Due Diligence 101: Top 10 Interview Questions - Peer Presentation - Mark Anson Oak Hill Investment Management - ILPA
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Due Diligence 101: Top 10 Interview
Questions – Peer Presentation
Mark Anson
Oak Hill Investment Management
Legal Disclosure
This presentation is confidential and has been prepared solely for the use of the intended recipient and may
not be reproduced, distributed or used for any other purpose without the prior written consent of Oak Hill
Investment Management, L.P. (“OHIM”). The information contained herein is proprietary and confidential and
may contain commercial or financial information of OHIM and/or its affiliates.
The information presented is intended to be a summary and for information purposes only and is not
intended to be an offer to sell or the solicitation of an offer to purchase any security or investment product.
Nothing herein should be construed as financial, investment advisory, legal or tax advice related to any of the
subjects or topics mentioned herein. The mention of, or reference to, specific strategies, actual companies or
instruments in this presentation should not be interpreted as a recommendation or opinion that you should
make any purchase or sale or participate in any transaction. Any statements regarding future events constitute
only subjective views or beliefs, should not be relied on, are subject to change due to a variety of factors,
including fluctuating market conditions, and involve inherent risks and uncertainties, both general and
specific, many of which cannot be predicted or quantified and are beyond the control of OHIM. Benchmarks
are shown for illustrative purposes only and have limitations when used for comparison or other purposes
because they may have volatility, credit or other material characteristics that are different from accounts or
investments discussed herein.
The information contained herein does not constitute any representation or warranty with respect to OHIM,
and no person has been authorized to make any such representation or warranty.
INVESTMENT
MANAGEMENT
2
Agenda
• ILPA members are the largest group of Private Equity investors in the world
• This session is about asking questions of PE managers in the Due Diligence process
• Both initial Due Diligence and the ongoing maintenance
• Ok—I fibbed—I actually have 15 questions to ask
• Some of these questions are meant to be more “off the wall”
• The key is to ask questions that are unexpected to gain insight into GPs with respect to
how they manage their business and how their personal lives might impact that business
• Plus, we will add some numerical examples to highlight some of the issues
3Question #1
Why is that whenever I see you guys on a flight, you are sitting further
forward than I am?
How cost conscious are our Private Equity partners?
When was the last time you saw a GP on a Southwest Airlines flight?
Let’s look at a Management Fee example
4Management Fees as a Profit Center
• Private Equity fees were invented more than thirty years ago when a LARGE Private Equity fund was $250
million
• Back then, a 1.5% management fee was necessary to support the efforts of the Private Equity firm as it
sourced new investments
• But now, Private Equity funds have grown to huge proportion
• $10 billion funds are now common
• But the Management Fee structure has not changed
• An example: A $10 billion LBO fund with a 1.5% Management Fee and a ten year life
• The Management Fee alone provides an income stream of $150 million a year—that can pay a lot of
utility bills and salaries
• If we assume a cost of capital of 8% then the Present Value to the PE Manager from just the Management
Fees is $1.006 billion
• Assume further that the Private Equity managers put up 3% of the fund— $300—this is an NPV of
Management Fees of $706 million
• With an IRR based on Management Fees alone of 49%
• Significant profits can be generated by Management Fees without incentive fees
• In fact, the IRR on the Management Fees might be a better return than what the Private Equity
managers offer to their investors
5Question #2
Describe how the carried interest is distributed within the GP?
• Is carry shared with a parent or any other entity?
• Can you provide specific carried interest allocations for your current fund,
previous fund, and planned fund by individual?
• What is your overall compensation expense?
Let’s examine the compensation of a well known Private Equity manager
6Blackstone’s (ticker: BX US Equity)
10K Reports (2007 and 2010)
2005 2006 2007 2008 2009 2010
Revenues
Man & Adv Fees $478,908 $1,077,139 $1,566,047 $1,476,357 $1,482,226 $1,584,748
Perf Fees 880,906 1,267,764 1,125,053 -1,247,320 221,090 937,834
Inv Income 208,418 272,526 359,048 -622,877 40,604 561,161
Other Income (dividends) 0 0 0 44,479 29,779 35,599
Total 1,568,232 2,617,429 3,050,148 -349,361 1,773,699 3,119,342
Expenses
Compensation $182,604 $250,067 $2,256,647 3,859,787 3,777,606 3,610,189
Interest 23,830 36,932 32,080 23,008 13,384 41,229
General/Admin 87,413 122,395 324,200 440,776 443,573 466,358
Fund Expenses 67,972 143,695 151,917 63,031 7,296 26,214
Total 361,819 553,089 2,764,844 4,386,602 4,241,859 4,143,990
Gains from Investments 4,071,046 6,090,145 5,423,132 -872,336 176,694 501,994
Less Income Taxes -12,260 -31,934 -25,978 -14,145 99,230 84,669
Net Income $5,289,719 $8,186,419 $5,734,414 ($5,594,154) ($2,390,696) ($607,323)
7“Compensation”: From the footnotes to the Blackstone
Financial Statements in their 2008 10K
• Compensation and Benefits Expense. Prior to the IPO in June 2007, our
compensation and benefits expense reflected compensation (primarily salary
and bonus) paid or accrued solely to our non-senior managing director
employees with all payments for services rendered by our senior managing
directors and selected other individuals engaged in our businesses accounted
for as partnership distributions rather than as employee compensation and
benefits expense. Subsequent to our IPO, compensation and benefits
expense reflects (1) employee compensation and benefits expense paid and
payable to our employees, including our senior managing directors,
(2) equity-based compensation associated with grants of equity-based
awards to senior managing directors, other employees and selected other
individuals engaged in our businesses and (3) performance payment
arrangements for Blackstone personnel and profit sharing interests in carried
interest
• It’s tough being a public company where you have to transparently disclose
what you pay your employees!
8And, Check Out the Compensation from KKR’s 2010 Fiscal
Year 10K (ticker: KKR US)
For the Years Ended December 31,
2010 2009 2008
Revenues
Fees $ 435,386 $ 331,271 $ 235,181
Expenses
Employee Compensation and Benefits 1,344,455 838,072 149,182
Occupancy and Related Charges 39,692 38,013 30,430
General, Administrative and Other 311,147 264,396 179,673
Fund Expenses 67,369 55,229 59,103
Total Expenses 1,762,663 1,195,710 418,388
Investment Income (Loss)
Net Gains (Losses) from Investment Activities 7,755,090 7,505,005 (12,944,720)
Dividend Income 1,250,293 186,324 75,441
Interest Income 226,824 142,117 129,601
Interest Expense (53,099) (79,638) (125,561)
Total Investment Income (Loss) 9,179,108 7,753,808 (12,865,239)
Income (Loss) Before Taxes 7,851,831 6,889,369 (13,048,446)
Income Taxes 75,360 36,998 6,786
Net Income (Loss) 7,776,471 6,852,371 (13,055,232)
Less: Net Income (Loss) Attributable to Noncontrolling
Interests in Consolidated Entities 6,544,016 6,119,382 (11,850,761)
Less: Net Income (Loss) Attributable to Noncontrolling
Interests held by KKR Holdings L.P. 899,277 (116,696) —
Net Income (Loss) Attributable to KKR & Co. L.P. $ 333,178 $ 849,685 $ (1,204,471)
Footnote to 10K: “Historically, employee compensation and benefits expense has consisted of base salaries and bonuses paid to
employees who were not Senior Principals. Payments made to our Senior Principals included partner distributions that were paid to
our Senior Principals and accounted for as capital distributions as a result of operating as a partnership. Accordingly, KKR did not record
any employee compensation and benefits charges for payments made to Senior Principals for periods prior to the completion of the
Transaction”
9Question #3
How do you define “proprietary” as in, “90% of our deals are proprietary?”
How is a Club Deal Proprietary?
BODs are under a duty to find the best deal
Even if it is sale of a non-public division, the Fiduciary Duty Standard applies
Large & Mega Funds have too much capital – they run into the FD standard
most often
What is proprietary about a large buyout fund?
10Question #4
Where do they like to vacation…do they have vacation homes there?
Fun question…and an indication of how wealthy and content the founders
might have gotten and how much time they spend on the business. We like
to see GPs that are hungry
Here’s one response: “I like to vacation on my island”
Even better: “He will be with you in just a minute sir, he’s still meeting with
his architect”
11Question #5: Please Describe Your Business Model
From KKR’s 2010 10K
The following simplified diagram illustrates our organizational structure as of December 31, 2010
My head hurts--does anyone have any Aspirin?
12Question #6
We see elaborate and detailed fair market value exercises to establish
NAVs in accordance with FAS 157. However, many exits are at a premium
to the most recent mark. Is this evidence of systematic conservatism or
effective, opportunistic selling when the market offers a premium?
FAS 157 is still relatively new
• Usually these are Level 2 assets. Assets that don’t have an observable
price but have observable inputs
• Market Comparables
• Private Equity
• P/Sales
• P/Ebitda
• Market Inputs
• Discount rate for DCF analysts
Bottom Line: There is still considerable discretion in PE marks
13Valuation: Again, Insight from Blackstone’s 2010 10K
• Private Equity Investments — The fair values of Private Equity investments
are determined by reference to projected net earnings, earnings before
interest, taxes, depreciation, and amortization (“EBITDA”), the discounted
cash flow method, public market or private transactions, valuations for
comparable companies and other measures which, in many cases, are
unaudited at the time received. Valuations may be derived by reference to
observable valuation measures for comparable companies or transactions
(e.g. multiplying a key performance metric of the investee company such as
EBITDA by a relevant valuation multiple observed in the range of
comparable companies or transactions), adjusted by management for
differences between the investment and the referenced comparables, and in
some instances by reference to option pricing models or other similar
methods. Private Equity investments may also be valued at cost for a period
of time after an acquisition as the best indicator of fair value.
14Question # 7
How do you benchmark your returns?
Many LPs are moving to public benchmarks out of frustration with PE
benchmarks. Does the GP systematically report its fund returns and deal
returns relative to a benchmark?
Preferably matching cash flow dates exactly….I believe the best way to do
this is against a general benchmark like the Russell 3000 for the fund and
against an industry benchmark for each deal
Lagged betas as a way to measure systematic risk exposure
15Benchmarking Illiquid Assets: Private Equity
[Ri,t(PE) – Tbill] = β0[RM,t – Tbill] +
β1[RM,t-1 – Tbill] +
β2[RM,t-2 – Tbill] +
β3[RM,t-3 – Tbill] + α + εi,t
• Private Equity is an illiquid asset class. Therefore, changes in value to Private
Equity portfolios may not be contemporaneous with changes in the public stock
markets--PE may lag the public markets
• To account for this lagged effect, we regress the returns to Private Equity on the
current market return plus the last three quarters of returns
• Betas are linearly additive, so we can take the sum of the Betas
• β0 + β1 + β2 + β3 should provide a more accurate picture of how the returns to Private
Equity co-vary with the public securities markets
• In addition, by taking into account both contemporaneous and lagged market effects,
we should get a better measure of alpha, or manager skill
16Multi vs. Single Period Measurement of the Market Beta
Associated with Buyout and Venture Capital Returns
Single Period Multi Period Change in Single Period Multi Period Change in
Venture Capital Beta Beta Beta Alpha Alpha Alpha
Russell 1000 0.61 1.37 0.76 1.88% 0.89% -0.99%
Russell 2000 0.42 0.93 0.51 2.12% 1.52% -0.60%
S&P 500 0.59 1.36 0.77 1.60% 0.18% -1.42%
Nasdaq 0.48 1.085 0.605 1.69% 0.48% -1.21%
Leveraged Buyouts
Russell 1000 0.42 0.713 0.293 1.80% 1.18% -0.62%
Russell 2000 0.28 0.587 0.307 1.95% 1.25% -0.70%
S&P 500 0.42 0.701 0.281 1.55% 0.80% -0.75%
Nasdaq 0.22 0.418 0.198 1.88% 1.20% -0.68%
• There is a significant increase in beta when lagged market returns are included
• There is a significant decrease in alpha when lagged market returns are included
• This indicates that some of what was previously classified as “alpha” associated
with Private Equity returns was, in reality, “beta”
17Another Potential Benchmark: The Global Listed Private
Equity Index (ticker: GLPEXU)
Business Type: The publicly traded stocks within the Index may be, but are not limited to, the following:
Business Development Companies, publicly traded Limited Partnership interests, Investment Holding
Companies, Special Purpose Acquisition Corporations, publicly traded Venture Capital Funds, Closed End
Funds, Financial Institutions, Real Estate Investment Trusts, and any other vehicle whose primary purpose
is to invest in, or lend capital to, privately held companies
Source: Bloomberg Finance, L.P. and Red Rocks Index Methodology at www.redrockscapital.com
18Beta Analysis with the GLPEXU vs. the Russell 1000 for
the Period 8/09 through 8/11
Alpha T stat Beta T Stat R-Square
Blackstone
vs. GLPEXU -0.22 -0.65 1.52 14.05 0.66
vs. RU1000 -0.21 -0.62 2.04 13.95 0.66
KKR
vs. GLPEXU 0.25 0.47 1.14 6.17 0.42
vs. RU1000 0.22 0.82 1.33 4.97 0.32
The GLPEXU picks up the higher amount of leverage/gearing associated with
Private Equity transactions
Source: Bloomberg Finance, L.P.
19Or you can Create your Own Private Asset Benchmark
• Publicly Traded Alternative • Regression Analysis of our Private
Asset Managers Asset Index vs. Russell 1000
Ticker 8/19/2011 Market AUM Date Standard
Coefficients Error t Stat P-value
Price Cap in $b in $b Traded
Intercept 0.002 0.012 0.188 0.8521
Apollo APO $13.82 $5.00 $70 Nov-11 Beta 0 2.103 0.222 9.486 0.0000
Blackstone BX $12.17 $13.30 $150 Jun-07 Beta -1 0.134 0.229 0.583 0.5640
Fortress FIG $3.31 $1.60 $43 Feb-07 Beta -2 -0.002 0.227 -0.007 0.9942
KKR KKR $10.76 $7.60 $61 Jul-10 Beta -3 -0.261 0.227 -1.149 0.2584
Beta -4 -0.607 0.220 -2.753 0.0094
Man Group MNGPY $3.11 $5.90 $71 Oct-94
Och-Ziff OZM $10.96 $4.00 $29.30 Nov-07 Total Beta 1.367
R-Square 0.752
• Given the limited track records of Apollo and KKR, I construct the Private Asset Benchmark using an
equal weighted basket of Blackstone, Fortress, Man Group, and Och-Ziff.
Source: Bloomberg Finance, L.P.
20Question #8
How big will your next fund be? Can you manage to bring along junior
folks with appropriate economics without significantly growing fund size
over time?
How do you think about growing your franchise?
Are you becoming an asset gatherer?
It used to be the fund raising cycle matched that of the J curve. Now it is
more accelerated
There is more money to be made in management fees than the carry
21Back to the Blackstone 10K
2005 2006 2007 2008 2009 2010
Revenues
Man & Adv Fees $478,908 $1,077,139 $1,566,047 $1,476,357 $1,482,226 $1,584,748
Perf Fees 880,906 1,267,764 1,125,053 -1,247,320 221,090 937,834
Inv Income 208,418 272,526 359,048 -622,877 40,604 561,161
Other Income (dividends) 0 0 0 44,479 29,779 35,599
Total 1,568,232 2,617,429 3,050,148 -349,361 1,773,699 3,119,342
Expenses
Compensation $182,604 $250,067 $2,256,647 3,859,787 3,777,606 3,610,189
Interest 23,830 36,932 32,080 23,008 13,384 41,229
General/Admin 87,413 122,395 324,200 440,776 443,573 466,358
Fund Expenses 67,972 143,695 151,917 63,031 7,296 26,214
Total 361,819 553,089 2,764,844 4,386,602 4,241,859 4,143,990
Gains from Investments 4,071,046 6,090,145 5,423,132 -872,336 176,694 501,994
Less Income Taxes 12,260 31,934 25,978 -14,145 99,230 84,669
Net Income $5,265,199 $8,122,551 $5,682,458 ($5,594,154) ($2,390,696) ($607,323)
22Negative Incentive Fees—Ever heard of These?
• Performance Fees and Allocations. Performance fees and allocations
represent the preferential allocations of investment gains (“carried interest”)
which are a component of our General Partner interests in the corporate
Private Equity, real estate and certain of our credit-oriented funds. We are
entitled to carried interest from an investment fund in the event investors in
the fund achieve cumulative investment returns in excess of a specified rate.
We record as revenue (and/or adjust previously recorded revenue to reflect)
the amount that would be due to us pursuant to the fund agreements at
each period end as if the fair value of the investments were realized as of
such date, whether or not such amounts have actually been realized. In all
cases, each fund is considered separately in that regard and for a given fund,
performance fees and allocations can never be negative over the life of the
fund.
23Question #9
Why do you offer LPs co-investment opportunities for no fee/no
carry? What is your process for determining how those are introduced and
allocated to LPs? Finally, what do you think about all these Canadian
pension funds and sovereign wealth funds getting into the direct deal
business?
Many answers, all likely true: offer a discount to my favorite LPs, keep the
deal away from a competitor, keep full control from governance standpoint…
i.e. bad memories of “club deals”
But do we get adverse selection?
Guilt over fee structure
Risk sharing
We love the fact that SWFs and Pension Funds are doing direct deals…right!
24Question #10
With respect to the current unrealized portfolio, walk through primary
value drivers - current update (and valuation methodology), near-term and
long-term outlook, and liquidity timing/strategy
Helpful for monitoring but also for informing ourselves around preliminary
response to inbound secondary opportunities on the funds in our portfolio -
it also provides a baseline for ongoing monitoring (When we check back in,
did they deliver on near-term objectives?).
25Question #11
Who is the likely successor to the Managing Partner from among the group
of partners?
No one!—Oops! Wrong answer!
I jokingly told a GP that, “CalPERS recently introduced a medical review into
its diligence process.” I followed up saying it was a joke, but a month later
someone in our office heard from the “market” that CalPERS was introducing
physicals as a part of their DD process.
26Question #12
How did you celebrate your last birthday?
• Best Answer: “I had dinner with my family and went to bed early”
• Worst Answer: “I flew a few hundred friends to Las Vegas for the weekend”
27Question #13
When do you plan to go public?
Never…Yeah, sure!
CalPERS held a Private Equity summit several years ago including
Blackstone, KKR, TPG, Carlyle, Apollo and others
All of them stated that they had no intention of going public
Too bad we didn’t take that one to the bank!
28Here is what going public can do: Fortress Investment
Group—ticker FIG
• Total holding period return: -80.96%
• Average Annual Return: -30.57%
Source: Bloomberg Finance, L.P.
29Question #14
Tell us about the personal situations of the lead
partners…married/divorced/any issues that could divert attention?
Some amazing information can come out of this
Funniest and Worst Answer: The GP eloped with his girlfriend. The
fascinating but sad story of billionaire VC Wang Gongquan of CDH Venture
Partners
30Question #15
What do you with your pocket money?
Answer: I bought the Magna Carta!
31Open Discussion
What questions do you ask in your process?
INVESTMENT
MANAGEMENT
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