High fees are a tough sell
A 10-year bull run in public markets is a mixed blessing for private equity. Yes, rising valuations make for an exciting market to sell businesses into, but the relative performance of the wider stock market – which is easily accessed through low cost trackers – can make private equity seem like a needlessly expensive option for an asset allocator. Earlier this year, Pennsylvania state treasurer Joe Torsella claimed the two state pension systems had “wasted” up to $5.5 billion in investment expenses and would have been better served by low-cost passive funds. This simple comparison of the last 10 years ignores some important factors, most notably the relative outperformance of private equity over the full market cycle.
Even so, our survey suggests Torsella is not alone in his late-cycle misgivings: 61 percent of limited partners said they either agree or strongly agree with the statement that “the fees charged by private equity funds are difficult to justify internally”.
Restructuring costs disputed
Our survey reports that most LPs (57 percent) have had a fund restructuring – where assets are moved from an existing vehicle to a new one with new terms – proposed by at least one of their GPs. In the last two years a number of storied firms have run such processes on their funds, such as Nordic Capital, InvestIndustrial and – ongoing as this publication goes to press – TH Lee. These are complex transactions and often divide opinion among an investor base. Per our survey, more than a third of LPs who have been involved in such a proposal said they did not have sufficient time to make a decision, while a similar proportion said they had insufficient information.
While this may seem alarming, it is to some extent expected. We have frequently heard a significant minority of LPs do not have the bandwidth to assess these deals within the timeframes. More divisive is the cost allocation of such a deal: nearly two-thirds of LPs said the costs of the process were not fairly divided between the GP and the fund.
I see style drift
Two words no one in private equity wants to hear: “style drift”. It can take many different forms: investing in an unknown sector, a new geography, moving from majority to minority stakes, buying public stocks; or buying larger (or smaller) companies. It tends to be a topic of conversation at the height of a market, when competition for assets pushes managers to get creative: 55 percent of LPs report seeing “occasional examples of style drift” among their GPs, while 8 percent reported seeing “widespread examples”. Just over a third said GPs were “remaining disciplined and sticking to their investment theses”.
Should we be alarmed by this finding? Other data suggest GPs are slowing their investment pace, rather than drifting beyond their remit. In August 2018, PEI reported distributions have outpaced capital calls for five years, and the gap between the two was widening. “If managers are keeping an eye on pricing relative to public markets and other M&A transactions, and decide to slow down on this basis, then I am more comfortable with a slower investment pace,” Angela Willetts, co-head of private equity at Capital Dynamics, told PEI in August.
Gender as an agenda item
Diversity and inclusion is an emerging factor among limited partners when selecting a manager. While the “staples” of due diligence – track record, team size and investment thesis – remain the central tenets of nearly all LPs’ due diligence, a portion – 43 percent – are including gender pay disparity at the GP as part of their due diligence process. We fully expect this percentage to increase in the coming years. Lobby group ILPA is now including gender and ethnic diversity in its due diligence template. Said Andrea Auerbach, head of private markets at LP advisor Cambridge Associates: “If [some of our clients] don’t see sufficient levels of diversity and inclusion, or well-intentioned and meaningful efforts to build towards a team and organisation that has more diversity of personnel, they will make an investment decision fully incorporating that information.”
It is a popular way to cut fees when investing in private equity, which is why, according to our survey, 65 percent of limited partners intend to deploy capital through co-investments in the next 12 months. Widespread co-investment is a relatively new feature of private equity investing. “I don’t think we’ve been through a whole cycle yet with co-investments and there are certainly some challenges there,” said Per Olofsson, head of alternatives at AP7.
The received wisdom in private equity is that rampant demand from LPs has put GPs in a position of firm negotiating power in fundraising; take our terms or we will easily replace you in our investor base. One data point from our survey suggests the situation may be more balanced. Most LPs (60 percent) told us they have consistently received the full allocation in their chosen funds, whereas only 28 percent had seen their allocations scaled back in some of their chosen funds. Rather than pare LPs commitments back, it is likely GPs are simply raising bigger – or additional – funds.
Asia on my mind
Asian PE has come of age and global investors are arriving in droves. The region’s GDP growth and rising middle classes, combined with the growth of “institutional-grade” general partners is proving a draw; a number of US public pensions are growing their exposure.
“In the past five years, nearly 40 percent of our global private equity commitments have been to managers focused on the Asian region,” said Art Wang, managing director, private markets at San Francisco Employees’ Retirement System.