If GPs syndicate their co-invest portions, how do you guarantee alignment?

Investors should pay attention to how GPs capitalize their own investment in a fund because it raises questions about their real ‘skin in the game’.

Every now and then, instances emerge of managers style-drifting with their funds as they strain to meet the pressures of deploying capital in a challenging marketplace. Engaging in development when promising stabilised property exposures is one such drift at the deployment level, for example.

In this prolonged lofty end of the investment cycle, a modicum of drift might be necessary. Of course, any strategy movement must be comprehensively communicated. But it is when drifting happens in the nooks and crannies of a manager’s operation that investors might find themselves in untenable situations. And harder to notice than a deployment shift is a capital formation alteration, for instance.

One such alteration to appear on sister title PERE’s radar last week related to the manager co-investment stake in a traditional blind-pool commingled fund. Conversations with market participants revealed how some managers have effectively been authorising fundraising roadshows for their own co-investment stakes from institutional investors, instead of self-funding them – the traditional way.

PERE is aware of at least one consultant currently raising capital for manager clients for both a fund and the manager’s co-investment piece. Another lawyer told PERE how he was even designing tax-efficient structures to raise around $5 million from European institutional investors for a GP client’s co-invest portion.

Typically, managers raising a real estate fund are required to commit 1-3 percent of the fund’s target capital raise to demonstrate alignment with investors. For private equity funds, the GP stake can be as high as 5 percent. The rationale is simple: investors want their managers to have real ‘skin in the game’. For the manager, the co-investment piece is simultaneously a means to ensure retention by keeping key principals financially motivated to staying.

In the case of the bigger managers, as well as open-ended funds that might require a larger manager ticket, the capital is often largely provided from the firm’s balance sheet, while senior executives are provided with low or even no-interest loans issued against future earnings to fund their co-investments. Either way, investors regularly prefer commitments to come from the teams running the funds, especially for closed-ended structures. Many consultants in fact ask during the initial due-diligence process whether key individuals are willing to write cheques into the fund.

To be sure, it is fairly common for boutique managers, or first-time managers spun from bigger firms, who have the track record, but lack sufficient personal funds, to meet co-investment criteria through friends and family rounds of fundraising. For investors, the personal responsibility taken by an individual’s nearest and dearest often suffices.

But syndicating instead from institutional investors raises legitimate questions about sufficient alignment. Certainly, investors get a portion of the manager’s fees and carried interest for their capital. But they must reconcile with diminished individual responsibility from their manager in the process.

Is there a universal standard for such an economic arrangement? What rights come with these commitments? Any higher negotiating powers? Critically, how visible are these arrangements? Sources suggest to PERE these arrangements are not always apparent to regular fund investors.

Fears of an imminent market correction have left little margin for error. At the last correction following the global financial crisis, investors’ biggest gripe circled around communication and transparency. Any suggestion of a lack of this – alongside diminished alignment and areas like deployment style drift – places a vehicle and its manager in dangerous territory.

Investors not already doing so, would do well to re-evaluate some of the fundraising practices they are exposed to today, particularly in the area of alignment.

PERE is keen to hear further anecdotes relating to manager co-investments. Contact Arshiya Khullar at akhullar@peimedia.com or get in touch anonymously by filling out this form.