In the same boat?
What’s the situation in today’s more challenging fundraising environment? Where are LPs pushing hardest? And how are GPs responding?
Much like in previous periods of exuberance, there is a general sense among investors that the alignment of interest between LPs and GPs in private markets funds deteriorated in 2021 and 2022 as capital proved easy to come by for most firms. “We expect carried interest to be the main financial driver for performance and behaviour and for a GP commitment to be sized such that it is painful if things don’t work out – these are fundamental to alignment,” says Joe Topley, CEO of GBL Capital. “One or both of these mechanisms have weakened as fund sizes have increased.”
The past year has seen something of a reset as LPs have slowed their investment pace to manage liquidity and keep within their target allocation ranges. But to what extent has this led to a shift back to the fundamental principles of LP-GP alignment? And how have some industry innovations affected this?
Although fundamental to the private equity model, the level of LP-GP alignment in funds often reduces in buoyant markets. So what’s the situation in today’s more challenging fundraising environment? Where are LPs pushing hardest? And how are GPs responding?
Smaller GPs were less prone to shifting terms, even in the buoyant fundraising period
“We saw fund sizes increase across the board, but that has affected players and relationships in different ways,” says Piet-Hein den Blanken, Managing Director of Primary Fund Investments at AlpInvest. “At the top end of the market, fund sizes are more correlated with the supply and demand dynamics and therefore move up and down more quickly. In the smaller end of the market, we see more managers that don’t try to go for the last incremental, marginal term in their favour but think more about the long-term relationship with their LPs. They don’t want to waste their brand equity with LPs negotiating every last term with them – these were the funds that were good to back in the market we just came out of.”
Some LPs used incentives to keep fund sizes in check
“We focus on the smaller end of the market, and in the US specifically we are continually having to renew our portfolio because fund sizes grow quite quickly,” says María Sanz García, Partner at YIELCO Investments. “In Europe, the sizes are more stable, but we have also worked with some on super-carry where managers continue to work with smaller fund sizes so they can achieve incremental carry when investments really work out.”
Fee reductions have emerged - in some funds
“In the first half of 2023, three funds raised 58% of total capital in Europe,” says Geoffrey Geiger, Head of Private Equity Funds and Co-investment at USS Investment Management. “There has been a flight to quality as capital has become scarce and, as far as I’m aware, there were few changes made to these funds’ terms. But I have seen some funds come to market with fee concessions in this environment and that is welcome. The balance between fees and carried interest had gone out of whack as funds had scaled enormously, but fees had stayed the same.”
LPs are seeking fee discounts for first close commitments...
“There should be a discount if you come in at first close today,” says Sanz García. “If I know that it will take at least a year to raise a fund, what’s my motivation to invest today when I could wait for final close and see what’s in the portfolio?”
“We like to be in the first close because we can shape terms,” says Geiger. “But in today’s environment, where we expect multiple closes, there is a cost to committing early. GPs should be reflecting that optionality in their terms.”
…and they want to see concessions at the start
“If a GP feels it is not getting the momentum it needs on a fund, making a couple of changes and improving alignment with LPs early on can make a big difference in a market like this,” says den Blanken. “Yet some GPs don’t recognise that LPs have limited bandwidth to evaluate a fund for a second or third time and think that if they offer a fee break at the end of the process, they can get people over the line. LPs don’t have the resources to keep revisiting a fund and its terms, so will just move on.”
LPs are watching continuation vehicles carefully
“There needs to be transparency,” says Sanz García. “I don’t like to see a GP bring a continuation fund transaction to market because it is a failed auction. That means it is the wrong time to sell to anyone.”
“Continuation vehicles are fraught with conflicts,” adds Geiger. “They have been accepted, but they have to be done properly. And we have seen more fail recently – that’s because LPs have become more confident in speaking up.”
NAV loans are viewed with hesitation...
“We see this more at the larger end, but some funds are doing NAV loans for distributions to help LPs commit to their next fund,” says Lee Lowicki, Director at ACE & Company. “Is it really good for their LPs to be borrowing at 12% to 15% on their portfolio so they can get a distribution and commit to a new fund managed by the same GP?”
There are other alignment issues that LPs should be concerned about, according to Viktor Vatinas, Senior Portfolio Manager at Baloise Asset Management. “Investors should be cautious of credit products such as NAV loans used solely for improving distributions,” he says. “This boosts the IRR as they are shifting the positive cash flows forward. While it does not increase the total value created, this might get a GP past the hurdle and into carry.”
…as are GP stakes sales
“The boom in GP stakes sales, where GPs sell their management fee flow, are effectively taxing LPs for the future, because we’ll have to pay that off,” says Geiger. “They show that there has been too much management fee floating around, but it also fundamentally weakens alignment. LPs want a GP commitment to be painful if things don’t work out, but if you’re funding it by selling future earnings you don’t yet have, you have to question how painful that feels.”
LPs are seeking alignment with peers
“Family offices tend to be smaller investors,” says Cristina Alcaide, Managing Director and Head of Private Equity at Cara Advisory. “So we speak to other LPs before committing to a fund to see if their thinking aligns with ours. After all, large LPs will be on the advisory board and after nine or 10 years will be making decisions on your behalf, so you want to see how aligned they are with you.”
And finally, LPACs have teeth once more
“LPACs have never been as active as they are now,” says Sanz García. “There are a lot of important topics under discussion and action needed. GPs are definitely listening more to LPACs and sometimes the discussions are uncomfortable, but we shaping what happens next.”
“Many LPs came into private markets in more positive times and some LPs may have been worried about speaking up for fear of missing out on an allocation to a GPs next fund,” says Geiger. “That has changed and LPACs are back to what they used to be. They are being used a lot. They are a key part of fund governance and the need to be exercised. GPs need to get that group working together because they will need them.”
