I would be surprised to find anyone surprised to learn that outsourcing private equity research and analysis has become a popular business to be in. There are, of course, differing extremes of the basic business model. Dump it all as far offshore and at the least cost possible, or, perhaps, retain an on-shore firm disposed to collecting e.g., bright, young ex-McKinsey sorts to run your deeply analytical due diligence.
Of course, the challenge in outsourcing effectively hinges less, I think, on picking the right provider, than structuring the incentives designed to produce the correct combination of quality and cost. This is, no doubt, much easier when performance is easily measured by quantitative analysis (i.e. average minutes of hold music experienced by irate customer), but even here one must be careful to avoid incentivizing abrupt sign-offs and "pass-the-buck" behavior as individual customer support agents press to shave minutes and seconds off call duration.
An interesting thought exercise for outsourced private equity diligence: If you were an overworked private equity fund needing smart brains attached to bodies to keep up with the deal flow that you are drowning in (let's remember that we are talking about 12 months ago for a moment) how would you design a fee structure for an outsourcing provider? It would depend, of course, on what kind of diligence you wanted. Yes? If it is your capital under management, I suspect you would want doggedly persistent and unrelenting diligence. I suppose I am assuming you, as a firm, regard diligence as a defensive part of the investment process, rather than a confirming check-the-box exercise, but I think I can be forgiven this optimism.
I would engineer a rather dull, but not ruinous, hourly fee for the work that covered my provider's cost, plus a slim but not insulting margin. To this I would add two sets of bonuses. First, a kicker for every issue discovered by my provider that allowed me to bring purchase cost down from the figure in my letter of intent. Second, a rather larger bonus if my provider unearths irregularities that cause me to exit the deal. (This would be easy to fund off of someone else's dime with a break-up fee assessed to the seller in such an event). I suspect my provider would be almost painfully skeptical, which is what I would want.
Leaving behind, for a moment, this fantasy world of aligned interests and prudent investment methodologies, what do you think the actual fee structure model looks like in these firms?
Fee with a major discount if the deal is not consummated. In otherwords: No fees of any substance whatsoever if it is not.
Pray tell, how often do you think diligence delivered in this way leans towards not consummating a deal? Give up? With respect to the firm that was described to me, not once. Glad I'm not one of their limited partners.
