Friday Letter How LPs can break the herd mentality

Committing to a fund because your peers already have is not a good investment rationale.  

Limited partners are continuing their rush to build exposure to emerging markets, judging by comments in the hallways and onstage at our Emerging Markets Investors Forum in New York this week.

But one major issue highlighted at the conference was LPs could be making a costly mistake in trying to push their way into what are now over-saturated markets. Three of the BRIC countries – Brazil, India and China – have attracted a great deal of attention from limited partners in recent years. And some say “MIST” – Mexico, Indonesia, South Korea and Turkey – will be the next tier of emerging market countries to attract investors en masse also.

LPs often develop a “herd mentality”, according to one LP who was considering an allocation to Brazil. Investors will watch what other institutions are doing; as they see more and more LPs crowding into a market in search of outsized performance, the fear of missing out takes over. The problem is, as more capital pours into a market, second and third tier managers will materialise and capture some of that capital flow, regardless of whether they have the skills to deliver.

“You see the same story in a lot of places,” Josh Lerner, a private equity scholar and Harvard Business School professor, told PEI late last year during a discussion about a PEI white paper on LP attitudes toward MENA private equity. “Limited partners move, by and large, in packs, where the decisions are sort of self-reinforcing. In a lot of cases it’s not based on where the best returns are but the areas seen as more fashionable for investing. In general, there’s a lot of caution and a lot of fear outside of a few markets that are perceived as safe – if they are or not is another question. For example, there are a lot of questions about China as a private equity market, but it’s … fashionable for private equity investing so you have a lot of LPs rushing in.”

Rushing in can mean settling for GPs who aren’t best-in-breed, delegates at the Emerging Markets Forum cautioned. One LP advisor felt that risk could be mitigated if investors re-think how they allocate to emerging markets. LPs for the most part tend to treat private equity like the public markets, saying, ‘I want to be in secondaries today, Brazil Tuesday and the US mid-market on Wednesday’,” the advisor said.

A better practice would be to think in terms of year ranges, he went on. Rather than thinking of committing a certain amount in one year, an LP would be better off to consider spending a certain amount over a five-year period, and only if the right opportunities arise.

Adopting that approach could make LPs less prone to following the herd and making decisions predicated on a fear of missing out, or a need to spend an allocation.

And if an LP does miss out on a great fund as it tries to avoid the herd and make cautious commitments to the most deserving GPs? Well, as another delegate at the conference said, “I’ve never regretted not being in a fund.”