January 15, 2012
Interviewed by: David Snow
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Realities of a Mature Market

Private equity GPs hitting the fundraising trail will encounter an investment community with a very different appetite for private equity than during the previous fundraising effort. Limited partners have matured and adapted; GPs who fail to recognize this may go home empty-handed.

This first of three programs in Privcap’s “Changing LP Appetites” series features an illuminating discussion with Peter von Lehe of Neuberger Berman, Hussein Khalifa of MVision, and Michael Elio of LP Capital Advisors. The second in this series is “Culling the GPs“; the third is “In Search of Growth.”

Private equity GPs hitting the fundraising trail will encounter an investment community with a very different appetite for private equity than during the previous fundraising effort. Limited partners have matured and adapted; GPs who fail to recognize this may go home empty-handed.

This first of three programs in Privcap’s “Changing LP Appetites” series features an illuminating discussion with Peter von Lehe of Neuberger Berman, Hussein Khalifa of MVision, and Michael Elio of LP Capital Advisors. The second in this series is “Culling the GPs“; the third is “In Search of Growth.”

David Snow, Privcap: We’re talking today about changing limited partner appetites. Certainly there are two big reasons why investors today would have a different view on the private equity opportunity. One is that simply they’ve been doing it for a long time, and they have developed a maturity and sophistication. And obviously the other big reason is that the world has changed, and therefore, their appetite to participate in the private equity opportunity has changed as well.

Let’s start with a bit of a conversation about how increasing sophistication and frankly maturity among the investors in private equity has changed their appetite to participate in private equity. Mike, I’d be interested in hearing from you what you think is important within the idea of sophistication and maturity.

Michael Elio, LP Capital Advisors: Sure. Well, clients as you say have been investing in private equity for quite a long time. In the early years it was more about access than it was really about any of the information that was going on in private equity. Now it has developed. Teams have been around for quite a long time. They’ve built up portfolios that are pretty substantial and have experienced exposure to quite a few different managers. With that has developed some pretty significant knowledge into the players in the marketplace, their strengths or weaknesses, and also what’s going on around the world. Private equity, of course, was an American institution that we have slowly exported to the world – first to Europe, now to Asia and elsewhere. With it the appetite of the investing public here in the U.S., at least the large institutions, is going with it as well. So geography is one of the first ways that folks are looking to expand their knowledge and focus on their private equity investments. Other things that are changing as far as the landscape is concerned are definitely the strategies that the managers are investing in. Managers earlier on were more generalist and focused on a broad range types of investments. Those building and constructing their portfolios in private equity are more concerned on the specifics of what the managers are doing now. They have knowledge of how their process works, how they differentiate themselves amongst each other, and they’re building portfolios with specific managers in mind and going on from there.

Snow:   Hussein, as you look at some of the changes in the ways that investors understand the opportunity and in many cases their tenure in the market, what strikes you as being important?

Hussein Khalifa, MVision: I think people are moving a lot more quickly and developing their programs out at a much faster pace. If you go back 20 years ago, up until about a decade ago, U.S. investors would certainly start with a U.S.-based program. Maybe after four or five years they would start looking at Europe. Then they would start looking at more specialized strategies maybe country-specific approaches within Europe, sector-specific approaches within the United States, and then five years later they started going into emerging markets. Today, people are doing that within two to three years.

You see new programs starting up with very experienced veterans that are hired from other institutions. Because you have to remember about ten years ago, you didn’t have enough people that had the kind of experience. And you’re often hiring people that have come out of public equities and they were sort of learning on the job. Today there’s no shortage of people that you can bring onboard. So that’s certainly starting up at a much faster pace.

Snow: So in other words, in addition to there being institutions that have been around for a while, and as you say, have sort of incrementally diversified their exposure to private equity, you might have a sovereign wealth fund somewhere in Asia that will start right out of the box with a program that reflects a lot of the learning that’s been taking place at other institutions over the past couple of decades.

Khalifa: Absolutely. It might take in practical terms six to 18 months to just roll out the different strategies so that they have a particular plan and they’re not trying to do everything at once. They can hire people in a pretty short period of time that have spent a lot of time in those particular markets, so it’s just a question of execution. But in terms of knowing where they want to be strategically, yeah, they have pretty much done that out of the box.

Snow: Peter, is that what you’ve seen?

Peter von Lehe, Neuberger Berman: Absolutely, that whole time-period that it takes for someone to build a sophisticated portfolio definitely is something that is going much quicker today than it was the case ten years or so ago. Another important aspect though of a sophisticated investor is knowing what they know and knowing what they don’t know. Another aspect we’re really seeing there is actually the most sophisticated investors are the ones that can figure out what they can do in-house themselves and what should they be outsourcing, because as I say, the truly sophisticated investor knows their own limitations, knows their own expertise, and focuses on what they’re actually good at. And then goes and finds other providers for the things that they would like to have exposure to that they don’t as well themselves, or just decides not to enter areas if they don’t have that expertise.

Hussein: You could say that there are a lot of LPs that have exaggerated their own sophistication.

Snow: Yes, everybody’s above average, right? In addition to the strategy of being able to go out and perhaps hire someone who is very sophisticated, I would also imaging that there’s knowledge that’s passed along a sense of best practices that are transferred from one institution to another. Are there some generally accepted best practices for establishing a private equity portfolio that are not very controversial to discuss?

Elio: Not very controversial? Well, each investor has a different idea of what they want to do with private equity. Early on you had to sell the concept of private equity. Now it’s an accepted given, so the investment committees, the trustees, the boards, whoever it is managing these investments, already have it as an accepted known that they’re going to be in the asset class. It’s just a matter of what the allocation is going to be going forward.

Von Lehe: It is important, though, for a client to think through what they want out of their private equity program before they go into it. Doing it just because everyone else does it is not the right thing. The people that end up getting to the asset class that end up being disappointed are typically the ones that actually didn’t think through enough what the downsides were, what the illiquidity actually meant for their program. I think you need to truly understand those issues before getting in to actually have a successful program.

Khalifa: And I think that’s a number one question you need to answer. What kind of illiquidity are you prepared to take when you are setting up a program? That is one that most investors come up short on the first time around.

Snow: Now that even a newer participant in private equity has the benefit of other group’s experiences, what are some mistakes that you think are being avoided now that might have been more common one or two decades ago?

Elio: Well, I think there are certain concepts in portfolio construction in private equity that are pretty standard now – investment pacing, vintage diversification – are all pretty standard and accepted. I think risk metrics have permeated at least a lot of the public plans that we deal with. So that’s a common that’s built into the portfolio construction model.

So as far as mistakes, I think you just learn from what others do. Folks also now, they have the ability to rebalance their portfolios as well, and they are using that model going forward.

Von Lehe: I do think that you still see investors oftentimes repeating the mistakes that others have made in the past. For example, if you look at the over-commitment strategies that one needs to pursue, if you want to be fully invested in private equity, if you want to reach your target investment level in private equity you have to commit something more than that amount to actually reach that target level. The problem is that a lot of times people will use rules of thumb, and they will say if I want $100 exposed to private equity I need to commit $170 or $200 to reach that target exposure.

The problem is that people when determining these numbers they are looking at the long-term averages in the private equity asset class. The problem is the average never happens in any given year. You’re always well over or well short in terms of cash flows, for example. If you are just looking at the averages rather than looking at the tails from a risk perspective, you can be way off in any given year. And if you haven’t planned for that, if you haven’t really thought through the risk aspects, if you haven’t really looked at the tail events and what that can mean for your portfolio construction, you can be very surprised by the outcome.

So that’s why I think it’s important that investors plan their programs well beforehand that their board members understand exactly what the risks, exactly what can happen. Now when they’ve done that sort of planning, I think they can be in a very good position so that when those downturns occur not to panic but to understand that things will get better, that their portfolio will improve, and actually then even take advantage of those situations to add to the portfolio at the right point in time.

Khalifa: We’ve seen recently a much closer cooperation between a lot of public plans and their gatekeepers and consultants because one of the issues I think they had given that they often had a pretty experienced private equity team, but they had to report to what was essentially a political board who are reacting to headlines. We saw them historically trying to almost chase returns, and they were going into certain geographies, certain strategies because they had performed well in the previous years. Certainly, Mike, you can talk to this – consultants are trying to get them focused on the next five and ten years to build out long-term portfolios as opposed to doing what seems to work for the next year.

Elio: Right. Well, it is human nature to say look at how much money was made in this space last year. Should this be something we consider? Or even now, if we look at what’s going on presently in Europe, the incentive is well maybe I should be jumping into something. Time and private equity is not so easy from the investor side. You’re investing in a GP who can invest over a number of years, and if you’re trying to time it right now you should have committed last year or the year before. So I think it’s human nature you tend to want to go in that direction, but I think folks are getting better at knowing what the limitations are.

Snow: Of course one of the best ways to become sophisticated is to go through a gut-wrenching crisis of some sort and learn the hard way how to be more mature and sophisticated. I’m interested in your views on what investors learned from the most recent crisis not that we’re necessarily out of it. But from the depths of the most recent crisis about private equity that is being applied to the forward-looking opportunity.

Elio: Well, I guess I’ll start with at first. I think first is allocation as you addressed earlier. Allocations instead of worrying and staying out of the market altogether, allocations rather increased or those bands of tolerance were expanded so that folks weren’t making decisions just pulling out of the market altogether. Folks had seen some sort of a downturn earlier in the 2000s and learned from that. So their tolerances increased this time around.

Snow: Is that what you say as well?

Khalifa: Yeah, I think there were some pretty artificial constraints when people spoke about the denominator effect, the fact that the public markets are down, or the fact that your private equity portfolio is marked up. That actually reduces the amount of money you have available to commit, and I think LPs are now finding more innovative ways to sort of ban themselves.

Von Lehe: That’s right. I think it’s also important to look at the range of asset classes within private equity. Oftentimes people have just been focused on the large buyout, for example, or just a small range of activities within private equity, or thinking that you have to have the same asset allocation inside your private equity program at all times. One of the things that we did, for example, in ’07, was we actually underweighted large gap and over-weighted distressed. Now our clients are very happy that we did that, and I think that those sorts of activities of knowing it’s not perfect market timing, but it wasn’t too hard in ’07 to realize you’re probably a little closer to a peak than you were to withdraw.

And oftentimes those sorts of environments like you had in ’07 were a leading indicator of a good distressed opportunity down the road, and none of us realized it would be nearly as bad as it was. But I think those sorts of activities of people trying to be a little bit more active in terms of their asset allocation within private equity rather than just having the same fixed allocations every vintage year. I think that’s another aspect that you’re seeing.

Elio: And I do think a lot of the knowledge learned in this last downturn wasn’t within the private equity space itself especially with some of the larger clients. It was more at the total plan level, and I think that’s where a lot of the changes were implemented.

Snow: Well, of course there is gaining and sophistication with regard to how you construct your portfolio. There is going after different kinds of assets or a different mix of strategies. But then there’s a way you structure your partnership with your general partners, and I’m wondering if any of you can comment on signs of sophistication in terms and conditions and in the way that the GP/LP relationship is structured.

Elio: Well, I’ll start with that one as well. The [Institutional Limited Partners Association] has done a lot of work, so I’ll give them a little plug, doling out what they believe are the specifics of a good partnership arrangement between the limited partners and the general partners. Simple things like 100 percent management fee offset for certain monitoring or other fees that are earned things like that. I think LPs now understand these partnerships a lot more. They understand the terms more, and they’re getting more knowledgeable in negotiating these upfront.

Von Lehe: I think the terms and conditions are important, but I think it’s actually much broader than that. It’s actually the spirit and the real relationship of partnership between the general partner and the limited partners that is important.

One of the things that we figured out after the financial crisis was actually that there was a positive correlation between the general partners that were good partners and actually their returns. So the people that were good people treated their LPs well, and as true partners, actually had better economic performance in the downturn than the people that perhaps were a bit more arrogant or who hadn’t treated their LPs as well.

Snow: So nice guys finish first in private equity?

Von Lehe: At least in the financial crisis it gave me some hope for the world.

Khalifa: Or they find it easier to raise money. But people always talk about the balance of power, and I think balance is a keyword, because it swings slightly between the GP and the LP that there has to be a balance. You can’t go completely in one direction. You have to realize that, for example, ILPA guidelines – that’s exactly what they are. They are guidelines not rules that are set in stone, and sophisticated LPs sit down and have a discussion on each of these topics to make sure that it fits the general partner in question.

Snow: Maybe getting a bit more specific in terms and conditions because certainly one could suggest a broad range of best practices in terms and conditions, and then there are the ones that people actually really focus on. Which of the various terms within a partnership do you feel we’ve turned a corner on that were not going back to whatever the previous way of structuring things was and whether it’s the management fee offset or something like that’s in the rearview mirror and it’s never coming back? Can you give any examples?

Elio: Well, that’s one for starters – the management fee offset. I think folks are looking at where the GP is making their money and spending their money, and it really goes down to alignment. So everything comes into question whether it’s fees or carry or preferred returns. It’s not necessarily about what the specific number is. It’s about is the combination of those in the guidelines appropriate to incentivize that general partner to do their best for the limited partner.

Von Lehe: I think that’s a key point because I think sometimes in these term negotiations people get too focused on the specific legal provision and exactly what the percentages are and exactly what the fee rates are. Those are actually much less important in my view than to your point the actual what’s the true economic alignment? What is the true incentive for the general partner in trying to parse through the legal terms to figure out what those incentives actually are. I think that’s the key aspect.

Khalifa: I would have say the one turn that’s obviously changed that is going to be very difficult to get back to is deal-by-deal carry. When there was a shift over here through European waterfall that, funnily enough, there had been a couple of cases of LPs allowing GPs to go back to deal-by-deal carry when they were underwater to incentivize the team. But I just don’t think it’s going to be easy to raise a large fund with deal-by-deal carry today.

Elio: And I do think that brings up one other topic of a change. LPs before were much more passive, and yes, there needs to be a balance. But I think advisory boards have gotten much more involved in communicating with the general partner when there are concerns. It’s the good manager that calls you when things are good and bad because as long as you get the heads up that things are happening and that you’re working on it, I think that LPs really understand.

Von Lehe: It’s interesting though. It’s about my third cycle here where the pendulum swings back and forth with that balance of power, and the LPs always talk a very good game when it’s a tougher fundraising environment. But then typically they sort of give on a lot of these points when things go back the other way. I think it will be interesting to see if and when we ever get back to the fundraising environments of an ‘06 for example if the LPs hold the line as much on certain of these points. I think that they will on some but maybe less though on others.

Khalifa: I remember about nine or ten years ago I was in a meeting with one of our clients, and a very sophisticated European investor, and that LP turned around and said, “We’re really interested in making a commitment. The ICs discussed this fund, and we have 27 points that we feel strongly about that we would like changed in the LPAs.” And he handed over a piece of paper to the GP. The GP looked at it and goes, “Okay we’re not going to do any of this”, handed it back. And the LP without skipping a beat says, “Okay that’s fine. We’re it.”

In Latin America, a lot of the nonpublic pension fund money some of the corporate plans family offices over there, you know, lawyers tell me they can’t cite a single instance of a single demand being made of a GP. They just accept the LPAs as they are. That’s what it was like maybe 20 years ago.

Snow: Mike, I think you mentioned the boards, and so in talking about understanding the asset class adopting best practices, there’s the investment staff in a lot of these organizations. In many cases they are veterans of private equity and have all the scars to prove it, but then there’s communicating both the benefits and how to be a sophisticated investor to the overseers of these investment staffs. I’m wondering to what extent you feel that the understanding at the very highest level of these organizations has evolved lately.

Elio: I think it has involved an awful lot. They are used to seeing the private equity professionals present investments to the team. It’s getting more and more common for the general partners themselves to present every time something is being brought to the board for investment, and there’s a lot more training and education going on at the investment committee level. Obviously, every organization has a different structure and different approval process, but there’s a lot more education and it’s permeating a lot of different groups around the country.

Von Lehe: Wouldn’t it be fair to say that actually a lot of credit to that really goes to the staff, the private equity staff at these organizations whose one of their key jobs is actually to educate those board members on the asset class. I think as the staffs become more sophisticated, they’ve been able to do a better job of providing education to the board members.

Khalifa: Absolutely.  You’ve also seen the whole investment process become much more sophisticated, a lot more due diligence being done, and that sort of filters up as well because the people on the boards are looking at the work that’s being done to get to that investment. If you went back to the 1990s, diligence was very rudimentary and there’s nothing a board member would be able to learn from that one page investment recommendation.

Elio: Right. There are a lot more knowns and unknowns in the policies and procedures that have been developed over the years, so most boards even if they’re newer they know what steps have been taken before an investment gets to them, and that certain things have been vetted and discussed and diligenced as well.

Snow: Well, certainly under the topic of changing LP appetites, there’s a lot more to talk about. We can talk about how LPs are streamlining their relationships. We can talk about how LPs are looking for growth in returns, but I think for now let’s pause. I’d like to thank all of you for being here today and think you for joining Privcap

EXPERT Q&Q WITH HUSSEIN KHALIFA, MVISION

Privcap: What should GPs know about today’s fundraising market?

Khalifa: So the fundraising market today has improved considerably over the last couple of years.  When many programs were shut down, LPs were looking at one another and looking at us in confusion not knowing if they would have money to invest or not and that’s opened up. We’ve seen a lot of money being put to work. But if you look into 2012 one thing is clear in that there is a finite amount of dollars available, and every large manager is going to be coming back to the market. Any new GP is going to have a challenge competing for those dollars with established names and a host of new first-time funds that are going to be out chasing the same dollars.

Privcap: How can MVision help GPs with the fundraising process?

Khalifa: At MVision, we view our service as funding a business. It isn’t just raising a single fund. It is working with a general partner to identify the best long-term investors over multiple funds. People that are going to grow with you and stay with you as you grow your own firm. What we bring to the table is a shortening of the amount of time that it is going to get you to raise money. We are providing insight into the way investors think and how they make decisions. It is not a question of opening doors. Anybody can buy a directory. Anybody can look up the names on the Internet of the big-named investors. It isn’t even access, but it’s making sure that you’re working with the investment team understanding what the consultants are doing with those LPs, and making sure that they are getting the right information to be able to move forward in their investment decision making.

The GP should be doing what the GP does best, which is investing money as opposed to being out in the world dysfunctionally spending a long time trying to fundraise. If we can help them shorten that process and make that process less painful, we believe we’ve added a lot of value.

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