Manager Selection Process for Private Equity

For investors, the manager selection process begins with their investment strategy.  Using this as the baseline, they identify which fund managers match their strategy.  The managers may be ranked in various categories based on their performance and experience.  Any team not falling in one of the following would not be invested in:

• Star - top quartile returns for at least 3 funds for at least 2 business cycles
• Established - top quartile returns for most of its funds (at least 3 funds) for at least 2 business cycle
• Emerging - new fund manager team with limited history in working together
• Re-emerging - turnaround situation;  previously star or established team that is being re-structured, had bad returns or had operational issues

The investors should use their network to find good investments and quality managers.  Star teams are referred to new investors by their current universe of investors.  New investors should establish a relationship with star managers before they start raising funds for their next follow-on funds.

In the prior post, we read a study on how private equity fund manager performance persists from one fund to another.  Therefore, successful managers are oversubscribed when opening a new fund.  They will first allow the investors of the original fund first crack at investing in the follow-on fund.  Because of this, the fund will generally be closed before new investors are invited.  Fund managers tend to retain known investors as fund raising can be time consuming and expensive.  New investors that could be invited to the fund would be those with industry experience or can help in exiting positions.

Once a manager is found and is receptive to having the new investor in a fund, the next step for the investor is to conduct due diligence on the manager.  The first step is screening.  This means eliminating funds that do not have the right investment strategy or performance/quality requirements.  About 1/3 to 1/2 of funds are pass this stage.  Then the investor interviews the manager to get a detailed understanding of the organizational structure, people, office dynamics, experience and track record.  Based on the information gathered, fund managers are evaluated to choose the best investment.  Funds are graded based on a relative ranking and much of the decision making is subjective.  More detailed due diligence is done for funds that get through the evaluation process.  The investors look at any legal issues, any issues from the initial due diligence phase and check references from co-investors, competitors, officers from past investments and past investors.

The investors decide whether or not to invest in a particular fund.  It does not mean that the investors will not look at the team again for another fund.  On the other hand, the manager has to accept the new investor into the fund.  The manager may reject the new investor if there is too much money invested already or if the investor has a history of defaulting on investments or causing problems for the manager.