Wouter Pelser: CIO Mn Services
“Changes are necessary to ensure the sustainability of private equity investments and commitments by pension funds”
Private equity (PE) has been praised as a profitable investment category, as well as for its benefits in terms of innovation, start-ups and for the beneficial development of portfolio companies. But it has also been criticised for high fees, irresponsible practices, insufficient governance structures, excessive leverage, lacking transparency of revenue distribution and for slow adaptation of responsible investment and corporate social responsibility.
Both public and politicical opinion has been negative, sometimes even hostile to PE. Although not all well founded, some criticisms have been valid and caused institutional investors, Dutch pension funds included, to be reluctant to allocate to PE. So changes are necessary to ensure the sustainability of PE and continued commitments by pension funds. In a joint initiative to stimulate debate and set the stage for future PE investments, Mn Services, SPF Beheer and Syntrus Achmea, fiduciary managers for pension funds, highlight some of the challenges the industry has to address.
In May 2010, Ludovic Phalippou published his research findings on PE showing some major shortcomings in current PE-practices*. His conclusions are disturbing: “Using internal rate of return not only means that the investor has a distorted view of performance, but in addition, creates perverse incentives for fund managers.” Two other quotes: “Private equity firms have lots of room to window dress their past performance” and “…the method used for industry benchmark systematically bias upward true performance in the long run.” Although gross PE returns may be above the performance of listed equities, risk-adjusted returns for private equity investors - limited partners (LPs) - do not match that positive outcome. Add to this the fact that due to inadequate responsible investment and CSR-policies PE-investments are generally considered as a major risk to the reputation of pension funds, it becomes clear that action is required.
There have been a number of initiatives to address these issues: the UN Principles for Responsible Investment Guidance on Private Equity, the (recently amended) ILPA-guidelines, and industry initiatives like the PEC Guidance and EVCA Professional Standards. However, we think that these initiatives are not enough. Suggested best practice does not always address the key issues, is often too weak to really make a difference or is voluntary and aspirational, creating an atmosphere where people in the industry feel comfortable with all the guidance, statements and codes, without sufficient progress in actual performance. The industry should leave this phase of good intentions behind and start to implement responsible investment practices in PE. Issues include PE-governance, responsible investment and CSR, alignment of interest and fee structures.
Although the corporate governance of portfolio PE companies is generally better managed than in public companies, governance structures that supervise the relation between general partner (GP) and LP do not provide the LP with sufficient control mechanisms. The International Limited Partner Association (ILPA) proposed best practices to overcome some of the governance issues LPs are facing with their GP. Putting these principles into practice would decrease the problems, but three issues remain:
• LPs need full transparency about all arrangements between GP and LPs at the moment of entering a limited partner agreement (LPA), including the application of the ‘most favoured nation’ principle;
• LPs must have the governance instruments to oversee the proper execution in line with the LPA;
• A mechanism should be in place to deal with any arising issues not dealt with by the LPA.
An annual meeting of LPs with agenda items like the annual accounts, appointment of the auditor, appointment of a new ‘key man’, appointment of members of the advisory committee, changes to the LPA, is necessary for LPs to be in control without changing position as an LP. Adoption of changes to the LPA should require a qualified majority of 75% in the annual meeting of LPs. As a matter of last resort, an LP who disagrees should have the opportunity to ‘opt out’ of an investment in a particular company or completely withdraw from the LPA.
A growing number of investors manage their assets in accordance with generally held views about responsible investment and have decided to take environmental, social and governance (ESG) issues into account in their investment policies and investment decisions. As signatories to the UN PRI we:
• Will incorporate ESG issues into investment analysis and decision-making processes;
• Will be active owners and incorporate ESG issues into our ownership policies and practices;
• Will seek appropriate disclosure on ESG issues by the entities in which we invest.
The UN PRI has published a UN PRI Guide for Limited Partners, which we endorse. But responsible investment also poses challenges to GPs. PE firms should sign up to the UN PRI and take steps towards implementing responsible investment policies, as well as secure corporate social responsibility in their portfolio companies.
Exclusion policies of LPs should be facilitated. ESG criteria should play a role in pre-investment decision making, management of portfolio companies and at exit, when portfolio companies should be fully compliant with UN Global Compact provisions, which include norms in the areas of human rights, labour rights, environment, corruption and (based on the OECD guidelines) supply-chain issues. Stakeholder dialogue should be a normal part of portfolio company management.
We believe the ILPA-guidelines provide clarity on how to align interests and create viable fee structures. The alignment of interest between GPs and LPs should be adjusted in the interest of the LPs, as the current situation is not viable long term. Current practice in areas such as management fees, operational costs, placement fees, transaction fees, catch-up arrangements and other arrangements beside carry, put alignment of interest in jeopardy and cause a distribution of gross revenues that is no longer acceptable. It is also no longer acceptable that GPs are rewarded for merely lifting on the general trend of the market. We have to return to the original idea that GPs get paid for well-defined operational costs and performance. Transparency of costs and performance is necessary as a first step towards better alignment of interest.
Despite the good work done by the UN PRI, ILPA, EVCA, and some of the leading PE firms, PE requires two things to remain a sustainable asset class. First, standards must be set even higher than what is proposed by the organisations mentioned above. We have made several proposals to raise the standards in this article. Second, good intentions must be translated into better practices. We believe PE, in most of its forms, is an important asset class, with great potential for creating sustainable economic value for society and investors.
But we fear that the industry is too complacent to recognise the challenges of this new era. Therefore, we call for better governance, better risk management, appropriate fee structures, improved alignment of interest, increased transparency, responsible investment and corporate social responsibility.
* Regulating Private Equity, 2010, Amsterdam Center for Corporate Finance