The days when limited partners were passive investors who waited patiently for returns are long over. Today’s LPs require more control over portfolio companies and more transparency in their relationships with general partners. They also insist on diversity, equity and inclusion (DEI) and environmental, social and governance (ESG) initiatives. Here’s Mergers & Acquisitions‘ in-depth look at everything GPs need to know about the new LP mindset.
The world is certainly changing and that holds true for the private equity industry as well. Perhaps one of the most pronounced changes is how limited partners are now approaching investments. The days when LPs were simply passive investors who patiently waited for returns are behind us.
In place of the old guard are LPs who are increasingly looking for greater access and control over portfolio companies and demanding more transparency from their general partner relationships. Today, the larger LPs are increasingly building direct investment vehicles. And most LPs — including mid-sized and smaller LPs — are looking for more co-investment opportunities, as well as more say into underlying investments. Many of these changes are driven by institutional investors looking to reduce their spending on deal flow.
“Going direct lowers fees and the carry paid to the GPs and that’s what LPs are looking for,” says Kelly DePonte, managing director at Probitas Partners, a San Francisco-based placement agent that focuses on placing LPs’ capital into private equity funds. “But they will have to pay more for internal staff that have expertise, and these types of plans can backfire.”
In addition to wanting to cut down on fees, LPs also want to ensure that their partners are meeting criteria on issues including environmental, social and governance (ESG) and diversity, equity and inclusion (DEI). ESG and DEI have been always important, but have become front and center over the past year.
StepStone Group, an investor in the private markets with more than $333 billion in capital allocations, works with LPs to make investments into private equity, venture, growth equity, private debt firms and more. Michael Elio, a partner with StepStone, says he talks to a growing number of limited partners. Before committing to a fund, LPs want to know that GPs aren’t just.
“There is a push here to do better,” Elio says. “StepStone has an impact investing team specifically focusing on these issues. This is too important to simply be a paragraph written in a response questionnaire to make LPs happy. LPs want the GPs held accountable.”
According to BDO’s recent private capital pulse survey, in rank of importance for LPs, more ESG investment options (19 percent) are only a hair behind harvesting and realizing investment gains (20 percent) and co-investment opportunities (19.5 percent). These priorities are driving LPs as they make investments going forward.
LPs Go Direct
Limited partners investing directly has long been the norm in Canada and for Sovereign Wealth Funds. In recent years, this practice has become more common for larger American pension funds.
For example, in 2019, the largest U.S. public pension fund plan, CalPERS, set up two funds to manage up to $13 billion to invest directly in buyout deals: CalPERS Direct: Innovation; and CalPERS Direct: Horizon. The new funds have to produce returns of more than 10.5 percent to be considered successful, as that’s what CalPERS’ traditional LP model has generated on average over the past 20 years. Although the returns are strong (the highest returns among all the asset classes in CalPERs portfolio), the hope is the direct strategy will cut down on the fees. In 2017, CalPERS paid $689.6 million in fees to private equity firms. However, the pension fund has had a hard time getting the new program ramped up between Covid and personnel issues. Still, the pension fund remains committed to direct investing.
“Going direct has been the trend for larger LPs, Canadian LPs and Sovereign Wealth funds,” says Probitas’ DePonte. “These firms have the resources to pay top dollar for talent. You have to be able to pay what a GP would pay, otherwise how will you attract top talent to invest on your behalf? This becomes politically tricky when you are looking at a state pension that could cost multiples more than what the state governor is making.”
In addition to the cost associated with hiring the right talent, going direct presents a conflict for the pension funds as they look to compete against the GPs that are still investing capital on their behalf. The general consensus is: going direct isn’t a prudent move. This head-to-head investing model will leave LPs and GPs competing for deal flow, which ultimately drives up the valuations. Canadian pension funds recognize this conflict and have typically only invested direct in Canada, where they do not have GP commitments, and do not invest directly in the U.S. because of their GP relationships.
“Some large Canadian plans have become strongly focused on direct investing, and a few have performed below expectations and have had a lot of staff turnover. Going direct isn’t as easy as some think it is,” says DePonte.
That said, Ontario Teachers’ Pension Plan, which typically acted as a traditional LP, did start focusing more diligently on investing directly a few years ago. In 2020, OTPP returned a net 8.6 percent, bringing its total assets to $173 billion as of Dec. 31. The plan fell short of its benchmark return of 10.7 percent, according to OTPP’s newly released 2020 annual report.
The desire to save money is there, but simply put, there is a lot more to it. “Lots of LPs want to do it themselves, but they don’t have the history, legal teams and capital to fund this type of program,” StepStone’s Elio says. “Picking a manager to back where the consideration is if they will be a good steward of your money is entirely different than trying to select deals that will perform.”
Teaming Up to Co-Invest
Although direct investment will likely remain elusive to most LPs, co-investment has become a successful alternative to direct investing, as well as passive investing. Co-investing opportunities are expected to continue to grow in popularity. There are many reasons why co-investment is highly sought after. Perhaps first and foremost are the returns. According to a recent study completed by Capital Dynamics and Preqin Data, co-investment funds have outperformed single-sponsor private equity funds on a net basis over the last two decades.
For funds launched between 1998 and 2016, sixty percent of co-investment funds delivered a higher net internal rate of return compared to single-sponsor funds. During the later vintages of 2009 to 2016, a still greater proportion of co-investment funds outperformed — and the results were similar when Capital Dynamics evaluated performance using multiples instead of IRR. The reason given for the outperformance is the decrease in fees, according to the study.
The standard fee structure for a multi-manager co-invest fund is about 1 percent flat management fee and a 10 percent performance fee, which is about half the 2-and-20 model. These lower fees have proven to be a strong draw for limited partners seeking to co-invest. For these reasons, the competition for co-investing has grown over the years.
Some will invest with emerging managers to get co-investment rights early on. Daniel LeMoine, a director with BPEA, a Boston-based firm that focuses on smaller- and lower-middle-market buyout and growth investment opportunities, says that’s one of the reasons he likes investing with emerging managers. “Any time we can get a co-investment opportunity, we like that scenario,” he says. “Co-investment is happening more, because there is a lot of capital moving into the asset class, and you can generate outsized returns with select co-investments. It’s a great driver of returns for us. There is also an increased appetite for co-investing due to the emphasis on value-add partners wanting to come together.”
BPEA has made more than 90 fund investments with more than 50 unique managers and completed more than 100 direct co-investments deal since its founding in 2002.
Josh Sobeck, a partner with 747 Capital, a lower middle market investor, agrees that co-investment is a benefit to his firm. 747 invests in buyout funds raising less than $350 million that take a controlling interesting interest in small businesses with enterprise values lower than $100 million.
“Of course, LPs like us have interest in co-investing. First of all, there is the potential for an expense advantage with co-investments and it brings us closer to our underlying fund partners. Co-investing can also bring you closer to the underlying portfolio company, and, quite frankly, a number of our investors like talking about the individual deals. There is also a psychological element to co-investing,” says Sobeck, who warns that even though co-investment is good, it’s not perfect. “The trouble can be when an LP tries to outsmart their partner GPs. If you back them, why do you think you can cherry-pick the best deal in their portfolio when they are doing this all the time? It makes no sense to me, but you do see LPs try to do it.”
According to Probitas Partners 2021 Private Equity Investor Trends Survey Results, 23 percent of respondents say there are focused on “no fee, no carry” co-investment opportunities going forward. “There is a push in the middle market buyout world for more co-investment opportunity,” DePonte says. “These LPs can’t afford to have someone on staff dedicated to co-investments, but can focus on a limited number of deal opportunities and make a quick decision to invest, or not, alongside a GP, who they already trust and have invested in. That level of trust makes the decision that much easier.”
DEI, ESG Take Center Stage
In addition to wanting to pay less to invest, LPs also want to be sure they are investing in private equity firms and underlying portfolio companies that are incorporating DEI and ESG initiatives into their business thesis. “When ESG started becoming more mainstream, a number of GPs would write out some high-level protocols, but then didn’t do much after that,” says DePonte. “Now LPs want to see how these initiatives are implemented and they want reports on it. Additionally, the SEC is now looking into this. This is a big shift and it’s a trend that’s here to stay.”
There’s no question LPs are concerned. According to a March 2020 survey of 2,800 CFA institute members, 94 percent of fund managers indicated that an ESG strategy was either “very” or “somewhat” important to the limited partners.
Additionally, according to StepStone’s Elio, all requests for proposals include questions on ESG and diversity, particularly gender diversity, which is a key focus of LPs today. “LPs want to be associated with GPs that are forward leaning on the diversity agenda,” says Elio. For this reason, StepStone is tracking diversity metrics on its GPs. “We heard the GP say they care about it, but now we are in a position to see what they are actually doing about it,” says Elio. “So far there has been more success in creating diversity at the portfolio level, because there is more turnover there, and it’s easier to change those metrics faster. Some GPs have a staff of 10, and you will not see change quickly. It can be a slow process.”
747’s Sobeck says it’s been an emphasis for his firm for a while. His firm’s last two commitments had female partners, and one firm was founded by a woman. “It feels wonderful to be able to back a female-founded private equity firm. I hope this trend continues for the industry,” says Sobeck.
The bottom line is that multiple studies have proven that greater diversity leads to stronger returns. Over the past five years, McKinsey has studied the case and concluded that companies with greater diversity within their leadership team correlate to stronger financial results. Companies in the top quartile for gender diversity were 25 percent more likely to outperform industry-median Ebit growth than bottom-quartile companies. Similarly, executive teams in the top quartile of diversity were 36 percent more likely to financially outperform the industry median.
Another change in private equity investing is how LPs are committing to funds. According to Probitas Partners 2021 Private Equity Investor Trends Survey Results, 2020 was a difficult year for fundraising with fourth- and fifth-time funds garnering more attention than emerging funds. This is attributed to LPs not wanting to invest prior to physically meeting a management team.
“Most LPs want to meet in person, and the pandemic made that impossible. It was harder to raise first time funds unless the fund manager knew a lot of LPs already from their previous employment. I think we will see a lot of funds looking to launch in 2022 when the world opens up again,” says DePonte.
Sobeck says although he never thought his firm would back a private equity manager without first meeting in person, the New York-based firm made two commitments to GPs during the pandemic without a physical meeting.
747 went into the pandemic believing you have to see someone in person before investing with them. “But we made two commitments remotely, and we have yet to meet those teams in person,” says Sobeck. Instead of meeting in person, Sobeck says, his team did tons of Zoom calls and massively enhanced their background due diligence efforts. “This has been a really interesting development. We were a lot more comfortable than we thought we would be, and we would do it again. I think we will see more of this going forward.”