60 Seconds with Sixpoint: Should You Be Focused on LP Diversification?

The recent pandemic has rekindled the debate around whether it’s worth building a truly balanced and diversified LP base — by type, mandate preference and geography. We have now been through two downturns in the past ten years, enabling us to measure the benefits and drawbacks of LP diversification more closely. Like most things in the private equity market, there isn’t a ‘perfect formula’ that works for every manager. To answer what makes the most sense for your fund you must first determine your firm’s long term growth plans and fundraising objectives. We’ve observed at least four distinct approaches that you may want to consider depending on your particular fact pattern as follows:

  1.  The Mono-line Fund Approach:

If your firm focuses on a single investment strategy with no plans to grow into adjacent markets or geographies, you may want to key in on LPs that can materially upsize and scale their commitment over time. As a mono-line investor with hyper focus, the messaging to your LPs should be more straightforward and in many ways you are selling focus and moderation. You’ll want to look for LPs that are highly attracted to the focused strategy with dedicated team; without the complexities of multiple investment committees and complex key man clauses.

In many ways, funds with a more focused business strategy tend to have the most stable LP base even if it comes at the cost of asset growth. One concern may be how quickly you scale your single strategy in order to ensure that the LPs anchoring your early funds can grow larger in size. You want to be careful not to outgrow your original backers. For example, some LPs may take issue with fundraising targets over $1 billion, a goal for a younger $500mm million GP down the road. By ensuring that your existings have the ability and desire to grow with you, you can avoid the need to constantly reimagine your LP base, making it easier to focus on re-ups and overall performance.

  1.  The Adjacent Strategy Approach:

If your firm manages existing adjacent strategies or is planning to launch one in the near future, it is critical to ask yourself the following question(s): Is this just one adjacency or multiple? Will this be a small market fund that is very similar to your existing strategy or something totally new? If your goal is to launch a strategy that is outside your typical wheelhouse, you will want to have a more diversified LP base supportive of your broader mandate and focus. This means you may want to court LPs that have a smaller, more unified investment team that encompasses the same individuals, making decisions over buyout and non-buyout strategies alike. Also look for LPs in your core fund that aren’t afraid of first time funds since adjacent strategies will by their very definition fall into this category. It’s critical to have re-up support into any adjacency so you want to build your core LP base not only for its own growth and stability but that of the entire platform.

It’s important to remember that some LPs feel that adjacent strategies can be a distraction; especially if they are ill-timed. Expanding into an adjacent strategy can potentially jeopardize a key re-up for your flagship fund, creating a hole in your investor pool and concerns for future investors diligencing your firm.

  1. The Catch-All Strategy:

Sometimes GPs seek to curate their LP base so carefully that they forget the other side of the fundraising coin: the importance of maintaining a broadly diversified investor base by LP type and geography. Broad diversification will help you avoid overexposure to one LP class which could become dangerous in times of distress like we all just experienced. Here, endowments and foundations suffered the double whammy of both degradation in their portfolio and reduced tuition. While every LP hit the pause button, E&F’s in particular took a bigger hit. By ensuring no one LP type represents more than a fixed percentage of your LP base you may be able to reduce the exposure to re-up risk under certain circumstances.

It is also important to consider diversification by geography. As we’ve seen in the past two recessions, Europe, North America, and Asia recovered at different speeds and their domestic LPs reacted accordingly. GPs who fared best this time around included those with sufficient exposure to each market but without overexposure. At Sixpoint, we have modeled out a variety of scenarios for clients in the past and would be happy to provide recommendations and observations on your LP base as well.

  1.   The ‘Not All LPs are Created Equal’ Approach:

This final school of thought to building the optimal LP base is to consider the points above while layering in a second level of analysis around each prospective LP. The thinking here is to dig much deeper into the essence of each LP’s behavior and mindset individually. Triaging each investor beyond whatever perceptions you may have had prior to engaging with them may surprise you. For example, many sponsors are concerned with having too much exposure to Fund of Funds. However, it’s possible that after a deeper look, you may determine to increase your concentration to this LP class well above the “accepted norm.” GPs may find that certain Fund of Funds players actually act more like consultants; like RCP or Pathway. Now more than ever, many Fund of Funds invest with a core dollar commitment of a certain number and then bring in discretionary and nondiscretionary accounts that follow them or that they advise. By engaging in this second level of analysis, many GPs will come to understand that an over-concentration to these select Fund of Funds may be less of a risk than it otherwise appears on a headline basis.

The deeper analysis and insight required is available to you through a variety of channels. As always, we would be please to discuss the same with you as well. If you’d like to learn more about where you fall on the LP diversity spectrum, reach out to us at info@sixpointpartners.com.