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Qualities of a good Limited Partner

In her presentation Anne-Maree Byworth, Portfolio Director at CDC responsible for fund selection in South and South East Asia and the Pacific, asks and answers the question 'What makes a good limited partner?' Most people tend to learn their roles in the form of an apprenticeship, or where no mentor exists, by trial and error, she finds.

Many people in the private equity industry have views on the qualities general partners need to demonstrate in order to attract commitments to their funds. Of course, as a community, we investors are paid to pass judgement on the virtues and failings of general partners. Indeed, it is a standard fall back topic for investor panels at many of the conferences I've attended over the years. One thing I haven't seen, however, is a presentation on what makes a good limited partner. There are no courses or qualifications for would-be investors in private equity funds, and most people tend to learn their roles in the form of an apprenticeship, or where no mentor exists, by trial and error.

As you might have already gathered, given my own fund selection activities both at CDC and institutions where I was formerly employed, any views I might espouse on this subject would be highly subjective. Therefore, rather than hold forth in my own right, I interviewed a number of people to gain some empirical insight as to desirable characteristics shown by the best fund investors. Participants included prominent general partners with investor bases comprising tens or hundreds of limited partners, placement agents who deal with investors on a daily basis, and some long standing and experienced investor types whom I deemed more objective than me. I augmented this research by scouring the press for sound bites. As I collected this evidence, many of the responses seemed to speak to the blatantly obvious - but in the experience of many of these veterans, investors who sport all these virtues and practice them consistently are lamentably few.

Most oft mentioned was the fact that private equity is a relationship business, not only between institutions, but also between the individuals who represent them. Like any healthy relationship, this does not rely on a one-way flow of ideas and information between partners. The best general partners and placement agents know they need to keep their investor base engaged and informed. However, as one well known investor relations professional wryly noted, the telephone works both ways, and investors could learn to pick it up and initiate conversations once in a while. Feedback from their investors, both positive and negative, was prized by many participants in this survey, as was the ability of investors to listen, and to hear both sides of the story (not just that of their competitors).

By proactively working at these relationships and showing some interest, investors are able not only to stay abreast of investment activity and industry developments, they may also gain an advantage over some of their peers. A manager of a multi-billion euro fund admitted that he enjoyed working with certain of his investors far more than others, and intimated that, regardless of their actual importance to the firm in terms of their commitment size, they might receive preferential treatment or advance information. Another mentioned that he used some of his investor base as trusted parties to bounce ideas off, giving them a greater ability to influence the firm and the way it operates. More than one manager of an over-subscribed fund in the past few years referred to investors needing to sell themselves in order to get their desired participation, rather than the other way around, and that even if they suffered scale back, favoured investors might be less affected than others. All of these cases suggest that smaller investors, who do not often have the right to appoint advisory board representatives or enough capital to contribute large sums to co-investment opportunities, could even up the divide between them and their larger brethren.

A particularly important quality that both managers and placement agents valued in their investors was their ability to keep confidential or market sensitive information to themselves. This was less to do with FOIA obligations in North America or more recently in the United Kingdom, and more to do with disclosure of sensitive information. Examples given included underlying portfolio company information appearing in the press, and recruitment of certain individuals or the departures of key executives prior to formal announcements.

In terms of a toolbox for investment, limited partners should have some knowledge of the universe of private equity managers, the markets in which they operate, and what they are trying to achieve. The most highly rated investors do their homework, and review fund offerings thoroughly and systematically. Too many investors, it seems, continue to turn up to meetings without so much as reading the executive summary in the information memorandum, let alone having done any homework on the firm and the market or geography in which it operates. More than one manager described taking calls from investors rejecting their funds, when it was patently obvious that they had not actually read the information received. These culprits were revealed as being ignorant of both the firm and fund offering, and the competitive landscape more generally.

However, lack of preparation is not restricted to the due diligence process. Post investment monitoring is obviously not a strong suit of some institutions, where the quarterly reporting enshrined in the legal documentation apparently falls into a black hole, such is their general knowledge of the general partner and its portfolio. The lack of attendance at annual investor or advisory board meetings is another bugbear. Many managers referred to the time, expense and effort expended in arranging these meetings, only for certain of their investor base to fail to turn up year after year. These same limited partners often go on to complain that they have no idea of what is going on in their portfolios.

On the other hand, the level of due diligence carried out by many investors is said to be much more professional and thorough than was once often the case. The best investors ask for sensible and relevant information that enables them to make a decision on whether or not to back a manager. Nonetheless, many of the questions put to managers have them scratching their heads. As one general partner put it, the investor who asked why margins had changed for a portfolio company in the third quarter three years earlier was missing the point, particularly as the business concerned had long since achieved a highly successful realisation. Enquiring about the structuring of that investment, however, would have shown far more thoughtfulness. In his opinion, irrelevant or trivial questions demonstrated ignorance, stupidity, or both. On the same subject, a placement agent dryly commented that investors turn themselves insides out in an effort to find a question that no one else had thought of, regardless of whether the outcome would change the way that they thought of the offering at hand.

It has to be said that virtually everyone interviewed did the telephone version of rolling their eyes at the mention of due diligence questionnaires. Some managers even reported that, although they were prepared to make available to investors much of the information requested in the form of a due diligence file or "universal" questionnaire, they were refusing to complete individual applications, which normally replicated the information already provided in a different format. One experienced investor stated that many groups simply don't have the staff to fill out 20 - 30 questionnaires, and that such activity represented a poor use of the general partner's time, which after all is paid to make and dispose of investments profitably, not engage in pointless administration.

It was further suggested that investors should either outsource their due diligence and decision making completely by using a fund of funds, or do the work themselves. This manager felt strongly that many investors who use gatekeepers and yet retain investment authority "become lazy, don't do any homework, are ignorant of the industry, and carry out a tick the box exercise which does not allow any informed judgment". Many players requested that investors who had not already done so consider putting in place defined systems and procedures that they adhere to, and which will in turn allow them to clearly articulate the decision making process to general partners. At present, more than a few investor representatives say they are going to do something according to milestones and stated timelines and yet do not follow through.

Moreover, investors should be clear about what is required of managers in order to receive a commitment, and they should raise any issues in a timely fashion. Too many institutions were said to sit on the sidelines watching what others were doing, rather than carry out their due diligence in a timely manner, leading to inefficient and extended fund raisings. The integrity of limited partners was put to the test, with one placement agent arguing passionately that investors state honestly whether a fund commitment would be possible or likely, rather than to waste both his and his client's time in a meaningless cycle of meetings and information gathering. A common refrain from general partners and placement agents alike was the request for more institutions to participate in the first closing - in the words of one: "a good first closing moves the herd".

Managers surveyed also raised the topic of stability of both individuals and institutions investing in the asset class. To summarise one placement agent, the best investors are consistently in the market, and long term in their approach. Everyone would prefer investors that are likely to participate in subsequent funds. Fund raising is made much more difficult when investors continually change their asset allocations, strategy or try to time the market. It also helps if investors have deep pockets, meaning that they always have the wherewithal (if not the inclination) to invest. A general partner added that it would be useful if organisations could embed a partnership culture within their firms that would outlive staff turnover. Such institutional memory would ensure an enduring knowledge of the private equity industry and its participants, and lead to less disruption in terms of bringing new staff up to speed during fund raisings or in replacing representatives on advisory boards. Several managers also pointed to the employment and remuneration policies in place at certain investing institutions, suggesting that this may well be a factor in the high turnover of investment professionals. Finally, there was the comment that fund selectors cannot be either responsible or informed if making fund commitments is only one of several responsibilities - in other words, institutions should have appropriate resources, and these staff members should be dedicated to fund selection activities.

In summary, the investor community is a mixed bag of the good and bad, and many limited partners were praised for their efforts. I would have liked to have been able to say that I have always faithfully represented all of the qualities that my correspondents considered valuable in a fund selector. Certainly, every suggestion and comment that is made in the above paragraphs is a truism. However, as I was concluding these interviews, I came to the rather humbling conclusion that on several occasions over the years I had slipped from my smug investor throne - and from what the participants in this survey have said, so have many of my peers. I hope that others in the investor community also take time out to reflect over these findings, which were often transmitted in very angry and passionate terms. The remark on my own school report in this instance reads "could do better".

CDC was established in 1948 and is the UK Government's instrument for investing in the private sector in developing economies. It has US$1.6bn invested through over 30 funds in more than 250 businesses. It focuses on emerging countries in Africa and Asia, with a preference for the poorest countries (defined as those with GDP per capita of less than $1,750) and has a target of investing at least 50% of its funds in Sub-Saharan Africa and South Asia. All of its investments are now made through private equity funds. Although wholly owned by the UK Government, CDC is required to operate commercially, and the Government has no involvement or responsibility for the firm's day-to-day decision making. For more information on CDC visit www.cdcgroup.com

Anne-Maree Byworth is the Portfolio Director at CDC responsible for fund selection in South and South East Asia and the Pacific. She joined the firm in 2004, having most recently been part of the private equity fund teams at Morley Fund Management and Hermes Fund Managers respectively, and commenced working in the private equity industry in 1992.