Private equity due diligence

Private equity due diligence questions to ask GPs before signing up for illusional IRRs, ludicrous leverage, dubious deals and compulsory capital calls.

1) A quant says she studied public market equivalents to evaluate private equity and found no evidence of your claimed portfolio diversification benefits. Your reaction:

i) If LPs invested in a public equity large-cap value index fund and borrowed 3X more cash and put that in also, they outperformed most private equity funds in most vintages. Please don't tell anyone leveraged buy-outs usually underperform leveraged public equity
ii) Quants like her should creep back into their hedge fund hovels. We are a pure alpha generator. Beta repackager? Pure brilliance drives our performance
iii) Our funds' returns are totally independent of the public markets and IRRs can never be transformed into time-weighted metrics anyway
iv) We comply with "peer" return reporting and our LPs are delighted with the numbers we claim to achieve and those muppets always commit to new fund raisings
v) We avoid anyone with mathematical ability beyond third grade arithmetic. It would wreck our business model. We would be nowhere without salesmen like David Swensen doing the marketing

2) Why is your firm trying to IPO when you claim a company being private is so good?

i) So we can take ourselves private again later after the public stock implodes. Only way to get the proprietary dealflow we pretended we have access to
ii) We urgently need a public stock currency so we can short sell our founders' equity before it's too late
iii) It's the master plan. Take all other companies private while we go public and the passive index crowd will only be able to buy us. Gotta love our buddy John Bogle
iv) Permanent capital - ten year lockups at high fees for the repackaged beta we provide doesn't pay for the standard of living to which we have become accustomed
v) Future carry monetization, getting out while we still can...anything else that sounds plausible to the unwashed masses and the sell-side analysts

3) Why did the private equity GP cross the road?

i) To avoid the roadkill of lending banks, default protection sellers and heavily indebted corporate dreck he bought recently
ii) Because there was an unemployed former head-of-state on the other side looking for another sinecure
iii) Trucks and SUVs cannot hit private equity GPs, just like economic downturns cannot hit us
iv) Road? I always use the helicopter. I might buy roads but I don't use them
v) Because he saw a bunch of disgruntled LPs ahead, that had just found out that private equity is not a diversifying investment

4) The most important hire for a private equity firm is:

i) A former corporate titan with a golden rolodex who I met recently in Davos
ii) A has-been politician who told you they have lots of global "friends"
iii) Very good-looking male and female fund raising placement agents. Sell the sizzle since we have no steak
iv) Some associates to do some actual work while I am out partying and pontificating
v) Anyone who can look at the balance sheets of our recent deals and doesn't vomit

5) What is the outlook for big private equity?

i) Big private equity is a dinosaur and the industry destructing credit cataclysm heading our way is getting bigger in the sky
ii) Private equity? What's that? We are a hedge fund firm now
iii) There will soon be no banks left who will finance the debt on our deals so we are reliant on dumber hedge funds that don't understand credit either
iv) We are going to crush those hedge fund clowns although we ourselves use more leverage and take higher risk
v) The day traders running hedge funds are bound to get it wrong if they try to step on our hallowed turf.

6) How many private equity people does it take to change a light bulb?

i) A syndicate of 10 private equity firms, 100 investment bankers and a 100 lawyers
ii) Not applicable. My deals never fail and my light bulbs never fail
iii) I think one of the underbutlers takes care of my light bulbs
iv) Don't know. But the LPs pay for our light bulbs somewhere in the numbers
v) The CEOs of our portfolio companies change our light bulbs whenever we say so

7) What are you working on right now?

i) I can't talk about future LBO dealflow but, off the record, the tickers GE, XOM, MSFT, AAPL and GOOG could be available soon
ii) sprucing up my resume to try to get a hedge fund job
iii) raising a new fund and getting our own and portfolio IPOs out while we still can
iv) Not much. We prefer to do deals just before carry calculations
v) Selling an overvalued pre-IPO stake to a big Asian investor so the retail punters will think we have a proprietary pipeline into "Asian" deals. If only!

8) What is your outlook for the alternative investment industry?

i) LBOs are widely understood now. Corporations can take on debt and recapitalize themselves. Quick flips are gone and we have little to offer long term
ii) Hedge funds speculate in synthetic securities, dubious derivatives and arcane assets incomprehensible to anyone without a Fields medal. Forget about hedgies. We are long only. Pensioners, widows and orphans need us
iii) We've had a good run with institutional investors and our IPOs permit some extra fun with retail as we exit the big private equity end game
iv) "Absolute consent", "Yank the bank", "Snooze you lose". As long as we retain total control of every aspect of the financing behind deals we will be fine
v) Who cares? My estates, planes and yachts will be secure after the IPO

9) Where have all the trade buyers gone?

i) Private equity people are supreme geniuses but trade buyers are just "corporate" bureaucrats that couldn't get a Wall Street job
ii) Trade buyers have a thorough understanding of the valuations, prospects and risks for their industry and deep domain experience but private equity firms don't
iii) Private equity funds have taken any potential strategic buyers private already
iv) Private equity firms invite banks into the syndicate and pay higher "advisory" and fairness "opinion" fees than trade buyers
v) Trade buyers acquire a firm when it makes a logical fit at a sensible price whereas private equity firms are a tad less choosy and a lot dumber

10) What do you think of your portfolio company CEOs, CFOs and chairmans of the board?

i) Are our partners in restructuring and realizing gains in a future public listing
ii) Are required, by law, to work to maximize shareholder value
iii) Were required, by us, to cooperate to minimize shareholder value to get the stock down to our target acquisition price
iv) Must agree to pay us vast dividends, transaction and monitoring fees they can't afford regardless of EBITDA and financial strength
v) Might receive a few crumbs of compensation that drop off our table. If they were that smart they'd be working here not there

Bonus question:

Fund A fully invests from day one and an independent administrator begins calculating accurate performance numbers. Investors have liquidity and access to all their compounded capital at worst a few month's notice. Even if the markets implode and the world economy collapses, Fund A still generates good absolute risk-adjusted returns. Fund A runs liquid strategies.

Fund B draws down your capital over several years. You must keep low yielding cash at hand because you don't know when the calls will come. It charges fees from day one but returns are calculated from when it invests. Investors won't know for a decade how the fund performed and even then it is not so clear. Fund B is dependent on good equity AND credit markets.

Should a prudent fiduciary seeking REAL diversification invest in Fund A or Fund B?