As private equity investors return to a somewhat more “normalised” fundraising environment after the financial crisis several years ago, a new set of standards started its way onto the private equity landscape.
“Big” private equity allocators have been establishing a new playing field with these new standards, which involve captive, specialised investment mandates, and will likely have a long-term effect on private equity terms. Even the sacred “2 and 20” is open for discussion.
It’s about more than terms though. Globally, institutional investors are looking for an edge. Customised solutions run by smart people can provide an advantage. Some call it a customised account, others a separate account or focused mandate. No matter the label, they all fall into the “strategic account” bucket, and for a good reason. It’s providing both sides with a strategic solution to particular challenges in their private equity activities.
Examples include the $1.8 billion strategic account that The Blackstone Group set up with New Jersey’s state pension fund. Similar deals also exist between the Teacher Retirement System of Texas and Kohlberg Kravis Roberts, as well as Apollo Global Management, which also has a custom vehicle with New York City’s pension fund. There’s more, and it’s not just a US public pension fund trend.
According to Coller Capital’s Summer 2012 Global Private Equity Barometer, 13 percent of the investors surveyed have strategic accounts. Large investors dominate this space, where the survey finds that participation is almost one-quarter of institutional investors with at least $20 billion of assets under management.
Trend or Fad?
The idea of strategic accounts is not a new concept but scarce in its application to private equity. The idea came about from both sides, the manager and the institutional investor, although for different reasons. Managers were challenged by fundraising and returns; institutional investors by fees and returns. Let’s look at the benefits to each, starting with the institutional investor.
The institutional investor benefit: A typical private equity institutional investor has a limited set of tools –decision to commit and the occasional consent or amendment. Strategic accounts can enhance this toolbox with the hope of more information and better returns. Like all limited partners, though, goals vary. From the institutional investor perspective strategic accounts can provide:
– Lower fees (management fee and/or carry);
– Greater investment control;
– Greater capital deployment control – on or off;
– Increased transparency;
– Closer relationship to leverage across asset classes; and
– Broader set of asset classes (aka “innovation portfolio”, “distressed debt portfolio”).
The private equity manager benefit: Indicative of the tough environment, the market recently experienced discounts to management fees and/or carry for the commingled fund investor who is investing at first close – a first for global names such as BC Partners and Providence Equity Partners. Alternative ways of fundraising, particularly when sizable capital can be attained in one close, is attractive. From the manager perspective, strategic accounts can provide:
– Longer term, sizable capital;
– Deeper relationship across asset classes;
– Opportunity to capitalize on existing deal flow;
– Niche strategies (deploy capital in volatile market; seed new mandates);
– Cross-selling capability;
– Co-investment opportunities; and
– Ability to create more value, and therefore more carry.
Strategic accounts, to date, are primarily limited to the large end of the market, for both institutional investors and managers. Typically, managers with multiple asset coverage, in particular credit, have secured strategic accounts; less tested is the buyout space, where the heart of managers’ established brands resides.
The Three A’s
As investment advisors, what do we worry about? Attention; alignment; allocation. This will make or break the relationships being created.
Interestingly enough, and likely for at least one of the “A” reasons, one-third of institutional investors at Hamilton Lane’s 2012 Client Summit found themselves less likely to invest with a manager offering strategic accounts. The Summer 2012 Coller Capital survey also found that nearly half of investors believed the increasing number of special accounts is “a negative development for private equity.”
This is troublesome for the industry. Part of the concern is likely a distrust of the unknown, which highlights the importance of transparency, a word not often attached to private equity. It behooves managers to be open with their investors about these accounts.
It also highlights the importance of institutional investor oversight – be active and ask questions. Understand the effect of the strategic accounts on the three A’s. The market must govern these strategic accounts to maintain the confidence in managers –the confidence that managers are working hard for every dollar managed, regardless of structure or source.
What about Me?
Investors are taking note of strategic accounts and asking what it takes to make the cut. Surprisingly, less than you may think.
First, understand what is valuable to you as an investor. Is it enhanced knowledge, lower fees, investment exposure, governance? We hear many different answers to this question.
Second, determine the sub-sector where you find this valuable. (Maybe it’s across sectors, which is what Texas Teachers accomplished in working with KKR and Apollo).
Third, consider your size. On second thought, start here. Usually $500 million is needed to get the attention of global managers to consider a strategic account. If you’re persistent, it may be done for as little at $200 million, but there’s not many of those slots.
This may come as a surprise to many US investors, but it’s not all about lower fees. Yes, fees matter. Private equity is an expensive asset class and all investors want (and need) a reasonable market rate fee. However, governance and knowledge have a price, and we’re seeing that creep into the private equity discussion.
Where do we go from here?
These are early days for strategic accounts in private equity. How these relationships work in practice and evolve over time is, at best, uncertain. Indicative of the market uncertainty is the opinion from Hamilton Lane’s September 2012 Annual Client Summit. One-third of managers attending said they held strategic accounts. And yet, more than 50 percent said they don’t intend to offer strategic accounts. We don’t expect strategic accounts to become the market standard, but they may set new standards for the market.
Tara Blackburn is a managing director with Hamilton Lane.