Over the last few years, there has been a growing debate about the scope for and merits of investors becoming more proactive in managing their investments and relationships with the fund managers with whom they invest.
This debate has been fuelled by a number of factors:
- ? The rapidly increasing size and sophistication of the private equity (alternative) asset class, especially the explosion of the secondary market
- ? Some public market trends, such as accountability, transparency and governance, crossing over to private equity
- ? The availability and use of financial instruments to manage the risk / return balance in private equity fund portfolios
- ? An increasing recognition of the dichotomy between fund managers which can easily raise new funds and those that face considerable difficulty – and the opportunities and threats that these represent for investors
The days of LPs merely signing up for funds, meeting drawdowns and then waiting for the cheques to come back are slowly waning, and a more proactive approach to investing is gaining momentum. The over-riding reason for investors to be more proactive is to improve returns and manage risk.
Obviously, the initial investment decision (which is beyond the scope of this paper) is a critical driver of the performance of a portfolio. However, it is our contention that investors can enhance performance by adopting more active techniques to manage their investments and relationships through the typical ten-year fund life.
What do we mean by pro-active management?
Our definition is the taking of actions intended to:
- ? Maximise the opportunities to make primary investments in funds likely to be out performing
- ? Capitalize on opportunities to increase exposure to overperforming managers
- ? Minimise the risk from unforeseen adverse events
- ? Protect value in funds where that value is threatened Proactivity means being a responsible and involved investor.
LP activism only hits the headlines where an extreme outcome occurs, such as the Forstmann Little or Venture Strategy Partners litigation, or the removal of a GP, of which we have recent experience. This may mean that the LPs’ perception of investor proactivity means dealing with major problems and is invariably confrontational.
We would like to challenge this perception, by considering ways in which LPs can maximize the benefits from over-performers as well as minimizing the damage caused by under-performers. We believe proactive investors can not only enhance their investment returns and decrease their risk profile but can benefit the businesses of the managers.
We have divided our subject into the five phases of the typical fund cycle. To help illustrate some points we will ignore the fact that often managers will be managing multiple funds, at different phases, simultaneously and will, occasionally, extrapolate from fund-specific issues to issues faced by the manager.
Phase 1: Positioning to invest in likely outperforming funds.
Most substantial LPs have well-developed strategies, networks and methodologies designed to identify the majority of funds that may fall within their investment strategy over time.
However, if the fund you are targeting is likely to be over-subscribed you face being scaled back or, even worse, not getting an allocation at all. It is too late at this point to start to try to demonstrate your qualities as an investor to gain access or minimize the scale-back. Being proactive in managing your relationship with prospective managers can lead to them perceiving you as being ?preferred?. A number of supportive actions are discussed in the subsequent sections but broadly investors should mirror their managers by offering more than money. This might include regular discussions and feedback on: competitive benchmarking – regionally and/or internationally, best reporting and governance practice, investment themes, or introducing managers or investors to a GP – things which the manager values.
A small number of investors extend their proactivity beyond trying to select the best of the fund offerings that are presented by seeking to act as sponsors to new or emerging managers, whether in developed or emerging markets.
Phase 2: The commitment decision. The investment process is not for discussion here but investors can be proactive in the consideration of terms on which they are being asked to invest. We have been surprised, when dealing with disputes between investors and managers, how rarely the Limited Partnership and other agreements governing the relationship adequately deal with the position when something goes wrong.
It is important for investors and their advisers to ?stress test? these agreements thoroughly by working through in detail how the worst scenarios would be resolved. This process should not just cover the Limited Partnership Agreement (LPA) but all the agreements setting out the rights and obligations of all parties from the investors, GP, founder partner, investment advisor and fund manager. Addressing these issues should avoid getting to year eight, discovering there are problems to resolve and learning there are no rights to do so. The deficiencies do not just apply to older agreements either; investors in one recently raised fund were frantically reviewing their key-man clauses when a senior partner left shortly after closing. In another case, a fund, which had held a first closing, was terminated before any investments had been made, at considerable angst and expense to the investors. Failure to contemplate, and therefore legislate for, such extreme events can be very costly.
Perhaps investors should compare and contrast a typical private equity investment agreement (which governs the terms on which a private equity fund invests in an investee company) with the typical LPA – it’s an interesting comparison.
Phase 3: The investment period. During this period, investments are being made and the seeds sown for the performance of the fund, which should become more visible as the investment period nears its end.
There may be some potentially negative issues to be addressed during this period, such as strategy drift, key-men leaving, conflicts of interest etc. It is rare for highly contentious and material issues to arise at this stage.
There are also opportunities for investors to increase their exposure to a fund that looks like it will outperform. Two strategies are to seek to acquire any secondary interests (staying close to the GP should assist in identifying these and make the process easier or using a third party adviser to help) and to make co-investments alongside the fund. These strategies are not limited to funds in which the investor already has an interest. We are working with one GP to assist in placing a substantial secondary interest with investors now keen to support the manager. Replacing an uncommitted investor with those likely to support subsequent funds and co-invest where appropriate is of great value to the manager.
One other potential opportunity is for investors to support (even promote) strategic development initiatives for the fund manager. Most managers have strategic plans to grow their businesses and these can involve doing more than just raising successive funds. Being perceived as a strategic supporter of the manager can enhance the relationship and bring other benefits to the investor.
Phase 4: The realization period. Once in the realization period, there are two primary indicators of the success of the fund. First is that its performance is becoming clearer and the key issue here is whether there is a realistic prospect of the manager achieving carried interest. Second is the success or otherwise of the manager in raising a successor fund(s).
With positive answers to both these questions, it is reasonable to expect a continuing and successful manager which is motivated to maximize the investment performance of the fund and investors should focus on the possibility of acquiring secondary interests and on deepening the relationship with the manager
If one or both of these tests fails then there will be doubts regarding the ability and/or motivation of the manager to maximize fund performance.
Where there are problems, determining an appropriate course of action is more difficult. However, commercial reality and fiduciary obligations of investors suggest that, at the very least, detailed consideration of the options is required.
In this situation there are two basic active strategies (and of course the well-established ?too difficult so do nothing? approach).
The first is to work with the GP (and other LPs and advisers) to address the issues constructively with the objective of returning the GP to a position where its longer-term future is more assured.
The second strategy is based on the premise that the underlying problems are not soluble and that therefore investors need to act to protect the value of existing investments, recognizing that the GP’s future (in its current form) is in doubt.
Phase 5: Termination/extension. As a fund draws to the end of its life, the prospect of an extension looms large. With the advent of new ?managers for hire? willing to manage existing portfolios, there are now real options available to investors which did not exist a couple of years ago. Investors need to be aware of the options available to them and the process and timing for making decisions. The most appropriate way to manage the tailend of a fund (and the associated cost) varies from case to case. Under the terms of most agreements investors (collectively) do have the ability to influence, if not dictate the outcome.
Going forward, there will be continued evolution of the market and its participants. We expect to see investors becoming more sophisticated and more proactive in how they relate to fund managers and flexible in the ways in which they support them. The secondary market will become more vibrant and liquid and investors will make use of this and financial instruments to obtain and manage their exposure, returns and risks.
We have touched on a wide range of aspects of investor proactivity. Some of these are largely already in investor consciousness but others are less exposed and have evolved from our thoughts and discussions with investors. Being more proactive requires a commitment of time and resource that we believe will be repaid, often to the benefit of both investors and managers.
David Morton and Grant Roberts are founder partners of Newgate Partners. Newgate is a London-based independent advisory firm specializing in the private equity market, combining fund placement services with financial advisory services focused around the acquisition, restructuring and sale of funds, portfolios and fund management businesses.