Not so much skin in the game

Fund regulations state that private fund managers should own a stake in the vehicles they manage for investors. This mechanism is supposed to foster alignment of interests between LPs and GPs and ensure funds' losses are felt by GP principals. However, this mechanism relies implicitly on three principles to be effective:

• First, that GPs are employee-owned, so that potential losses are split among everyone and hurt every principal in a significant way;

• Second, that GPs are focused enough to be affected by the losses of a given single fund;

• Third, that GPs' commitments in the fund will represent a significant share of the principals’ net worth.

Unfortunately, these three principles do not hold true.

Even though a significant number of GPs have spun off from banks and insurance groups, they are not necessarily independently owned. Some have been acquired by other groups. Others have gone public. In the first instance, employees are less likely to own significant stakes in the company. In the second, employees are distant and diluted owners with at best a modest portion of their wealth at stake. For GPs which have effectively bought themselves out, the sheer size of the structures often leads the new ownership to be concentrated instead of being spread out among principals.

Moreover, private equity has experienced a concentration of funds among a smaller group of players, notably due to increased regulation, industry consolidation after the financial crisis, and LPs' greater selectivity when it comes to relationships with GPs. This has fed a “winner-takes-all” phenomenon, with GPs turning into merchant banks. Less focused on specific investment strategies and on fund management, they are thus logically less affected by losses of a given fund.

In addition to this, past performance and the resulting accumulated personal wealth of principals have also loosened alignment of interests. Principals at GPs are now often simply immune to the pain of losses from the funds they managed. An example would probably illustrate this statement.

Let's assume that a GP raises a $10 billion fund. Technically, this GP should be required to contribute at least one percent of the fund size (so $100 million). A principal owning 10 percent of the GP would contribute $10 million. A 10 percent loss by the fund would translate in a loss of one million for the principal.

If the GP charges a 1.5 percent management fee, its income is $150 million per year. Assuming that it spends 75 percent of this on costs and 25 percent is distributed to the owners, the principal should collect roughly $37.5 million over ten years plus his/her salary and any other fund-related gains. The commitment of the principal represents 27 percent of this specific income stream and the loss represents a paltry 2.7 percent.

In conclusion, individual principals at GPs can only realign their personal interests with LPs if they commit a significant share of their personal wealth to funds, rather than relying on their GP employer to do so. This solution is not unlike the original private partnership model that used to be more widespread in the private banking industry, whereby the health of banks was better assured because principals put their own livelihoods at stake. Going back to basics and returning to the source of the private equity model might in fact be the way to reinforce alignments of interests.

Cyril Demaria is an executive director and private markets analyst in the chief investment office at UBS Wealth Management. He is the author of “Introduction to private equity” (2^nd ed., Wiley, 2013) and “Private equity fund investments” (Palgrave, 2015).