Most private equity practitioners, when asked about their views on gatekeepers, will demand a more specific description about exactly what kind of intermediary they are asked to comment on: ?When you say gatekeeper?? is as likely an initial response as you may get. And people are right to ask.
This is not just because there are so many advisors active in the market with as many different business models. It is also because over time, the gatekeeper's role in the private equity process has changed substantially.
Gatekeepers first emerged in private equity in the 1970s in the United States, acting as advisors to institutional investors and developing close relationships particularly with public pension plans operating under strict rules that often made the use of investment consultants obligatory, but also other types of investors such as banks, insurance companies, family offices, endowments and high net worth individuals. Originally these advisors focused on helping clients develop allocation strategies across asset classes, private equity portfolio construction, fund due diligence and fund selection. However, as the asset class matured and spread into international markets, many of the first generation consultants added additional revenue streams to their business models, while new types of advisors made their way into the market as well.
Today investment consultants, in addition to supplying the aforementioned services, often get involved in negotiating limited partnership agreements on behalf of clients and represent them at board level of general partners, track and monitor the performance of private equity funds, act as legal advisors to limited partners and produce research products ranging from general research papers, statistical analysis, benchmarking to value at risk analysis. Some leverage off their market expertise by offering fund placement services to general partners. Most importantly, however, many of the original consultants have moved into asset management offering money owners a range of discretionary investment products such as funds of funds and separate accounts, sometimes in addition to providing non-discretionary investment services.
Moving into money management
While the term ?gatekeeper? remains part of market parlance, it struggles to do justice to the various product lines that investment advisors have developed, particularly the large houses that are looking after an increasingly global client base. Eric Hirsch, chief investment officer at Philadelphia-based Hamilton Lane Advisors, refers to his firm as a ?full service private equity solution provider?, describing a model that involves both discretionary and non-discretionary investment consulting as well as a wide range of auxiliary services. ?Private equity is a complicated asset class where people have problems that need solving,? says Hirsch, implying that the firm's one-stop-shop approach is designed to address different client requirements.
In part the decision to move into fund management was simply demand-driven: institutions were looking for specialists that could administer a private equity portfolio, and the consultants found that they had as much relevant product knowledge as anyone. ?For many gatekeepers the move into asset management was a natural one to make?, says Kelly DePonte, a former executive at Pacific Corporate Group (PCG), the La Jolla-based advisor and fund of funds manager, who recently joined placement agent Probitas
Partners to help it build an investment advisory practice. ?Given their experience as consultants, their due diligence and fund selection skills are often superior to what many of the investment banks are able to offer, even though the investment banks tend to have stronger distribution.?
Investors in private equity, both prospective and existing, have different requirements depending on numerous internal and external factors, and so gatekeepers quickly began to offer different products to different clients. Newcomers to the asset class excited by the prospect of a learning curve and keen to acquire the necessary expertise to run a private equity programme themselves for instance, would look for an advisor to effectively coach them on a non-discretionary basis, i.e. a relationship where control over the investment process remains with the investor. Others may choose to purchase the required skill set in the market place and use a consultant to help select an experienced team. Yet another type of investor would appoint an advisor to discreetly manage an allocation on their behalf – either by way of allocating money to a co-mingled fund of funds vehicle, or through a separate account. It is easy to see why advisors cum fund managers were keen to win business from clients no matter what their preference, and strive to offer suitable product to them all.
Another powerful source of motivation for consultants reinventing their business models is to do with simple economics. The fees paid by a limited partner investing in a fund of funds are attractive because they ?stick? and generate guaranteed revenues over several years, as opposed to a consultant's retainer which can be terminated at short notice. The fees are also considerably higher. Says DePonte: ?If you converted a consultant's retainer into a management fee based on the amount of assets advised on, the standard rate would be around five basis points. Co-mingled funds of funds typically charge around 1 per cent in fees, and even a single client programme costs between 25 and 50 basis points. For those without a fund of fund income stream it is hard to pay competitive wages and grow their businesses.?
The difference in compensation helps explain why only a small number of ?pure? consultants have remained in the market place, deriving their earnings exclusively from providing non-discretionary advisory services to clients. The most prominent representative of this group is Boston-headquartered alternative investment advisor Cambridge Associates, which counts around 600 US pension funds, family endowments and investment trusts among its clients, in addition to another 100 relationships with investors in Europe and Asia. Smaller operators include Strategic Investment Solutions, Canterbury, Callan Consulting and R.V. Kuhn, all based in the United States.
These purists compete for advisory work with large consulting groups that combine consulting and fund management capabilities such as PCG, Pathway Capital and Hamilton Lane. Other organisations that also fall into this category but place greater emphasis on discretionary management and less – or indeed none – on non-discretionary work include Wilshire Associates, Frank Russell, Adams Street Partners, Pantheon Ventures, Harbourvest Partners, Goldman Sachs Asset Management and JP Morgan Chase. There are also a number of independent European funds of funds in the market with significant capital under management including LGT Capital Partners, Adveq Management or Danske Private Equity.
For those that made it, expansion into asset management on the back of a strong consulting franchise may have been an obvious if not inevitable move given the commercial pressures in a more and more competitive market place. However it also gave rise to some difficulties. One charge often levelled against the hybrid approach is that it is prone to creating conflicts of interest that are tough to manage even where there are organisational structures in place designed to make them manageable, or even to stop them from arising in the first place.
Sceptics ask whether gatekeepers can advise clients objectively and with a view to what is best for them when they have their own investment products to promote and look after. ?It isn't necessarily helpful to the institution being advised if they feel under pressure to buy their advisor's product first,? says Rhonda Ryan, senior director with responsibility for alternative investments at Insight Investment, the UK fund manager backed by HBOS.
There is also an issue relating to the advisor's role as a facilitator of access to underlying general partnerships for their clients. General partners offering primary product will only allow a finite amount of capital into their funds. So how can a non-discretionary client be certain that they are getting their fair share out of an allocation to a GP when their advisor is busy placing discretionary money out of their own fund of funds and charging other clients a premium for managing a separate account on their behalf?
Faced with these issues, some groups decided to eliminate the resulting complications by dropping non-discretionary product lines altogether. Wilshire Associates, which started out as a financial software maker in the 1970s and later built a consulting business advising investors on both public and private market products, found in the late 1980s and early 1990s that working with private equity investors on a non-discretionary basis was fraught with issues that were better avoided. ?It proved not to be the best model for either our investors or the firm?, recalls Daniel Allen, who heads up Wilshire's European private equity business in Amsterdam. ?There was a problem with access and capacity at the general partner level: people have to know that everybody is being treated the same, and we couldn't recommend quality general partners to all our clients.? Another difficulty was that few non-discretionary clients had sufficient resources to do the necessary due diligence themselves. ?Often institutions couldn't react fast enough to an investment recommendation we had made,? says Allen. Wilshire eventually decided to package all available general partnerships into a discretionary fund of funds product which it has since been offering to clients on an annual basis.
Similar considerations prompted Adams Street Partners, the Chicago and London-based fund of funds, to decide in 1994 to no longer accept any new non-discretionary consulting mandates. Today the firm still runs separate accounts for four long-standing clients alongside a number of co-mingled vehicles, but it does so in each case with full control over the investment process. ?Non-discretionary advisory work can be difficult,? says Hanneke Smits, a partner at Adams Street. ?You don't control the ultimate investment decision, a client's investment performance is not your track record, and what do you do if they want to do things that you don't agree with? You end up having to do confirmatory due diligence on a fund that you wouldn't necessarily recommend yourself.?
Not the gatekeeper's call
Another aspect worth looking at is to do with the fact that dedicated fund of funds groups offering discretionary services often manage several types of funds of funds alongside direct investment vehicles, secondaries and co-investment funds, each with a different compensation structure. Some say this can put a fund manager in a difficult position when it comes to prioritising between them, but the managers typically reply that different products are handled by different teams that do not interact with each other than on an informal basis. Also, they say, it is the clients that make the choice as to which product(s) they want to buy. ?They make up their own minds as to which funds they want to invest in, and Chinese Walls mean there are no conflicts for us investing the funds,? says Smits.
Even as far as non-discretionary work is concerned, not all consultants view it as a hindrance. For many it remains an important element of their business models. Hirsch at Hamilton Lane says that helping some clients with their own investment decisions while offering others discretionary product does not create conflicts. ?Once we've decided we like a general partnership, we will recommend to a non-discretionary client that they invest in it, while advising investors in our co-mingled funds that we are going to invest in it on their behalf. It's effectively the same letter that we send out.?
Neither is there an industry-wide consensus as to whether providing different types of clients with access to investment opportunities is indeed a problem for the gatekeeper. ?In my experience, the issue of who gets into which fund resolves itself quite nicely,? says DePonte at Probitas. ?The decision is taken by the general partner, not the gatekeeper.?
Another point of debate among practitioners relating to consultants is to what extent they can grow their franchises without jeopardising the quality of their offerings. Investors want to be sure for example that they are being looked after by their advisor's top professionals and so they take an interest in how many other relationships the advisor has. Gatekeepers are aware of this. As Hirsch points out: ?Pure product generation is easily scalable, but providing excellent client service is not. As a firm committed to delivering personalised service, we are required to continue to add additional resources to meet those needs. Others have viewed the whole platform as scalable and have failed.?
More importantly still, there is the issue of return on investment. Private equity investors tend to work from the premise that funds under management and ROI are negatively correlated, as there are only so many GPs in the market delivering top quartile returns that money can be allocated to. John Hess, chief executive officer at Altius Associates in London, says he wants his firm to operate as a niche player advising on a limited amount of capital. ?We want to cultivate relationships, not focus on pushing product.
We're currently working with six institutional clients, and the number we're aiming for is ten.?
Altius, which was recently selected by the California State Teachers' Retirement System (CalSTRS) to advise it on private equity investments outside the US, grew out of Helix Associates, the placement agent, whose partners saw an opportunity to leverage off the firm's market knowledge to build an LP advisory business. That, says Hess, brought with it a need to avoid possible conflicts as well, and required the strict separation of the two businesses: being seen as both poacher and gamekeeper was not an option.
Are conflicts really the issue?
All told, there is no straight answer as to what the market's consulting model of choice looks like at this point in time. Neither do observers agree as to how serious investors are taking the question of whether gatekeepers should be serving a diverse range of clients with different products.
It is a topical issue though. Critics say consultants are taking a risk when advising and investing at the same time, particularly in the current environment. As one UK based investor who advocates a ?one fund, one fee? approach puts it: ?The corporate governance agenda is becoming more robust, particularly in the politically correct world of US pension plans. All you need is for one thing to go wrong, and who needs the grief??
Unsurprisingly, representatives of the ?advice-only? school of thought do view this kind of scepticism towards one-stop shops as an opportunity. They say they are now coming across new clients particularly in the pension community who are now placing greater emphasis on working with consultants that do not generate revenue from asset management, because that is what their trustees are increasingly keen to see.
However, relate this to advisors who do manage client money, and expect to be told that even the traditional gatekeepers are having their work cut out if they want to be seen as whiter than white. As one fund of funds manager puts it: ?If a consultant persuades a client to invest in ten general partnerships, they can charge a success fee for each one. But if the client choses to invest in a fund of funds instead, that will generate only one fee. This constitutes a potential conflict as well.?
To complicate matters further, by no means everyone in the industry regards the issue of conflicts as a particularly pressing concern. There are in fact investors working with gatekeepers who say that this debate is nowhere near the top of their current agendas. Reál Desrochers, director of alternative investments at CalSTRS, is one of them: ?Conflicts of interest is an issue, but only one of many. As a public pension, we take our fiduciary responsibilities extremely seriously, and we expect the same of everyone we work with. The advisors we come across are professionals, and I am confident that everyone will behave, acting in the interest of our beneficiaries. When we selected Altius to work on our non-US portfolio, the suitable candidates were evaluated on a number of selection criteria such as years of experience, depth of the team, performance of partnerships that they had recommended in the past, access to managers and so on. The fact that Altius does not run a co-mingled fund of fund was a factor too, but it was by no means decisive.?
This ties in with the argument that what matters most to the buyside when working with external advisors is the impact these have on how their assets are performing. The extent to which investors conclude that gatekeepers do add value will continue to change the way private equity investment consulting works. Track record will be a key differentiator. ?The quality of service that is available in the market varies enormously,? says Jonny Maxwell at Standard Life Investments. ?People tend to look at brand names, which is helpful, but it's not everything.?
Already large institutions are changing the way in which they buy consulting services in the market. The old model of one gatekeeper advising a client on every aspect of their private equity programme is breaking down. CalPERS and CalSTRS are among the large limited partners that are already taking a more differentiated approach, using different types of advisors at any one time that focus on different parts of the pensions' private equity strategies and increasingly bringing in non-traditional strategy consultants such as McKinsey and KPMG.
Gatekeepers are increasingly selling into a buyer's market, especially as investors are becoming clearer about what their requirements are. As these requirements change, gatekeepers will continue to adjust to them. But although the model is undoubtedly going to evolve further, it seems highly unlikely, given the nature of the asset class, that there should ever be a one-size-fits-all private equity consulting model. But equally far-fetched seems the prediction that the hybrid approach is going to retreat any time soon. What matters in private equity is track record, and the large gatekeepers turned fund managers have demonstrated that being successful at one thing doesn't mean they're having to compromise when doing another.