GUEST POST: DEAL KILLERS: 8 Steps to Avoid Killing a Capital Transaction
by Anthony Hagan
March 27, 2024
There is a certain momentum that occurs during GP/sponsor due diligence. Positive momentum can be exhilarating for all parties involved. The LP conducting the research feels excited because a selected-for-further-scrutiny (from a large list of candidates) manager is showing encouraging signs of potentially becoming a winner.
On the other side, the GP/sponsor is thrilled because there is a good chance a new and fruitful relationship is on the cusp of being formed.
However, there are a few things that can derail this momentum – these factors often become unignorable relatively late in the process, so their effects have wasted time, dashed expectations, and bad blood ramifications. At its essence, manager due diligence is an exercise where the prospective LP attempts to quantitatively, qualitatively, and intuitively connect dots of various sorts. These dots are purposely, subliminally, or inadvertently laid out by the GP/sponsor, so in most cases where a late-term process breakdown occurs, there is clear evidence as to why it happened. Here are a few reasons why seemingly bullish sentiment takes a nosedive at or around the 11th hour.
- Preparation: A lack of preparation is an issue that is prominent with emerging managers. During introductory meetings with emerging managers, most prospective LPs get an earful about all the amazing and resourceful things the GP did in their prior lives – these stories depict grit and extreme thoughtfulness. However, the same amount of rigor is conspicuously absent in the GP’s fundraising journey – there is a high degree of ignorance around LP expectations and how to show investment leadership in a chosen field. This causes many LPs to take a “wait and see” approach to avoid their capital being used as a “learning” or “experimentative” tool. GPs should apply the same amount of research, relentlessness, and advice-seeking that made them successful before embarking on the institutional fundraising journey.
- Due Diligence Support: Related to the above point, many GPs choose to use intuition to go about the fundraising journey. They have often focused much of their preparation around the deck or the first conversation and have not prepared for the in-depth due diligence process that the potential institutional LP will undertake. If the due diligence process takes too long and the GP is not prepared to support their initial statements with hard data and validating information, the LP will lose its bandwidth to maintain their momentum and focus on making an investment in the GP. This is usually the kiss of death to a closed deal. It is vitally important to prepare for the full transaction process in addition to the first conversation. . Many idiosyncrasies of fundraising require expert advice. Although advice can be wide-ranging and, in some cases, economically restrictive, truth-seeking, open-minded, and systematic research will lead to individuals who can offer solid guidance.
- Transparency: Transparency is one of the most important concerns of prospective LPs. Capital is being locked up for a relatively (compared to other asset classes) long time, so if the degree of a manager’s transparency is viewed as deficient during the due diligence period (where nothing has been signed), the willingness to get into a captive/discretionary relationship quickly diminishes. The lack of transparency takes many forms, but the main culprit is when a manager doesn’t explicitly state some fact, occurrence, and/or attribute about itself that they know would stall or delay any LP’s process. This information is not necessarily hidden but is usually buried in the data room, or only mentioned when a prospective LP specifically asks for it. Research analysts quickly run the other way when this occurs. Examples of these facts, occurrences, and/or attributes include ongoing lawsuits with serious accusations, historical bad press for a particular deal, important turnover related to rainmakers, deals in a prior portfolio marked decently but the manager has lost conviction around their viability, etc.
- Alignment: Alignment assessment is a continuous process. Certain aspects of alignment come into clearer view at the latter part of a GP’s fundraising process. Things like who/where the GP commitment will be coming from, who (and at what amounts) will participate in carry, who will be spending time on different aspects of the strategy, what terms have been provided to other LPs, etc. become more apparent the longer the amount of time you spend with a manager and the closer the fund gets to a final close. The judgment of motivation also tends to be more informed as more time is spent with the manager. Prospective LPs are not amenable to surprises and/or the perception of misalignment, so if some aspects around the fund’s economics or processes feel overly lopsided/unfair, and if perceived motivation does not correspond with desired expectations, halting the whole process is usually the prudent course of action.
- Information from References: This is a tricky one because it falls into a “lack of thoroughness by the GP” category, but it cannot be disregarded by prospective LPs because it has detrimental ramifications. GPs tend to colorfully express to LPs the various ways they added value to their portfolio companies. Judicious prospective LPs will look to corroborate these expressed actions with portfolio companies, operating partners, co-investors, and past LPs/investors. If information regarding official and/or verbal attribution cannot be verified, the due diligence process will break down. The onus of making sure the actions portrayed match with the recollection of the parties involved falls on the GP.
- Obscure Terms and Allowances: Some fund peculiarities come to a clearer focus as due diligence is nearing its end. Things that were designated as “we can talk about that later” become more consequential as a commitment is nearing consummation. These include valuation policies, accounting peculiarities, permitted security types (e.g. debt/equity, public/private, preferred/common, minority/majority, etc.), board seat coverage, UBTI, etc. In the GP’s defense, some of these are being refined in real-time, and some are open to negotiation, but for an LP who is not necessarily large enough to move the needle, the added headache of investing in something that could look fundamentally different than initial expectations, may not be worth it.
- Background Checks: Past personal or business acts by members of a manager’s team that could be viewed as negative quickly cause the cessation of due diligence. There are usually reasons for these disagreeable acts that can be clarified. However, the GP has to be aware of what an LP is likely to find if a background check is executed and get in front of the problem with extreme transparency. Some LPs conduct background checks at the beginning of their process, and others do it at the end – executing a background check is usually a sign of a positive inclination to move forward. Regardless of when background checks are done, the overarching point to be heeded is that a GP should be aware of what comes up in background checks and be forthright (voluntarily and early) about explanations.
- Late Turnover: This is somewhat covered in the “transparency” section but has to be underscored because there is a particular type of turnover that throws a wrench in many due diligence processes. Embarking on a fundraising journey is a serious commitment, and many funds go through a soul-searching exercise around this time. It is not uncommon to see members of a GP choose to break away when the thought of a 10+ year commitment becomes too heavy to bear. This usually happens before the first close of the fund. However, depending on how long the GP took before its first close, many LPs are most likely in various phases of their work when the departure occurs. The departure of a key team member at this critical time is very disruptive and many prospective LPs will choose to sit out the current fund to see what happens in the future. These things happen in the real world, but to avoid this potential image-tarnishing scenario, GPs should use all means to ensure that their team (particularly the key personnel) is on board for the full ride before broadcasting the members to the world.
| Deal Killer | How to Avoid |
| Lack of Preparation | Get a clear understanding of LP expectations from an institutional GP.Apply the same level of grit, resourcefulness, and relentlessness to the fundraising process. |
| Lack of Due Diligence Support | Prepare for the full LP due diligence process and avoid losing the momentum that it takes to close capital.Seek guidance from those who have expertise in the field. |
| Lack of Transparency | Have a clear sense of what aspects fall under “relevant information”.Reveal all relevant information voluntarily to all prospective LPs.Understand the detrimental effects of relevant information that is found by prospective LPs compared to being divulged by the GP. |
| Lack of Alignment | Ensure the reasonable sharing of the GP commitment and profit-sharing arrangement.Try to provide equitable treatment of all LPs around fund terms.Have a clear sense of what motivates – ideally something more substantive than “trying to get rich”. |
| Reference Disconnect | Ensure that the information given to prospective LPs matches what affiliated parties would say.Have reference sessions with affiliated parties to confirm that everyone remembers the same thing. |
| Obscure Terms | Try to keep fund terms as plain vanilla as possible. There is no need to stray too far away from peers in this area. |
| Background Checks | Run background checks on the key people within the GP and have answers/explanations for any inconsistencies – ideally, any critical issue should be expressed to prospective LPs before the background check. |
| Late Turnover | Constantly assess whether your team is ready for the long ride.A GP should be made up of like-minded folks when it comes to the time commitment and long-term nature of the asset class.Ensure that incentives compensate for the long-term commitment. |
