Are LPs ignoring operational due diligence?

Investors in private equity need to pay closer attention to the operational infrastructure of their managers, writes Hamilton Lane's Mario Giannini.

The private markets are a really young asset class. With the exception of private real estate, you could argue that the industry has existed for little more than two decades. While practitioners may view it as established and robust, in truth, most of the industry is barely ready for prime time. That’s particularly true when you look at the asset class from an institutional framework perspective.

The need for limited partners to sufficiently invest in their operational infrastructure and due diligence capabilities is a crucial topic, and yet receives little attention within our asset class, despite being an increasing area of focus for those operating in other industries. Operations – the nuts and bolts powering private equity’s cash and data flows – has not traditionally been a focus for LPs.

The very structure of private equity, with just-in-time capital calls and distributions, reduces many operational risks. We also haven’t seen as many blow-ups of private equity funds as we’ve seen in other asset classes.

The reality is that this asset class has very low standards of operational diligence.
Some of this is due to the relative immaturity of the asset class, which has achieved size and scale rather quickly. The infrastructure simply hasn’t kept pace. More problematic is the general lack of recognition of the issue, coupled with the fact that most GPs and LPs don’t want to spend money on something that doesn’t directly benefit them today; in other words, unless they absolutely “have to.”

And in the absence of something having gone horribly wrong, the “have to” hasn’t happened.

What exactly could go wrong, you ask? If you’re an LP, in what other area of investing do you simply either take for granted or take the investment manager’s word for:

• Effective implementation of the investment strategy;
• Ability to provide information and transparency that is both timely and accurate;
• An infrastructure and process that protects from losses due to fraud, both internal and external;
• An infrastructure that is effective in meeting ever-expanding regulatory requirements around the world; and
• Policies and procedures that appropriately address conflicts of interest.
• These are just an obvious few of the many operational items you should think about in any investment.

The LP response has generally come in two forms: One, ignore it. Or, two, force much of the responsibility onto the general partner community. In the latter scenario, the attitude seems to be: “This should be your problem, so go ahead and meet these 10 requirements that are on some check-the- box form and we’re all okay.”

“It would be easy to blame general partners for this state of affairs”

Let’s leave aside for a moment the fact that, depending on the LP, the GP world is generally confronted with hundreds of variations on which boxes to check. Historical behavior seems to suggest that many of the players in the PE game have determined that back office controls and processes don’t really matter, and, in many cases, the conversation has become mere lip service to best practices.

It would be easy to blame general partners for this state of affairs. There is no question that many fall far below the proverbial bar of operational best practices. In fairness, the overall risk is small and, bluntly, their investors don’t seem to care.
No, the real blame lies with the investors. When pressed, most LPs would be unable to clearly communicate what controls, if any, their various fund managers have in place; how they are ensuring that their GPs are acting in accordance with the terms of their partnership agreements; what specific procedures and protocols their managers have in place to mitigate potential conflicts of interest.

Now, as I said before: the risks in private markets investing are generally less than they are in other areas, but, people, they’re not zero.

There’s much talk of resource constraints among LPs, and those constraints are real in many cases.

Understanding and analysing operational risk costs money and requires resources; many investors simply don’t know where or how to start. But investing in your operational infrastructure – or choosing not to – is nevertheless a choice that needs to be made. There are costs associated with investing in the private markets, and all LPs must subsequently decide where they will allocate that spend.

My advice? Spend the money, spend the time, and figure out what operational risks you want to take. Hell, first spend some time figuring out what operational risks you currently have. Even that might be a major first step for many investors.

Mario Giannini is chief executive of private markets investment firm Hamilton Lane.