How LPs are Influencing the Evolution of GPs

In the decade since the 2008 financial crisis, investors in private equity funds (Limited Partners or “LPs”) have gained substantial influence and leverage over the funds in which they invest. This has resulted in significant changes in the traditional balance of power between LPs and the General Partners (“GPs”) who manage and operate private equity funds and their investments.

On the plus side for GPs, LPs – particularly institutional investors – have broadened their investment criteria and loosened traditional portfolio restrictions in favor of increased alternative investments. Long-term investments in private equity and real estate are viewed more favorably than in the past, and there is a widespread belief that returns garnered through alternative investments can outperform a diversified public securities portfolio.

At the same time, institutional investors -- who often operate as boutique asset management firms themselves -- have professionalized their investment procedures. They’ve built robust back offices with policies, and technology mimicking that of many large asset management shops. Many firms have hired experienced front office professionals whose research capabilities and overall investment prowess match the teams of some of their best investments. Several investment managers, in recent years have shifted to a near-family office model, making direct investments on behalf of the fund itself. This is typical of the overall trend.

The Catalyst

Why the shift? The 2008 investment crisis was particularly scarring for institutional investors who watched entire livelihoods and retirement nest eggs under their purview go up in flames as the mortgage crisis threw the entire economy into the most severe U.S. downturn since the Great Depression.

Not wanting a repeat of 2008, LPs sought greater transparency and involvement in their investments, demanding transparency, governance oversight of investment managers via clawback provisions and “insurance” in the event their investment went sideways via side letter provisions.

For years, GPs had provided basic reporting on a quarterly or semi-annual basis. Now, they faced demands for institutionalized operations and regular transparency for their investors. And it wasn’t just LPs – at the same time, various domestic and international governing bodies were stepping up their regulatory scrutiny of private equity funds via regimes that include FATCA, GDPR and MifID II, to name a few.

Even outside of the usual market challenges, it certainly hasn’t been easy for GPs post 2008. Investors and regulators both have demanded a great deal and with good reason. However, GPs have also benefitted. Given the chance to see behind the curtain of private equity operations and investments, LPs have gotten comfortable writing substantially larger checks -- albeit with conditions. GPs have adapted to this shift in three ways.

Providing Greater Transparency

LPs’ post 2008 demands for greater transparency haven’t just been limited to quarterly reporting; they’ve also sought more visibility into investments being made by GPs, liquidity provisions and operational nuances such as selection and sometimes vetting of third party vendors. GPs have learned that the “good old days” of reporting – a simple, twice-yearly statement that included the starting capital balance, called capital for the period, P&L, expenses, investment balance and outstanding capital – no longer cuts it. LPs want a detailed understanding of their investments and potential risks.

One area where GPs have come under scrutiny of late has been the use of subscription lines of credit. Concerned with the potential liquidy risk associated with using credit facilities and their impact on IRR, more LPs are seeking assurances that the subscription lines are being utilized for the right reasons (i.e., in a pinch to make an investment and for operational smoothening). Although GPs often have good reasons for utilizing these lines - having the ability to call capital after the investment has been made provides flexibility and can shorten the J-curve while enhancing IRR - LPs want assurance that their investment returns aren’t skewed in a way that opens the door to potential liquidity risk.

The International Limited Partner Association (“ILPA”) has weighed in on the use of subscription lines and has encouraged LPs to ask GPs a series of questions pertaining to the use of these credit facilities prior to investing.

Standardize Reporting (ILPA)

For over a decade, ILPA has worked with both LPs and GPs to standardize private equity reporting and provide more transparency and clarity into investments. As LPs have demanded that they meet the ILPA reporting standards, many of the larger private equity firms have found that adhering to the standards provides a useful reference point and common language when speaking with LPs. Service providers and software providers, including TresVista, have endorsed and adopted the ILPA reporting templates and provide support to private equity firms in this aspect.

ILPA has also been involved with reshaping the subscription agreement template and other standard forms now utilized by many GPs. The organization has also served as an advocate for LPs, lobbying on their behalf on issues that range from subscription lines to clawback provisions and deferred capital.

With impending regulatory changes, ILPA is expected to update its reporting standards to capture the information expected to be required by regulators.

Co-Investments

The key push from LPs has been in the area of governance. They seek greater control of their investments and want a firm grasp on operations and a general familiarity with who the service providers are. This has also given way to an increase in the number of co-investments in which LPs invest directly alongside GPs. This provides increased visibility into a private equity fund’s activities as well as increased control and better economics for the LP.

We expect this trend to continue as LPs look to take on more complex investments with trusted GPs. Given that sophisticated institutional investors already have built out their internal operations, direct investing seems a natural next step. (Five Ways the Family Office Playbook is Evolving)

As private equity continues to become more institutionalized, LPs will expect a base level of transparency and reporting and will continue to want to invest alongside GPs. The savviest of GPs will meet these demands while continuing to provide a unique value proposition that sets them apart in the increasingly crowded private equity marketplace.

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