LP RADAR: Sovereign risk

For limited partners, staying ahead of the curve in private equity requires constant reinvention. In this fast-moving environment, the prevailing view on best practice may have changed entirely by the end of the current cycle.

At an event sponsored by The Private Capital Research Institute in New York in February, a number of panelists – including current and former LPs – spoke about the changing nature of private equity, drawing on new research about the future of investment in the asset class.

One of the main topics of discussion was the (now more or less universal) enthusiasm among LPs for direct investments and co-investments. Some big investors – notably the big Canadian pension funds – appear to have made that transition very successfully, providing encouragement to others with ambitions in this area. Josh Lerner, director of the PCRI and a professor at Harvard Business School, argued on the basis of his latest research that LPs need to be more cautious about the risks involved.

“This is a local game,” he suggested. “The winners are really cases where you have a Canadian institution investing in a Canadian deal, or a Singapore fund investing in a Singapore deal. There seems to be a strong home field advantage.”

While LPs have clearly developed a greater appetite for co-investments in recent years – 65 percent currently expect to increase their allocations to co-investments, according to a study cited by the PCRI – Lerner argued that co-investment has actually had a negative effect on many LPs’ returns, because it has given them more exposure to underperforming deals.

“Too much money gets invested in hot markets,” Lerner warned. “If you look at the co-investments, these are even more bunched up at exactly the wrong times.”

The trouble is that to do co-investment well, you need the right team – and that team will probably look nothing like the relatively small staffs of mid-sized pension funds, endowments and foundations.

However, if you’re an ambitious, wealthy sovereign fund, there’s no reason why you can’t build that team from scratch.

“We’re in the very early stages of disintermediation taking place in private equity, and the driver of this trend right now is these very large institutions, especially the sovereign wealth funds,” said Scott Kalb, the former chief investment officer of the Korea Investment Corporation (who is, as such, well placed to comment).

While the average headcount among the top 200 US pension funds is about 15 investment professionals, according to Kalb, the average headcount at sovereign wealth funds is more like 200. Some have as many as 1,000 people, he suggested.

“They have a mandate to actually develop their internal capabilities,” Kalb said, adding that the number of sovereign wealth funds of a substantial size has grown from 14 in 2000 to 75 today. “You now have over 100 institutions which have large scale, large staffs and are intent on investing and testing the capital markets in new ways,” he said. “They’re engaged in what I would call unconventional investment behavior.”

What’s particularly interesting about this dynamic is that it’s happening at a time when the industry’s traditional LPs are actively trying to boost their private equity allocations – which have grown from around 3 percent among public pensions in 2000 to more than 11 percent today, according to Joncarlo Mark, a former senior portfolio manager at the California Public Employees Retirement System and the founder of Upwelling Capital Group.

That sounds in theory like it ought to be a win-win for LPs and GPs alike. But in practice, some investors have had a difficult time gaining sufficient levels of exposure to the right managers.

“GPs are saying ‘We want to maintain your level of exposure to our fund [but also] diversify our capital base to include sovereign wealth funds and offshore investment entities,” said Tim Kelly, an advisor and former partner at fund of funds Adams Street Partners. “Before, the GP was just happy to achieve their target in whatever way they could, even though inherent in that fundraise was perhaps some risk of having too much concentration in one or more type of LP.”

The increasing sophistication of LPs – which might manifest itself in an appetite for a particular fund or sector – is also making life more difficult for funds of funds, adds Kelly. “CIOs and portfolio managers are saying the fund of funds model doesn’t fit anymore,” he said. “They don’t want to have a ‘one size fits all’ type of functionality. They’re looking for more exposure to this type or that type.” Consultants that have evolved from providing advice to deploying capital are also changing the game, he points out.

It all adds up to a changing world for some of the institutions that have been investing in private equity for years and years. They clearly haven’t lost their appetite for the asset class; quite the reverse. And there’s no reason why they can’t continue to enjoy great returns from it. But they’re up against competitors of a very different type now, who act in unconventional ways and often have far greater resources. To survive and thrive, LPs don’t necessarily need to act in the same way – but they do need to adapt very quickly to new practices and structures.