Due diligence: ‘ESG is front and centre’

LPs are pushing back on fund expenses and overly complex key-person clauses.

Track record is, of course, essential to LP decision making, but past performance does not guarantee future success. In particular, a GP’s team size and investment capacity were cited by 91 percent of respondents in Infrastructure Investor’s LP Perspectives 2022 Study as forming a major part of their due diligence processes.

Similarly, succession and retention planning were deemed important issues by most respondents. There has also been a significant increase in the proportion of investors that consider ESG to be key, rising from 38 percent a year ago to 57 percent today.

Brent Burnett, co-head of real assets at Hamilton Lane, highlights the importance of sourcing capabilities. “Investors are looking for a demonstrable ability to source proprietary transactions in what is a very crowded space,” he says. “Due diligence also goes beyond looking at the merits of an investment strategy and investment team. Investors are scrutinising the strength of the organisation.

“In addition to investment capability, a firm needs a sound back and middle office, and robust cybersecurity, for example. ESG is another important component, not just on the way into a deal, but in the way the GP monitors, measures and reports on ESG improvements.”

“ESG is front and centre in LP due diligence,” says Jessica Kennedy, a director at Northleaf Capital Partners with responsibility for investor relations. “It is increasingly becoming its own diligence stream, alongside investment due diligence and operational due diligence.”

“Another key consideration for investors, specifically in infrastructure, is that the risk profile matches the return profile that the GP is communicating,” says Burnett. “Institutions are very sophisticated in how they approach due diligence today. Those GPs that are successful in raising capital will be consistent in how they define the risk and return within their strategy and stick within those parameters.”

“Definitions of ‘greenfield’ and ‘value-add’ strategies have evolved and are increasingly blurred,” says Tavneet Bakshi, partner and head of EMEA at FIRSTavenue. “As a result, we are seeing increased scrutiny on the underpinning of returns and a lot more focus on risk. For example, greenfield risk is something a lot of investors think they should be exposed to in order to achieve higher returns, but there are many different facets to it. Delineating and illustrating the type of risk-taking involved, in a digestible format, is an important part of our job.”

Deep specialisation is another key consideration for investors. “Over the past couple of years, we have seen an increase in LPs looking for more specialised managers – whether that is a sector-focused manager or a mid- or large-market-focused manager,” says Kennedy. “We expect that to continue as infrastructure as an asset class further matures. We have recently seen a lot of investors either adding more mid-market managers or beginning to invest in the mid-market for the first time.”

Tension on terms

Respondents deemed a terms and fees benchmark to be the second most significant element of due diligence, with 81 percent citing it as a major factor. Half of investors surveyed said that management fees represent the most common cause of contention between LPs and GPs.

However, Threadmark founder Bruce Chapman says fees have largely remained static: “The GP market in infrastructure has really benefitted from the fact that there have not been many new entrants and the fact that most have performed very well, of course. Even the very largest infrastructure managers have not had to make any dramatic fee concessions, even though they are managing funds that are four or five times larger than when they started out.”

“Management fee and carry used to be the most common source of discord,” adds Burnett. “But with the evolution of the asset class, there is more of a market standard for those simpler economic terms.

“Clawbacks are also less of an issue, now that the majority of infrastructure funds have adopted whole fund, European waterfall carry structures. Instead, there is more likely to be pushback around what is included as a fund expense. One of the more troubling trends that we are observing is that GPs are increasingly moving what would have historically been GP expenses into fund expenses that are reimbursable by the LPs. But from the LPs’ perspective, the expectation is that GPs should be bearing the cost of being in business through the management fee.”

Bakshi adds that LPs are also seeking greater clarity on undisclosed fees.

Just under half of respondents said that insufficient key-person clauses, or none at all, is a significant issue. “We are seeing key-person provisions being stretched,” says Burnett.

“GPs want to have these complex 10- or 15-person provisions that are only triggered if three or perhaps five of those individuals leave. But LPs are pushing back. They know that there are a few key decision-makers that really matter to them, and they want to make sure the key-person provision refers to those individuals specifically.”