Friday Letter The ‘trouble’ with preferential treatment

Fund managers have a delicate balance to strike with their investor base as some LPs are getting hot and bothered over larger institutions securing special terms. 

Size matters in the limited partner community. It’s not exactly news that investors who anchor funds – or make very large commitments – often receive a discount on fees or secure terms other, smaller LPs cannot.

But as fundraising conditions have changed, large institutional investors have become much more aggressive in negotiating better terms from their fund managers.

“It’s much more in your face,” says one advisor to limited partners.

And not everyone’s happy about that.

A number of smaller investors have started grumbling privately about what they perceive as unfair treatment. That was also touched upon in Coller Capital’s investor sentiment study published earlier this week; about half of the 101 LPs surveyed felt the growing number of separately managed accounts was a negative development for the asset class because of the potential for conflicts of interest among a fund’s LPs.

The situation is already causing serious “fragmentation” in the LP community, says Mario Giannini, chief executive officer of Hamilton Lane. And, by the way, it’s one that the US Securities and Exchange Commission is interested in, too. Back in 2010 it said it was going to look into side letters that offered “preferential treatment” for some investors.

Still, it seems unlikely the practice will go away or become outlawed. A number of sources pointed out that investors willing to put larger amounts of capital at risk should be given some breaks on terms for doing so, and that it ties in with the very tenets of capitalism. And, as one LP pointed out, investors who aren’t happy with terms on offer can “vote with their feet” – and in fact, some institutions have decided to avoid funds that offer special terms or even funds that have sold management stakes to other investors if they perceive that as a potential conflict of interest.

It’s also worth noting that large institutions are unlikely to give up on pushing for better terms, whether it seems fair to others or not. As Joe Dear, chief investment officer for the California Public Employees’ Retirement System, told Private Equity International earlier this year, he thinks it would be great if fees could come down across the industry for every LP. “But if that’s not going to happen, then investors with strategic positions and the capacity to make large commitments should go forward and make more sensible arrangements with the managers.” If not, they wouldn’t be doing their fiduciary duty.

GPs are thus faced with striking a delicate balance between offering select LPs special deals and keeping their whole investor base happy.

That balance may become harder to get right – and certainly result in more work and difficult conversations for investor relations professionals – as small LPs get increasingly frustrated about being left out of what they perceive as generous arrangements, and large institutions continue to look for ways to get better value for money from GPs.