The perfect LP base: Diversification or concentration?

European GPs are making the most of a buoyant fundraising market. In 2015, Blackstone VII, Carlyle IV, EQT VII, Warburg XII and Bridgepoint V all held fast and final closes. And it looks as though 2016 could be an even bigger year for fundraising with Advent International aiming for $12bn, Apax Partners $7.5bn, BC Partners €6.5bn, Permira €6.5bn and Cinven seeking $5.5bn.

According to Mounir Guen of MVision, these funds should raise relatively easily: "European GPs have been consistent and have been underweight in US LP portfolios. Good, solid names, with good track records, are being well received by the investor community, which hasn't done enough of these."

On the surface, the situation looks rosy – LPs are positive about private equity as the industry continues to outperform other asset classes. However, a closer look at LP behaviour reveals some interesting nuances. Institutional investors might be increasing their allocations but internal resources on the whole have not grown in step with this development. Pablo de la Infiesta, European head of the Lazard Private Fund Advisory Group, says: "In many instances, the number of professionals at LPs has not grown, though their allocation to private equity has – so, many of these investors are shifting towards focusing on fewer relationships and increasing ticket sizes. Some sovereign wealth funds and pension funds are examples of this trend."

So while the appetite might be there for European GPs, it is likely that many funds in the market will find themselves oversubscribed and will be thinking more carefully about which investors to work with.

In this situation, there are varying schools of thought over the best direction to take.

Allsorts of thoughts
Traditionally, a diverse LP base has been the preferred option. Synova Capital, which recently closed its third fund on £250m after just three months on the road, opted for widening its investor base. Managing partner Philip Shapiro explains how it had to scale back commitments but was able to provide acceptable allocations. And when deciding which LPs to work with, he outlines four main factors: "We thought about the long-term commitment of the LP to the asset class. You want a healthy level of re-ups, so you're looking for partnerships over three funds and we were able to filter those LPs whose outlook was less long-term."

We thought about the long-term commitment of the LP to the asset class. You want a healthy level of re-ups, so you're looking for partnerships over three funds and we were able to filter those LPs whose outlook was less long-term" – Philip Shapiro, Synova Capital

The next factor was relationships. "If there are difficult decisions, you want to know you will be able to work well together and that those individuals on the advisory board are key decision makers," says Shapiro.

While this was an important feature for Synova, Lazard's de la Infiesta believes GPs should not be overly concerned on this front. "Each LP type has a different investment decision-making process and at the outset some of these processes may look more complex than others. We encourage GPs to also approach those LPs with less familiar or more complex investment decision processes so that the GP can benefit from a diversified investor base. Having said all this, it is key that you feel positive about the relationship at the outset," says de la Infiesta.

Third, the Synova team was keen to include a mix of LP types in its fund. "You don't want to be overweight with one type in case there are changes in their industry," says Shapiro. Indeed, looking back over regulations that have come into force over the past decade shows the danger of being overweight in one particular LP type. Basel III hugely restricted how banks could invest in private equity, essentially making it much more expensive. This resulted in some GPs having to entirely overhaul their LP bases when bringing new funds to market, or for captive funds themselves spinning out of their former bank parents and becoming independent entities. Meanwhile, Solvency II restricted how insurance funds could invest, resulting in similar outcomes, with Axa's private equity arm notably spinning out in 2013 to become Ardian.

The fourth consideration was the geographical spread of investors. "We always put effort into fundraising outside the UK and Europe, because, with something like the European economy in 2011-2012, where investors turned away or stopped investing, you need to have the ability to bring in funding from other geographies," says Shapiro. Furthermore, Synova has been building LP relationships further afield to develop a more diverse network. "If you've only raised from domestic LPs and they are no longer active, then it's very difficult to break into new markets. We have grown in Asia with sovereign wealth funds – that will be an important reference for future funds as we further diversify outside of Europe," says Shapiro.

Concentration contemplation
While diversifying the LP base appears a sensible approach in terms of ensuring the success of future funds, this traditional method fails to take into account changing LP behaviour. Many LPs, particularly pension funds and sovereign wealth funds, are looking to deploy larger tickets with fewer GPs. While some funds continue to push for diverse LP bases, one extreme being Advent, which is understood to be expanding its LP base even further, others are happy to take on a more concentrated investor base, with Cinven thought to be at the other extreme.

Furthermore, the most obvious consideration for a hugely diverse LP base is the sheer level of resource needed to administer a high number of investors. For GPs such as Advent, having a large back office team to look after LPs is feasible. But for many GPs, it is important to have face-to-face relationships between senior partners and the chief investment officers of the LPs. "We focus on building relationships with our LPs. It's all well and good to have a great back-office function administering LPs, but you want that face-to-face contact between senior partners and key decision makers," says Shapiro.

Now, as a GP, you need to make a decision on having a broad and diverse LP base or a concentrated one. In the short term, this depends on how long you want to be in the fundraising market or how quickly you can execute the fundraise. You have to weigh out that dynamic" – Mounir Guen, MVision

For MVision's Guen, GPs will soon have to start making a choice between diverse or concentrated LP bases: "Now, as a GP, you need to make a decision on having a broad and diverse LP base or a concentrated one. In the short term, this depends on how long you want to be in the fundraising market or how quickly you can execute the fundraise. You have to weigh out that dynamic."

According to Guen, when MVision is placing a fund, it models for a 50% re-up rate, with existing LPs coming in at 1.5x their previous commitment: "If you lose less than 50% of your investors then you are in a good position; if the rest come in at 1.5x you'll automatically be over subscribed."

But to adapt to changing LP behaviour, is it possible for GPs to absorb the larger commitments on offer? Guen says that some GPs are opting for more concentrated LP bases because it means managers have the ability to really get to know their investors.

Furthermore, Guen estimates there are currently around 20 mega-LPs in the market and this number is set to double in coming years: "Those GPs demonstrating that they can work well with mega-LPs will find it easier to create alternatives for those investors when their programmes change."

While there is plenty of reason behind having a diverse LP base, it would seem a new private equity model is emerging to satisfy the shifting needs of investors. "Those that are concentrated are showing they are differentiated, which is what it's all about," says Guen. "For them, it's about a partnership, not a limited partnership."

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• Topics
• LPs
• Fundraising
• LP selection series
• Top story
• Synova Capital
• MVision Private Equity Advisers
• Blackstone Group
• Carlyle Group
• EQT
• Warburg Pincus
• Bridgepoint
• Advent International
• Apax Partners
• BC Partners
• Cinven