Limited partners are evolving. Gone – or at least going – are the days of passive investors willing to take general partners at their word, commit money and sit there waiting for the profits to roll in.
The new breed of investors – led by large institutions like sovereign wealth funds – demand much more control over their private equity exposure than simply making fund commitments. That means they’re far more interested in co-investment opportunities, separate accounts and active portfolio management. These investors want personalised attention from their managers.
They are also looking for ways to control fees, so that the ‘cost’ of private equity does not become prohibitive. This can be achieved through customised accounts – which give an LP more leverage to negotiate fee levels.
The sovereign wealth funds’ desire to have more control over their private equity programmes is driving a broader trend: LPs in general are breaking out of the more traditional fund commitment mold and adding some more diverse instruments to their portfolio, like separate accounts.
“Asian and Middle Eastern limited partners are less comfortable being passive investors,” says one LP advisor who works with sovereign wealth funds. [To get their capital, GPs] have to be more interactive and more customised. ”
There is a different “evolution” going on in the Asian and Middle Eastern private equity markets: LPs are clamouring for more sophisticated forms of private equity investment vehicles, according to several market sources.
Other LPs that are new to the asset class are bringing their ideas about control with them. In Brazil, for example, the biggest pension funds have generally refused to commit to private equity funds unless they can sit on the investment committee and take part in decision-making.
This growing desire for more control is, inevitably, changing the complexion of the private equity industry. These days, a greater degree of sophistication is needed on the parts of LPs and their advisors to derive the most benefit from the asset class.
One way in which LPs are adapting to the changing environment is to become much more proactive in their management of their portfolios. Making use of the secondary market, LPs can be much more flexible with their private equity investments. While the asset class remains illiquid, the thriving secondary market allows for movement in and out of funds.
Some LP advisors have taken to offering a more “holistic” approach to private equity: this includes almost continuous active portfolio management, monitoring, co-investing and seeking ways to find tailored vehicles that fit an LP’s needs.
“If you talk to LPs, the biggest concerns they have about private equity is the illiquidity and the rigidity of the structure – and the high fees,” says Monte Brem, the chief executive officer with advisor StepStone Group. The ideal is for an LP is to have “flexibility” in how to structure and adjust portfolios via fund investments, co-investments and secondaries, Brem says.
This approach to private equity requires more communication with LPs than would normally happen in a traditional fund structure. Communication is key to helping an LP understand their programme and the needs it has in terms of potential secondary sales.
LPs have also been making concerted efforts to deal with ‘end of fund life’ issues, which have become a growing concern in recent years as more firms face the prospect of not being able to raise future funds. This puts the LP in a tough situation – they have to make sure the GP continues to work hard at maximising value in the portfolio, and doesn’t just extend the fund life in order to keep collecting fees.
So why is this happening now? Big losses in LPs’ portfolios after the market crash in 2008 caused them to significantly re-think their private equity programmes, their goals for the asset class and just how much exposure they wanted to investments that could tie up their capital for years.
The industry is still being reshaped by this process of introspection, and it will continue to evolve as LPs take more control. This is surely a good thing. The more the much-vaunted “partnership” between GPs and LPs becomes a reality, with common commercial and governance interests, the more likely private equity is to serve everyone’s needs.