IVCA Article: Highlights of IVCA Luncheon, “Private Equity GP/LP Relationship: Dynamics of the Future”

October 14, 2015

A luncheon co-presented by the Chicago Area Limited Partner Association (CALPA) and the IVCA, and sponsored by the legal firm of Neal, Gerber & Eisenberg on  the important topic of “Private Equity GP/LP Relationship: Dynamics of the Future” had an attentive and packed room at The Conference Center in the UBS Tower in Chicago. Moderator Michael Gray, Partner at Neal, Gerber & Eisenberg, moved the panel through a variety of topics in 3 categories:

  1. Strategic shifts in private equity fund economics
  2. End of Fund life issues
  3. Spin-off funds

The expert panel included:

  • Joanna Rupp, CFA, Managing Director of Private Equity, University of Chicago Office Of Investments
  • Greg Uebele, Director - Private Equity, The Boeing Company
  • Kelly M. Williams, President, GCM Grosvenor Private Markets


Moderator Michael Gray divided the topic into sub-categories, and the accomplished veterans on the panel contributed their take on the subjects.

Strategic Shifts in Fund Economics

Michael Gray: Let’s start with a fund concept. Kelly, what do you think about ‘permanent capital’ and how do you think it will evolve in the industry?

Kelly Williams: I think that while some GPs would raise capital for those strategies, I don’t see it as a trend. I don’t see a number of LPs who would want to commit large amounts of capital. I think eventually relationships change and strategies change. That being said, from the GPs perspective there is certainly an attractiveness to it, and limits the wear and tear from a raising of capital standpoint, and lends itself to structure strategies where you have a very long pulling period. But from my point of view, it’s only appropriate for a very small percentage of LPs, and even a small number of GPs, from a strategy standpoint.

Gray: Another issue is co-investors, which the SEC has been looking closely at recently. Greg, how is it affecting your investments?

Greg Uebele: Obviously the trend over the last few years is an increased demand for co-investment from the LP base. Some of the things we focus on as it relates to co-investment are situations that arise that may create a misalignment of interests for those LPs that are active co-investors, and those LPs who are not. Everything works well when those investments perform well, but we’ve seen situations – when there is active co-investment from the LP base – where the investments don’t perform well. And if those co-investors are also on the advisory committee, we worry about potential conflicts. We spend quite a bit of time on those funds up front, when we perceive that there may be active co-investing. We try to assure that there is a diverse mix of LPs on the advisory committee.

Gray: Do you ever experience advisory committees who address the co-investment conflicts more?

Uebele: That is the case, particularly at the base of buy-outs funds. We are disciplined at Boeing, we right size our commitments with a broad array of General Partners. We try to understand the allocation policies, and if there are any special rights that anyone has. These are, however, long term partnerships – we look at the patterns, we look at the histories of the co-investments, to access the comfort level of advisory committees. We request the minutes of the meetings, and try to be an active LP.

Joanna Rupp: It seems as if the motivations for co-investment are twofold. One, is to reduce the fees, but the returns may not be better because of that. The other element is to put more capital to work. Many of the co-investments come from known players. One of our fundamental beliefs is that more capital leads to less discipline. So having a robust co-investment pool, we don’t believe, necessarily leads to better outcomes.

Williams: We’re very active co-investors and have been for a long time. There are some important things to think about. If an investor is thinking about co-investing, you have to distinguish between syndication and co-investing. With most of the large private equity firms that offer co-investing; it is really syndication. They’ve already done the underwriting, they’ve already done the diligence. As an individual, you would have very limited ability to ask for information beyond what they are prepared to share with you – in that case you’re relying on your judgment of the fund manager, and their expertise. We certainly saw the results of that during the 2008 downturn. The co-investment programs that have been analyzed, and the returns that came from them, really came from buying into a large syndication.

In our view, co-investing is truly being a partner with the GP. You can add value if you are an expert co-investor. You need experts on your team, who have served on boards, there is always something that can come up – deals have different qualities, they have different return profiles. It’s very important to be disciplined, and have a great relationship with the GPs, that they are transparent with you, and you have great experts on your team.

Gray: What amount size do you think you need for co-investing, and what size team would you need for its due diligence?

Williams: We suggest to our investors that 20 percent should go into the co-investments, and it depends on how much money you’re trying to deploy, and the GPs you’re working with, and at the minimum you should have one member on your team that has experience as a direct investor, rather than just a fund investor.

Gray: What about ‘side letters’ in co-investments and the GP access of those letters to see what rights are stated. Can you touch upon that?

Uebele: It poses a challenge for us, it’s just an awareness. At least I think we understand the top ten investors in those bigger funds, and where the large commitments are made. We know that there are differentiated terms, we don’t know what that are, and the GPs might give us some suggestions as to the categories to those co-investment rights. In our side letters, we stipulate if allocation policy changes or advisory committee members change, we are notified of that. It’s a fuzzy area for us.

Gray: What are you seeing in fees? What trends are you seeing regarding termination of fees after ten years, what’s happening with setoffs and caps on fees for certain expenses, and how is it being monitored by the SEC?

Rupp: I think there has been a lot more transparency and discussion on issues like management fee offsets, and moves toward more offsets in that area. We’ve had a couple of conversations with new funds that we’re looking at, where they have had fees that were aggressive, and they are able to get away with it. There are others that are market reactive, and more LP friendly. I only know what is in the legal documents, and I know that those legal terms will govern the terms of the relationships, and you’ve got a headwind if you have less friendly terms for LPs. So we’ve walked away from managers whose terms were too aggressive.

Uebele: I like to think we take a balanced approach to the terms and conditions, so we do focus on the fees being mindful of what the market is. We also recognize with premium groups, there are going to be premium fees. We try to strike a balance, sometimes we’re some of the larger investors, and we have a lot of influence, and sometimes we’re not, but we still take the same approach – we try to construct it with managers and raise our points. We see it as a partnership and a relationship, we’re not trying to beat them down on fees. But if we think the fees are not market, we’re going to raise that point. If they stick with it, we have to make a decision as to if we want that in our portfolio.

Williams: I think the managers who have become most creative with fees are the mega-funds, because of the backlash from investors regarding those fees. What you often see is an LP who has been paying full fees on a $100 million, will get an additional up to $200 million more for free. If you’re not an LP of that size, you have to realize that you are subsidizing the management of that other LP’s capital. This is a real issue for those smaller LPs to think about.

Another issue around that is expenses, and the SEC is really driven for transparency and dialogue around that, because as fees are charged to the portfolio companies, expenses are obviously a drag on our returns. In smaller funds, the important thing is viability, to make sure those managers have enough money to pay their staff and grow their firms. We spend a lot of time talking budgets with those managers, and we’re happy with a manager having a higher fee as long as they can show that the reason is to be competitive. LPs can’t be shy about having that type of fee conversation.

And finally, there are some funds in the middle, about $2 billion in size – they put up good numbers, they get a placement agent, they raise more money – so they don’t feel they need to negotiate. And that is where I feel the LPs should be able to walk away. There is always another fund, and someone with which to establish a new relationship. 

AUDIENCE: Back to co-investment, what are your thoughts on the co-investment sidecars a lot of GPs seem to be raising, and is it really co-investment?

Williams: The first time I saw a sidecar fund was in the early 1990s. My view of what they are is just an expansion of a fund at a lower fee rate. It’s a way for an LP to put in more capital, and usually the fees are lower. There is no discernment among deals – every co-investment they do goes in there, so it’s sort of a hybrid between having your own staff who does every deal that is shown, or having the GP intermediating and indicating that they’ll do the co-investment for you. There would be a bunch more LPs in a sidecar, and there would be a lower fee. 

End of Fund Life Issues

Gray: Secondaries have become a tremendously large market place. Today it creates liquidity among LPs. What are your thoughts about the secondaries market place?

Rupp: I think its a difficult area, unless you have a real portfolio construction issue: if it is hugely undervalued or overvalued. It’s also tough to understand and have convictions around the economics. If you try to sit and ‘model through’ what the return is, the economics are not necessarily clear. So it becomes a bit of a push.

I also feel secondaries would become a more useful tool, if we were to redeploy those dollars immediately into higher conviction assets, but in the way we manage portfolios that doesn’t necessarily happen. The framework for making the decision: if we would immediately not be redeploying the dollars into a higher expected return Private Equity position, it doesn’t impact our capital commitment budget. So the dynamics around the deals have not been compelling enough for us to look at it.

Uebele: The secondaries space has clearly evolved quite a bit in the last decade. From the seller’s perspective, its now another tool to manage a portfolio. There is a situation where an LP would want to sell some of their assets, and with the liquidity that is in the marketplace, this is one of the reasons secondaries have expanded. From our perspective, it’s a great situation. It’s another side of the Private Equity space that is evolving and maturing. It’s just a matter of if you think it would be something that would help you and manage your portfolio from different perspectives, then I think it’s an advantage.

Williams: It’s fascinating to look at the development of secondaries. Ten years ago, institutional investors wouldn’t dare initiate them, and they wouldn’t want their boards to know they were selling portfolios, it would imply that they were doing something wrong. Now it’s a common portfolio management tool.

In the last two major downturn, the tech bubble and financial crisis, what was happening was that in investment banks – in order to get the underwriting for these transactions, were being required by the sponsors to take portions of these transactions on their balance sheets as well – they were putting equity and debt into a lot of these deals. Or in order to get assignments from the GPs, a lot of them were committing capital to the funds. So as the GPs were raising money, they would require the investment banks to become limited partners, so they would become an underwriter. During the financial crisis, a lot of what was seen as secondaries at really big discounts, were coming from banks. Institutional investors got great prices for their portfolios. There were double digit billion dollar secondary funds being raised very quickly.

It will be interesting to see, now that secondaries have become a more proactive portfolio management tool, as many LPs are rationalizing selling off the relationships – they realize they have too many GP commitments, and they want to concentrate their relationships – that they’ll sell off those relationships that they don’t see as key to their portfolios going forward.

Gray: There is a phenomenon in the market called ‘Stapled Funds.’ It’s typically an existing fund that is 12 to 14 years old, and because of its age the GPs are having trouble raising their next fund. What happens is a secondary player comes in, buys out all the LPs in that older fund, and simultaneously makes a commitment to the new fund so the GP can stay in business. What are your experiences in this type of market, especially as the SEC focuses on them?

Rupp: It is an interesting area around both an array of interests and conflicts of interest. We’ve been in two situations like this, and one was done very fairly. The LPs were given options to reset or sell their interests, and that seemed like a very fair and reasonable way to make objectives. That was a situation with stapled secondaries that went well.

I’m in the middle of another situation where we have a fund with a very narrow LP base, it’s an older fund, and the manager is raising the point of the stapled secondary. We think the manager is fine, but it’s a fund position – outsized and with little liquidity – that we’d like to reduce our exposure to. Can we go out and find a secondary buyer, or can the GP structure a stapled secondary? It may be the case that part of the incentive for coming into the new fund is that the buyer would get a price reduction on the old fund. That doesn’t feel like a good alignment of interests and outcomes. It is fraught with conflicts of interests, and having a good LP base really helps in these situations.

Williams: We certainly saw a lot of Stapled Funds that were sponsored by financial institutions or insurance companies, and the sponsor no longer wants to be in that business, so they are effectively selling out the GP or LP commitment. We’ve had some success doing some of those, and we’ve had options where the LPs could stay in or cash out. The biggest concern is what’s going to happen to the management team, how they lock down or transition when a secondary Stapled Fund comes in.

Gray: Nobody enters a fund thinking about end-of-life issues. What have any of you done at the front end, in contract or otherwise, to think about who will be ‘minding the store’ at the end of a fund?

Uebele: From our side, nothing unique really, but we do focus on what we call early dissolution parameters, whether that is about changing partners or ‘no-fault divorces’ or otherwise. We have been in situations where we have a disagreement with the GP, and then get together with the other LPs to garner enough votes to dissolve the product. So we have dissolution provisions, we don’t necessarily want to use them, but we want them to be there.

Gray: One of the last end-of-life issues is when people end up with in-kind distributions. How much have you all been seeing a distribution when you end up with asset of a private company, where you really don’t have liquidity for the asset?

Uebele: We haven’t received much on the private side, but we do have a third party vendor to manage those situations.

Williams: One of the adjunct issues is this phenomenon of replacing GPs. There is a business now with firms who do nothing but step in as replacement GPs, and not because you’ve come to the end of the life, but because the LPs get fed up. It’s interesting that one of the strategies that is being deployed is to work with the LPs to get the GP out. As LPs, if GP behavior begins to affect a portfolio, it’s good to know the players out there who are doing these step-ins, because there is litigation and other difficulties. It is a drain on time and resources to get rid of a GP.

Gray: Often on a ten year life of fund there are extensions built in. How often have each of you NOT seen the extensions come into play?

Williams: It’s not the extensions, which are pre-negotiated, it’s the coming to the end of the extensions and it’s still not done, and the questions that arise at that point.

Spin-off Funds

Gray: With spin-off funds and new groups, how are people evaluating the managers, and what provisions are people are focusing on?

Williams: We started our business focusing on smaller managers, and there are managers who do well from spin-outs. There are issues there obviously with attribution, as in how that spin-off is going and whether it is friendly. More often than not it’s not a friendly separation. Of the hot funds in the current market, a lot of those are effectively spin-outs.

Uebele: Our portfolio is fairly mature, when we see a spin-off that is from a group in our portfolio, it makes it a lot easier. If it’s a potentially new relationship, with a lot of work that we’re trying to understand, we have to explore attribution and so forth.

Rupp: Emerging and new managers has been a big focus for the university. We did a study, and we concluded we have a good governing structure for backing new managers, and we can back smaller funds. We’ve also been trying to understand the characteristics that we see as early indicators for management success, and typically the teams are younger, less wealthy and very focused.

We feel that 25% of our capital each year should go to refreshing our portfolio with new managers. We rarely do a buyout that is greater than $1billion, that is outside our sweet spot. With that backdrop, we view GP spinouts as if they are all in. What kind of situations are they leaving? How much of their own money are they putting in? And what is the clear distinction to their approach? We write smaller checks to put in more bets, recognizing that not all of them will be successful. It does give us access to some emerging names, when they get into funds two, three and four. If we’ve made a bet to an early management team and it was successful, we will participate in those subsequent funds.

Gray: There is an art to getting into funds, what does it take to be the LP that the GP wants?

Uebele: From our side Boeing has been in Private Equity from the 1980s, and we’re just trying to continue the success that our predecessors had. It is about the capital ‘P’ in partnership and reputation, we are very clear with our GPs and have a very disciplined program. We’ve never had liquidity issues, and have earned a reputation over time, and people know our brand. We are in a favored position when a GP wants to add some corporate LPs. When we look at the lists, we like to think we’re on the short one. I’ve worked at public funds before, and they don’t get the calls that Boeing does. It’s a great advantage that we have.

Rupp: We call it constructive engagement. We try to be there, we try to be supportive and give good insights that represent the LP base. And of course, as part of the University of Chicago, we like to play on our reputation. To the extent that the GPs create economic value for the endowment, it supports a lot of things that matter in this world – it’s important for us.

Williams: To add to that, as an we LP try to be as transparent and honest as well. We spend a lot of time on feedback, as to how to be different in what is important. There have been cases in which we turn a fund down, but we do it in a constructive way. If you’re a co-investor, that helps, and also if you can act quickly with early closings. Never underestimate as LPs the impact of coordinating with a GP at a first closing. There are risks at both ends, but its important to support a person who brought you there. Everybody always remembers behavior.

What we often do is have GPs come in, and give a pitch, so that they can get some real time feedback on what is working and what’s not. That benefits all of us, and it makes a GP better at what they do.

Gray: What about GPs selling minority stakes in some of the larger fund complexes. I’m curious to your thoughts on this, what changes will come about because of this?

Uebele: We can think about ownership and transition periods. Once a firm gets to be a certain size, it’s challenging to a firm to take up that ownership, and exit paths are fewer. We’ve seen the evolution to IPOs and public stakes, so we are always mindful of the ownership and the economic stakes in the firms. We try to explore the future when we perform our deep diligence with groups, and ultimately it comes down to adjusting the terms and conditions regarding transitions, that we put it in the initial agreement.

We want to make sure we have some protection, and that the key people are engaged for the life of the fund. The reality is that there are few doors for them, and the market will continue to evolve. It’s an attractive business for someone to take on those GP stakes, and we just have to keep our eyes open, and communicate with the GPs to understand the path they are exploring.

Williams: It’s a very interesting topic, and the firms are focusing on different strategies. It’s about the exit, and the exits that you allude to are about packaging the whole thing, and taking it public. For us, as LPs, we need to know the reason. Is it going to provide liquidity and provide an exit for the founders? It could be with some firms that they want to provide their founders with a value sheet, and they can see these strategies on new platforms.

We’ve seen a number of GPs use that capital for different purposes, and as LPs we have to understand what is changing as far as the governance of the fund. How active will these minority stakeholders be in decision-making? That’s a conversation we haven’t had to have before – we have to be more proactive in having those conversations with our GPs. Because I guarantee you, they are being called by everyone, and there are more outside entries into the Private Equity market.