How to Vet Sponsors Before Investing Your Hard-earned Dollars?

If you're into investing, do you always want to find lucrative private investment deals as a limited partner (LP)?

If you feel like an outsider, this article is your inside track to successful investing as an LP. At the end of it, you'll find 2 useful resources. Click to make a copy to your own Drives, they'll be useful eventually.

My goals are to give you an idea of how I find hidden opportunities with a due diligence process and give you the tools to ask tough questions of fund managers.

Pain Points in the Vetting Process

Here are the six most common hurdles you'll need to clear:

1. The best deals often circulate within closed networks, leaving you out.
2. Getting reliable, in-depth information on a fund's track record, strategy, or current investments can feel like pulling teeth.
3. Analyzing funds is a complex, time-consuming beast. It requires specialized knowledge you may have yet to gain.
4. Private fund investments aren't like stocks — you can't cash out quickly if needed.
5. Whose Side Are They On? Fund managers might prioritize their profits over yours, creating conflicts of interest.
6. High management and performance fees can seriously chip away at your returns.

Due Diligence Strategies for LPs

In my process, here are the key areas a successful LP due diligence process should cover:

Request and carefully review essential documents like the private placement memorandum (PPM), subscription agreements, and side letters.

Analyze the fund's strategy, investment restrictions, fee structures, and other pertinent terms.

Examine the fund's historical returns, comparing them to relevant benchmarks.

Be aware of how performance is calculated (net of fees, IRR, etc.). Request audited returns if possible.

Investigate the backgrounds and experiences of the fund's key individuals.

Look for relevant sector expertise, a history of successful deals, and a strong reputation within the industry.

If feasible, get information on the fund's current holdings, including company valuations, deal terms, and planned exit strategies.

Evaluate the potential risks and upsides of these investments.

Assess the overall market environment and the fund's investment space (is it overvalued or undervalued).

Are the targeted sectors likely to grow? What are the significant risks or headwinds to be aware of?

Information Gathering Methods

Information sources are important, and these are the steps I take.

1. Engage in in-depth discussions with the fund manager. Ask probing questions to assess their strategy, investment philosophy, and risk management process.
2. Utilize databases like Pitchbook or Preqin to find industry reports, fund performance data, and relevant benchmarks.
3. Contact other investors in the fund or past funds managed by the same team. Seek informal insights about their experiences.
4. Consider engaging a consultant or advisor specializing in private fund due diligence. They can provide tailored analysis and valuable insights.
5. The depth of your due diligence should be proportionate to the size of your potential investment and your overall risk tolerance.
6. I have checked on sponsors and found bankruptcy on their records. An online service allows you to run checks for a low fee.

Overcoming Information Asymmetry

One of the most significant challenges limited partners face is the need for direct access to valuable market information and access to deal opportunities.

Here are some strategies to bridge this gap:

• Build Your Network: Proactively cultivate relationships with other LPs, fund managers, and industry professionals. Attend industry conferences and events to connect with relevant players and tap into informal knowledge exchanges.
• Leverage Online Resources: Several platforms cater to the LP community and offer deal-flow opportunities. Examples include Trusted Insight, Leafwire, and others specifically focusing on private market niche strategies.
• Join LP Associations:  Organizations like the Institutional Limited Partners Association (ILPA) provide valuable resources, networking opportunities, and educational content specifically for LPs.
• Proactive Introductions: Don't hesitate to request introductions from your existing network to expand your reach into promising funds or investment opportunities.
• Develop Internal Expertise: If your organization has significant LP activities, consider building in-house analytical capabilities. This could help with preliminary screening and opportunity assessment.
• Use Advisors Strategically: Specialized advisors can be invaluable in sourcing deals, facilitating introductions to fund managers, and aiding in due diligence.

The takeaway is overcoming information asymmetry takes effort but is crucial for LPs.

Building a strong network and using available resources can unlock better investment opportunities.

Questions for Aligning Expectations and Objectives

After you have everything prepped up, here are some questions to start with.

1. Can you provide details on the amount of capital the General Partners have invested in the fund alongside LPs? (This demonstrates "skin in the game.")
2. Does your fee structure include fee deferrals or clawbacks to ensure incentives remain aligned during the fund's life?
3. How do you balance the interests of LPs and the investment team when making decisions about portfolio company exits?
4. Are there specific mechanisms to address divergent priorities?
5. What governance structures ensure transparency and regular communication with LPs?
6. How are LPs represented (e.g., advisory committee)?
7. How do you handle co-investment opportunities?
8. Do LPs have preferential rights, and are any measures in place to prevent conflicts of interest?

Now, download the DD checklist my community and I use in the resource section for your next deals.

Managing Risk and Expectations

Success takes patience and a clear understanding of the risks involved:

Unlike stocks, you can't sell your LP investments overnight. Be prepared to hold them for the long haul.

Don't put all your eggs in one basket. Diversify your LP investments across different funds and strategies.

Know what you'll pay in management and performance fees (carried interest). These cut into your profits!

LP investing means building wealth over time.  Don't expect immediate, outsized returns.

Conclusion

Grab the due diligence checklist I prepared below and add it to your toolkit.

Be bold, ask questions, speak to other investors, and have professionals reviewing your deal.

Being an LP can be rewarding when you invest in the right operators; this can be truly passive income.