Friday Letter A glimpse of the future

CalPERS has elected to do away with traditional allocation labels, may push for performance-based fees and prohibit private equity advisors from also managing its capital. Is this a sign of something bigger coming over the horizon? And is it a good or a bad thing?

Private equity industry insiders like to talk about the “power pendulum” that swings between general partner fund managers and their limited partner investors. It's fair to say that 2010 maintained the post-crunch trend that saw the pendulum firmly on the side of LPs who demanded concessions on fund terms and conditions and became much more selective about making new (and, on occasion, standing by existing) fund commitments.

The pendulum analogy works, of course, because the GP/LP relationship thus far has ebbed and flowed with market cycles. But a much more permanent change seems to be on the horizon, as some of the biggest and, by extension, most influential LPs – keen to avoid losses suffered in prior years, and in pensions' cases, to meet rising liabilities – fundamentally reconsider how they manage and compose their investment portfolios.

The California State Teachers' Retirement System (CalSTRS) began experimenting with this in 2009 when it created an “inflation-linked” allocation silo for things like infrastructure assets and treasury securities. And this week, the California Public Employees’ Retirement System (CalPERS) took things even further, revealing it would cast aside its own traditional allocation structure that had been divided by security type and geography.

This is not an entirely new concept, some will point out, and indeed, it's too soon to tell if such changes will impact private equity commitment levels very much, for as CalPERS' chief investment officer Joe Dear said earlier this year, “I don't know how we make our return objectives without investing in illiquid assets, so it's certainly not going to disappear.”

But the two California pensions, the largest public pensions in the US, have long been considered pacesetters among institutional investors that invest in the private equity asset class. Thus the revisions to their investment strategy will likely influence many more investment staff than just their own and hence merit close scrutiny.

That's particularly true of several other proposals CalPERS revealed this week that, if enacted, would fundamentally change the relationship between the pension and some fund managers and advisors. For example, a push toward incentive-based fees rather than flat management fees was declared to be an imperative. As was prohibiting firms that serve as investment consultants for the pension from also managing its capital.

Should these proposals become policy, there will no doubt be further friction between LPs and GPs on the fee front. But is that such a bad thing? After all, a leaner, hungrier group of smart, hardworking managers who merit their fees is good for the industry as a whole – not just CalPERS. The squeaky wheel complaint from LPs of GPs growing fat on fees gets jettisoned and instead there is an unambiguous alignment of interest. No more “heads I win, tails you lose” as one fund formation lawyer recently put it to PEI.  

As the pension's investment staff now deliberates on just how its private equity programme might implement the recommended proposals, it's also a good time for the wider private equity industry to reflect on ways to evolve the GP/LP relationship so it's fit for 2011 and beyond. After all it's an industry that prides itself on being a positive agent of change to the wider world.

PS – As you ponder how you and your firm will grow in 2011, can we invite you to also think about the LPs, GPs, advisors and transactions that stood out in 2010? Cast your vote now in the PEI Poll 2010, the source of the industry's most comprehensive and prestigious awards.