Is More LP Diversity Always Better?
Wake up any business school student in the middle of the night and they will tell you – diversification is a hedge against risk, whether that be in your investment portfolio, your supplier base, your end markets, or anywhere else. This heuristic has long been used in the fundraising market and the reason seems deceptively obvious – GPs assume that diversifying their LP base as much as possible will help minimize re-up risk when it comes time to raise their next fund or in the event of a financial downturn. While this may be true as a broad statement, it is important for GPs to recognize the nuances of LP diversification as it relates to re-up risk and orient their fundraising efforts accordingly.
Throughout the last decade since the Great Recession, GPs have been acutely focused on hedging against re-up risk in the event of deteriorating market conditions. Looking back at the aftermath of the Financial Crisis, however, we can draw two important lessons that challenge this school of thought. Firstly, in a distressed environment, no type of LP is immune from the bearish sentiment. That is to say, if your goal is to simply have as broad of an LP base as possible, that may not help protect you from losing re-up support in difficult market conditions. The second lesson is that pensions, endowments and others, often seen as “better” long term partners, were ironically some of the hardest hit LPs after the Great Recession.
Remember that the “Partner” portion of “Limited Partner” is what will ultimately help provide long term support as your grow your franchise. With that in mind, go beyond simply seeking a diversified LP base and think about the specific profile of LP you are looking for. Consider your plans – are you looking to raise adjacent strategies? Will you continue to offer co-invest or seek LPs who won’t demand it in future funds? How do you foresee your investment pacing or criteria changing over time and will your LPs be supportive? Find LPs that match these criteria. The other side of this coin is to take a cold, rational look at your LPs’ behavior in past down cycles as an indication of their orientation in various market conditions. What has their re-up support been like for other funds that they have invested in? Will they look to grow your fund too fast, or alternatively try to restrict your fund size in the future? Do they suffer from endemic turnover – will you be dealing with the same team at their institution over the next decade or will they constantly have to re-underwrite your firm?
Ultimately, diversification itself will not protect your firm in the event of a downturn. Rather, strategic alignment with your LPs will help minimize re-up risk. When markets turn for the worse and LPs have limited bullets to fire, they are more likely to re-up with GPs that they have a strategic alignment with. While I am certainly not suggesting that LP diversification is not important, remember to dig deeper and identify LPs that will continue to be aligned with your firm in the long run. Your relationship with an LP is a marathon, not a sprint, and scrutinizing LPs in a rigorous manner prior to accepting commitments from them will help de-risk your firm long term.
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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).