LP Radar: The real OC challenge

For limited partners, investing in top-quartile private equity can be a double-edged sword. Sometimes, the price of backing the best managers for LPs is that they end up paying top dollar in fees.

The demand for more attractive economics has been the main driving force behind the customised partnerships between LPs and fund managers that continue to gain traction throughout the industry.

One of the most recent examples is the Orange County Employees Retirement System’s agreement with Pantheon, which was chosen to manage a new fund of funds platform that will allow multiple public pensions to invest in private equity.

The platform will offer a flexible private equity portfolio structure for smaller pensions and new investors in the asset class, and a more customised portfolio for larger pensions. Pantheon’s proposed fees will reduce fund of funds investment management fees by roughly 50 percent, according to OCERS (though the total value of savings is dependent on how much pension systems commit to Pantheon each year).

Chuck Packard, chair of the OCERS board investment committee, refers to the plan as a “game changer for the industry”; while Jim Link of PFM Advisors predicts that the platform “will likely result in a permanent downward shift in fund of fund management expenses for public pension funds nationwide, even for public plans that do not take advantage of the attractive terms offered by Pantheon”.

But while OCERS deserves credit for its highly collaborative efforts to push through the creation of an innovative new offering for LPs (a team comprised of California pension CIOs helped develop the request for proposals), not all fund of funds managers are convinced that this partnership with Pantheon is particularly revolutionary.

“What they’ve done here, to my mind, is really nothing different than a customised account – but instead of having just one LP, they’ve pooled like-minded LPs from similar systems in the same geography, which essentially would suggest that their respective liabilities are probably pretty similar,” argues one US-based fund of funds manager.

“It’s innovative, but it just underscores the overall trend of these types of separate account structures, which is an area where the classic fund of fund manager who is experienced enough will take an increasingly important role.”

It’s true that Pantheon’s platform could in fact lead to substantially lower fees for participating LPs. But will that make the programme a success in and of itself?

“That’s one element and it’s important, but I think more important is the aspect of being an integral part of your LP teams,” the source says. “It really goes very much down the line of additional access to data, ongoing communication, and introducing LPs to the target markets and target investment opportunities. “So if you create a best-in-class approach, there’s a lot more that should come with it than just the fees.”

Though many LPs continue to argue for reduced fees across the industry, it bears repeating that sophisticated LPs are still flocking to managers with proven strategies and stellar track records, as opposed to those with the lowest fees.

“We all want to reduce the J-curve as much as possible, but at the same time we need to recognise that it’s not cheap to run very experienced teams,” the source says. “The more experienced the team, the more expensive they are. So there’s a limit to how much you can work on the fees. Clearly having larger pools of capital with arguably a longer duration is the way to go, but it shouldn’t just be that … That should be in conjunction with a lot more real value-add that you provide to these customers.”

The traditional fund of funds model is being forced to reinvent itself, now (at least the larger) LPs don’t really need a fund of funds to gain access to the large buyout segment. But investors writing smaller cheques for more niche strategies will typically still need funds of funds to achieve their objectives.

“You can’t always have it wholesale price cheap, yet create very customised vehicles and strategies,” the source says. “It doesn’t always work.”

To be fair, OCERS isn’t exactly chasing performance on the cheap. And you can understand why it’s so keen to keep fees to a reasonable level: the system’s indirect investment management fees jumped from $22 million to $45 million in 2013. 

Equally, it will retain a fair amount of discretion over its commitment to the new platform: OCERS’ investment committee is in the process of reviewing final documentation, and chief investment officer Girard Miller is only willing to put in $100 million annually for three years if it can be accommodated “efficiently and prudently” in the Pantheon fund, OCERS said in a statement.

Should LPs be excited about inking new partnerships with more attractive economics? Certainly. Is the idea of LPs teaming up in order to get more leverage on fees an intriguing one? Certainly. But it’s probably wishful thinking to start talking about the new platform as a “game changer” before a dollar of capital has been put to work.