LP terms of endearment

One of the meaningful changes for the private equity industry this past year – at a time fraught with them – has been the emergence of a new activism on the part of limited partners as regards the status quo in their relationships – and investment agreements – with their private equity general partner correspondents.

Gone is the almost shy deference that characterized many LPs in their efforts to be able to invest in the top funds not so long ago. Now they’re talking more authoritatively, and much more often, to their GPs, as also in their discussions with their investor confreres, hitherto a rarity. And their new message boils down to this: it’s our money, so we want more, and more specific information and communication, as to where it’s being deployed, and under what terms and conditions.

There’s also a noticeable drop in tolerance for ‘style drift,’ and a sharpening appetite for co-investment and direct investment.

Taken together, these things could amount to a significantly changed private equity playing field in the not-too-distant future. All of this noted, however, there remains a considerable variance of views among them. And in this installment, AVCJ tracks the thoughts of some leading LP lights among developed-nation giants and industry leaders.

Back story

T. Bondurant French, CEO of Chicago-based Adams Street Partners, which for more than 30 years has been one of the longest-established – and largest – investors in the private equity and venture capital spaces, currently with some $20 billion+ under management, offered this perspective:

“It isn’t normal anymore. And I think that’s healthy,” he told AVCJ bluntly. “Investors are once again concerned about risk, especially in an asset allocation context.”

This stands in contrast to the fallout from the tech boom-and-bust of a decade ago, he recalls. While many of the venture funds of that cycle turned out to be very poor performers, when these GPs (in general) went back to raise funds in 2002-04 in the US, they were oversubscribed.

Why?

“Partly because people were willing to give the venture community a pass on their poor performance,” French explains.

A sudden sea change …

But underlying this was a much more fundamental driver, he contends. In the aftermath of 9/11, then US Federal Reserve chairman Alan Greenspan suddenly dropped interest rates to 40-plus-year lows. That meant that pension funds and endowments could no longer earn an overall 8% return with a traditional 60/40 mix of stocks and bonds, or some near derivative thereof.

This spurred managers to “…move up and to the right along the efficient frontier, allocating more money to alternatives; in other words, reverse-engineering their asset allocations to deliver the 8%.”

Obviously, that meant a lot more money going to private equity, as well as real estate, hedge funds, emerging markets equity, oil and gas, and all of the other components of the alternatives segment.

“So overnight there was a tremendous tailwind of fundraising.”

…and then the storm

But of course, what goes suddenly up often descends in the same way.

Or, in more academic terms, the efficient frontier is hinged on the vertical axis at the risk-free rate. So, as risk-free rates dropped early in this decade, the whole curve dropped. And as money moved from the left or lower risk side to the right, the curve flattened, meaning that, as managers allocated assets out and to the right, they were getting incrementally less return for the much greater risks that they were taking. And this contributed in no small part to the disastrous events of the past couple of years.

“People have now learned some hard lessons,” French avers. “They are re-thinking this whole concept in very tangible ways.

“Back to my earlier Silicon Valley venture example, poor-performing venture firms are not getting a pass these days. And that’s due to the fact that LPs generally, unlike seven or eight years ago, just don’t have the capital.”

That’s for various reasons, among them shrinking fund sizes and, even more importantly, the so-called ‘denominator effect,’ which in turn was generated by the value plummet in LP public equity holdings as related to their overall portfolios. This had a biting effect on the many that for years had been investing at, or near, their allocation ceilings. When the crisis exploded; these were at the epicenter.

Obviously that spawned secondaries.

“But it has also forced a ranking of managers in venture, private equity and, in fact, all asset classes because LPs realize they can’t back all of those they’ve backed before. There is a real shakeout going on now.”

A more benign view

John Breen, head of private equity globally with the Canada Pension Plan Investment Board (CPP IB) takes, perhaps, a more benign view of the present situation. But that’s no doubt due in part to the fact that CPPIB, despite its relatively young age of 11 years, manages some $120 billion of assets, with the comfort of knowing it will have $7-8 billion in net inflows coming for the next ten years, marking it among the world’s elite few relatively unimpaired funding giants.

Queried as to his view of how much alpha private equity has actually delivered over the past couple of years, allowing for multiples expansion, normalizing currencies and historically high leverage ratios, he says, with considerable understatement:

“Certainly, this has been a challenging period. But when you look at how private markets have performed relative to public markets (once you factor out the stickiness of valuations), private equity has done pretty well, and we at CPP IB anticipate that will continue to be the case. In other words, being able to create value without focusing on short-term results is a tremendous value driver that can be perpetuated.”

At the same time, however, Breen is not an advocate of keeping to the status quo of the past few years in terms of the LP/GP relationship. In fact, he and CPP IB were significant players in the drafting of the recent IPLA proposals (see AVCJ Dec 15). And he notes that factors pertaining to this relationship have changed, or at least are evolving.

A new code of conduct

“First and foremost, LPs are looking at results from their private equity funds, and whether or not those historical performances are going to be repeated vis-à-vis it outperforming the public market alternative. And key to this, in our and the ILPA’s point of view are a few simple factors.”

Topping this list is the expectation among LPs that GPs will deliver on their potential and make a lot of money from carried interest – but not from management and transaction fees.

“Further, to the extent that [GPs] take carried interest that, at the end of the movie, they weren’t entitled to because of a lack of performance, LPs don’t want to go chasing after GPs to get it back – that’s the clawback issue in a nutshell.”

Thirdly, he says, every LP commits to a fund based on a strategy articulated by the GP going in. So, LPs want to see this adhered to going forward – this being their ‘style drift’ concern. The corollary is that they want to be better informed.

“We need to know what’s going on,” Breen says baldly. “We want to be able to make better decisions that will, in turn, help us to make more compelling arguments to our investment committees that private equity is an asset class that – despite recent performance issues – is one that we want to grow in.”

Towards a better MO

Finally, Breen sees it as a future essential that there are structures in place: meaning, LPAC structures and processes, where LPs and GPs can work together to deal with emergent issues that might not have been contemplated at the time the ILPA document was written: issues like insufficient funds for follow-on investments, which, in today’s credit-constrained environment, are sometimes needed for covenant cures or for working capital, or other unforeseen events like broken syndicates where one entity defaults, meaning the others have to come up with more money.

As to drilling down into the details in aid of effective manager ranking, he adds:

“When we look at the partners we want to grow with, we look at what they do post-closing. In short, how do they create value? Specifically, what is their ability in making portfolio businesses more efficient? How do we rate their ability to apply financial engineering to bring the most leverage to bear without undue risk to the business? And what of their skill in attracting and retaining seasoned executives?”

As well, when CPP IB does its analysis, it will thoroughly vet all investments made by specific fund managers to break down the components of value creation: was it EBITDA expansion? Was it multiple expansion? Was it leverage and debt reduction? And who, exactly, among the GP’s team drove the value creation?

In other words, benign overview or not, there will be no more free passes.

Data points

This leads naturally to the data question; namely, what weight should it be given in making these crucial decisions.

Aazar Zafar is principal of the Alberta Investment Management Corp, which oversees more than $60 billion of government pension and endowment assets, of which about $2 billion is earmarked for private equity. The fund, headquartered in Edmonton, capital of Canada’s oil-rich province of Alberta, currently has $300 million in co-investments, and a reputation of being more data-driven in its decision making process than many others.

But Zafar readily acknowledges that it is nothing like a definitive tool.

“Data can only take you so far,” he told AVCJ. “As any investment memorandum points out, past performance is not necessarily indicative of future performance. So, in our evaluations, maybe half of our due diligence is data-driven. The other factors, just as important, include transparency and how the investee businesses are actually run, plus how well they communicate with us as an important investor.”

Pressures to downsize

Steve Byrom, global head of private equity with Australia’s Future Fund (and a former GP himself) is much more of a skeptic on the data issue. Noting that his is an unabashedly opportunistic fund, with $75 billion under management, fueled by one-time fiscal surpluses, and therefore not expecting future inflows, he says that they don’t have a specific private equity allocation per se. Rather, they run their program internally, competing with capital against other investment opportunities as they present themselves.

“We go out looking for long-term business partners, and these come through to us in many ways that aren’t in numbers or data rooms. It’s got a lot to do with their attitude in the way that they deal with their LPs, plus what other people we respect think about them. We’ve been fortunate in being able to form a pretty good group. But that said, there are still issues that need managing, and I’d agree that the dialogue is getting more intense.”

He points out that, as much as GPs are having to work harder, so are LPs on both sides of the table, so to speak; both with their trustees, in explaining why the private equity asset class isn’t performing up to expectations, and then on the other side, with their GPs, helping them through their issues.

“That’s combining to drive changes like reductions in the number of relationships and reducing the number of funds LPs try to work with. But, as for the increased appetite for co-investment or direct investment cited earlier, I’d just add that, while it may be true, it’s still not the same as doing a fund investment; it’s a different skill set. So, while the willingness may be there, having the real capability can be another thing.”

Breen says that CPP IB is content with its 55 current relationships, and is not contemplating a reduction. But Alberta’s Zafar admits that with a change of CEO has come a change of attitude, and so relationship reductions, while writing bigger checks, is now a likelihood.

After the deluge

All agree that some kind of a tipping point has been reached, the hard reality of which is perhaps best summed up by Stewart Hay, partner and director at SL Capital in Edinburgh, Scotland and one long-experienced in emerging markets, the Middle East in particular:

“I’d say that, with the large managers, there has been an enormous dispersion in the returns that they’ve produced, and the valuation declines. Some managers have rushed out and spent the money raised far too quickly; in other words, they’ve basically bought the market. But others have been far smarter and have gone slowly, specializing in specific sectors and businesses.”

He reckons that the winners and losers will be very evident before long, and that the subsequent winnowing will be thorough.

“I’m sure everybody has an opinion on which funds will never raise another fund again; it’ll be a pretty long list of people. From our point of view, there’s almost nobody that we’d want to take on in this fundraising market. We’re hearing managers say, go from 2009 and push it out to 2011. They see no sign of market improvement. I mean, how many Future Funds or CPP IBs are there? Not many. Rather, the vast majority of LPs are at their limit. And so the losers will not survive, and even though they might be a long time dying, what with their management fees and so on, they will die nonetheless.”

The others are more or less in agreement, but John Breen adds that this is simply prerequisite to creating a better, more effective – and profitable – relationship between LPs and GPs longer term. With better communication and a better alignment of interests, it’s simply a case of when the going gets tough, the tough get going.

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• Topics
• LPs
• Funds
• Advisory
• Performance
• Adams Street Partners
• T. Bondurant French
• Piau Voon Wang