September 15, 2014
Interviewed by: David Snow
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Strategy Deviation Without Explanation

What happens when a GP has changed direction from their last fund and can’t explain the reasons to their LPs? We ask experts from MVision, StepStone and Zurich Alternative talk about the potential consequences.

What happens when a GP has changed direction from their last fund and can’t explain the reasons to their LPs? We ask experts from MVision, StepStone and Zurich Alternative talk about the potential consequences.

Strategy Deviations Without Explanation
Five Reasons Why You Won’t Raise Your Next Fund

David Snow, Privcap: We’re joined today by Michael Elio of StepStone, Moose Guen of MVision Private Equity Advisors, and William Chu of Zurich Alternative Asset Management. Gentlemen, welcome to Privcap. Thanks for being here.

Snow: We are talking about reasons why you might not raise your next fund. Reason #1 is deviation without explanation. In other words, you failed to explain convincingly to your LPs why you didn’t do what you said you were going to do from your last fund. And that is the reason they might not back your next one, even if your performance is good. William, can you talk about why an LP might pass on a fund just because of failure to explain a deviation?

William Chu of Zurich Alternative Asset Management: I would say that deviation without explanation is one of the more frustrating points that all LPs face. What was evidenced was probably during the 2005, ‘06, ‘07 era, where a lot of general partners said, when they came to market, “We want to raise $X billion,” so let’s say $10 billion, $15 billion, $20 billion the next mega-buyout fund, with the view that they want to do corporate carve-outs or buy particular divisions out of what-have-you. That was the thesis for many general partners going into that era, but, of course, as we’ve all seen given the Gray financial crisis, people had to be flexible. Ultimately, at the end of the day for investors, we spend the time, energy and effort to underwrite what the general partner’s trying to articulate as the thesis. The last thing we want to do is get negatively surprised, where they completely do a 180 in terms of that strategy without thoughtful articulation.

Snow: Moose, do GPs get demerits for deviating what they said they were going to do from their prior fund?

Moose Guen, MVision Private Equity Advisors: Yes, they do. It’s interesting, because if you look at the emerging markets, for example, the targets are moving because of the growth rates, the developments and the changes. It’s very natural for a general partner to come back and say, “I’m doing the same companies as I’ve done before, but they’re twice the size, so I have to be twice the size.” But, when you look at opportunities that present themselves, one big point that one has to look at is how much of an equity stake a general partner is taking. Interestingly enough, a lot of the deviation is done over very simple parameters, one of them being size of ticket per investment. Not necessarily taking into consideration a co-invest or what percentage of the company was involved, and that investors first fixate around that. Then, they fixate on loss ratios, and one thing they don’t want to see is volatility within the portfolio. They want consistency of execution as opposed to taking significant bets.

Snow: Michael Elio from StepStone, are too many GPs not clear? What happens as a result of that?

Michael Elio, StepStone: Very many GPs are not clear. When you think back to the very basics, to what William was getting at, LPs and investors really like a good story. But it needs to be a complete story and, of course, end in good performance. So, as a GP, you have to make sure you state your strategy—what it is, what your differentiator is—and give an example of how that differentiator has worked for you and how both of those end up contributing to good performance. Just like when we read a book, if you’re looking for that “A-ha!” moment, things will stand out in your story.

Snow: I have a follow-up question for any one of you: shouldn’t GPs be flexible? And, to Moose’s point, in the emerging markets, as the opportunity changes they think differently, they try different things and they respond to a changing market instead of sticking to a rigid formula that might have worked for the past fund. Isn’t that an argument that they would have back to you if you wanted to give them demerits for experimenting?

Elio: It is. It gets very dangerous when a GP deviates from an area where the investor is comfortable that they’re investing. If they have a history of deviating to some degree, that’s fine, but as William said, if they’re a buyout investor all of a sudden doing credit, it is not a space they’re normally investing in. Frankly, it’s not the space that the investor gave that GP the money to invest in.

Guen: The bigger problem is if they fail. Because if they fail, it’s unforgiving, and it sets them straight back when they come back to fundraise. They’ll go through quite a bit of hardship on that.

Snow: It must be challenging for an LP to sit and to not re-up with a GP team that has actually produced good results, in part because they deviated from their strategy, correct?

Chu: Yes, obviously that happens. But, going back to what all three of us are trying to echo—the point about communication and being proactive about the communication. That’s absolutely critical. At the end of the day, investors are all—well, I shouldn’t say we all are, but for the most part, most investors are rational. And they are flexible, to some degree. But what Mike hit on was completely spot on, which is that the LP or the consultant spends the time to go forth and underwrite that particular managers. We recognize investing is certainly a world of uncertainty. But the vast majority of the LPs out there have to actually report to the ultimate client, their beneficiaries or their CIO. So, it is actually mission critical that the LP understands actually what the general partner did. Deviation without explanation is a bit challenging and it puts pressure on that LP to now explain something that, frankly, was not within their control to understand.

Guen: There’s one point I’d like to raise within this theme—that, in the U.S., the GPs are becoming more and more specialized. If we look at the funds we’re working with or the funds we’re pitching to work with, in the technology space you have this type of profile company. In the consumer products, these types of companies to which we will invest in this manner. We haven’t seen it at all in Europe. A handful of groups are talking in that direction, even though people have sectors of expertise that they focus on, but it’s a moving target.

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