How Giants Should Do Private Equity

Six ways to build a private equity portfolio over time

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Almost every Giant I talk to feels that in order to deliver the necessary and, indeed, promised investment performance to their plan sponsors, they have to make a significant allocation to private equity (PE). Without a PE allocation, I am often reminded by these folks, meeting a 7.5 percent, 8 percent or even 8.5 percent return target is unlikely. So they end up pouring money into the asset class, chasing the double-digit returns most general partners promise their limited partners. I’ll admit that PE can be very compelling and rewarding when it’s done well. The problem, however, is that most limited partners don’t do it very well ... at all.

This problem is exacerbated by the excess demand for what GPs are selling, as it creates an environment in which GPs have almost absolute power to do what they want. As such, the PE industry’s relationship with its own LPs has become downright dysfunctional. Consider this: The SEC recently discovered that more than half of the GPs they were investigating (as part of their sunshine project) had “numerous problems” with the manner in which they charged fees to LPs. More than half? So low has the industry sunk that some GPs now have to allow monitors in their shops just to ensure that nothing shady is going on.

In private equity investing, as in drinking, the road to recovery begins by admitting that you have a problem. So let me help the Giants with this: You. Have. A. Problem.

The silver lining here is that the PE industry is so tilted in favor of the GPs that the only real direction it can go is toward the LPs. And, encouragingly, some things are starting to move. A growing number of Giants are finally realizing they need to do things dramatically differently. Even CalPERS, a bastion of bureaucracy, has announced it will “take an axe” to its private equity portfolio (which, I must admit, sounds rather un-bureaucratic). Granted, CalPERS currently has 390 PE managers, so the portfolio likely needs a nuclear device to go along with that axe, but this is at least a start. In short, some Giants are realizing that harvesting PE alpha in the decade to come will require breaking the existing model and doing things differently.

To be sure, such a disruption won’t be for the faint of heart. Consultants, unfortunately, reinforce the PE insanity by focusing their efforts on the selection of existing GPs, instead of trying to help launch new ones. Some LPs are scared of their own shadows, preferring to have their pockets picked by established players rather than take on the political and career risk of selecting new GPs that offer more alignment. (Though this will inevitably change once the world sees LPs’ boards and management teams as complicit in the PE “febezzlement,” which many undoubtedly are). There is a tyranny of precedent here that reinforces one-time winners for a lifetime. To make matters worse, coordination among LPs against GPs is very, very hard. Too often LPs break ranks and cave to secure access to the very managers they are trying to pressure. It is all too much for many of these LPs to handle, and this is partially why we find ourselves in this situation.

So, can anything be done to right this ship? Is there a path to a more aligned version of private equity? My answers are simple: Yes!


I’ve had the good fortune over the past few years to spend a great deal of time with certain LPs who I believe are doing private equity extremely well. In particular, there’s a $100 billion fund up in Montreal, Canada, and another Giant in Juneau, Alaska, that I’d describe as downright inspirational. Anyway, what I’ve learned from these LPs (in particularly a rather “forthright” individual named Derek Murphy) and others about doing PE well can be summarized in the following six insights:

1) Prune: When it comes to PE relationships, less is more. LPs need to build a concentrated portfolio of GPs with whom they have meaningful, two-way relationships. The Giants need to recognize that diversification within PE is best done at the portfolio level and not by stacking similar managers on top of one another. The latter approach is a recipe for paying alpha fees in exchange for beta returns, which seems particularly unwise. Here’s a rule of thumb that might be useful to Giants: you can reasonably have one to three managers per billion of a PE allocation. And the larger the allocation to PE, the more I’d push toward a single manager per billion (of which, to be clear, I’d reserve 50 percent for co-investments and put 50 percent into the fund). In order to achieve all of this, the LPs may need to pursue secondary sales to clean things up in their portfolios. There are a lot of specialists out there that can help with this today. And if you don’t want to sell, you could always just let the legacy funds wind down.

2) Cultivate: Now that our smart LPs have a more concentrated set of relationships, they can begin to cultivate and harvest these relationships in more creative ways. The obvious way is through co-investments. By committing in size, LPs can drive preferred economics and alignment, but they can also secure favorable co-investment rights to the best deals. This, again, offers a great way to reduce the cost of the overall PE strategy.

3) Funds of One: As relationships of trust build with the small and aligned group of GPs, savvy LPs will take the time to understand how they can be useful to GPs. This is especially the case in launching so-called funds of one, where the GP creates a fund with a bespoke investment strategy based on investing style, geography or sectors, with relatively few investments per fund. The idea in setting up funds of one is to focus on what the GPs are truly good at, and then allow them to create a vehicle that can target those sweet spots in creative ways. These single LP funds are far more common than perhaps you realize.

4) Seeding: With deeper relationships in the PE industry — and experience working with deal teams within GPs — the possibility of standing up entirely new PE firms becomes real. If the above has been executed well (especially the co-investments), and you are seen as a credible player, would-be GPs will begin to come and seek you out. This offers LPs a great opportunity to work more collaboratively with GPs, building and drafting their investment guidelines jointly. Many LPs have told me that the only time they’ve had meaningful influence over fund terms was in these early conversations. The secret sauce to making this work, however, is to ensure that the GPs are putting real skin in the game (not just contributing deferred fees).

5) Han Solo: Eventually, with the experience of running the above program well for a period of time, the LP will have a network of folks that can bring proprietary deal flow. This is direct investing in private equity, and it’s a bit of a unicorn among LPs. While many people talk about doing it, very few can do it well. And that’s because it’s not something you can start doing right away. It comes after building a successful and respected PE program. With such a program in place, the LPs will start to see good deals, as their long-term horizon and deep pockets tends to attract the best kinds of corporate CEOs and CFOs to their doorstep.

6) Onramp V. Evergreen? There was a point in my life when I was a big proponent of evergreen, permanent capital vehicles. I remain a fan of this model, mainly because of the potential alignment of interests, but I’m increasingly aware that alignment is far more than just getting the timing of a vehicle right. In fact, if everything else is wrong about a fund, an evergreen vehicle can exacerbate the problems by locking in economics that are very unfavorable. So I’m changing my tune a bit and have been encouraging investors to be more thoughtful about how rights and terms can be structured (rather than just evangelizing evergreens). Why not create a way for institutional investors, that are backing GPs, to step into the shoes of a GP in certain investments? In other words, I guess what I’m proposing are “onramp funds” instead of evergreen funds.

These six insights provide a reasonable approach for Giants to build a PE portfolio over time. It’s not an approach that can be undertaken quickly, however. In fact, what I’ve laid out above would likely need 5-10 years to be implemented. This might strike you as a long time, but that’s how long it’s taken the funds I’ve been looking at to do this. To reiterate, though, the above approach is at least a way to begin thinking about how to implement what I would like to call “Private Equity 2.0.” It offers, I hope, ways for the community of LPs to begin pushing back against the egregious behavior of GPs and get more alignment from managers.

Most Giants haven’t yet realized the need to rewrite the rules of engagement in private equity; nor have they been shown a path to doing so. In fact, most LPs are their own worst enemies. Instead of choosing managers in objective ways, they behave like the Marx Brothers (any GP that will have me isn’t a GP that I want in my portfolio). We need to break this viscous cycle. So, here’s to hoping, spurred on by the SEC investigation, that such a path is now visible ...