The debate: Are LPs even LPs any more?

THE PARTICIPANTS: Mounir Guen, CEO of placement agent MVision, who served as moderator; Sandra Bosela, co-head of the private markets group and global head of private equity at Optrust Private Markets Group ($18 billion in assets, $3 billion in private equity globally); Steve Byrom, head of private equity at Future Fund ($120 billion, $13 billion); Suyi Kim, managing director and head of Asian private equity at Canada Pension Plan Investment Board ($197 billion, $51 billion); and Ivan Vercoutere, managing partner and CIO at LGT Capital Partners ($50 billion, $25 billion). What follows is an abridged version of their discussion.

ON THE EVOLUTION OF PRIVATE EQUITY AND CO-INVESTMENT

VERCOUTERE: I think back 25 years ago and what the private equity industry looked like - $10 billion in capital raised, mostly US buyouts, with a little bit of Europe. You had the GP and the LP and they lived in two different worlds. They got together every four years and the GP would raise the capital and tell the LP, "I'll come back in 4-5 years, tell you how I've done and hopefully you'll give me money again." Today I can't think of an industry that has evolved so quickly. The lines between LPs and GPs are blurring more and more. They definitely live in the same world, they share a lot more information than they used to. LPs moving up the food chain and not doing just primaries but secondaries, co-investment, directs. It is part of this evolution, GPs and LPs learning to work more closely together and have a more symbiotic relationship.

Today I can’t think of an industry that has evolved so quickly. The lines between LPs and GPs are blurring more and more. They definitely live in the same world, they share a lot more information than they used to – Ivan Vercoutere

KIM: We are a very large investor in funds, but over time we have also built direct investment capabilities. Within directs we have three buckets: co-investment, co-sponsorship or co-underwriting, and strategic investments. The evolution is from co-investment to co-sponsorship to strategic investment. The underlying criteria are the check sizes we can invest. We have a large pool of capital that is growing very fast, but we don't have unlimited resources. For the smaller deals, we cannot afford to put in five or six-person teams for a couple of months. We only do these smaller co-investments with our GPs and we largely want to rely on the GPs to source and monitor investments. Strategic investments are more for us to mitigate the re-investment risk. Building scale is important and one of the headaches is you have to realize every five years. You deploy $5-6 billion on the funds side and some years you get back $7-8 billion and so the overall portfolio ends up shrinking. We don't need liquidity because of our asset-liability profile, so we can be a longer-term investor as opposed to buying and selling, buying and selling. This strategic investment is not necessarily what our GPs would pursue.

ON THE IMPORTANCE OF GP-LP COMMUNICATION

GUEN: Imagine that I'm a GP; I've just closed my fund, I've got a big deal and I want you to co-invest, but all four of you turn me down. I find it very frustrating, so why should I give you co-investment?

BYROM: It is coming to a point now where to get the fund investment it's going to be important. There is an underlying message in that: in a slow return environment, the economics on the fund don't work. That is what the LP community is saying to the GP community by demanding co-investment opportunities. Different investors have reasons peculiar to them as well. We are a commodity-based currency and we don't run annual allocations, so co-investment is an important tool for us to manage our capital flows.

BOSELA: Every LP today wants co-invest and GPs know there is a handful of LPs who say they want it but never execute; they will very quickly put them to one side. I think that as long as an LP comes back quickly and tells a GP if it's a no and why it's a no, the GP will appreciate that and move on. It's important for certain LPs to show they can do it and that is why they are going to get the calls over and over. When you are doing due diligence on a manager, track record and team obviously come first, but co-investment is pretty important to us - for 10-20% of our relationships it is okay for there to be no co-invest, with everyone else we want it. We are only going into managers where we think there is a need for our capital. So we will often ask, "Who is your investor base? Who are your co-investors? Who actually does co-invest? What size checks do they write?" If there are already 10 guys who write the same check as us, we are probably not going to get what we want. The onus is on the LP and if you are a serious investor you have to make sure you partner with the right type of people to get that relationship. And there is a respect there. Once you do one co-investment, they know you can execute, and so if you turn down the next two or three, the GP will understand as long as you have an efficient process.

VERCOUTERE: The four "no's" you have gotten might mean very different things. Have you done a co-investment with one of us before? How did that work out? Was it no in 48 hours or no after three weeks? Was it a no with an explanation that makes sense to you? It means different things.

GUEN: One of the things I always tell GPs is get to know your investors. If they tell you they are active in co-invest then get them to present to you how their program works, what their interests are, how their decision making process operates.

VERCOUTERE: Who is going to work on it? Is there a dedicated team? How quickly can they expect the initial feedback? Do they want to recreate due diligence? Do they want to meet management? There is a long checklist and everyone does co-investments differently.

BOSELA: When we go into GPs, we spend a lot of time with them trying to understand their sector focuses. Our team then tries to get smart on those sectors so we can respond when opportunities come up, or we can proactively hunt with the GPs, or source opportunities to show them our competitive advantage in the Canadian market. When everyone wants co-invest we must try to differentiate ourselves, ask how can we get up the curve quicker and be the partner of choice.

ON FEES IN CO-INVESTMENTS

GUEN: [Imagine that I'm a GP]; I've got the hottest deal you've ever seen. I know you it because you heard through the bankers that I've been looking at this deal and it's pretty much proprietary. You want $250 million? You got it. It's 1% [management fee] and 10% [carried interest].

KIM: We don't pay fees and expenses for direct investment.

GUEN: Okay, I'm giving it to Steve...

BYROM: I don't pay either.

KIM: We believe we have strong relationships with all our GPs, and in addition to that we have a significant amount of capital that normally pays 2/20. On the direct side we have managed to build a significant portfolio and we've not paid any fees or carry.

GUEN: I know an example of a GP that went to its existing investors, as per the understanding, and they all said 0/0. The GP went outside the fund and found two people who would do the whole thing at a handsome promote.

BOSELA: But are those two people going to be in their next fund?

GUEN: Yes.

KIM: I understand there are economics, but there are a lot of other considerations as well. One of the important points being the certainty of capital. When you get into a deal situation it is very important that you have certainty from your partner and when things work out you will have the capital. We can provide that certainty and transparency; we can also provide a deal team that works alongside the GP and thinks about things in a similar way. I think we bring more than just the capital.

GUEN: What if I give you zero on the management fee, 1% on the monitoring fee, and I get a 10% carry if I make 3x net or more. Are you interested?

BOSELA: No.

VERCOUTERE: If it's a $500 million fund that has a slightly bigger deal and it has those risk-return characteristics, then I would consider it. These GPs work in a different world; the performance fee is what makes a difference at the end of the day. If they find a proprietary deal - which is very difficult in the mid-market - and it makes 3x-plus, am I willing to share that? Yes, because how many big deals do 3x-plus?

BOSELA: We will do deals alongside our GPs, but we don't pay economics on them because we are in the fund. If someone were not in our fund and comes to us - maybe they don't have a fund or their LP base can't do what they need us to do - then we would be willing to pay some economics.

ON GPs RAISING VEHICLES ALONGSIDE THEIR MAIN FUNDS

GUEN: [Imagine that I'm a GP]; I'm going to raise a $2 billion fund, I'll probably have $500 million in co-invest, and I'm going to do a top-up, because that way I don't to go to you guys every time I need some money for a big deal. I'll put in a sidecar fund for $500 million. Are you happy?

BYROM: It's a really complicated question, because of the incentive arrangements that come out of that. If you have a fee mechanism that switches on as you use that vehicle, you are incentivized to use that vehicle. How you manage that is an issue. For me, with a commodity-based currency with no annual allocations, we try to use co-investment to moderate our capital demands and unfunded commitments. Having a sidecar vehicle doesn't achieve that. It still leaves me with a big unfunded commitment.

KIM: I have seen a number of those cases and there are cases in which we have participated as well. It brings a lot of complexity from a GP perspective. We have seen cases where the top-up fund didn't work out too well because the allocation has been an issue, the different investor base and the complexity that brings. At the end of the day, in the cases I have seen, there aren't any top-ups after the first top-up.

VERCOUTERE: You don't see too many of those. There was a period of time when you saw them but I think there are fewer today because of the pressure to offer co-invest.

GUEN: What if I did a SPAC [special purpose acquisition company], a one-off UK-listed vehicle where you don't really have to define the asset, and got $600 million to put into a direct deal?

BOSELA: Then I'm not going to be in your next fund. We are not aligned. Why are not putting what you have in the SPAC into the fund? Now you have a competing vehicle with the fund and you have created misalignment. Whenever there is strategy drift, whenever there is any kind of competing fund, those are not happy conversations. If it's something that was discussed in advance and we knew there was a risk of that happening, then that's something we took on. But if there is a surprise during the fund we are not going to be happy.

VERCOUTERE: Look that the dynamics of the private equity market today. A lot of investors have been active for a long time and they have many managers. The motto is: I need to reduce the number of managers and put more capital to work. You as a GP think you are going to be in the inbox or the outbox. If an important LP is asking for co-invest you are going to ask twice about these things that might upset the LP. You want to strengthen the partnership between you and your most important LPs.

ON CREATING LONGER-DURATION STRUCTURES FOR CERTAIN ASSETS

GUEN: In certain portfolios there are exceptional companies that are paying back their equity every couple of years. Why should the GP sell their best asset to fundraise? And why should they be selling it at 3.5x when it could be generating cash for you for a long time? [Imagine that I'm a GP]; would you come with me and buy it out of the fund, at third-party price, where the fund investors are happy because that's what they wanted? We put it in a special purpose vehicle that I will manage and we will hold that investment for 10 years, assuming it pays back the equity every two years. At some point a strategic might come along with an incredible price or perhaps we list the business six or seven years from now. But this is an interesting direct...

KIM: We do have a business that has grown significantly - direct secondary or GP restructuring. We have done a number of large transactions from 2009-2010 and that was exactly the idea: provide liquidity to the LPs that need it and provide a solution for the GP as well. For those investments it is generally important to have control, but Asia to date at least, a big part of private equity has been minority investments and controlling the exit has not been that obvious.

BYROM: If I was on the advisory board of the fund I'm not sure I would sign off on it. But as a new investor coming in, it's an interesting idea. You don't get these secondary trades in Asia because of the power of primary capital going into the growing business. Are you better off putting that capital into the company as a primary investment to accelerate the growth rather than do a secondary trade?

VERCOUTERE: We've had a number of funds where they had one of those assets and they kept it until the bitter end of the fund and provided those types of returns. It can work, but the other part is there is a need for a GP to get liquidity and think about an exit. It is a good discipline, a good exercise. It is also how we as LPs measure the GPs. We proposed this exact structure to one of our GPs and it went to the advisory board. They could sell the business to a third party or we could create a structure for those that wanted to roll over and the others get liquidity. All the other LPs took the cash and the asset was sold to another GP and it is going to do extremely well. There is a rationale for it, but the question is how to structure it so as not to create conflict for certain GPs.

GUEN: Sandra, it's a phenomenal deal, you've known me [the GP] for a long time. The fund is happy because all the LPs have made 3-4x, but we can get 10x, still run the company and you get your equity back every two years. Why not do this?

BOSELA: But do I need you there for it? I could be there on my own. We try not to be direct investors, but it's interesting because that is part of the pitch when we do co-investments with GPs. They come with the industry expertise but often a company says it doesn't want to go through the sale process in five years. Being at the table as a long-term investor, I can say our whole purpose of being is to pay pensions years down the road, so I'm happy to not keep churning my capital because every time I get it back I have to go sit and wait and find other companies that can earn that type of return. It's an interesting conversation with GPs because we can buy them out if they need to be bought out. We are happy to stay in if we are earning 20% year in, year out - I don't want out in three years just because the market timing is good. My group sits with the infrastructure group and when we make investments from the infrastructure portfolio we are modeling them in perpetuity, so we have a very long-term focus. Those are the types of investments that we love. We don't have to show exits for fundraising so if we can come in and find a way to keep long-term high-growth assets on our books we will do that.

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• Topics
• LPs
• Investments
• Fundraising
• Fundraising
• LPs
• Asia
• Co-investment
• MVision
• Future Fund
• Canada Pension Plan Investment Board (CPPIB)
• LGT Capital Partners