Desperate for Access to Flagship Funds, Allocators Struggle to Say No to GPs

“If I stop committing, I lose relationships.”

Illustration by II

Illustration by II

Top-tier private equity firms are using “fear and intimidation” tactics to raise money for new funds.

According to allocators interviewed by Institutional Investor, some alternatives managers are dangling access to flagship funds over asset owners’ heads in order to secure commitments for sub-strategies and side funds. II spoke with seven allocators ranging from pension CIOs to endowment heads — all on background due to reputational concerns — who voiced the same thing: investment managers are getting pushy in the fundraising process, and there’s no clear way out of it.

“If they want to seed a new strategy but don’t have capital for it, [managers] can tell LPs they don’t have access to a flagship fund until they sell the strategy,” said one investor at a major endowment.

And it’s not easy for limited partners to say no. Managers “have pricing power,” said a pension fund CIO. “When they’re launching new strategies, it’s not even a gentle suggestion. It’s pretty much like you do it or you’re going to be cut off.”

It’s a complicated time to be investing in alternatives, with asset owners putting more capital to work in these strategies than ever before. Take the California Public Employees’ Retirement System for instance. In November, the pension fund announced that it would increase its private equity portfolio from 8 percent to 13 percent of its total assets, which at the time amounted to roughly $25 billion in additional commitments.

And CalPERS is not alone. In 2021, private equity fundraising hit a record of nearly $1.2 trillion, having increased nearly 20 percent year-over-year, according to a McKinsey report published in March.

“You have all this capital sloshing around that is extremely hungry to seek yield and alternative return streams,” said John Bowman, executive vice president at CAIA Association, an organization that offers alternative investment credential programs and advocates for both limited and general partners.

Allocators say they want access to top-tier managers — especially their best-performing flagship funds. But when managers can raise money at a rapid clip, they can afford to say no to certain asset owners, or at least set the terms of the deal.

Those terms may include additional allocations to sub-strategies, side funds, or otherwise unusual investment vehicles.

What makes it worse, according to an endowment head, is that some investment managers will try to push allocators into sector funds where the GP has no experience. To the CIO, it seems like the investment managers are saying, “‘Give us capital to be undisciplined and reckless so that I can let you into the fund where I will be disciplined. If you don’t play the game, you don’t get in the flagship fund.’”

He added: “They’re using fear and intimidation with investors.”

A senior pension staffer explained the dynamic as “good cop, bad cop.” The investor relations team will say that the firm’s founders are committed to the fund and think that all the investors should be in it.

“They’ll say, ‘If people pass, the founders will have to reevaluate what kind of partner you are,’” the source said. “It’s gaslighting a bit.” Some will be blunter, and they will follow through with cutting off access to investments.

For some investors, this move is a red flag. “When I hear that tone, I chalk it up to a marketing gimmick,” another pension investor said.

Others have seen a softer side of this dynamic. One foundation investor described it as a Tinder date that goes well, but afterward, the date never responds to their text. “It’s like, we’re not getting a call back or they’re too busy right now, even though they said they’ll stay in touch.”

Either way, asset owners have a problem: They are tapped out. With every GP coming back to market with a new fundraise, allocators don’t have enough capital to go around.

The down-market in public equities is no help. When public equities drop, the percentage of an allocator’s portfolio held in that asset class declines. At some institutions, when the percentage drops to a certain point, those investors must rebalance their portfolios to remain in a certain target allocation range.

All of this is threatening to erode the relationships that allocators have worked hard to build with private equity firms. “I’ve had multiple people from endowments and pension funds talk to me about how their private equity team is about managing relationships with the firms as opposed to doing diligence,” the senior pension staffer said. “They have to cultivate relationships just to get an allocation to the fund.”

The other pension investor heard the same from a private equity team member at his retirement system. “He used the same argument,” the allocator said. “‘If I stop committing, I lose relationships.’”

Allocators are taking different approaches to handle this dynamic.

The pension fund CIO, who is focused on concentrating assets by allocating to only a few top-tier managers, said he supported several side funds at one manager to access the flagship. “Now they’re launching another one, and this time I will not do it,” he said. “I will argue that I supported it already. I think I will still get full allocation to the flagship fund.”

Others try to call the bluff. If enough investors do it, the fund manager may back down and change the terms. But it doesn’t always work.

A second endowment CIO said he cut off a relationship with a major private equity manager after being pressured to put capital into a side fund. “I talked to about ten other CIOs,” he said. “Everybody complained about it, and they all invested. It’s probably a function of career risk.”

Bowman suggested that funds of funds for private equity and other alternative asset classes could help smaller limited partners gain access to some of these flagship funds while providing investment managers with the scale and stability they need from a partner. Platforms like iCapital are also providing smaller investors with access to larger funds.

But the pendulum is also likely swing back in favor of limited partners.

With less capital to deploy moving forward, allocators will be forced to start saying no to GPs. “It will definitely start to slow down because I think you’ll see pushback from LPs and allocators,” the endowment CIO said.

The first endowment head believes general partners may even become kinder if the market drops further. “Everyone is a lot nicer and they’re your friend more when the market is down,” he said. “I’ve seen this cycle before.”

The pension CIO disagreed: Private equity firms are expected to post better first-quarter returns than their public market counterparts in the coming weeks.

“When the returns are going down, they become even more powerful because they are so good compared to others,” the CIO said.