Keeping LPs happy: It's a whole new ballgame for private equity

Keeping LPs happy: It’s a whole new
ballgame for private equity
Timely topics in private equity Issue 5
®

About the author
About the sponsors
Jack DiFranco
National Managing Principal, Private Equity
Grant Thornton LLP
Jack DiFranco is the national managing principal for
Grant Thornton’s Private Equity Services. He also served as national
managing principal for Grant Thornton’s Transaction Services Group
as well as Grant Thornton Corporate Finance LLC.
Jack has assisted clients with business acquisitions, divestitures,
recapitalizations, management buyouts, and financing transactions
for senior debt, subordinated debt and equity. He specializes
in providing M&A advisory services to clients in a variety of
manufacturing and service industries. In addition, he has helped
companies and their shareholders identify and evaluate their
strategic and financial options for increasing shareholder value.
Prior to joining Grant Thornton, Jack was a managing director
in the Investment Banking Group of Stout Risius Ross, Inc.
Preceding his experience with SRR, Jack was a member of the
investment banking groups at First of Michigan Corporation
and Ernst & Young Corporate Finance LLP. In these positions,
he provided M&A, financing and transaction advisory services
to corporate acquirers, private equity firms and middle-market
companies and their shareholders.
Jack has served companies in many industries, including
automotive, building products, information technology services,
industrial equipment, health care, business services, software,
distribution, television and radio, education, insurance, retail, and
food processing.
Jack earned an MBA in finance and corporate strategy from
the University of Michigan and a bachelor’s degree in finance from
Oakland University.
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Introduction
To say the last few years in the M&A business have been a roller-coaster
ride is an understatement. I know that many of my peers who have been
in the business for 20-plus years agree. At the beginning of 2011, we
were eager to start the new year and looking forward to a more stable
deal-making environment. That said, while transaction market conditions
continuously improved during 2010, 2011 has brought on a whole new set
of challenges for private equity professionals. Many private equity firms
deferred fundraising until market conditions improved. With the slight
recovery we have seen, private equity firms were expected to flood the
market looking for capital this year. However, with limited partners (LPs)
remaining somewhat cautious about investing, many private equity firms
are faced with the prospect of not being able to raise a new fund in 2011
or, for some, ever again. Needless to say, the implications of this could
be widespread. New regulatory requirements that go into effect in July
for private equity firms will also change the landscape. This white paper
explores the current fundraising climate, what LPs expect from private
equity partnerships going forward, and how regulatory issues will affect
private equity firms and the industry in the future.
To explore these issues, we spoke with professionals who focus on
various elements of the private equity industry. These specialists include
LPs, general partners (GPs), regulatory professionals and fund managers.
In addition, Grant Thornton LLP searched many data points, including
those from PitchBook Data Inc. (PitchBook), Dealogic, Standard &
Poor’s, and Probitas Partners. Through these sources — and original
reporting — Grant Thornton provides readers with the context of the
current fundraising and regulatory environment. In addition, we offer
a candid view of what LPs can expect going forward and what’s on
the horizon. In order to preserve confidentiality, we have withheld the
names of LPs who agreed to talk with us off the record. This white paper
will give readers a better understanding of how new developments may
change the industry and how private equity firms can meet the increasing
expectations of LPs in the context of the current economic and deal
environment.
Contents
1 Introduction
2 Fund performance and the
economic environment
5 The regulatory environment
7 Alignment of interest
10 Firms that perform
11 Potential solutions
Infrastructure, operational
enhancements, transparency and
better reporting
Industry specialization
Alternative investment strategies
Value creation
16 Concluding thoughts
With limited partners (LPs) remaining somewhat cautious about investing, many private
equity firms are faced with the prospect of not being able to raise a new fund in 2011 or,
for some, ever again.
Keeping LPs happy: It’s a whole new ballgame for private equity 1

Fund performance and the economic
environment
After emerging from one of the most difficult economic
environments in history, most private equity professionals had
started to feel a little more confident by the middle of 2010 and
were looking forward to 2011 — and rightfully so. Companies
that had held out on selling started to creep back into the
market in 2010, and by the end of last year, deal volume had
picked up significantly. In 2010, private equity deal volume
reached $195.7 billion globally, up 53 percent over 2009’s total
of $105 billion. The fourth quarter alone saw $57.8 billion
worth of private equity deals get completed, according to
Dealogic.
What’s more, investment banks saw $9.9 billion worth
of revenues come from advisory work on behalf of financial
sponsors, according to Dealogic. That was more than twice the
$4.4 billion generated in 2009. The data leaves no question that
private equity activity began rebounding in 2010. That’s the
good news. However, regulatory changes and difficulty raising
new funds are two obstacles facing dealmakers today.
After aggressively putting money to work during the
2004 through 2007 period, private equity firms that raised
capital during that same period now need to raise new funds.
According to PitchBook, private equity funds globally raised
only $148 billion in 2009, 54 percent less than they did in 2008.
2010 wasn’t great either; only $90 billion of capital was raised
during the year (see Figure 1). Funds that would normally have
raised capital in 2009 and 2010 postponed fundraising in hopes
of launching new funds in more favorable market conditions.
Now that dealmakers are seeing a marked improvement,
2011 is expected to be a crowded fundraising market. In fact,
globally there are about 700 private equity and venture capital
funds either already in the market or expected to be in the
market to raise funds during 2011. They are all competing for
the same dollars to be doled out by LPs.
Figure 1
Private equity fundraising by year
Number of
funds closed
300
Capital raised ($B)
Number of funds closed
Capital raised
$ in billions
$350
250
$300
Companies that had held out on selling
started to creep back into the market in
2010, and by the end of last year, deal
volume had picked up significantly.
200
150
100
$250
$200
$150
$100
50
$50
0
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: PitchBook Data Inc.
2 Keeping LPs happy: It’s a whole new ballgame for private equity

With all the pent-up demand for new capital, private equity
firms are finding that LPs are firmly in control these days;
LPs aren’t quickly forgetting the challenges that arose during
the 2005–2007 time period that left them less than enthusiastic
about private equity firms for most of 2009 and 2010. As a result
of private equity firms being able to raise a record amount of
capital and the wide-open leverage markets, many firms paid
aggressively for the companies they purchased. As expected
(with the benefit of hindsight), this is already negatively affecting
returns. Private equity vintage funds from 2007, for example, are
showing an average internal rate of return (IRR) of negative 14
percent. Mezzanine funds from the same year are showing an
average IRR of negative 32 percent (see Figure 2).
It’s not all bad news, though. In fact, LPs’ sentiments toward
private equity are actually becoming more positive than they
have been in recent years, especially toward middle-market
funds. According to a survey conducted by Probitas Partners at
the end of 2010, Private Equity Market Review and Institutional
Investor Trends Survey for 2011, 46 percent of respondents plan
to focus their attention in 2011 on investing in middle-market
($500 million to $2.5 billion) buyout funds (see Figure 3).
Figure 3
Private equity sectors of interest
During 2011, I plan to focus most of my attention on investing in the
following sectors: (choose no more than five)
Figure 2
Average internal rate of return for U.S.-based funds
PE
Mezzanine
Internal rate of return
25%
20%
15%
10%
5%
0
-5%
-10%
-15%
-20%
-25%
-30%
-35%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Vintage
Source: Pitchbook Data Inc.
It’s not surprising that LPs have pulled back on their
allocations, as evidenced by the already changed fundraising
environment. For example, in 2007, The Blackstone Group
raised a $21.7 billion fund, the largest private equity fund ever
raised. But its latest fund, Blackstone Capital Partners VI, held a
final close of just $13.5 billion in July 2010. Madison Dearborn
Partners set out to raise a $10 billion fund in 2008. After 28
months, the firm closed on roughly $4.1 billion, far below its
revised target of $7.5 billion set in the summer of 2008.
U.S. middle-market buyouts ($500 MM-$2.5 B)
Growth capital funds
U.S. small-market buyouts ($5 B)
Timber funds
European/Israeli venture capital
Source: Probitas Partners
46
39
37
33
30
27
25
22
19
19
18
17
15
13
13
11
9
9
8
5
4
2
Keeping LPs happy: It’s a whole new ballgame for private equity 3

However, the number of private equity firms that are able
to raise capital will likely diminish overall, and there will be
a divide between firms that can raise new funds and those
that can’t. “Fundraising will be subjective based on the GP.
There will be a growing divide between the haves and havenots.
Fundraising will be very easy for some because they
have had spectacular track records and a loyal LP base. These
firms won’t have to make huge concessions either,” says
Erik Hirsch, chief investment officer for investment adviser
and funds-of-funds manager Hamilton Lane, whose clients
include MassPRIM, the state of Washington and the United
Brotherhood of Carpenters. “Then there’s another group
for which none of this is true. These firms are having serious
problems, which will eventually lead to a weeding out in the
market.”
It’s important to note that even the firms that can’t raise
new funds will not go away immediately — we won’t see
the wind-down of those funds for another five years. “It’s a
slow death,” warns Kelly DePonte, a senior professional with
placement agent Probitas Partners. “In the venture capital
industry you saw a ton of funds raised in 1999 and 2000 that
didn’t finally decide to wind down until 2007 or later. I think
about 10 percent to 15 percent of private equity firms may
disappear, but it will happen slowly.”
If a private equity firm raised its most recent fund in
2006, it should be raising its next fund in 2011. Even if a firm
can’t raise a new fund for three years and isn’t making new
investments, it will still be managing some portfolio companies
bought with its previous fund. It won’t be until 2014 or 2015
that these private equity firms will finally cease operations.
As an aside, with fewer firms in business and the size of
some firms potentially smaller, it only stands to reason that
there will be a decrease in investment professionals’ headcount
over time as well. “We are expecting fewer professionals to
staff the firms, but this isn’t necessarily a bad thing. It will help
bring down administrative costs associated with being a larger
fund which the LPs ultimately pay for,” says one LP, referring
to the fees they pay private equity firms to manage their assets.
It’s important to note that even the
firms that can’t raise new funds will not
go away immediately — we won’t see
the wind-down of those funds for another
five years.
4 Keeping LPs happy: It’s a whole new ballgame for private equity

The regulatory environment
In addition to dealing with a more difficult fundraising
environment, private equity firms must meet the requirements
of the Private Fund Investment Advisers Registration Act,
which was signed into law on July 21, 2010, as part of the
Dodd-Frank Wall Street Reform and Consumer Protection
Act (the Dodd-Frank Act). The new legislation requires
advisers of private equity and hedge funds with more than
$150 million of assets under management to register with the
SEC by July 21, 2011, which is quickly approaching. (Venture
capital funds were given a pass.) The Dodd-Frank Act was put
in place to promote the financial stability of the United States
by improving accountability and increasing transparency in
the financial system. While the largest private equity firms will
most likely face greater scrutiny from the SEC, all firms that
will be required to register with the SEC should do so and
prepare themselves now for SEC inspections.
Every registered firm is required to appoint a chief
compliance officer (CCO) to maintain the firm’s books and
records, which will be subject to SEC examination as the
agency sees fit. Private equity firms will need to have a formal
compliance policy, in addition to keeping track of their assets
under management, use of leverage, counterparty credit risk
exposure, trading and investment positions, valuation policies
and practices, types of assets held, side arrangements with LPs,
and trading practices, if applicable.
Additionally, there is a required change in sales materials,
and more disclosures from private equity firms will be needed.
As part of registration, Form ADV Parts 1 and 2 must be
filed. “We are finding that many private equity firms don’t
have these things in place,” says Steven Goldberg, a principal
in Grant Thornton’s Business Advisory Services practice.
“However, as partners came back from the holiday at the
beginning of January, they started realizing that they have to
take this seriously. We are now getting more and more calls
about registering, every day.”
Some experts estimate the cost associated with registering
to be about $250,000 for a smaller firm; however, costs can
vary widely depending on how in-depth a firm gets with its
registration and how prepared it is when beginning the process.
Appointing a CCO is the first step toward satisfying the
requirements set forth by the SEC. The CCO can be a fulltime
person or someone who is outsourced — the cost is
expected to be roughly the same regardless of which route a
firm takes. The CCO should not be one of the firm’s partners.
“It shouldn’t be someone who gets paid off the proceeds of the
firm’s investments. That creates a conflict,” warns Goldberg.
“The CCO should be someone who is knowledgeable,
competent, empowered by the firm and up to speed on
registration requirements.”
While the largest private equity firms
will most likely face greater scrutiny from
the SEC, all firms that will be required
to register with the SEC should do so
and prepare themselves now for SEC
inspections.
Keeping LPs happy: It’s a whole new ballgame for private equity 5

Next, the CCO has to have the firm ready for SEC
inspection, which is a periodic examination of the firm’s books
and records. The ADV forms are where the initial process
really begins. Filling out the first part of the ADV form is
easy. It requires general information such as ownership and
control, regulatory, disciplinary history, and balance sheet
information, along with additional information about the
business. The second part is more complex. Private equity
firms are required to create a narrative brochure that provides
information such as affiliations, conflicts, fees charged,
investment strategies, and specifics on the adviser’s past
performance and services. This material needs to be updated
annually and delivered to current and potential clients.
“A lot of firms think the process ends with their newly
appointed CCO filling out the ADV form. But that’s where
the process really begins. The information in the form needs
to be accurate, and firms have to live by the information they
put in there. Inaccurate, misleading or omitted disclosures
could lead to regulatory action, which will not look good on a
firm’s track record,” says Michael Patanella, an Audit partner
in Grant Thornton’s Financial Services practice.
Because there will be several thousand new funds
registering, observers are speculating that the SEC will not
get to every firm immediately. “The SEC will probably look
at the larger funds first and the funds with troubled assets
or ones that have had regulatory issues in the past,” says
Goldberg. “But that doesn’t mean a squeaky-clean smaller
firm shouldn’t be ready because the SEC could just as easily
inspect those firms too.”
In fact, to deal with the influx of new registrants, the SEC
recently asked Congress to form a separate organization
that can examine the private equity firms and hedge funds
registering. While how the SEC plans to deal with all the
new registrants is not yet sorted out, private equity firms that
comply early on will be in better standing in the long run, not
just with the SEC, but with LPs as well. “I don’t want to say
that a blemish on a private equity firm’s record with the SEC
will cause the firm to close its doors, but it would certainly
be looked at negatively by the LPs and could certainly slow
money from coming into a fund,” says Patanella.
While how the SEC plans to deal with
all the new registrants is not yet sorted
out, private equity firms that comply
early on will be in better standing in the
long run, not just with the SEC,
but with LPs as well.
6 Keeping LPs happy: It’s a whole new ballgame for private equity

Alignment of interest
These three words have been thrown into the private equity
discussion for the past several years. And while many believe
those words are overused, LPs still care very much about
alignment. Alignment of interest really comes down to a
feeling that all parties are sharing the risks and benefits of the
relationship in a fair and appropriate way.
Many LPs believe that GPs gained too much power over
them during the boom years, and now they are trying to take
back some power and are making their demands clear. At
the heart of the issue is fee structure. When raising very large
funds, private equity firms were able to charge significant fees
to manage LP assets, and the fees were not based on return
on investment. Granted, the problem had a greater effect on
the larger private equity firms because they generated higherdollar
fees, but middle-market firms are coming under scrutiny
as well.
During the last couple of years, LPs felt their alignment
with GPs was out of whack. To deal with the alignment
issues, in September 2009 the Institutional Limited Partners
Association (ILPA) put out Private Equity Principles, a set of
best practices for private equity firms to follow (see page 9).
More than 100 LPs have endorsed the principles, which were
revised in January 2011 and fall within three guiding tenets:
governance, transparency and alignment of interest. 1 The goal
of the principles is to make sure that the GPs’ interests are
aligned with those of the LPs.
“LPs are monitoring their portfolios closely, and so the
Private Equity Principles were published in an effort to restore
the alignment of interest between GPs and LPs that existed
in the original private equity model. When there is more
emphasis on carry and less on fees, both LPs and GPs share
in the upside of the value added to portfolio companies.” says
Kathy Jeramaz-Larson, executive director of the ILPA. “It’s
important for the GPs to understand what is important to the
LPs as they enter into fundraising.”
Indeed, according to a survey conducted by Probitas
Partners at the end of 2009, 47 percent of LPs believed
the management and transaction fees on large funds were
destroying the alignment of interest between fund managers
and investors, and last year 39 percent still said that these same
factors were destroying the alignment of interest between GPs
and LPs. What’s more, LPs are focusing more heavily on fund
structures, with 53 percent of them saying they are spending
more time focusing on the GPs’ level of financial commitment
to the fund.
When raising very large funds, private equity
firms were able to charge significant fees to
manage LP assets, and the fees were not based
on return on investment.
1
Institutional Limited Partners Association, Private Equity Principles, Version 2.0, January 2011
Keeping LPs happy: It’s a whole new ballgame for private equity 7

GPs are listening. At the end of January, Kohlberg Kravis
Roberts & Co. (KKR) made headlines as it prepared to raise
its newest fund, KKR North American XI Fund LP, which is
targeted to raise $8 billion to $10 billion. Its most recent fund,
which brought in $17.6 billion, was raised in 2006. What is
most newsworthy about the firm’s new fundraising effort is
that KKR is offering potential investors concessions to invest.
According to The Wall Street Journal, “[f]or the first
time, KKR is giving investors the choice between a lower
management fee and [a] more favorable split on fees charged
to the portfolio companies that the buyout firm purchases,
including transaction and monitoring fees. The firm’s
predecessor vehicle … gave 80 percent of fees charged to
portfolio companies to investors, while 20 percent went to
KKR itself. Now LPs … can opt to receive 100 percent of the
fees but must pay a higher management fee, or they can stick
with an 80-20 split without an increase in management fees.” 2
KKR will also include a 7 percent preferred return hurdle
before the GP receives any of its share of investment profits,
which is something LPs have been pushing for.
Still, according to most GPs, the ILPA principles have
been a good starting ground for LPs and GPs to engage in
dialogue about the alignment issue. And with increased ability
to influence fund terms, LPs are increasingly identifying issues
that are most important to them, often using those terms as the
final filter when choosing among potential opportunities.
“Investors are really worried about the alignment of
interest,” says Probitas Partners’ DePonte. “The large fees
have really messed things up. To go to the heart of the matter,
GPs can make money even if LPs can’t, and it ticks LPs off.
Unless your returns have been spectacular, which now about
5 percent of firms can probably claim, LPs are asking for fee
reductions and better alignment.”
Lots of private equity firms have started listening. Many of
them have revisited their fee structure, with some even opting
to cut their fees to entice LPs to continue investing with them.
It is important for private equity firms to listen to what
the LPs are asking for and be ready to address management
fees as appropriate. The ILPA guidelines are a good starting
point for discussion, but in all of our interviews, we never
came across any private equity firm that was willing to adopt
all of the principles. Unfortunately, because there are about
100 principles, it seems many private equity firms can’t
endorse them 100 percent. As one GP puts it: “If you ask 10
LPs to rank the three principles they care most about, they
all say different things, which makes it hard to please all of
them and makes the principles seem less important. Also, a
GP may comply with 90 percent of the principles, but it’s the
other 10 percent they don’t comply with that one LP cares
about. The guidelines are a starting point for open and honest
conversation and need to be treated as such.”
It is important for private equity firms to
listen to what the LPs are asking for and
be ready to address management fees as
appropriate.
2
Willmer, Sabrina and Dai, Shasha, “KKR Sweetens Terms for New Mega Fund,” The Wall Street Journal, Jan. 29, 2011
8 Keeping LPs happy: It’s a whole new ballgame for private equity

ILPA principles
The list of principles initially published by the ILPA in September 2009 and updated
in January 2011 is very comprehensive and includes nearly 100 items.
Below is a select list of principles:
Calculation of carried interest
Alignment is improved when carried interest is
calculated on the basis of net profits (not gross
profits) and on an after-tax basis (i.e., foreign or
other taxes imposed on the fund are not treated as
distributions to the partners).
No carry should be taken on current income or
recapitalizations until the full amount of invested
capital is realized on the investment.
Clawbacks
Clawbacks should be created so that when they are
required, they are fully repaid in a timely manner.
The clawback period must extend beyond the term
of the fund, including liquidation and any provision
for LP giveback of distributions.
Management fees and expenses
Management fees should be based on reasonable
operating expenses and reasonable salaries, as
excessive fees create misalignment of interests.
During the formation of a new fund, the GP should
provide prospective LPs with a fee model to be used
as a guide to analyze and set management fees.
Management fees should take into account the
lower levels of expenses generally incident to the
formation of a follow-on fund, at the end of the
investment period, or if a fund’s term is extended.
Expenses
The management fee should encompass all normal
operations of a GP to include, at a minimum,
overhead, staff compensation, travel, deal sourcing
and other general administrative items as well as
interactions with LPs.
The economic arrangement of the GP and its
placement agents should be fully disclosed as
part of the due diligence materials provided to
prospective LPs. Placement agent fees are often
required by law to be an expense borne entirely by
the GP.
Term of fund
Fund extensions should be permitted in one-year
increments only and be approved by a majority of
the limited partner advisory committee (LPAC) or
LPs.
Absent LP consent, the GP must fully liquidate the
fund within a one-year period following expiration of
the fund term.
GP fee income offsets
Transaction, monitoring, directory, advisory [and]
exit fees and other considerations charged by the
GP should accrue to the benefit of the fund.
GP commitment
The GP should have a substantial equity interest in
the fund, and it should be contributed in cash as
opposed to being contributed through the waiver of
management fees.
GPs should be restricted from transferring their
real or economic interest in the GP in order to
ensure continuing alignment with the LPs.
The GP should not be allowed to co-invest in select
underlying deals; rather, its whole equity interest
shall be via a pooled fund vehicle.
Team
The investment team is a critical consideration in
making a commitment to a fund. Accordingly, any
significant change in that team should allow LPs to
reconsider and reaffirm positively their decision to
commit.
Investment strategy
The fund’s strategy must be well-defined and
consistent.
The investment purpose clause should clearly and
narrowly outline the investment strategy.
Any authority to invest in debt instruments, publicly
traded securities, and pooled investment vehicles
should be explicitly included in the [agreed-upon]
strategy for the fund.
Fiduciary duty
GPs should present all conflicts to the LPAC for
review and seek prior approval for any conflicts
and/or non-arm’s-length interactions or transactions.
A majority of LPs must be able to remove the GP
or terminate the fund for cause.
Changes to the fund
Given the long-term nature of the private equity
partnership, the fund’s terms and governance must
be well-defined upfront but also be flexible enough to
adapt to changing circumstances. With appropriate
protections for the interests of the GP, LPs should
have the option to suspend or terminate the fund.
Management and other fees
All fees generated by the GP should be periodically
and individually disclosed and classified in each
audited financial report and with each capital call and
distribution notice.
All fees charged to the fund or any portfolio
company by an affiliate of the GP should also
be disclosed and classified in each audited financial
report.
Capital calls and distribution notices
Capital calls and distributions should provide
information consistent with the ILPA Standardized
Reporting Format.
The GP should also provide estimates of quarterly
projections on capital calls and distributions.
FINANCIAL INFORMATION
Annual reports — Funds should provide
information consistent with the ILPA Standardized
Reporting for Portfolio Companies and Fund
information at the end of each year (within 90 days
of year-end) to investors.
Quarterly reports — Funds should provide
information consistent with the ILPA Standardized
Reporting for Portfolio Companies and Fund
information at the end of each quarter (within 45
days of the end of the quarter) to investors.
Portfolio company reports — A fund should
provide a quarterly report on each portfolio company
with the following information:
• Amount initially invested in the portfolio company
(including loans and guarantees)
• Any amounts invested in the portfolio company in
follow-on transactions
• A discussion by the fund manager of recent key
events in respect of the portfolio company
• Selected financial information (quarterly and
annually) regarding the portfolio company,
including:
- valuation (along with a discussion of the
methodology of valuation),
- revenue (debt terms and maturity),
- EBITDA,
- profit and loss,
- cash position, and
- cash burn rate.
Source: Institutional Limited Partners Association
Keeping LPs happy: It’s a whole new ballgame for private equity 9

Firms that perform
First and foremost, the private equity firms that have performed
well and have a stellar track record will be able to garner attention
from their LPs. Top-quartile firms such as TPG Capital, Leonard
Green & Partners, and WL Ross will most likely have an easier
go at fundraising (see Figure 4). According to a recent Probitas
Partners survey, investors are likely to commit slightly more to
private equity in 2011 than they did in 2010, but the appetite for
new managers is limited; most investors are focused on reviewing
current relationships with strong GPs and renewing with only a
select few. Coming out of the recession, LPs have realized they
simply do not have the time or capacity to monitor an extensive
number of GP relationships, so they are placing greater focus on
the relationships they value.
“A lot of LPs came out of the downturn realizing they have
too many fund relationships. They are asking themselves, ‘Do
I really need six firms with the same strategy in my portfolio?’
At the core of the issue is LPs taking a hard look at which firms
with good track records are additive. It’s not about simply being
different, but being different and being able to perform,” says
Hamilton Lane’s Hirsch.
Lori Campana, a managing director with fund placement
agent Monument Group, agrees. “Fundraising is a challenge, but
it is improving. LPs are making commitments, but much more
selectively. They are only reupping with their best managers
and ones that add something really compelling to the mix, like a
regional or sector focus, for example,” she says.
Figure 4
Internal rate of return by year 2006 – 2010
Fund name Investor name Vintage Close
date
Fund size
($M)
Walnut Investment Partners I The Walnut Group 2000 02-Jan-04 105.00 120.66%
T3 Partners II TPG Capital 2001 02-Jan-05 378.00 95.40%
GCP California Fund Leonard Green & Partners 2001 02-Jan-05 50.00 91.00%
Information Technology Ventures Information Technology Ventures 1995 02-Jan-99 75.00 89.71%
WLR Recovery Fund II W.L. Ross & Co 2002 02-Jan-06 400.00 79.30%
Providence Equity Partners Providence Equity Partners 1996 02-Jan-00 363.00 78.50%
Permira Europe I Permira 1996 02-Jan-00 890.00 74.50%
Clessidra Capital Partners Fund Clessidra Capital Partners 2005 02-Jan-09 1,100.00 63.70%
Platinum Equity Capital Partners Platinum Equity 2004 02-Jan-08 700.00 60.59%
DLJ Merchant Banking Partners I DLJ Merchant Banking Partners 1992 02-Jan-96 1,000.00 58.10%
Carlyle/Riverstone Global Energy and Power Fund II Riverstone Holdings 2004 02-Jan-08 1,100.00 55.80%
Carlyle/Riverstone Global Energy and Power Fund II The Carlyle Group 2004 02-Jan-08 1,100.00 55.14%
OCM/GFI Power Opportunities Fund II GFI Energy Ventures 2005 02-Aug-09 1,020.00 55.03%
Advent Global Private Equity IV Advent International 2002 11-Jan-06 1,768.69 52.30%
Advent Global Private Equity V Advent International 2005 26-Apr-09 3,235.79 50.80%
First Reserve Fund IX First Reserve 2001 02-Jan-05 1,375.00 48.10%
Lincolnshire Equity Fund III Lincolnshire Management 2005 02-Jan-09 433.00 47.16%
OCM Opportunities Fund IVb Oaktree Capital Management 2002 02-Jan-06 1,340.00 46.50%
Source: Pitchbook Data Inc.
IRR
10 Keeping LPs happy: It’s a whole new ballgame for private equity

Potential solutions
So what will it take to attract new investment and keep LPs
happy? Well, not all LPs’ needs and expectations are alike.
Certainly investors will have their own specific combination
of concerns and expectations. That said, some common themes
and approaches will resonate with most LPs. As previously
discussed, better alignment of interest (including addressing
concerns about management fees) will be important. In
addition, improving infrastructure and operations to reduce
costs and heighten transparency will become an area of focus.
Differentiation through industry specialization and alternative
investment strategies is gaining momentum. And finally,
enhancing performance through a more proactive approach to
value creation will be required to produce attractive returns in a
very competitive marketplace.
Infrastructure, operational enhancements, transparency and
better reporting
Better infrastructure and operational enhancements as well
as more transparency and faster financial reporting will be
key differentiators for private equity firms. Believe it or not,
registering with the SEC can be beneficial. While registration
may take some time, it will help firms keep better track of their
information and in turn help them disseminate it to LPs faster.
“Firms that register will be more attractive to investors because
LPs will be able to invest in them with more confidence,” says
Grant Thornton’s Goldberg.
Additionally, outsourcing the CCO function could be an
advantage in the long run. As Patanella points out, it takes
the possibility of any conflicts out of the equation, which is
a positive for the private equity firms. “There’s sometimes a
negative connotation when firms do their own books. Firms
are not thrilled about paying outside administrators to handle
this function, but then there’s less of a concern of management
manipulation of transactions and misappropriate of assets,”
says Patanella.
That said, while many LPs look at the new registration
guidelines as “bogus because the SEC does not have the
resources to enforce them, as a practical matter, registration
can add more structure to private equity firms, which they,
especially smaller firms, are lacking,” says DePonte.
DePonte goes on to point out that LPs don’t really care
about infrastructure per se. They care about getting their hands
on data regarding their investments. “I am not hearing a lot of
LPs saying they want to see more infrastructure, but they are
saying they want faster access to information,” he says.
While registration (with the SEC) may take
some time, it will help firms keep better track
of their information and in turn help them
disseminate it to LPs faster.
Keeping LPs happy: It’s a whole new ballgame for private equity 11

Hamilton Lane’s Hirsch agrees. LPs are making a greater
push for operational enhancements, he says. LPs are under
pressure from their pensioners to know more about how
their money is being invested, especially if there’s any type of
irregularity in the market. Illiquid assets like private equity
assets add extra concern. From there, the pressure trickles
down. LPs then turn to fund management, demanding accurate
information in a timely manner. “LPs are under pressure to
let their investors know where their assets are and what their
exposure is. Right now there is a gap between private equity
firms that get this done in an acceptable time frame and those
that lag four weeks with the excuse that they don’t have a CFO
or a back office. LPs are absolutely going to make a distinction
and will penalize firms that can’t produce this information
when it is requested,” says Hirsch.
For example, before Monument Group allows any of its
private equity clients to present funds to LPs, it insists that
GPs be prepared to demonstrate their firm’s infrastructure
strength. “LPs notice it, comment on it, and are more and more
interested in hearing about it,” says Campana. “We have our
GPs talk very specifically about their back office initiatives and
how they help the firm better manage its portfolio companies.
The next thing LPs want to know is how that translates
into returns. Sometimes that’s hard to answer. Some value
additions can actually cost money, but GPs should then be
able to demonstrate how having better reporting technology or
providing more purchasing power to the portfolio companies
has turned into more sales leads or greater demand.”
The bottom line is that a private equity
firm’s job is twofold — to be a good
investor and a good fund manager.
There are companies that can help private equity firms
organize their financial information. In 2005, John Grabski
founded ClearMomentum, a software firm that provides
financial reporting and analysis tools to private equity firms
so that they can better manage their portfolio companies.
Grabski, CEO of the company, says it’s incredible how
much demand for his product, ClearFinancials®, has grown
during the last couple of years. “With macrodrivers like the
Dodd-Frank Act and the push for more transparency, there
is a lot of interest in our solution,” says Grabski. “The more
transparency there is in the industry, the less risk there is in
investing in the industry. This will drive more money into the
industry.”
ClearFinancials will typically shorten the average reporting
cycle by 25 days, which means private equity firms learn
about problems at the portfolio level sooner and can address
them quicker. It also allows private equity firms to report
information about fund performance to their LPs faster and in
a uniform style.
The bottom line is that a private equity firm’s job is
twofold — to be a good investor and a good fund manager.
Being a good fund manager is something most LPs feel GPs
have lacked in the past. Being a good fund manager requires
private equity firms to have best practices in place concerning
infrastructure, reporting and cost. “The big guys are good at
this because they have been under pressure to disclose more.
More firms need to hire CFOs, invest more in their firm
and give LPs timely information that’s usable,” says Hirsch.
“Going forward, having infrastructure in place will be a
requirement to play the game. An LP won’t even look at you if
you don’t have it in place.”
12 Keeping LPs happy: It’s a whole new ballgame for private equity

Industry specialization
Going forward, attracting LP investors will require more
differentiation. Industry specialization will endear private
equity firms to LPs, but as Hirsch says, the firm’s offering has
to be additive, not just different for the sake of being different.
That being the case, over the past five years there’s been a
push toward private equity firms becoming more specialized.
In fact, according to a Probitas Partners survey, 49 percent of
respondents find middle-market funds focused on operational
improvements and heavily staffed by professionals with
operating backgrounds to be the most attractive funds to invest
in.
“Firms used to be able to use financial engineering and
increase the leverage at a portfolio company, but with less
leverage available this strategy is less likely to be successful. The
only thing that consistently generates value is increasing the
earnings of a portfolio company. The best strategy to increase
earnings is to make positive changes within the portfolio
company. You have to have experienced people onboard
making that happen,” says DePonte.
Successful private equity firms have begun adding areas
of specialization to their offerings in hopes that operational
efficiencies will help boost returns for their funds. For example,
the Riverside Company, historically more of a generalist
firm, has developed specializations in select industries like
healthcare, training and education, franchising, and software.
Fortune magazine reports that in early 2011, “Hal Rosser
announced his departure from Bruckmann, Rosser, Sherrill
& Co., a New York-based private equity firm that he had cofounded
in 1995 with two other veterans of Citicorp Venture
Capital.” 3 Shortly thereafter, he announced the launch of a
new firm called Rosser Capital Partners, which will have a
narrower investment thesis. He told Fortune that he left his old
firm because he wanted to focus on buying companies in the
restaurant, retail and multiunit consumer industries.
Wynnchurch Capital Partners, which is in the midst of
raising Wynnchurch Capital Partners III, is a generalist fund,
but it has special expertise in the areas of manufacturing;
transportation and logistics; energy and power; and business
and industrial services; while Jefferies Capital Partners, which
is raising Jefferies Capital Partners V, touts industry expertise
in distribution and logistics; restaurants; manufacturing;
energy; health care; media and telecom; financial services; and
transportation.
“Being a generalist fund can make people think you will
financially engineer the company, which isn’t what anyone
wants to hear today,” says one LP. “We want to hear that
private equity firms can make a real difference at the company
level.”
The only thing that consistently generates
value is increasing the earnings of a
portfolio company.
3
Primack, Dan, “Term Sheet: Hal Rosser Talks About His New Firm, and Why It’s Always a Good Time to Buy Restaurants,” Fortune, Jan. 11, 2011
Keeping LPs happy: It’s a whole new ballgame for private equity 13

Alternative investment strategies
Alternative investment strategies will also help differentiate
private equity firms.
In addition to having some sector-specific expertise, private
equity firms that have flexible mandates may also fare better
with LPs. Being able to invest in more than one point in the
capital structure is appealing.
Deerpath Capital Management, founded in 2006 by
James Kirby, Gary Wendt (former chairman and CEO of
GE Capital), and John Fitzgibbons (founder and chairman
of Integra Group), targets equity and debt investment deals
between $2 million and $20 million.
“Having flexibility won’t seal the deal, but it could help,
especially in times like we just went through. Being able to
choose to put debt versus equity into a deal can be a real
advantage at certain times,” says one LP.
Private equity firms that raise funds with a flexible mandate
will be in a good position to take advantage of minoritystake
investments as well. These types of investments gained
popularity during the last couple of years as fewer sellers
wanted to exit their companies fully during turbulent market
conditions but nevertheless needed some liquidity. For
example, Clearlake Capital, a Chicago-based private equity
firm, is agile enough to invest at all different points of the
capital structure.
For instance, a company in a distressed situation may
need rescue financing to avoid a bankruptcy, but a company
in bankruptcy may decide to sell off all or a portion of its
business, and Clearlake can assist with either. LPs see the logic
in this investment thesis. In January 2010, Clearlake was able to
close its first institutional fund with $415 million — an almost
impossible feat today.
“In this market, GPs have to have the ability to work
different points of the capital structure. It is a real benefit,”
says Monument Group’s Campana.
Private equity firms that raise funds
with a flexible mandate will be in a
good position to take advantage of
minority-stake investments as well.
14 Keeping LPs happy: It’s a whole new ballgame for private equity

Value creation
And of course, value creation at the portfolio level is key.
Like Kelly DePonte says, private equity firms need to improve
earnings at the companies they buy. Making fundamental
improvements is really the only sustainable way to do that.
Financial engineering and benefiting from multiple arbitrage
cannot be relied upon in the future to generate favorable
returns.
The topic of portfolio company value creation justifies a
great deal of discussion. In fact, our next ACG white paper will
be focused on this topic. That said, there are some important
factors that should be highlighted here.
• Value creation starts with understanding the key value
drivers in a business. These are the levers that create the
opportunity to enhance value. Sales growth, operating
margin efficiency and (in the case of add-on acquisitions)
synergistic SG&A cost rationalization are all examples of
value drivers.
• Every deal has the potential to be a good deal or a bad deal
— it depends on what you pay for it. Aggressively valuing
a business or paying for synergies means that the bar for
creating value is getting raised higher and higher. People
say they don’t pay for synergies, but it happens all the time.
• During the deal, everyone is focused on the deal. Not
enough buyers focus on the 100-day plan or how the
pursuit of operational improvements is going to be actively
managed post-transaction. An effective performance
improvement program (or integration plan, in the case of an
add-on acquisition) is often the key to success.
• Before a deal is consummated, thorough due diligence must
be undertaken to understand the impact of the value drivers
and challenge the potential achievement of operational
synergies. Proper due diligence is not just about the quality
of the earnings or other financial measures.
Before a deal is consummated, thorough
due diligence must be undertaken to
understand the impact of the value drivers
and challenge the potential achievement of
operational synergies.
Keeping LPs happy: It’s a whole new ballgame for private equity 15

Concluding thoughts
As an asset class, private equity will continue to play a
very important role in the economy and the transaction
market. Investors still like and need this asset class. Private
equity provides growth capital and succession liquidity to
privately held businesses. Private equity has also proven to
be a great home for corporate divestitures. However, the
industry is changing. The regulatory environment is getting
more difficult. At the same time, LPs are becoming more
demanding. Add to that a very competitive marketplace
and an economy that is moving slower toward recovery
than everyone had hoped — these circumstances all create
challenges as well as opportunities. The private equity firms
that step up to the challenge and strive to enhance their
operations and distinguish themselves in the eyes of LPs will
be successful. This will require a more effective approach to
meeting LP expectations. If private equity professionals aren’t
clear about what their LPs want, they just need to ask. As we
found in our interviews for this white paper, they won’t be
too shy about letting you know what they want.
The private equity firms that step up to
the challenge and strive to enhance their
operations and distinguish themselves in
the eyes of LPs will be successful.
16 Keeping LPs happy: It’s a whole new ballgame for private equity

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