A Private Equity Utopia
Bridging the gap between LPs and GPs is often a significant challenge given how fundamentally different each group views the private equity market. These conflicting viewpoints can lead to strained discussions, heated negotiations and unnecessary confusion. In a private equity utopia this wasted energy would be eliminated for both parties and a more streamlined and efficient system of information exchange and investment would take its place. I won’t be able to tackle all of the myriad issues underpinning the strain in the LP-GP relationship, but let’s discuss the two most critical ones: economics and transparency.
LPs like to dress up the discussion with words like “alignment”, but at the end of the day the issue that they care most about is fees. To this point, one of the most talked about stories of 2016 was CalPERS revealing that they had paid over $3.4 billion of performance fees to the funds managing their assets. While many were aghast at that startling number, it only told half the story – and not the interesting half at that. Looking at just how much a program pays in fees does nothing to enhance our understanding of the value that is being created relative to those fees. Management fees or transaction fees in and of themselves aren’t important because their significance can only be properly evaluated in light of the performance generated. Increasingly, we have seen firms offer more creative fee structures, but it’s typically the best performing or best known groups who can command the greatest incentives for their performance while the rest of the GP universe feels LPs apply pressure. In fact, LPs should strive for their fund managers to be overcompensated because those huge payouts typically happen when LPs themselves are reaping handsome returns on their investment. We often hear GPs argue that the constraints of a European-style waterfall and pressures placed on their management fees are inconsistent and even detrimental to their successful management of their teams/firms. Private equity requires highly capable and sophisticated investment professionals and the firms that try to recruit and retain the finest PE talent need to offer a compensation structure that attracts the best minds. One could even argue that the superlative returns witnessed over the past few years in private equity are a direct result of the attractive compensation available to those that succeed in this business.
On the opposite side of this debate, GPs complain about how opaque the LP investment process is from their perspective. GPs by their nature are transaction-oriented and are accustomed to having a clear line of sight on all critical pieces of information. LPs and the fundraising process can force them way out of their comfort zone because of the number of unknowns and variables. Who are the key decision-makers? How does their IC work? On what metrics do they base their decision to invest? Navigating each LP’s distinct investment process can be a mind-bending exercise for even the most experienced fundraisers, but if GPs want American-style carry then they need to take the time to explain their ability to create value to LPs in detail. GPs are too frequently frustrated that the value they see in their portfolios isn’t readily apparent to prospective LPs. The truth is that in spite of all the analysis and meetings, LPs are making a judgment call based on a sense of trust and building trust can’t be rushed. Too often exasperated GPs become impatient with LPs’ diligence process and the conversations stall or hit a wall. This makes the fundraising process an even more cumbersome and expensive process than it needs to be. GPs that show LPs the appropriate amount of patience and work with them through their diligence process and even build relationships with them outside the office find far greater success than those who try to steamroll LPs. Put simply, if GPs want the LPs to act like partners then they need to approach and interact with prospective investors as partners.
As we know, private equity is a “show me” business not a “tell me” business and the onus is on the GP to take the first step in building these relationships. If you do that, whether on your own or with the help of an advisor, you will reap the benefit. I promise.
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Sixpoint Partners, LLC, is a registered broker/dealer, member FINRA (http://www.finra.org) and SIPC (http://www.sipc.org). Sixpoint Partners Asia Limited is licensed by the Securities and Futures Commission (http://www.sfc.hk).
