind for a coming-of-age private equity industry. What is the view from across the GP-LP divide? The Drawdown recently touched base with Sam Kay, head of investment funds at Travers Smith, to discuss the state-of-play with operational due diligence (ODD). What follows are his views on emerging strategies by LPs such as specialist ODD teams and why some are looking to co-investment as a gateway into a manager’s operational thinking.
The Drawdown (TDD): What has been the evolution in how investors approach operational due diligence (ODD), what have been the latest developments?
Sam Kay (SK): In general, institutional investors are more sophisticated in approach when it comes to assessing GPs. Whereas previously for some investors the analysis may have focused more on performance or a compatible strategy, now it is likely to cover a wider range of issues. An analysis of the operational excellence is one part of that broader approach. Over the years, we have seen investors increasing engaging consultants to advise on suitable investment opportunities. These consultants can often become gatekeepers to gain access to high-performing GPs; they will have the size and scale to do deep dives into the market and look at a range of issues, including how GPs operate.
Other investors will have their own teams who carry out ODD. The added value can be two-fold: if the GP has a well-oiled machine, then it is likely to also drive operational excellence in its investment activity. If the underlying portfolio companies are streamlined and efficient, then that is likely to improve returns. Secondly, the vast array of tax, regulatory and compliance requirements will also affect a lot of institutional investors (e.g. large asset managers and funds of funds). If there is a streamlined approach to the investment process (e.g. reporting, providing FATCA and CRS forms, checking underlying beneficial ownership) then that is likely to mean the operational obligations on the investor are easier to deal with.
TDD:What is typically happening in terms of follow-up, what are investors doing to monitor operational excellence once fundraising is over?
SK: These days, you will often hear GPs saying the fundraising process never really stops: as soon as they hit final close on Fund I, they are moving to pre-marketing of Fund II. So, in some ways, the follow-up is simply that investors will keep up the relationship with the GPs and keep monitoring activity – participating in LPAC meetings or annual investor meetings represent another potential channel to keep an eye on things. Incidents such as mistakes in drawdown or distribution notices, reports not provided in time or a lack of assistance by the GP with tax and other filing requirements (e.g. providing K-1s or PFIC confirmations) could all become a sign for LPs that there are issues with the operational performance of the GP.
TDD: Could co-investment become an alternative route for LPs to gauge GP operations, what can they learn through that interaction?
SK: A lot of a GP’s marketing pitch for a fundraising will be on how they source investments, what makes the GP different from the crowd and how they execute transactions. Co-investing alongside the GP gives investors a chance to see if what has been said rings true. By co-investing, an investor will have a closer eye on the terms that the GP negotiates in the underlying transaction and what points are important (e.g. does the GP impose ESG or financial reporting requirements on the underlying portfolio company); the investor will see how the GP interacts with management teams and other service providers; how ‘slick’ the process is when making the investment; how the GP performs when under stress.
TDD: What advice would you have for a private equity house seeking to make ODD as smooth as possible, ensuring LPs are satisfied with the interaction?
SK: My simple advice would be to stick as close as possible to ILPA recommendations e.g. the template reporting (including the recent template fee reporting) and using the pro-forma capital call and distribution notices. More generally, through the life of the fund the GP should focus on ensuring all filing requirements (especially ones that are investor-facing, such as tax-related filings) are complied with in a timely fashion, there are no valuation mistakes, and investor meetings and LPAC meetings are run smoothly and efficiently. When the GP begins to think about fundraising again, it would be a good idea to spend a good deal of time working on the general due diligence questionnaire and making sure that demonstrates a good level of transparency.