The Default Yes

Every GP deck has one. Buyout, venture, credit, infrastructure, big or small, fund-of-funds or secondary, every deck has “the funnel slide”. They all imply the same thing. “We see a big universe and through a process at every step, we whittle down the universe to smaller and smaller slices to ultimately get to the culmination where we make an investment”. The steps can be varied, but they usually go like this: first determine if something is good (worthy of more work), then if it has potential to be great (increasing time and energy, and potentially financial cost), and ultimately what is deemed the best (where a commitment is made).?

If you hold that process to be true (I’m not sure I ascribe fully to it), then the default answer to every new opportunity is no. As an LP, you need to be increasingly convinced at every stage that a deal is worth doing, through material due diligence, reference calls, quantitative analysis, etc. Once the LP has spent the requisite time and energy, once the memo is written (more on that in a little) and the deal approved, and the digital ink on the docs is dry, LPs move into the post-commitment period. Many LPs call this ‘monitoring’, which gives it short shrift, in my opinion. Sure, this isn’t a liquid position where you can change your mind and wipe the slate clean; more than likely, the decision made is one you will live with, and monitor, for the next decade-plus. So, if I’m just ‘stuck’ with this position, what is the value of monitoring??

Back to the investment memo. No investment decision is 100%. You can never know everything, so when the decision is made, the memo becomes the capstone, the governing document that memorializes the facts and findings at the time and the rationale for the investment decision. This document differs a lot from LP to LP, but it should always cover the who, what, where and when. Most importantly, it needs to cover the how and the why. Deeply understanding each of those should be the focus of the diligence process, and that understanding should drive the decision.?

Of course, you’ll never have complete information, and blind pool investing is exactly that, blind. You are basing your decision on things that happened in the past. Because of this, two critical things that I recommend in every investment memo are what I call NTBs and WOFs – ‘need to believe’ and ‘watch out for’. These are either concerns that couldn’t be mitigated, questions about evolution and where the firm is going, holes in the current offering, or statements made that you want to hold the manager’s feet to the fire on. These are not big enough red flags to make you pass on the investment, but they do provide the framework and basis for what you hope to achieve in the monitoring process.?

I put monitoring in quotes above because I don’t think it does it justice. I refer to the process as ‘post-investment due diligence’. While traditional monitoring includes reviewing quarterly reports, financial statements, attending the AGM (and taking notes), and informal interaction with the GP as warranted or desired, there is much more involved in it. What you really want to gauge from these efforts is three-fold: first, are they doing what they said they were going to do? If something has changed, have they explained why, and if so, does it make sense for their (current and/or future) strategy? Second, how are they doing on the NTBs and WOFs? Has the passage of time allayed some of those concerns or do they still exist? Lastly, are the people the same? Not just from a team turnover / names and faces on the page perspective, but has anything changed in terms of the intangibles of why you wanted to begin a long-term partnership with this group? I always tell managers that I am re-underwriting them every day and that’s really what this process is about.

This is all meant to put you in a position when that manager is raising their next fund, you are working off a significant base of information. While I know not everyone will agree with this, but so long as a manager continues to perform, sticks to the strategy that they promised you they would execute on, and has done so as a good partner, you move from that position of default no to default yes. I find too many LPs pick up their pencils only during an active fundraise process and forget the work they did in the past (and present), which can result in a scramble with a lot of redundancy. When you simplify it, you did the hard work on the initial underwriting, you got to the yes, through all the stages when your default was no. Then you’ve continued to do that same level of work through your post-investment due diligence. A default yes isn’t a set it and forget it and this is not meant to say a re-up is guaranteed, as there are idiosyncratic circumstances, such as internal budgeting or new policies or a new regime with a different focus, or something related to the legal terms of the new offering. You still do your work and write your investment memo – with perhaps new NTBs and WOFs – but lean in, not out.?

In a world where short attention span content rules the day, and the shiny new thing gets all the attention (and raises all the money), too many investors treat their commitments like transactions, not like relationships. People and relationships should always outweigh the next sale, especially in a long-term asset class. Keep that in mind when you are building your investment process, both pre- and post-investment.?