Investors demand more than just an exemplary deal team these days. The presence of operational expertise and a well-structured back office also function as a deciding influence when limited partners decide which vehicles to invest with.
Unfortunately for general partners, those functions do not come cheap.
“Our expense base has probably gone up 4x in the last decade. We’ve tripled the number of people, we’ve added a lot of functionality,” said Thomas H Lee Partners co-president Scott Sperling during PEI’s CFOs and COOs Forum 2013 Thursday keynote. “One of the things that’s happened in the last few years – there’s been recognition on the investment side that those people have to get paid.”
“Those are critical functions and, quite frankly, you couldn’t do what you do without them.”
However, as LPs pressure for lower fees, accommodating that sort of expansion is not easy on private equity firms’ balance sheets. To make up for growing costs, firms have to use their added functionality to create more value in their portfolio companies – thereby generating greater returns upon exit, Sperling said.
“The equilibrium that has been reached between GPs and LPs on fees, even as we increase investment in our organisation, works because we’re going to make money on the other side, on the carry. I think that’s what the business was for decades,” Sperling said. “I think we’re returning to a new normal that may be an old normal.”
Hamilton Lane chief investment officer Erik Hirsch moderated Sperling’s on-stage keynote, which evolved into a frank discussion of how the LP/GP relationship has evolved over the years. In addition to the emergence of operations teams and back-office support, the pair also explored the balance of power between investors and their fund managers, as well as the emergence of LP co-investment strategies.
The industry’s evolution over the last few years has also included increased competition in both the fundraising environment and deal market. Although Sperling was unsure about the possibility of private equity firms consolidating as a result – a possibility Hirsch jokingly dubbed “shrinkage” – he did say that some teams would likely be absorbed under “umbrella” organisations moving forward.
On the LP advisory side, Hirsch offered a more blunt perspective.
“I think our space is consolidating,” he said. “LPs are demanding the global scale, and operations and outreach. And they demand the same of us, if you don’t have scale; it is going to get more difficult.”