The Evolution of LP/GP Relationships: Moving Closer to the Deal

Over the last few years, relationships between limited partners and general partners in private equity have started to evolve. For a time, GPs had a pretty tremendous advantage. The public markets weren’t producing predictable results, real estate was down and emerging markets were still rocky. LPs were sold on the IRR of previous funds and, with few other places to put their money, would commit fairly quickly.

But for many funds, the simpler times of raising a fund and returning capital in a decade are drawing to a close. LPs are increasingly scrutinizing results of individual deals, digging deeper during fund due diligence and either co-investing or funding individual deals more often. In many cases, the belief that GPs are investing to get fees, not carry, is what pushes LPs towards different models.

The problem has been exacerbated as more and more funds are created. According to Preqin, there are now 2,199 funds in the market — a record level. The shifting dynamics and sheer number of funds is causing many LPs to seriously reconsider their existing relationships and investments. The ability to raise another fund in the future may come down to being creative during fundraising and further aligning pay with results.

LPs Are Looking for New GPs

As LPs start considering ways to shake up the model, they’re starting to look past their traditional “core relationships.” Coller Capital found in their Global Private Equity Barometer that 85% of LPs are not planning to re-up with GPs whose last two funds they backed. Instead, they’re seeking fresh relationships and ideas. Nearly 70% of North American LPs are planning to back new, first time funds directly rather than relying on funds of funds to find new deals.

Coller Capital partner Stephen Ziff explained to Investments & Pensions Europe, “Often, talented individuals or teams will leave big franchises that perhaps aren’t offering them the challenges they expect, in order to start up on their own – and LPs that know them well are prepared to back them.” As a result, the amount of competition is continuing to grow.

Although one recent study found that the top private equity funds had persistent outperformance of other funds by 7-8% per year, one of the paper’s authors noted, “The problem is that there is a lot of luck mixed in with the skill. If you want to find the truly skilled managers, you’ll probably have to look at something more than just past performance.”

Though some LPs have had allocations for emerging managers in the past, the proportion seeking ideas beyond generalist buyout funds seems to be slowly climbing with LPs trying to find real beta in individual managers.

Deeper Due Diligence

But, as LPs search for the best returns, they are looking beyond simply the team.

“The LPs we talk to are looking for evidence of a repeatable model,” Hugh MacArthur, Bain & Co’s head of global private equity, recently said to the Wall Street Journal, “The due-diligence process is a lot more intense than it was seven or eight years ago.”

Instead of simply listening to a few pitches and signing off on a fund, LPs have started digging into past funds on a deal by deal basis. They’re beginning to recognize that they can do much of the same due diligence on funds as their funds do on potential acquisitions. GPs now need to have a much better understanding of their value add and their competitive landscape.

Investors are starting to ask about deal sourcing strategies, what made each deal successful or unsuccessful, and whether the investment patterns seem to be repeatable or were simply luck. As we’ve found in our own conversations with different private equity groups, few have repeatable sourcing strategies. Our recent Business Development Playbook has a few ideas for creating more predictable streams of investable deal flow.

The Era of Co-Investments and Deal-by-Deal Investments

The biggest changes, however, seem to be in the structure of the investments themselves. With more than 60% of the LPs surveyed by Prequin for their special report on co-investments noting that they’d trade lower hurdles for lower fees, it’s obvious that LPs are seeking new ways to get access to private equity at lower cost. And they’re not waiting for the funds to change on their own, they’re pushing the changes.

As the Coller report noted, nearly a quarter of LPs have backed GPs on a deal-by-deal basis in the last 5 years. Prequin’s report found that of the LPs they tracked, “43% are actively seeking co-investment rights when committing to funds, and a further 11% are considering such opportunities.” Even Pensions & Investments noticed the discrepancy between direct returns and fund returns in a recent article, noting that the public data from CalPERS showed direct investment net IRR of 12.8% versus an 11.4% net IRR for its commingled funds.

With LPs becoming more sophisticated, private equity funds will have to find new ways to create alignment whether it’s through investments on a deal by deal basis, co-investment commitments, or through more flexible terms on fees. Investors are willing to back new teams, direct invest and dig much deeper into the actual strategies used by different funds to ensure they’re getting the returns they need. Are you prepared?