Finding value in the GP/LP relationship
Private equity investing has always been rooted in forging trusted relationships between managers and investors. Relationship building has been central to its success, but the impact of Covid-19 and the move to remote working has arguably put a strain on the GP/LP dynamic this year.
As such, maintaining strong ties has become more important than ever; not only to find value in financial terms, but also in terms of communication, transparency, and a willingness among GPs to evolve with the times, in respect to fee structuring.
Over the past couple of years, the pendulum has swung between an LP-favourable and a GP-favourable market. And despite record amounts of dry powder and seemingly faster fundraising cycles, the coronavirus pandemic has arguably brought the pendulum into equilibrium, as both parties take stock of the upheaval.
Transparency on asset valuations
“One former colleague of mine who is now a COO at a private equity fund said that Covid-19 had really impacted some of their retail-focused investments in their portfolio,” says James Morris (pictured), Senior Commercial Director, TMF Group (London). “One of the biggest pressures managers face is comparing performance with past years and fund vintages. This former colleague added, ‘You’ve got to keep going with your strategy, and stay committed, to ensure your LPs remain loyal.’
“Keeping investors on side is key for GPs in this environment, especially if they are aiming to raise billions for new funds.”
In the eyes of investors, GPs don’t want to lose their reputation by having bad investments on their books. Some managers who were hoping to deploy some of their dry powder into opportunistic investments are now using it to support the financial health of portfolio companies.
Even if some underlying portfolio assets have been badly impacted by Covid-19, provided there is good communication and reporting, in terms of potential liabilities, it is likely to give investors the trust they need to continue supporting that GP.
GPs see the value of keeping LPs abreast of developments to strengthen the relationship and technology has been instrumental in this, as investors ask for different levels of transparency and bespoke reporting for conveying key performance indicators.
“What does technology involve?” asks Morris. “It’s the output the LPs ultimately see, and it’s an ever-evolving target with respect to GPs. It’s expensive to do, it takes time to generate reports in the right format and so on. From an LP’s perspective, if you are investing a lot of money with a GP you want to see some real clarity on what that investment looks like; short-term and long-term liabilities, potential gains, how the fund is performing from a risk perspective, etc.
“As an industry, I think the whole approach to reporting on real assets has been a little slow to catch up but some platforms are now gaining traction. Indeed, we have implemented a platform, which propagates all of TMF Group’s data into one place for GPs to access. Real time access to all relevant information right across the investment structures empowers GPs to deliver that clarity and transparency to their clients.”
Accurate valuation reporting is a key part of the value proposition today, given the dislocation in pricing in vulnerable industry sectors such as retail, energy, aviation, and commercial real estate. The near-term focus should be on adjustments to multiples and discount rates rather than long term projections so that LPs are clear on what the fair value of an asset is, should they need to go to the secondaries market to free up liquidity.
Going forward, Morris thinks there’s a huge opportunity for more third parties who provide valuation expertise. “I think that the market will evolve if PE wants to be a more open, transparent market; to achieve this, investors will continue to want more information and this will rely on assets being accurately valued. LPs want much more transparency on valuations, especially in this environment.”
Bespoke reporting will vary depending on the sophistication of the underlying LP and what it is they want to see reported but Morris is quick to assert: “I have seen a massive shift in this over the last few years. If managers are looking for something more bespoke and flexible, and want speed to market, smaller independent administrators will be better placed than the big bank-owned administrators.”
Side letters and lower fees
Part of the drive behind more bespoke reporting is down to LPs seeking to use side letter agreements to find additional value in their GP relationships. These agreements might be used to re-negotiate carried interest, management fees, and other considerations but all come with their own set of reporting, which the GP cannot standardise.
Morris expects to see more LPs insisting on side letters and separate arrangements. He illustrates the point by referencing an infrastructure manager who recently launched a large fund. However, overall LP commitments were significant, almost 45% were in separate arrangements.
“The bigger LPs have this buying power. If you’re one of the more established, large-cap GPs in the market you have to move with the times. Better terms can be absorbed in a side letter, which is much more profitable for them to do so than just reducing the fees for the first tranche of investors coming into the fund.
“However, smaller GPs who want to get their fund to market will have to accept lower management fees to bring investors into the pooled vehicle as opposed to using specific side letter arrangements, as they are timely and costly,” comments Morris.
He adds that mid-market GPs may be slower to adopt the use of side letters “but they will follow”.
“I don’t think GPs, broadly speaking, can realistically maintain their current management fee structures; they are too high. In the current environment, if some investments in the portfolio become insolvent, and a GP’s track record is impacted, investors will want a better price for what is potentially a higher risk investment.”
For the PE industry to continue to be successful, it will need to look for ways to evolve and mature: maturity as it relates to reporting, transparency, and valuation methodology.
“Everyone has to take a step forward and move with the times to maintain a good GP/LP relationship, and ensure PE remains a viable asset class to invest in,” asserts Morris.
LP investment focus
As LPs evaluate future investment opportunities in private markets, a few areas could look appealing. One is the secondaries market. This market has continued to go from strength to strength, with deal volumes and numbers building up some good momentum in 2019. The outlook for 2020 has obviously been tempered by the pandemic, and while there are a lot of GP-led deals currently, the reality is not a great many will likely be completed on. The same applies for LP-led secondaries; why sell today unless it is necessary?
That said, some LPs will look to capitalise in the lower- and middle-markets where sellers are more willing to accept a discount if they have a low fund liability (ie 20 per cent) compared to a fully funded liability. And if valuation reporting is accurate, this too could support further deal activity as LPs divest parts of their PE portfolios.
“Coming into the early part of 2020, especially in the US, we were seeing a lot more PE secondary structures coming to market; mainly Cayman/Delaware structures. With Covid-19, though, I think both GPs and LPs are battening down the hatches a bit, consolidating their position, certainly while the public equity markets continue to perform well,” states Morris.
He concludes that UK-based LPs are focusing their efforts on taking advantage of investment opportunities within distressed and dislocation credit portfolios, core and value add infrastructure as well as specialist private equity strategies:
“Infrastructure will continue to be strong and in the real estate market, we might see some UK Government-backed bailout funds. Much depends on what happens next with Covid-19 and whether there ends up being a second wave. I see more distressed assets coming into view as we head in Q4.”