Putting The ‘P’ Back In ‘LP’
GPs often look at the universe of over 2000 LPs and see one vast homogenous market, but nothing could be further from the truth. Private equity may be one industry, but it is comprised of dozens of markets each with their own particular set of nuances. In 2015, private equity represented an approximately $400 billion market, but 80% of this market was represented by the mega firms, which we define as groups managing assets north of $10 billion. Sub-$1 billion funds, Sixpoint’s core area of focus, comprise roughly 10% or $40 billion of the market. Nobody would argue that this market is small, but it’s not infinite and knowing your addressable universe is crucial to how you identify true partners for your business. As LPs have become savvier in their due diligence and more demanding in their negotiations, it has become increasingly important for GPs to understand how to attract capital without undermining their ability to effectively run their businesses. Investors have guided GPs toward the ILPA Principles to determine the best terms for their funds, but each firm has a unique set of business interests that needs to be balanced against the market’s current mood on structure and terms. If you wait to communicate your rationale until the moment the negotiation begins it is likely too late to make your case. LP’s own positions will likely have hardened by then. If however, you lay the foundation for the business rationale underlying such critical fund terms early in the relationship building process you can increase the likelihood that LPs will buy-in to your point of view. The goal is to truly create alignment not just on the GP side but from the LP side as well. At the same time, highlighting potential roadblocks early can also help you weed out LPs that may not align with your long-term plans or allow the LP to self-select themselves out of the process earlier because of a key issue. Fund size, personnel, total assets, fund number and the particular financial needs to employ the investment strategy often don’t receive the proper weighting from LPs focused solely on negotiating strong terms. Likewise, GPs often focus solely on the portfolio and firm updates during fundraising rather than explaining terms and the rationale behind them.
In that light, it is increasingly important for GPs to look for LPs that have the best interests of their firm in mind. That sounds simple, but many LPs seek the lowest fee structure possible, co-investment rights or near-term secondary opportunities as a means to generate returns more quickly. In fact, some LPs have specific incentives tied to more short-term goals or benchmarks that can place their interests in almost direct conflict with the fund managers with whom they are invested. LPs with a longer-term orientation view the market and their partnership with the GP differently. They seek multi-fund relationships that align their interests with those of the fund’s senior management in the spirit of true partnership. For example, there’s been a well-documented push by many LPs away from American style carry toward European or modified European structures, but there are many reasons why American style carry may be necessarily advantageous to a firm. One advantage of American style carry is that it can be a very effective tool for fund managers who are concerned with the recruitment and retention of highly-talented mid-level candidates. A carry structure that allows these core investment professionals to participate in the upside of their transactions earlier can be a very attractive option for the GP. American style carry isn’t appropriate for every situation, but LPs that are looking to support younger firms understand and appreciate how this reduces turnover and potentially improves the talent pool from which the GP can recruit.
Sixpoint recommends that GPs pay very close attention to the behavior of LPs throughout the process of building a relationship. GPs are often so busy being evaluated and analyzed by investors that they forget that they should also be asking questions and making informed decisions about the sources of their funding. Among the questions that GPs should answer for themselves are:
- How supportive is the LP to the firm’s platform? Does it frequently look to re-up into subsequent vehicles, act as quality references and try to add value outside of their individual capital commitment?
- How does the LP negotiate fees/terms? Are its requests focused on issues that are sensitive for its program or is it just interested in getting more for the sake of more?
- Are the LP’s terms in conflict with the firm’s ability to execute its strategy?
- How does it behave during a down market or periods of adversity?
- Does it unnecessarily take up time and resources from the GP?
In our view, the highest quality investors enter long-term partnerships with their GPs seeking to support and enhance their underlying firms. As is common with many partnerships, there are frequently areas of disagreement or friction during the initial negotiations. However, when both parties approach the partnership with a positive and supportive attitude they can build something that supports their collective long-term interests.
Next on 60 Seconds with Sixpoint: How to Secure an LP Commitment from the Endowment & Foundation Community
Sixpoint Partners, LLC, is a registered broker/dealer, member FINRA (http://www.finra.org) and SIPC (http://www.sipc.org).