It’s a question that drives at the heart of the private equity model as we know it: is the traditional 10-year limited partnership here to stay?
Contained within this simple sentence are a whole host of assumptions upon which the private equity industry is built. It drives at the nature of the relationship between LPs and their fund managers, the effectiveness of alignment and incentivisation, the structure of partnerships and the increasing importance of liquidity in a supposed illiquid asset class.
According to The Carlyle Group’s David Rubenstein, the classic 10-year fund is not on its way out, but we are likely to see much more variation. The market is experimenting with different fund formats “in both directions”, the private equity titan told an industry conference in Geneva in March.
To pose a question about the future of private equity fund structures is to also ask what a typical LP will look like in 10 or 20 years’ time – whether closed-ended fund investments will still play a prominent role in LP portfolios or whether co-investments, directs and separately managed accounts take the lion’s share; what fee structures will look like and how technology such as blockchain will disrupt reporting processes.
The rise of customised accounts
The desire for LPs to customise their portfolios, cut costs and boost returns has sparked a shift towards more bespoke fund models, such as separately managed accounts. According to data from Coller Capital, 42 percent of LPs held separately managed accounts last year, up from just 13 percent in 2012.
“If you look at the phrases ‘limited partner’ and ‘general partner’, those will become not fit for purpose in the future,” says Eamon Devlin, managing partner at alternative asset management consultancy MJ Hudson. “It presupposes that your relationship is in a fund, and there’ll be a lot more shadow capital in the next 10 years, which is not a GP-LP structure.”
Increasing LP consolidation is likely to play a role in the rise of shadow capital via SMAs over the 10 years, with pooled pension groups such as the UK’s Local Government Pension Scheme Central a prime example. In January, LGPS, which manages around £40 billion ($52.4 billion; €46.3 billion) in assets for nine UK pensions, established its debut private equity fund. The vehicle is structured via a traditional private equity model with bespoke provisions for the pensions, Alex Amos, a partner at law firm Macfarlanes who advised on the fund, tells Private Equity International.
“Pension funds are consolidating, family offices are consolidating, those are all trends leading into bigger pools of money, which will in turn lead to investors having separate account mandates with GPs,” Devlin says.
Innovation in SMAs should help LPs deploy in a more efficient manner. In the traditional fund model, LPs are often unable to respond quickly enough to GPs’ calls for co-investment capital. To address this, more investment company-type structures are likely to appear with LPs on their boards, according to Shawn D’Aguiar and Ajay Pathak, fund formation partners at law firm Goodwin.
LPs will still expect outperformance from their private equity portfolios to justify the associated fees and expenses. But rather than sticking an absolute number on those expectations, they are likely to judge performance in relation to other investment options, such as generating 200-400 basis points over public equity benchmarks, says David Fann, president and chief executive at consultant TorreyCove Capital Partners.
LPs themselves are also likely to change how their own investment professionals are compensated. Data from Coller Capital’s Global Private Equity Barometer Summer 2018 show LPs whose remuneration is tied to private equity performance are almost three times more likely to deliver annual returns in excess of 16 percent than their non-performance-tied peers.
Edi Truell, co-founder of private equity firm Disruptive Capital and a key figure behind the UK’s public pension consolidation, says low salaries are a significant impediment to UK pensions’ success in private equity.
“You’ve got to be prepared to pay proper money to attract the talent to take on private asset managers on equal terms,” he told PEI last year.
While the 10-year limited partnership is unlikely to disappear completely, the idea that LPs are locked into illiquid vehicles for a decade or more is likely to become a thing of the past. With the rapid growth of the secondaries market, which has grown more than seven-fold over the last decade to $74 billion last year, according to data by advisor Greenhill, LPs will have no unwanted funds that have outlived their 10-year lives. Portfolios will be devoid of zombies, assets will have been rolled into separate structures, or pre-agreed liquidity processes will have been triggered giving LPs the option to cash out.
GP-led liquidity options for a fund’s LPs are already starting to appear in limited partnership agreements. Macquarie Infrastructure and Real Assets’ Super Core Infrastructure Fund, which launched last year with a €2.5 billion target, includes a facility for secondaries sales every five years from and including year 10, according to public pension documents about the fund seen by PEI.
The savvy use of the secondaries market will also allow chief investment officers to adjust certain investment exposures on a frequent basis. Over time the secondaries market could become “far more liquid and with less friction from a transaction perspective”, says TorreyCove’s Fann.
LPs will become used to having access to every piece of information about a manager they invest with and a fund they commit to. In 10 years’ time, it is likely there will be a completely clear channel between LPs and GPs through which information will flow freely back and forth. If a manager is not willing to open itself up to this degree, there is a high chance investors will take their capital elsewhere.
Transparency and disclosure between GPs and the limited partners that commit to their funds is an area of top priority for investors and regulators alike. Industry insiders agree progress has been made over the last few years, but there’s still work to be done to address the perceived double standard between private equity and other forms of investing, such as mutual funds or ETFs, where fee disclosure is explicit.
While technologies like blockchain are likely to aid in areas such as GP reporting, trust between LPs, GPs and service providers will remain key. As LPs continue to cut their number of GP relationships, this will only become more important, says Pablo de la Infiesta, head of private funds advisory for EMEA at Moelis.
“The moment you have trust in somebody, you are OK with them doing your fundraise, your secondaries deal, [and regarding ownership of the GP] generation changes that need to be dealt with at the ownership level,” de la Infiesta says.
Will there be robo-advisors in the future? Probably, he says.
“You can trust a robot, but there’s also the advice. Advice will always be relevant. The world never gets easier, the financial world never gets easier. Because of the competitiveness of everything, you need to combine advice with trust.”