The dangers of being open

Over the last decade, public institutions in the US have become increasingly open and transparent leaving some general partners with more public scrutiny of their funds than perhaps they are comfortable.

Many public systems in the western portion of the US have made their retirement board meetings completely transparent, including several public pensions that outright broadcast the meetings to the public. These include the San Diego County Employees’ Retirement Association, and the Texas Teachers’ Retirement System.

For those, like us, who monitor the market, this is good news and makes public a whole world of previously private information: fundraising targets, terms and conditions, strategies, key men and even other LPs in a fund. Also in the spotlight are the professionals running the fund: there to sell the fund to the pension and field some frequently tough questions about the offering.

This transparency is not only good for the market analyst. It is also beneficial to those pension scheme members who want to understand how their retirement fund is being invested so that it will meet its obligations in the future.

For GPs and LPs, however, this level of openness could be detrimental.

During a recent roundtable discussion hosted by PEI with a group of high-profile LPs (see p. 25), participants found general consensus when discussing the transparency of public institutions regarding private equity. Most of the people around the table thought the openness was risky and would even be harmful if it included too much detail about portfolio companies.

Objections to too much transparency included the idea that part of the value private equity adds to its portfolio companies is keeping them out of the limelight, so they can be restructured and grown without distraction of public scrutiny: a luxury sorely missed by public companies.

Long-term returns will suffer if GPs have to disclose information about underlying portfolio companies, the group agreed. For example, a GP’s position in sale negotiations could be weakened if too much financial information is disclosed about the company on the block. The knock-on effect could hit the sale price and ultimately the LP’s return.

Furthermore, GPs could become vulnerable to their competitors if too much intimate information about the fund is known. For example, a firm’s competitors could glean that the fund is over-levered through information on portfolio companies.

LPs, of course, want all the information they can get from GPs. Details about underlying portfolio companies are vital to help an LP understand its exposure to various sectors, strategies, geographies and leverage levels, among other things. In this way, an LP is not looking at his private equity holdings in terms of funds or GPs, but in terms of portfolio companies. This level of detail gives LPs a competitive advantage, participants agreed, but that does not mean it needs to be communicated to the wider public.

For some LPs this may be more detail than they are ready to accept. Many institutions invested in the asset class are under-staffed, and have alternatives teams that are seeing too many PPMs. They simply don’t have time to really dig into micro-details. Through due diligence, they figure out which managers to trust with their capital.

Some participants agreed routine fund performance data was appropriate to open up to public scrutiny. In the case of fund performance, though, numbers can be deceiving, especially to members of the public who may not understand the delayed nature of private equity performance. Funds that achieve some sort of negative internal rate of return early on may grow to generate high returns by the end of its life. For the first few quarters, however, when the performance numbers are out in the open for everyone to see, the fund looks terrible.

In this case, it’s incumbent on the institution to explain exactly what is being presented to the public.

For now, the trend seems to be toward more openness, not less, and if this is the case, GPs will have to decide just how much transparency they are willing to tolerate on the part of LPs. As one participant said, it’s surprising so many GPs decide to partner with public institution knowing how much detail will be out in the public. Perhaps the treacherous fundraising conditions have something to do with it.