Private Equity: Springclean for portfolios
Joseph Mariathasan looks at the challenges facing pension fund limited partners trying to manage the size, complexity and risk exposures of their private equity portfolios
A fundamental characteristic of private equity investments is that they are illiquid. But that does not mean that investors should forget about their private equity portfolios once they are set up.
“Good LPs are constantly reviewing their programmes, assessing asset allocation, looking for new markets, and justifying their fund selections,” says Kathy Jeramaz-Larson, executive director of the Institutional Limited Partners Association (ILPA).
And yet, while the average US pension fund that committed 3% to private equity at the turn of the century now commits more like 10%, Joncarlo Mark, founder and managing member of Upwelling Capital Group points out that the private equity teams at those funds have not grown by anything like the same factor. He should know: before establishing Upwelling Capital in 2011 Mark managed private equity investments as a senior portfolio manager with CalPERS, and saw its programme grow five-fold to $48bn during his tenure. So how easy is it today to manage a private equity portfolio once it has been set up?
That is a function of many variables, but clearly a key issue is the number of general partner (GP) relationships. That number, as Jeramaz-Larson finds, is highly dependent on the size of an LP’s programme, the size of the team and the goals for the portfolio. “Having said that, LPs are trying to cull their relationships to make them more manageable,” she observes.
Clearly, smaller, less well-resourced investors using a fund of funds will probably have fewer direct GP relationships than those who are investing via individual funds.
“Generally I think that it is – if possible at all – very difficult to determine which is the optimal number of GPs,” says one treasury representative for a large European corporate pension scheme. “You will probably have fewer direct GP relationships when investing via funds of funds and more relationships when investing via single funds. Next, size matters; the bigger your allocation the higher the number of relationships. But when your allocation is higher you are probably working more with single fund managers than with funds of funds – hence a bigger number of GPs for larger plans.”
Alan MacKay, CEO of Hermes GPE, offers some general guidelines: “A global private equity programme will struggle with just 10 GPs but can make do with 30. However, a UK-only portfolio could easily manage with 10 GPs and you would ask questions if it had 30.”
He sees a minimum of 50 as preferable in a completely unconstrained global portfolio, but questions whether there is any logic in having more than 100 GP relationships.
“If you imagine there an average of 15-20 investments in each buyout fund – and in venture significantly more than that – an average of 100 managers and 2-3 funds with each manager means exposure to 6,000 underlying companies,” he estimates. “Most thoughtful investors would see that this level of diversification has an averaging effect which dilutes the performance of what is intended to be an alpha-seeking, return-seeking asset class.”
But that is the problem with committing to this asset class. Investors with a long-term allocation almost inevitably see the number of their GP relationships creeping up. The challenge is to recognise this tendency and try to stay balanced.
“You need to re-up with those GPs who have provided you with a wonderful return, culling those GPs who haven’t performed, while making sure you maintain a diversified portfolio from venture capital to mega players in the various geographic allocations,” says Russell Steenberg, head of private equity at BlackRock. “That is a constant process.”
A re-up with a successful manager is an easy enough decision to make. But ‘culling’ is surely trickier: if there is something seriously wrong, is it satisfactory merely to let a relationship run its seven-year course and then not re-up?
When portfolios run into difficulties, there is a clear route to follow, explains Mark at Upwelling, which, as well as managing over $50bn in private equity commitments, also handles more than $4bn in what it describes as “legacy, tail-end commitments, transfers and workouts for leading institutional investors”.
“First of all, LPs need to understand their legal rights in the partnership agreements and know the value of their portfolios at the underlying asset level,” he says. “They can then decide to either watch developments and do nothing. Alternatively, they can use the secondary market to extract liquidity, albeit often at a discount. And thirdly, they can adopt an active stance with their manager, resetting terms, re-aligning interests or restructuring the fund, and in extreme circumstances, dissolving the partnerships.”
Active management can encompass strategies ranging from changing the fee terms on a fund and committing an extra pool of capital to the manager, to the opposite extreme of the removal of a manager and the sale of assets. “In many cases, an LP cannot do this by itself, but as a group of investors, it is possible, although this activity clearly requires dialogue and communication,” Mark explains.
Thomas Kubr, executive chairman of Capital Dynamics, downplays this kind of scenario. Fraud is very rare because the nature of the underlying investment is very transparent, and compensation based on long-term performance keeps a lid on major dissatisfaction. But he concedes that personnel changes can have a significant impact.
“There may be a partner with a new set of priorities that don’t necessarily align with those of the other partners or the investors,” he observes. “This can really shake up the dynamics of a team or even a firm.” He also points out that the financial crisis exposed a number of issues within partnerships, and sapped a lot of the energy and incentive to perform from many partners.
“They may not have any carry in their existing funds and are not in a position to raise new funds,” he says. “Some well-known firms have funds that still exist, 10 years beyond their expected lifetime, and 20 years after the fund was launched.” Such funds will have no economic impact on the economics of the GP or the LP; the IRR has already been set for the period, but the firm is still struggling.
One clear distinction Kubr makes is between those GPs that would be able to launch a new fund and those that would not. In the latter case, the GP is in crisis. The firm should have been set up to make investments but now is in the situation where it can only harvest. A GP in distress will usually come up with a solid plan on how to switch the activities of the firm to reflect the current environment and challenges, which usually involves reducing the team size while gradually selling off the portfolio. How the partners deal with this situation is a mark of their integrity, says Kubr. “A fundamental part of due diligence is understanding the basic business ethics of the GP,” he says.
The fact that private equity investment is based on commitments rather than up-front cash can help – there is usually spare capacity available to top-up funds that are doing well, opportunistically. But today’s marketplace also offers more tools for portfolio management than it has in the past.
“The only management you used to be able to do was by adding things and letting things drift into the sunset by themselves,” says Steenberg. “In today’s world, you have a far more active secondary market – although it is not as liquid as many people would like you to believe. CalPERS has done two or three secondary portfolio trades, State of New Jersey has done one and there are probably many other examples of LPs using the secondary market as a tool to manage their portfolios.”
There has been a significant change in the positive attitudes both LPs and GPs have about the use of secondary markets, says Mark at Upwelling. As well as helping LPs manage complex portfolios and mitigate the j-curve associated with the early stages of fund investments, GPs tend to be happier to see their fund taken up by a new LP that is more likely to commit to a future fund, he explains.
“In 2003, the secondary market turnover was just $3bn, but in 2011-12, it averaged $25bn per annum,” he says. “That needs to be compared with a total market size of $3trn, however, so there is plenty of room for further growth.” He adds that secondary trading, so far, has been predominantly in the US and European markets and that over the next few years we can expect an increase in emerging markets, particularly Asia.
But despite this growth, Steenberg notes how cyclical the secondary market has been – and the extent to which that cyclicality is linked to regulatory developments. When financial institutions are forced to hold more capital to back risky assets, private equity is not that attractive, so Basel I, II and III, the US Dodd-Frank Act, and Solvency II have all forced financial institutions to cut back their private equity portfolios using the secondary marketplace. And while he concedes that wholesale, CalPERS-type portfolio restructurings can be quite efficient, he warns that opportunistic sales of stakes in one or two funds for rebalancing are less so, and often force investors to take a bigger discount. “A lot of players, particularly fund of funds like ourselves, are buying and selling in this space,” he says.
Virtually every option for secondary trading that exists in the public markets has an analogy in the private markets, but is very underdeveloped. For example, public markets are supported by large numbers of retail investors – but while there are retail investors in private equity those numbers remain negligible. Mark even sees the rise of private equity exchanges where LPs can trade interests in private equity funds.
MacKay at Hermes GPE sees public and private equity markets as ultimately different facets of the same asset class, with the tools and management approaches converging and the two ecosystems looking much more similar, with both markets getting a better balance between primary and secondary trading. For private equity LPs, that can only be a good thing.