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Part II: Identifying Red Flags in Private Markets Due Diligence

Jamie Ebersole, CFA, CFP, is the Founder and CEO of Ebersole Financial LLC.

 

In our last piece we talked about some of the red flags to keep an eye out for during your due diligence process.  There are myriad issues that present themselves as you look at any investment firm, so highlighting them all would be impossible. Remember, this is a process, so you will become more attuned to potential issues as you gain experience. But, the key takeaway should be to keep your eyes open for those things that don’t seem to make sense. 

In this post I will shift my focus away from red flags to delve a little deeper into some of the ways PE managers may (or may not) differentiate themselves.  While we expect all firms to be different and distinct, the truth is that most look pretty similar on the surface. While this observation is unscientific, I would bet that if you were to review the transcripts from 100 GP pitch meetings along with their marketing materials, you would find very little difference in the content of those presentations.  Since most firms talk the same talk, it is likely the subtleties that set one firm apart from another. So, how do they do it? 

All firms will at some point discuss with you how they “add value.” This is a rather generic term that everyone uses. And everyone hopefully adds some value, but it doesn’t tell us much of anything. So, what is it that PE managers do to add value to their portfolio companies? From my perspective the number one role is to provide a strong governance framework and put/keep the right management team in place. (We are assuming that the PE firm bought the company at the right price and put in place an appropriate capital structure.) Growing sales and cash flow, de-levering the balance sheet or reducing expenses are all the domain of management, not PE investors.

I don’t know about you, but I want my investors to oversee the performance of the portfolio, find good new investment opportunities and generate returns, not figuring out how to market to clients in a business where they have little to no expertise. While the latter area is what many say they do, the former is where most spend the majority of their time. Aside from Jack Dorsey, how many people can be the CEO (or CIO or CTO, or CMO, or COO or CFO, etc.) of more than one company? In order to understand what PE firms actually do with their companies, reference calls or meetings with company management teams are very insightful. Digging down a few layers in the organization will help to flesh out the story very quickly.  

So, if not with operating expertise, how else can GPs differentiate themselves? How about investment sourcing. First, let’s clear one thing up, no one has a proprietary deal sourcing process.  Everyone says they have a proprietary process, and it may be exclusive to their firm, but it is unreasonable to think that anyone has a great edge in sourcing investments these days given the level of technology and efficiency in the market.  Again, meeting with management teams and speaking to them about which other PE firms contacted them about an investment is very insightful.  Speaking with GPs that passed on the deal or lost an auction is also a great source of information. In the early days of PE, cold-calling approaches of firms like TA and Summit Partners were novel, but nowadays, everyone is doing it.  So, what is it that differentiates a sourcing process? Not much. So, if sourcing isn’t proprietary, we should then look elsewhere for the secret sauce.  Next up, Operating partners. 

In this age of increasing specialization, everyone is adding Operating partners. Many firms tout operating partners, but from my experience, firms with operating partners perform no better or no worse than the broader market. I have seen cases where the operating partner model has created a sense of overconfidence in the team’s ability to run businesses and it has led to significant future losses. I remember many years ago when one firm touted its partnership with Jack Welch and how he was revolutionizing their operations approach. Upon further digging, it is true that Jack was involved in quarterly review meetings, and he was available to work with management teams as needed, but at the same time he was running his own consulting business, writing a book, on CNBC every day, getting remarried, etc. So, while he was involved in the review process, he was not intimately involved in the operations of portfolio companies. And I’m not sure the presence of a star CEO added to the performance of the firm. It was fun for LPs to meet Jack and hear his stories, but I don’t know if it added much else.

So, don’t be blinded by Star Power. It may end up being marginally helpful, but many times creates no better results. The need to have “Stars” on the team may also highlight that there are areas of weakness in the firm or its strategy to be explored. You hire a Star to fix a weakness, but it is a short-term fix.

The PE firm’s job is to invest your capital for a return, not run businesses, and as investors ourselves, we don’t really want our investors running businesses. Again, in my view, the appropriate role for the operating partner is to provide oversight, mentoring and expertise to the current management teams, and then get out of the way. If you have the right team in place, having an operating partner “running” a business is redundant.  While on paper operating partners look great, you need to be sure they are playing an appropriate role and not creating more issues than they are solving. Having a bench of operating partners may make for good copy for the Annual LP meeting and for the press, but you need to dig deeper to understand what they are doing, if they are doing it well and if it is anything more than a marketing pitch.  If firms with operating partners aren’t outperforming the market and consistently generating top-quartile or better returns, should we choose them over the generalist with similar returns and a simpler model? 

So, if we can't rely upon the old standbys to "create value" where does this leave us? The core of any investment firm is the investment process. This is where I believe most firms differentiate themselves from one another. And this is where the “value add” is. Most managers will agree that the money is made on the buy. Buy well and you have instantly created value.  This will be our one more thing for the next time.

About the Author

Jamie Ebersole is the Founder and CEO of Ebersole Financial LLC, and independent registered investment advisory (RIA) firm in Wellesley Hills, Massachusetts.  Jamie works with widows, divorcees and executives, and their families, to help them achieve their financial goals and personal dreams. Jamie also consults with smaller institutions and high net worth clients to help them understand and invest in alternative investments, focusing on private equity.  Prior to founding Ebersole Financial, Jamie spent 15 years helping institutional investors reach their investment goals through private equity investments. During that time he managed investment programs of more than $1.5 billion for SL Capital Partners and Allianz Private Equity Partners.

Jamie has both Bachelor's and Master's degrees from Tufts University with a concentration in European History. He has MBAs from The Red McCombs School of Business at the University of Texas at Austin and the Pontificia Universidad Catolica in Santiago, Chile.

Jamie is a CFA Charterholder and a CERTIFIED FINANCIAL PLANNER(TM) and frequently appears in print.


Ebersole Financial LLC

Ebersole Financial LLC provides a full range of financial advice and investment management services to executives, widows, divorcees and their families. We also offer private equity consulting services to smaller institutions and UHNW clients. We are an independent firm which allows us to put your interests first. We work with each of our clients to develop customized strategies and plans to allow them to reach their financial, investment and life goals.  We have expertise dealing with the complexities of private equity, executive compensation plans and closely held businesses. Please visit us at www.ebersolefinancial.com

Investment advisory services are offered through Ebersole Financial LLC; a Commonwealth of Massachusetts domiciled registered investment advisor. This article is not to be directly or indirectly interpreted as a solicitation of investment advisory services. This document is intended to be used in its entirety. Any other use beyond its author's intent, distribution or copying of the contents of this article is strictly prohibited. Nothing in this document is intended as legal, accounting, investment, or tax advice, and is for informational purposes only. The opinions expressed in this article are those of the author and he alone is responsible for the content.

 

Jamie Ebersole is the Founder and CEO of Ebersole Financial LLC, and independent registered investment advisory (RIA) firm in Wellesley Hills, Massachusetts.  Jamie works with widows, divorcees and executives, and their families, to help them achieve their financial goals and personal dreams. Jamie also consults with smaller institutions and high net worth clients to help them understand and invest in alternative investments, focusing on private equity.  Prior to founding Ebersole Financial, Jamie spent 15 years helping institutional investors reach their investment goals through private equity investments. During that time he managed investment programs of more than $1.5 billion for SL Capital Partners and Allianz Private Equity Partners.

Jamie has both Bachelor's and Master's degrees from Tufts University with a concentration in European History. He has MBAs from The Red McCombs School of Business at the University of Texas at Austin and the Pontificia Universidad Catolica in Santiago, Chile.

Jamie is a CFA Charterholder and a CERTIFIED FINANCIAL PLANNER (TM) and frequently appears in print.

Ebersole Financial LLC provides a full range of financial advice and investment management services to executives, widows, divorcees and their families. We also offer private equity consulting services to smaller institutions and UHNW clients. We are an independent firm which allows us to put your interests first. We work with each of our clients to develop customized strategies and plans to allow them to reach their financial, investment and life goals.  We have expertise dealing with the complexities of private equity, executive compensation plans and closely held businesses. Please visit us at www.ebersolefinancial.com

Investment advisory services are offered through Ebersole Financial LLC; a Commonwealth of Massachusetts domiciled registered investment advisor. This article is not to be directly or indirectly interpreted as a solicitation of investment advisory services. This document is intended to be used in its entirety. Any other use beyond its author's intent, distribution or copying of the contents of this article is strictly prohibited. Nothing in this document is intended as legal, accounting, investment, or tax advice, and is for informational purposes only. The opinions expressed in this article are those of the author and he alone is responsible for the content.