Friday Letter The pros and cons of LP conservatism

For investors in private equity there’s a fine line between making sure your managers stick to their investment mandate on the one hand, and giving them the freedom to invest opportunistically to generate superior returns on the other.

Some limited partners are scared of change, to the potential detriment of returns in their portfolios. Recently we came across two examples of LPs requiring GPs to pursue a narrow investment strategy than these GPs would have liked. It could be that this was good risk management in both cases. But it could also be that the investors deprived themselves of strong return opportunities.

The first instance involved The Blackstone Group’s debt investment arm GSO Capital Partners. GSO has delivered strong performance since being acquired by the mega-firm in 2007. Its first mezzanine fund has been generating a net 15 percent internal rate of return. One LP said the fund had “blown [our] mezzanine portfolio out of the park”.

A unique characteristic of the first fund was that a small portion of the capital was available for control mid-market private equity investments, which sprinkled a light layer of equity over the mezzanine exposure. Those private equity investments didn’t move the needle to a game-changing extent, but they did sweeten the return by a meaningful amount, sources said.

LPs in the second GSO fund, which closed earlier this year on $4 billion, overwhelmingly requested the firm get rid of the private equity strategy and keep the fund as pure mezzanine. This is understandable – big institutions have certain asset class buckets they need to fill and a hybrid vehicle like GSO’s first mezzanine fund clouds the issue.

Equally, LPs on the whole like to see managers “sticking to their knitting” – focusing on what they’re good at, and not trying to over-extend themselves. That has merit, in that it stops GPs over-reaching themselves. However, it can also seem a little narrow-minded in some cases. Where the GSO fund is concerned, it seems peculiar to temper the firm’s move towards a hybrid strategy when it had successfully been applied first time round.

The second example involved energy-focused firm Natural Gas Partners, which closed its tenth fund on $3.58 billion recently. The firm had attempted to raise a fund that would have focused on water resources and agriculture-related investments, but couldn’t drum up enough support for the proposition. The firm decided to roll the strategy, which it called Global Adaptation Partners, into the tenth fund, and allocate it 25 percent of the capital. LPs requested and received a reduction of that exposure to just 10 percent of Fund X.

As one LP said: investors don’t think of water resources and agriculture when they think of NGP; the strategy – premised on the need for a growing population to adapt to a world of shrinking resources – sounded a bit lofty, especially for institutions obsessed with practical obligations.

Nevertheless; investing in water resources and related sectors is part of what NGP does best. From its work in the trenches, the firm had identified the opportunity created by the shale gas industry’s dependency on large volumes of water – which has to be sourced, transported, treated, stored and recycled.

NGP of course will still get to explore its strategy, but at a much reduced-level from what it had first envisioned. If it’s successful, LPs may end up wishing they’d given the firm more leeway.

Perhaps the investors were right to reject the firm’s attempt to expand its focus. Investors need to be cautious – it’s a brave LP who takes a big punt on a firm with an unusual (and perhaps unproven) strategy, especially when public money is at stake. But then again, GPs worth their management fee are the ones with superior sector knowledge and a knack for taking calculated risks outside the mainstream. 

In other words, there’s a balance to be struck between taking risks and allowing managers too much leeway. It’s too early to tell if GSO’s LPs were right to restrain the fund’s private equity activities, or whether NGP’s water-focused segment of its strategy was a bridge too far. But in an asset class that has made its name by thinking outside the box and by taking risks, it might pay to give managers the chance to push the envelope. Because what is also true is this: who dares wins.

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