Institutional investors increasingly see private assets – and in particular the private equity industry – as a salvation for their high (read: unrealistic) expected return targets. Indeed, as I noted from a recent Institutional Investor event, many funds are trying to get creative in order to meet their obligations, and, in a poll canvassing the fifty or so funds in the audience on asset shifts, illiquid and private assets topped the list.
So, I feel we have to ask, what are the implications of this shift for the institutional investment community?
This could have a profound impact on some of these investors. Many are being forced into segments of the asset management industry where they (the owners) have traditionally been outgunned by the managers. In the (only-slightly-out-of-context) words of Dan Primack: “...most private equity firms have their investors over a barrel...” True.
And this is why “alignment” has become such a buzzword throughout the institutional investment community. LPs realize they’re going to rely on private equity GPs to meet their long-term objectives, but they don’t want to get screwed by the GPs in the process. (How about an alignment of interests ratio? Anybody?)
Why so worried? Well, when PE funds are performing well, the status quo works. But when funds start performing poorly, research shows that alignment of interests goes out the window. And, moreover, with mega-buyout shops going public, there are a variety of questions that remain unanswered. Perhaps these public entities will fight to keep management fees high because that’s what drives the stock price? And perhaps these funds will gather assets for the same reason, despite the fact that now we know from recent research that the largest PE shops do worse than their smaller cousins?
Anyway, let’s just say that there are two things happening: 1) institutional investors are going to need private equity GPs; and 2) GPs are in the process of changing many of the rules of the game.
It’s in this context that I bring you a new paper by Ann Leamon, Josh Lerner, and Susana Garcia-Robles entitled, “The Evolving Relationship between GPs and LPs.” It’s a good read. While the final sections are no doubt focused on emerging markets, the document serves as a useful primer on the history of GP-LP relationships. And, as with the recent Kauffman Report on the venture capital industry, I think the authors do a good job of sharing the blame between the GPs and LPs. And that’s really important... In my view, the LPs have as much work to do on their own organizations as the GPs.
Indeed, most LPs are totally outgunned by GPs, and, worse still, many key stakeholders of LPs simply don’t seem to care (...probably because their benefits are backed by the state...) As one sovereign fund CIO once told me, ‘we’re bringing knives to a gun fight’. And you know what happens when you do that? Exactly the point!
Anyway, let me sum up some of my thinking on this: The ingredients for successful private equity investing by pensions and sovereigns is really quite simple:
- Pensions and sovereigns need Boards that understand the business of investment (sadly, many don’t);
- The new financially savvy Board can then approve high levels of compensation to hire staff that really understand the business of investing; and
- The new smart private equity folks that are compensated according to industry (not government) norms can begin negotiating credibly with GPs... leveling the playing field (a bit).
I also like the idea of LPs threatening the status quo with in-sourcing, creative outsourcing and new negotiating tactics. That, to me, sounds like a more sensible way to develop a long-term partnership with the private equity industry...