Sorting the wheat from the chaff
How will LPs decide who to back through more challenging times?
After a period when virtually every private equity fund posted strong returns, how are LPs determining who they should back to take them through more challenging times?
It may seem like a good problem to have, but the great performance among pretty much every GP over the past few years is causing LPs some headaches. “It’s tricky for investment committees to understand that 40% to 50% IRRs are not normal,” says an executive at a large North American pension plan. “You can’t rank these against historical numbers of around 20%.” And, as a portfolio manager from a large US asset manager says: “We were discussing a fund in one of our investment committee meetings recently that had a 35% net IRR – they were second quartile.”
John Stake, Co-Head of Fund Investments at Hamilton Lane, also identifies with this. “What we’ve seen in recent times runs against historical trends,” he says. “For the period between 2000 and 2015, top quartile funds registered returns of around 20%. Yet since then, that figure may not get you into the top half – you’re looking at IRRs of north of 30%. GPs need to refresh what it means to be top quartile – it will come down at some point and revert to the mean, but this is where we are right now.”
While this has been a great run for private equity, the fact that all managers have been able to generate good returns is leaving LPs with the issue of trying to work out which GPs were just riding the market, and which have the right skills and strategy to continue outperforming in a very different, much more difficult period. “Which are the best funds when everyone has posted great returns?” asks the pension plan executive. “How do you cut through the numbers and dig more deeply?”
Beyond the numbers
One indication of the direction of travel for many LPs seems to be contained in some of the responses to Probitas Partners’ private equity Investor Outlook survey for 2023. When asked about the fund structure issues they would focus on most when investing, the survey’s LP respondents placed GP commitment in top spot, with 75% citing this. Yet the next two issues are potentially more telling, given the market we emerged from in 2022 – second was a dramatic increase in fund size from predecessor vehicle (63%) and third was significant strategy drift from previous fund (60%).
This may be something of a shift from what we’ve seen in the more buoyant period running up to 2022. “Until recently, investor due diligence felt like a conveyor belt,” says Adam Turtle, Partner at Rede Partners. “Many LPs were going through the motions and decisions were being made almost upfront.It was very difficult to discern who was actually good because everyone looked good.”
Stake agrees. “With hindsight, there has been a potential blind spot for LPs,” he adds. “Many will find they were too focused on good relationships and re-upping and not enough on looking under the hood to see where alignment might be in the future and who was raising too much capital. A lot of LPs are pretty good at cutting relationships after a fund or two of underperformance, but that means they were in these funds. LPs need to figure out how they can decide not to re-up before a manager starts underperforming.”
For Lindsay Sharma, Managing Director of Industry Ventures, managing the issue of fund scale creep comes down to being disciplined as an LP – her firm has cut-off points for fund sizes, for example. “In early stage, some managers have been wildly successful,” she says. “That has allowed them to raise ever-larger funds. But we stop investing in early-stage funds that are above $250m. We have the same evaluation for small technology buy-outs, where we have a sweet spot of between $200m and $1bn. That means we have some managers in our portfolio that will likely outgrow our platform, although we do guide GPs as to whether we feel what they are proposing has the potential to result in strategy creep.”
Size is also important for the Teacher Retirement System of Texas. “We are transitioning to move a little further down the market than we’ve focused on historically,” says the plan’s Managing Director, Neil Randall. “As funds have grown, they have had a greater reliance on IPOs as an exit route – we’ve seen this in our own portfolio. Part of our decision to commit to more smaller funds is to build in more exit paths.”
LPs need to figure out how they can decide not to re-up before a manager starts underperforming.
Will the past catch up with GPs?
Past behaviour will also be a big determinant of whether LPs are prepared to back GPs in the coming period, with many pointing to rapid deployment pace over the past two years as a potential sticking point. LPs will also be digging into managers’ capacity to deal with problems in in the portfolio. “The operating environment will be much more challenging,” says James Roebuck, Managing Partner, Opera Investment Partners. “So we are looking at how managers have previously dealt with issues that have emerged in their portfolios. We only have to look back a couple of years to the Covid period – how proactive or reactive were they? But we’ll also be looking at what managers have bought during 2021 when the best assets were often priced to perfection and whether they overpaid. Assessing pricing discipline and the capacity to manage operational complexity are essential in the current environment and when separating luck from skill.”
And, of course, terms will be under the spotlight, in particular where GPs have sought more generous economics for themselves when capital was flowing freely. “We did see super-carry of 25% to 30% being charged by top-tier funds,” says Nadine Fugert, Principal, Investor Relations at Adams Street Partners. “We anticipate that will come down, although we are not seeing the more standard two and 20 pricing moving where managers have performed well.”
Term time
Focusing on high quality managers that are best placed to manage capital in a tough environment and are focused on longer term themes, such as digital infrastructure, healthcare and renewable energy
LPs will also be seeking better terms than they have been able to secure in recent years – and while these may not be the sole determinant of which funds they back, they may provide an edge when comparing two similarly attractive opportunities. “First close discounts have moved down the fund size brackets,” says Fugert. “And we’re seeing more offers of management fees on invested rather than committed capital. That is a meaningful discount.”
“As LPs, this is an important time to be evaluating our LPAs,” adds Randall. “We don’t always have the pendulum swing in our direction. The market will bear what it will bear, but LPs should be looking at this.”
And then, of course, LPs will be looking at the strategies that should stand the test of time in good times and bad. “We are looking at recession-proof investment opportunities,” says Imogen Richards, Partner at Pantheon Ventures. “That means focusing on high quality managers that are best placed to manage capital in a tough environment and are focused on longer term themes, such as digital infrastructure, healthcare and renewable energy.”
The coming period will almost certainly see some casualties, as GP performance diverges. We’ll also see a return to more detailed due diligence among LPs as a means of separating the wheat from the chaff. “If there is a market correction or a pullback in performance, the places we’d expect GPs to face challenges in fundraising are those that lacked vintage year diversification, groups that evolved strategy or regions and those that ratcheted up terms but not performance” says Stake. “These will face a lot more scrutiny than others.”
