LP versus GP: buy-ins to the GP

The restless stirring of limited partners in private equity funds, exemplified by the advent (for the first time, at least in any quantity, in my memory) of litigation initiated by limited partners has invigorated the LPs, particularly the fiduciaries of state and municipal employee pension plans, to a new level of activism vis-à-vis the funds which their capital supports.

This is not at all, unusual, of course: disappointing results require the trustees, often career politicians and sometimes (in the case of CalPers) union representatives, to demonstrate to the beneficiaries they represent (and, indeed to the public at large), that they are prepared to do something about the current state of affairs. Thus, an ambitious politician (say, the state treasurer or comptroller in charge of the state teachers retirement fund), cannot sit idly by and shrug her shoulders when the newspapers call to inquire what the heck is going on. She must show some initiative or else their political career is at an end. I don't mean to be critical on this point. It is high time that the LPs take a proactive interest in the management of the alternative assets which they have funded for the last twenty-some odd years, ever since the Department of Labor published the Plan Asset Regulation and freed up pension money for investment in alternatives.

What is truly interesting is that the activist stirrings seem to be going beyond simply carping and complaining about the results in the portfolios of the private equity funds in the United States. Litigation is always a possibility, attempting to recover damages of some kind or another; but it is not likely to be highly profitable. A lawsuit make the general public feel good – that their tribunes are in fact seeking redress – but the impact on a given pension fund's P&L is likely to be trivial, if not negative.

That said, some steps are productive in my view. Thus, the idea of compelling the general partner to scale back existing commitments has substance to it; the notion is now gaining acceptance that, at least in the traditional venture sector, mega-funds simply have too high a hill to climb. The job of picking winners with a billion dollars in commitments to deploy is perceived as being too much for any group of individuals, no matter how talented.

Moreover, since the clawback for most of the funds will not be energized until the tenth anniversary, the LPs can take an activist posture by, for example, insisting that the management fee be reduced as a trade off against the exercise of the clawback well down the line. The time value of money and the uncertainty of ever being able to collect the clawback in full suggests that a near term trade may be in the LPs' best interests.

However, the rumblings which strike my eye most dramatically at present are not of the 'put up your dukes' variety. What gets my attention is, first, a piece in The Wall Street Journal which suggests that the major public pension funds are looking for a piece of the action, meaning a share of the GPs' carried interest. In some funds, of course, the lead investor gets a share of the carry simply by virtue of being the lead investor. However, that is not an option for investors in what I call the trophy funds, which (at least to date) have been over-subscribed. Led by CalPers, the pension funds are seeking to buy into what one of my clients has called the 'franchise value' of the private equity fund managers.

One cannot blame the LPs for looking for a piece of the action, a piece which is often lush when portfolio valuations are spiking upwards. It can be assumed, however, that the metrics are tricky because, as they say about most people-intensive businesses, the franchise value walks out the door every night and goes home. In order to invest, you have to believe that the constituent elements of that value will show up the next morning and the managers will be as successful as they have been in the past in raising and investing money and harvesting the portfolios.

The jury is still out, I think, whether the results of the cited investments will prove to be sufficiently profitable for the LPs that the fashion will catch on around the sector. If it does, of course, the members of the GP can only become more enthusiastic than they are today, particularly those members who are seeking to retire, if there exists a methodology for cashing in one's chips at the end of the day.

Another piece of LP activism appeared in The New York Times story a month or so ago, reporting that the retirement system of Alabama had elected to make a direct investment, beating out Texas Pacific Group, in the assets of U.S. Airways. The fund's chief executive has been making direct investments right along; but the U.S. air deal looks to be his signature statement. Again, if the State of Alabama gets away with buying U.S Airways when its plan is confirmed (in consideration of an investment of $240 million, being about 1% of the Alabama fund's assets), then one can expect other pension funds to follow suit.

It is only human nature indeed, for the underpaid (relatively speaking) managers of huge multi-billion state and municipal pension funds to feel some resentment, as what they perceive of as 'their money' winds up making general partners rich. If they cannot share in the profits personally, at least they can share in the fun of making direct investments and attempting to throw their expertise into the melee, along with the GP members they have so long supported.