When Cambridge Associates is doing due diligence on private fund managers, like any savvy investor, it pays special attention to how the ownership and economics are shared.

Cambridge’s head of private markets Andrea Auerbach says that when her firm senses – through data, inference and constant meetings – that there might be a succession challenge, they take notice.

“We pay attention to, ‘Wow, that individual is a very strong performer in a firm where it looks like succession may be difficult’ or, ‘They seem to not be as compensated through carry or acknowledgment or promotion as other groups that we’re paying attention to – I bet there’s going to be a spin-out here. In fact, I can predict it.’”

That’s a bold claim, but Auerbach is one investor who can make it with a straight face. Her 50-strong team at Cambridge puts $10 billion of capital to work in private markets every year. Almost half the funds it underwrites every year are spin-outs.

Given the amount of private equity capital Cambridge accounts for, Auerbach’s voice is one worth listening to. That voice recently expressed concerns about the use of subscription credit lines, which in our conversation she dubs “5-Hour Energy for IRR” after the caffeinated drink popular among truckers and traders.

“The siren song of easily increasing IRRs by using a currently inexpensive financial solution is just too great for a competitive GP to ignore,” she wrote in a note to clients. By drawing on a credit line to both make investments and prematurely pay out distributions, a fund manager can lift returns by 300 basis points or more, she added, noting that GPs are pursuing such lines “in droves, like a Black Friday shopping mob”.

“It’s never going to get easier to make a good return in private equity, it’s only ever going to get harder,” Auerbach tells Private Equity International. “Managers are very cognisant of putting up headline numbers that are better than the field, and subscription line financing can enable that efficiently.”

Auerbach’s advice to LPs? “Never just look at one number!”

VIDEO: Cambridge’s Auerbach says GPs are returning to market too early

“We look at 20,” she says. “Don’t get distracted by this headline fund IRR number, always look at more indicators of performance. I’m not hiring a manager because they’re really good at manufacturing an IRR through the use of a subscription line. I’m hiring a manager because I believe they’re really good at the fundamental process of private equity investing.”

Auerbach concedes there are some institutional investors who are primarily compensated on that headline fund IRR, and therefore at risk of preferring managers that aggressively use subscription credit facilities. “The reality is, at the end of the day, if the manager doesn’t have that fundamental ability to generate a compelling return, I do believe eventually the truth will out. If you’ve built a portfolio of managers that have really just maxed out their use of commitment facilities, what do you really have at the end of the day? Who are you going to re-up with?”

Accessing the smart money

So, what do you need to do if you’d like to get a slice of that annual $10 billion committed to your fund? Here are Auerbach’s top tips for fund managers:

1 Clearly identify your “sustainable competitive advantage” to prove you’re a firm of the future. One of Auerbach’s favourite questions to ask a GP during due diligence is, what is the last material change you’ve made to your investment process? “I’ve been in meetings with managers who are quite storied and have been in the market a long time, and some of these GPs kick back and laugh and say ‘oh, well we’ve never made a change to our investment process’. And I think to myself, ‘after 20 years, you might want to’.”

2 Prepare for the long game. “We’re not a fan of the shotgun wedding. If a manager were to come to see us and assume after one meeting we’ll be completely supportive, if we haven’t been meeting with them previously or in prior incarnations – highly unlikely.”

3 Make sure you have a coherent story. Auerbach’s team will be checking whether your proposed strategy meets your team’s skillset, whether you actually execute the strategy you said you were going to follow and whether that results in good performance. During due diligence, Auerbach and her team draw on all resources available within the Cambridge network and database, and are not afraid to challenge managers with probing questions, the placement agent says. “Andrea is particularly smart. Some GPs like how she challenges them – others don’t. She is very respectful, but doesn’t pull any punches.”

Hidden fee breaks

Despite clearly being a fan of private markets and a big believer in their ability to outperform other forms of investment, Auerbach is under no illusions that returns are as good as they once were. Despite the median return for private equity falling from the mid-20s when Auerbach started in the industry to 12 percent today, the headline fee rate remains two-and-20.

“Is that really going to stand? And what happens if returns glide lower?” she asks, predicting continued pressure on fees. “We’re heavily negotiating fees and terms on behalf of our clients.”

The default position will remain two-and-20 for the foreseeable future, Auerbach predicts, because “to proactively go to lower fees is difficult due to the perception that lower fees must mean you’re lower quality”. But those headline fees are being eroded from several sides.

Along with the typical fee reductions for committing before the first close and discounts for commitments over a certain size, Auerbach notes co-investment has become a “hidden fee break”.

“Co-investment, which for the most part is fee-free and carry-free, is roughly a third of market activity,” she says. “Ninety-nine percent of managers we meet with offer co-investment.”

A commitment from Cambridge Associates is a good signal to other potential investors, according to market sources.

“It’s seen as smart money,” says one New York-based placement agent. “If you can get Cambridge Associates into your fund, you want to take it, because it’s sticky. But they’re a hard LP to penetrate.”

Auerbach is also seeing greater innovation on fees within the emergent strategies her team is keeping an eye on. Some groups within the fundless sponsor and operating company arena are opting for laddered compensation – say, 10 percent carry on a 10 percent return, 20 percent carry on a 20 percent return, and so on.

Another way to compress fees is to approach these portfolio company assets from a completely different angle – through private credit.

“The private credit space has bloomed over the last several years into a very substantive market of its own,” Auerbach says. “In fact, because there’s always more debt available than equity in a deal, the private credit space is eventually – if it isn’t already – going to loom over the private equity space.”

While the median return in private equity is 12 percent net, the median net return in private credit is around 9 percent, and comes with fees on drawn capital of around 1 percent with a 15 percent carried interest.

Auerbach notes that this creates a dilemma for private investors: do you back a private credit fund and be more senior in the capital structure, basically earn a 10 percent net IRR and only pay one-and-15? Or do you do a private equity fund where the manager’s last vehicle delivered 10 percent, but they’ve since tightened up and distributed more carry, and you pay two-and-20?

Mastering the data

As institutions become more familiar with private equity – and more confident accessing it themselves – how does a firm like Cambridge stay relevant? A big part of the answer, according to Auerbach, lies in its mastery of data.

Cambridge tracks data on 20,000 private investment funds across the globe, containing 60,000-70,000 individual underlying investments. It has been collecting operating metric data on 5,000 companies in the US for the last decade.

“The private investment space is only getting more complicated, with more opportunities, and you need to be able to go deep in a lot of emerging areas to be able to make that informed investment decision, incorporating a growing amount of data that’s coming at you,” she explains.

While LPs have an increasing desire for access to information, their capacity for processing it is not increasing at the same rate. Both the level of detail and the type of data collected is growing, as metrics related to issues such as ESG or impact investment become increasingly valuable to LPs.

“There’s always new levels of transparency and information entering into the dialogue,” Auerbach says. “Knowing what to do with all of it, having a repository for it, knowing how to analyse it and then leverage that data, that’s the constant challenge any investor in private investments is facing.”