As shown in the International Monetary Fund's annual forecasts, growth rates across the globe are not doing private equity firms any favours. The days of pulling in impressive returns on the back of macro trends and creative financial engineering are well and truly behind us. For the better, some may say.
It does, however, mean that generating strong returns is less straightforward than it used to be. It is perhaps unsurprising, then, that for the second year in a row, “understanding and influencing drivers of returns” was – by some distance – the number one concern for the respondents to our survey.
More than 80 percent of LPs globally chose this issue as one of their top three concerns, and 55 percent voted it their single most important concern, with LPs in all three regions attaching a similar level of importance to it.
“Understanding drivers of returns is important because my job when committing to the next fund is to assess whether I believe these drivers are still valid in the economic climate that I expect to prevail during the life of the next fund,” says Jonas Nyquist, head of buyout fund investments at Skandia Mutual Life Insurance.
“Understanding drivers of returns is also important in order to understand the risk profile of my portfolio. I want to have exposure to a diversified set of managers with different drivers of returns, in order to create the most attractive risk/return profile of my portfolio.”
Likely related to the challenge of producing returns in today’s low-growth environment, 53 percent of respondents chose “proven operational expertise” as one of their top three criteria beyond track record that they use when selecting a private equity fund manager.
The weight which LPs place on the need to understand how returns are generated is underscored by the second most popular choice: establishing reliable performance metrics and benchmarks.
“If you can’t benchmark it you don’t know whether you have done a good job or not. PE is only a worthwhile investment if it outperforms liquid strategies,” says Brian Murphy, managing director at Portfolio Advisors. “Clients need justification for paying the high fees in PE, and performance is the only real justifier.”
“It is imperative that we have the ability to monitor the performance of funds on an ongoing basis, both on [an] absolute and relative basis,” adds Matt Rowland of Lowery Asset Consulting.
“The idea of locking up money for up to 10 years without regular updates on performance is unthinkable. As a fiduciary for our client’s money we are responsible for overseeing the portfolio investments and dealing with any problems as they occur. Without regular performance updates and proper benchmarking and peer group comparison it is next to impossible to do so effectively.”
This year, LPs were offered three additional options: optimising the number of manager relationships; building investment expertise for direct investing; and diversifying away from core PE.
Just under a quarter cited building investment expertise for direct investing as one of their top three considerations, making it the sixth highest concern overall.
LPs have made a more decisive move into direct investing, with some investing more than half of their private equity allocation directly and others taking a more pro-active approach toward co-investment.
Canadian pension fund CDPQ, for example, invests 55 percent of its private equity allocation directly, and Turkish pension fund Oyak told Private Equity International in October that it has $5 billion in cash allocated to make direct investments in companies in Turkey, North America and Europe.
A clear incentive to move toward direct investing is cutting out the fees and carry paid to investment managers. Both European and Asian LPs said when it came to fees and terms, they were most concerned about the current level of management fees.
Their US counterparts, on the other hand, are most concerned about how those fees are allocated between GPs and LPs, no doubt brought to their attention by recent action by the US Securities and Exchange Commission (SEC). In June this year, in its first case targeting an industry giant for fee and expense policies, the SEC charged KKR with misallocating $17.4 million in broken deal expenses to its funds, resulting in a breach of its fiduciary duty. KKR agreed to pay close to $30 million to settle the charges.