With growing interest in alternatives, Laven Financial Services has released a white paper on how to do operational due diligence on private equity funds. PE is unique because its illiquid structure often means that money is locked in and managers rotate less often. It also means that asset valuation can be more challenging since it’s not always possible to simply check market values. Laven’s advice helps investors tackle these challenges head on and make the most of their investments.

Laven Financial: Find out who’s running the show

“Successful hedge fund managers often remain at the helm for 10 to 20 years,” says the report. “In the case of private equity, however, long tenures can be as much a curse as a blessing. The main difference lies in PE funds’ illiquid structure. Because underlying assets cannot be easily liquidated, investors are generally prevented from redeeming capital for the life of the fund, which can be as long as 10 to 12 years,” says Laven’s report.

Of course you should ask the PE fund to supply you with information, but the challenge is finding a way to independently verify it before getting involved, especially for funds with a truly global scope. Whenever possible, you should conduct onsite meetings with key personnel so that you can bring up any discrepancies or red flags that you find.

Laven Financial: Manager past performance is critical

Anyone who has studied probability, or just had some experience in the stock market, know that you can’t read too much into past performance, but PE turns this dynamic on its head.

“Researchers at the University of Chicago and MIT showed that unlike public equities, where the mantra ‘past performance is not indicative of future results’ is an enshrined principle, PE is indeed an industry where past performance is strongly suggestive of future returns,” according to the report.

In addition to past performance being strongly correlated with success, most people are used to young, innovative hedge fund managers beating the market, but in PE they tend to fall short. Experienced managers tend to have the best returns, though the actual spread in performance is smaller than many other investment options.

Laven Financial manager dispersion

Laven Financial: Look for a good incentive structure

Private equity lives by the notion of ‘skin in the game’. In other words, you want the people running acquired companies to share risk with investors as much as possible. “Proper alignment of executive compensation with performance insures that sustained execution remains the overarching objective and that there is an appropriate risk mindset,” says the report.

There’s also a pretty clear connection between successful PE funds, and those that spend a lot of face time with executives. You want fund managers to help executives develop a good long-term plan that matches investor expectations.

Size doesn’t matter, but rate of growth does

Investors often worry that larger funds won’t be able to allocate money effectively, and that growth will suffer as a result, but there isn’t much correlation between size and performance, according to recent research done at the University of Chicago. The smallest PE funds tend to underperform, and are possibly small precisely because they aren’t being managed well, but there’s no difference between medium and large funds.

“Investors should therefore not be overly preoccupied if a PE fund is very large, unless it has acquired significant assets in a very short period of time. The best PE firms tend to grow less quickly relative to their hedge fund counterparts,” says Laven’s report.

An investor who is looking for explosive, short-term growth probably shouldn’t be looking for a PE fund in the first place. It’s a better option for someone with a ten-year time frame looking for experienced managers with a track record of giving their investors solid returns.