Six LPs and a table

An open debate among peers, it said on the invitation, a chance to exchange views on some of the key issues affecting limited partners in the private equity asset class today. No general partners or placement agents allowed. Don't mind the journalists in the room, although they may chip in from time to time. And yes, they will write about it afterwards.

We had tabled the idea of a small group of private equity investors getting together partly because there aren't many opportunities for limited partners to meet up on this kind of basis, especially in Europe. In the US, on a much grander scale, the Institutional Limited Partner Association is beginning to gain momentum, but whilst it is formulating its mission statement and polishing its agenda it remains in stealth mode. Its arguable too whether the ILPA is the best place for many European LPs to play an active role at this stage: although many will remind you that private equity is a global asset class, it still has sufficient regional characteristics to make a regional forum suitable for most investors. The maturity of the respective markets, the regulatory and operational environments and the different cultures too are all factors.

The establishment of the ILPA though was one telling sign that investors saw the need for a properly instituted body representing limited partners. LPs have plenty of issues about how the asset class is organised and operates – and many feel strongly about the need to change the way they interact with the managers of the funds that they invest in. But there has until recently been no ready means it seems to crystallise and codify the concerns (and frustrations) of the buyside and put them in front of general partners in ways that can affect change. At the same time LP to LP communication, if it happens at all, takes place informally and mostly on a one-to-one basis. The fact that some of those gathered around the PEI roundtable don't actually know each other illustrates this point. No wonder veteran limited partners often lament that little has changed over the many years that they have been buying private equity funds.

Plenty to talk about
A roundtable may not be a substitute for a proper buyside forum, but it is a great way for a small group of people (see the profiles of each) to get to grips with some big issues, particularly when the subject is substantive enough for individuals with views (and few LPs lack these) to get their teeth into. At the moment of course there is plenty of substance in the private equity world: think depressed returns, reduced allocations, public disclosure of IRRs and GP compensation for a start.

To get things started we ask whether LPs are doing enough at this point to lobby for change in their dealings with general partners. The balance of power is said to have swung from GPs to LPs: this is now supposed to be a buyer's market. But are investors really making much of an effort to change the rules of the game? Is there such a thing as investor activism or is it more a case of a few disgruntled individuals grinding personal axes?

We're deep in the debate almost instantly. Jonny Maxwell is leading the charge. He is due to deliver a talk at the conference the next morning discussing the potential influence of limited partners on private equity funds going forward, so he's come to the roundtable armed with a raft of ideas on the issue. He's in no doubt that on the buyside too little is being done to make private equity a more investor-friendly place. ?Investor activism is a contradiction in terms. ?Institutional intertia question mark? would be a more appropriate theme. None of the organisations represented here have been known for sitting on the fence but frankly, there is still very little inclination to do anything.?

?To the LP, the GP ought to be more than just a conduit to making three times capital?

?Investor activism is a contradiction in terms?

Maxwell relates the story of his team taking exception to a manager who wasn't behaving as expected, so he and his colleagues tried to persuade the other limited partners invested in the fund to take action. The response was underwhelming. ?What you hear is 'I can't be bothered with this. 0.25 per cent of my portfolio takes up 20 per cent of my time. It's a bad call, we'll just take a writeoff and move on.' People get very complacent.?

Rhonda Ryan points out that historically part of the problem stemmed from investors doing private equity as an add-on to their main responsibilities who lacked the time and experience (and enthusiasm) for the product.

?This is not an excuse, but at least it seems to be changing now. The European market is maturing. It used to be only a handful of investors willing to be active, but as allocations are increasing, more investors are employing more resources and become more willing to be active than they were before.?

Rod Selkirk, who before joining Hermes was part of the fundraising team at Bridgepoint Capital and therefore sat on the other side of the fence, still finds it odd just how poorly the relationship between LPs and GPs in private equity funds compares to the way GPs relate to their portfolio companies. ?GPs are working so closely with investee companies, backing management, partnering with them and removing them if they think they're not running the business in the best interest of shareholders. It's proper corporate governance but then there is this big gap: the relationship between LP and GP is just surprisingly hands-off.?

Neutered by legals
Maxwell has no doubt as to where the root of this problem lies: ?It's all driven by a legal infrastructure which neuters the investor from day two.? He makes the point that unlike a corporate structure, which allows shareholders to submit resolutions, vote and force actions, the limited partnership leaves investors operating in a legal vacuum. Take a fund's advisory board: ?Provided it has a constitution, an advisory board can opine on valuations, strategy and conflicts. But even where you have a screaming conflict, all you can do is request access to talk to other LPs and hope that the GP isn't going to turn around and say, ?by the way, you're not on the advisory board anymore?. You can gum your GPs with the legals, but you can't bite them.?

Sasha van de Water wonders if this is not rather late in the day to be getting worked up and suggests that investors can always vote with their feet before committing to a fund ? if they feel strongly enough about a particular issue. ?If you do your due diligence on the legals before you invest, that's where you've got the leverage. If you can't get the right terms, you don't invest. The problem is that nobody has really had the determination to do this. At the end of the day, when you're risking not participating in a fund that you believe is going to make money for you and your investors versus saying no on the basis of what appears to be rather unimportant legalese, most people will take the punt.? Maxwell agrees: ?You don't get any brownie points for being the champion of good ethics if you walk away on principal from capital return. You'll have to bite the bullet and take your chances that you can manage the relationship with your GP even when the going gets tough.?

As John Shearburn points out, ignoring concerns relating to seemingly trivial items in the partnership documentation wasn't such a big deal until the market turned from sweet to sour. ?I think a lot of people calling for activism now weren't proactive enough initially. They didn't sit back and say, ?I'm going to be with these people for eight or ten years, I better make sure I think through everything that can go wrong beforehand.? But when the industry began to experience difficulties, those investors who failed to do their homework properly started asking questions and reading their agreements and they found a lot of things they hadn't realised.?

?More investors are employing more resources and become more willing to be active?

Along with van de Water, Shearburn believes that in order to avoid any surprises hidden in the partnership agreement, investors need to be focussed, push people hard if needs be and tell GPs they won't go into their funds when the terms are not market.

To Maxwell, that's not enough though. His quarrel is with the legal position that the investors finds himself in once he's signed up to a partnership. ?If you look at the legals for the partnerships that we all invest in, the reality is that there are practically no empirical sanctions in these documents. And the ultimate irony is, even if you do decide to take action, under the partnership structure, you have indemnified the general partner against litigation. So if you sue the manager, the fund covers all their costs!?

Reinvent the fund structure?
Is the solution to these documentary wrangles to reinvent the fund terms? ?No,? says Maxwell, ?the clauses are all there, the point is there's no sanctions. What we need is these contracts to stipulate what happens if people don't deliver. There should be sanctions against the management fee, because if it hurts the manager in the pocket, reasonable efforts are going to be best efforts. But if we say to a manager, we want you to pay €100,000 for every day that you are late with your reporting, they'll say we're doing our best, we've always done it like this, and besides, nobody else is hassling us for this, so go away.?

The point is directed at a number of aspects that are potentially damaging to the investor, including the problem that too many limited partners, no matter how influential, too often take on their general partners in isolation, fail to build an alliance with other investors and end up fighting a losing battle. There are several reasons why this happens. One is that few LPs are prepared to take the initiative. Stefan Marelid: ?There is a free rider problem in private equity. Many LPs think someone else will shake the GP's tree. Many say this asset class is tough enough, I am going to let someone else do the arguing.?

?We tend to write down Asian valuations for instance, regardless of what the GPs say?

?I don't want the industry on the web?

Shearburn says free riding is also at work when some investors do due diligence to select funds: ?Reputable LPs pave the way for others. The argument is, if LP x or LP y go into a particular fund, it'll be ok for me as well.?

?Fiduciary responsibilities of board members have never been tested but this will happen in the next two years?

Another reason why many LPs like to tread carefully when challenging general partners and are reluctant to follow others making waves is that they are loathe to jeopardise relationships that may have taken a long time to build. Everyone agrees that such relationships can be immensely valuable in a business like private equity. Not only is being on good terms with a manager the most effective way for the LP to get access to this manager's next fund, it can also enable the investor to exert some influence in a non-confrontational manner over terms and conditions. But it does also mean that the dialogue is one-to-one and the GP has a far greater likelihood of managing the discussion to a conclusion that suits them.

?The relationship between LP and GP is just surprisingly hands-off?

?I do wish every GP would send me their performance data in the same format?

For van de Water, these are soft issues that cannot be overlooked. ?Private equity is a people business. To the LP, the GP ought to be more than just a conduit to making three times capital. A good relationship means you have a much better chance to get proper information and a dialogue about problems that might arise. If a GP is on good terms with their investors, it puts them on a much better footing and gives them a chance to sort things out. And this is true among LPs as well. Those that are invested in the same funds, if they are friendly enough to have a conversation on an honest level, without too much posturing, about problems with GPs that they share, even though there is obviously an element of competition between them.?

Advisory boards with teeth
One way LPs can impact the running of a private equity fund that they're invested in, on a level that ensures the GP is actually inside the loop, is the advisory board ? but, as everyone at the table knows from experience, historically the buyside's enthusiasm for advisory board meetings has also been severely limited. ?I remember from my days as a GP, it was the devil's own job to get people to attend advisory meetings, and it was hard to get any input from investors once there either,? recalls Selkirk.

?Have you tried paying them?? asks Maxwell. He says that his funds of funds at Standard Life are paying advisory board members €3,000 for each board meeting they attend.?

?What we need is these contracts to stipulate what happens if people don't deliver?

Selkirk is sceptical: ?They show up because the get €3,000, not because they have €50m in your fund?? Maxwell: ?A non-executive director of a public company expects to get paid. You would not not pay any other professional for looking after your interests, would you? Advisory boards should be taken seriously. The fiduciary responsibilities of board members have never been tested but this will happen in the next two years. After all the venture disasters that have occurred, people will point to the advisory boards and ask, ?why did you let this happen???

Thus accused, these board members may try to take refuge in the argument that their roles weren't all that clearly defined to be begin with, which many in the industry believe is indeed the case. According to standard limited partnership terms and conditions, part of what advisory boards are meant to be doing is to consult on a fund's strategy and to ?opine? on portfolio valuations. What exactly the latter involves, and how it is best executed, can be interpreted in many different ways. Should it mean having the final say over what price a fund should hold an investment for instance?

Former Bridgepoint man Selkirk is not convinced, taking the view that this is a job best handled by a fund's investment committee. ?I don't believe advisory boards are in the best position to approve valuations and effectively second-guess the GP's view on the portfolio. It's too detailed, you have to be close to it, you're using your discretion and you will be caught out in the long term if you're doing it wrong.?

But what if the GP can't necessarily be relied upon to be doing a better job? As John Shearburn comments: ?With falling markets over the past couple of years, particularly in the venture capital industry, many more questions are now being asked. Advisory boards are having constructive dialogues with GPs about valuations and related issues. They are asking tougher questions and, where necessary, helping GPs to ensure that valuations are as accurate as possible.?

?You can gum your GPs with the legals, but you can't bite them?

The alternative, says Ryan, is to simply disregard the numbers that GPs give out to their investors ? which is what many limited partners are doing anyway. ?We tend to write down our emerging market fund valuations for instance if we believe they are overvalued, regardless of what the GPs say,? says Ryan.

But lack of enthusiasm for the job or poor understanding of responsibilities aren't the only things that prevent advisory boards from doing an effective job. According to van de Water, over-loaded advisory boards can also be a problem: ?10 years ago you'd typically have four people on an advisory board, talking about things in a substantive way. Now everybody who makes a €10m commitment to a fund demands a seat on the board, so you end up with 15 people on a board. Staff turnover at institutions is pretty high so GPs have to redevelop relationships with board members all the time. And some smaller LPs who may be really important to the GP are driven out by the big guys making demands.?

To resolve these issues, says Maxwell, advisory boards need to be given constitutions. ?Come up with a 10 point wish list of nonprescriptive corporate governance principles and have the funds embrace it as a means of pre-emptive self-regulation.?

Better reporting??
What Stefan Marelid wants funds to focus on is introducing a reasonable degree of codification and consistency: ?I believe in greater transparency of reporting, and I do wish every GP would send me their performance data in the same format. And I wish legal documents could to some extent be standardised. I have no problem with different terms for better teams, but the fundamental principles should be the same, and the language should be the same.?

Marelid is not alone in making a critical distinction between reporting to investors and reporting to a wider audience: one issue that everyone sat around the table are clearly not in favour of is the ongoing push in the US for largescale public disclosure of fund and portfolio company performance data. UTIMCO's release of interim IRRs of the 70 private equity funds it is invested in is perceived as unhelpful and potentially damaging to the asset class.

?I don't want the industry on the web,? says Maxwell. ?Disclosing the return figures of an underlying partnership is of no benefit to the general public. Transparency of returns is of importance to the prospective investors, who can buy the relevant numbers if they wish to, but to publish them is not necessary.?

?Many say this asset class is tough enough, I am going to let someone else do the arguing?

Shearburn: One of the reasons investors are attracted to private equtiy is the lower degree of transparency in the asset class. Managers are often able to capitalise on inefficiences in more cloudy markets. But this lower degree of transparency also extends to reporting, which makes interim statements about valuations and performance somewhat confusing. What does it mean, for instance, to say that a 2000 venture capital fund is held at a negative 16 per cent IRR? Unfortunately, there is no context to these numbers and no explanation of the inherent difficulty of making short-term statements about a long-term asset class where performance is ultimately judged by fully realised, cash on cash returns from a portfolio of investments.?

And Marelid: ?It's dangerous to the industry, not least because the beneficiaries of pension funds investing in private equity read these articles as well, wondering what is happening to their money.? Everyone nods in agreement.

And what about fees?
Meanwhile Selkirk is pondering arguably more farreaching changes. He is surprised that there hasn't been any movement on management fees. That fees have not reduced as funds have become bigger is of course one of the buyside's most long-standing complaints, and many practitioners find it one of the most dysfunctional aspects of the private equity model. Selkirk: ?I am astounded that fees have managed to stick where they are. It is still possible for a GP to charge a 1.5 per cent fee on a $5bn fund. If the LP community can't get together to challenge that, how are people supposed to get exercised by lesser issues? Fees really should have come under more pressure. What I don't have time for though is investors complaining about fees after they've invested. If you pay up, shut up.?

Sasha van de Water says the extraordinary thing about LPs willingly paying high fees for even the biggest funds is that it isn't at all clear whether they're getting value for money. ?People think they are making a really safe bet when investing in the big funds, because the partners have been around for a long time, they have track record ? but wouldn't you be around for a long time if you were pulling in $10m a year in salary? To me, that's a very unsafe bet to make. To be fair, some of them are going to do well because there are people that are not motivated by money only. But I think we should be betting on a guy who's life epends on performance and who doesn't make a living out of asset gathering.?

On a more positive note regarding fees (for LPs at least), there are now signs that progress is being made on this front. ?We've recently complained to a GP about the management fee,? reports Maxwell, ?as they were going to charge on the excess capital they had raised. Initially they turned us down. But we got the support of the other LPs and went back to the manager informing them that unless terms relating to the excess were altered, the fund's first closing would not happen. We got what we wanted and, importantly, the relationship with the GP was not lost.?

?Part of why you can make money in private equity is because it is a non-transparent, opaque business?

Van de Water says the ball is in the court of the institutions with the most financial heft in the asset class. ?If you look at the LP lists of the very largest funds in Europe, they all have a small number of very big investors and a large number of small investors. And if those large investors are willing to start those discussions, even the big guys are going to have to think about it.?

The point is part of a more general observation, which is that because of the difficulties facing the asset class at present, now is good time for LPs to take the conversation to the managers. Van de Water again: ?As an investor you now have the opportunity to convince the GPs that matter to you, in a firm but friendly way, that certain things have to change. Now the LPs have more leverage to do that, and whatever they can achieve now they will be able to bring forward with them. Because any changes will be written into the partnership agreements, once you've signed up they won't go away.?

But don't expect any groundbreaking changes across the entire industry quite yet. As van de Water says: ?It's not going to happen with everyone. There will be GPs that are not going to engage in this dialogue, and that's where LPs will have to make their bets. But there are reasonable opportunities to get this working.?

The point is well received around the table, and is part of a key message to the buyside at large: get moving, but pick your fights sensibly. Talk to your GPs and stay close to what you're buying from them. Most importantly though, talk to your peers about what you want ? and are getting – out of the asset class. Private equity is ripe for change. Limited partners owe it to themselves, and their own investors, to actively try to bring it about.

Postscript: notes from the next European LP Roundtable will appear in the April issue of Private Equity International.

?When distributions dried up investors started asking questions and reading their agreements?