Transparency beats performance

Have you ever eaten at an expensive restaurant where the food was great but the service and décor were mediocre? Of course you have. You might have even made your dissatisfactions known to Zagats.

Similarly, have you ever invested in a private equity fund where the returns were quite good but the fees were too high, the investor servicing, poor, and the management apparently disdainful of the customer? Survey says … yes you have.

Just like people become furious when served delicious food by rude waiters, they complain when otherwise strong returns are served by firms that lack a culture of customer-comes-first.

According to a survey from Gracechurch Consulting and Hawk Partners, the findings of which have not previously been made public, not only do investors highly value things like communication and alignment of interests, but by at least one important measure they value these higher than they do performance track record.

The findings fly in the face of the conventional wisdom that limited partners consider historic returns the most important consideration when considering a fund commitment.

The study, concluded last year, collected the views of 274 institutional investors around the world, asking each to rank the factors that would lead them to recommend a private equity firm to another investor. Here are the results:

Exhibits integrity in deal process
Provides good value for fees charged
Has a clearly defined and differentiated investment strategy
Provides clear, transparent, open communication
Aligns its interests with those of its stakeholders
Has a track record of successfully exiting investments in a reasonable period of time
Has an overall track record of good financial returns
Is skilled in building long-term relationships with key stakeholders
Adds value through its operational expertise
Is a trusted brand name

Prior to seeing this ranking, I too would have assumed that number 7 would have been number 1, although I’ve long been aware that LPs have become adamant about better investor servicing.

The first two reasons-to-recommend indicate an asset class that has developed such that its investors now place a premium on truly institutionalised processes and expense structures. That the quality of the deal process is number one shows a real focus on risk controls, investment committee excellence and attribution tracking. A firm that does a good deal now needs to demonstrate that the success is repeatable.

That the second most important factor is “value for fees” indicates a growing rejection of the market terms of yesteryear, during which management and deal fees existed too often as GP entitlements rather than as supports for operating expenses.

But “overall track record” being at number 7 is, at first glance, something of a shocker.

I think the right way to read this ranking is not as the demotion of performance, but as the placement of performance in a new context for manager selection. Every investor will tell you that returns are paramount. You only want to invest with a manager that has a proven record of beating the index. But within the population of top performers, it is not necessarily the case that the firm with an IRR of 45 percent beats the firm with an IRR of 40 percent in the eyes of investors. If the better performance were delivered with a litany of bad GP behaviors like poor communication, egregious fees and squirrely conflicts, an investor is highly likely to choose the team with the lower IRR, because the lower performance is still good enough.

According to Bob Brown, managing director and global head of limited partner services at Advent International, “The results of this survey reveal that investors have reconciled with one of the greatest lessons learned during the last cycle: Too much emphasis was placed on chasing returns and too little emphasis was placed on alignment, which is likely the greater determinant of long-term, repeatable success for our industry.”

But, counters the industry cynic, investors usually pay attention to nit-picky considerations like fees during periods of low returns but then don’t give a rip about such things when the party starts back up. This observation could be directionally accurate, but in the meantime, how to explain GPs investing huge amounts to upgrade their investor-servicing functions? It’s as if they know that a star chef can’t make up for the bad lighting, inattentive busboys and a sommelier who chortles when you ask if 2006 is a good vintage.