The perfect LP base: A taste of traditional investors

Read part 1 and part 2 of this series

Foundations and endowments
For European private equity, one of the most active players in this space is an Oxbridge cluster of student college endowments. One of the flagship names is Oxford University Endowment Management (OUEM), which has gone from allocating 8% of its capital to private equity in 2012 to 20% in 2015. Interestingly, the uptick comes after CIO Sandra Robertson launched a scathing attack on the asset class at the 2013 BVCA Summit, questioning whether the industry's returns are worth the fees and effort.

OUEM's US-based counterparts include Ivy League heavyweights Yale and Harvard University. The former is, by all appearances, a private equity enthusiast: at 33% of all allocations, the asset class was the endowment's favourite in 2014, far ahead of real estate's 17.6%. In spite of the evident appetite, Yale vowed that same year to bring down its allocation to 31%, mirroring the Harvard endowment's decision to slightly reduce its exposure.

As with many other investors within the private equity space, rising valuations are acting as a deterrent. Helped along by generous tax breaks and strong private equity returns, the dedicated programmes from both LP types are sitting on large cash piles, seeking to be reinvested in private equity. However, as more capital flows in, the issue of rising asset valuations is only exasperated further. Indeed, a recent survey by consultancy NEPC found that 58% of foundation and endowment managers regard rising private equity valuations as their top concern.

The report also found that 48% of these LPs expect a decline in private equity returns in the coming years. Against this backdrop, foundations and endowments are turning to co-investment, much like the rest of their LP peers.

The impact of these reviews by foundations and endowments remains to be seen. However, as they are traditionally more active investors in US GPs, these LP types remain cautious when investing in Europe, particularly the southern European region, says Activa's Michael Diehl. According to him, one way to entice these investors is to make sure ethical and ESG aspects are accounted for in the investment process. One of the key supporters of the fossil fuel divestment movement, academic institutions have felt the pressure to stick to environmentally friendly allocations.

Sovereign wealth funds
Sovereign wealth funds (SWF), alongside pension funds, are leading the charge when it comes to major shifts in LP behaviour – namely investing bigger tickets with fewer GPs. Despite this, private equity firms appear to enjoy this set of investors. Equistone managing director Peter Hammermann, says: "It is pleasant to deal with investors who have a lot of experience and are willing to invest larger sums if they like a GP. This can make fundraising a lot easier at times."

The Sovereign Wealth Fund Institute calculated that private equity makes up around 5.7% of all allocations, with those from Asia and the Middle East topping the list. The institute also stated that those state-owned funds are continuously growing, despite the shrinking oil and commodity prices, and are seeking to increase their commitments to private equity funds.

SWFs make such a good fit with private equity because, unlike pension funds, they don't need to worry about immediate liabilities and they enjoy tax sovereignty immunity, so are more flexible than pension funds when investing in illiquid assets. They are, therefore, better protected than other LPs against some of private equity's intrinsic weaknesses.

Despite those positive aspects of the relationship, SWFs are increasingly of the mind that the standard distribution scheme is unfair on them. Some are trying to sidestep private equity altogether by creating their own investment teams. So in order to stay attractive and relevant, GPs must be flexible and boost their co-investment offerings.

A neat example of their growing co-investment appetite is the Korea Investment Corporation, which hosted the first co-investment roundtable of sovereign and pension funds in November 2014, with 30 global investors participating. GPs are also responding to these new needs. CVC, for example, launched a $4bn fund dedicated to SWFs, with a lifespan of 15 years and a targeted IRR of 12-14%.

Funds-of-funds
The presence of a fund-of-funds in an LP base is good news for any GP, says Activa's Diehl. Their added value stems from strong expertise of the private equity marketplace; positioning themselves as an authority. "Funds-of-funds are well respected by other investors, they can be strong opinion leaders. Having one of them in your fund can act as a bit of a bell-cow that brings in more investors," says Diehl.

Christopher S Bödtker, managing partner at fund-of-funds Akina Partners, echoes this view: "When we work alongside other LPs for a fundraising, they often ask us about the strategies and fund terms and conditions we're seeing used in other European markets. We try to establish a bit of a dialogue with other LPs, to bring more than money to the table."

Another well-regarded feature of funds-of-funds is their predilection for under-served markets. "They fill a bit of a gap in the sense that they tend to have a very strong bias towards small- and mid-cap funds and country-based investment. They usually do extensive work mapping what they consider the best players in each European country," says Activa's Diehl.

"Countries and local understanding are important for us," agrees Akina's Bödtker. "When we invest, we want to see not only that the GP is strong in certain themes and specialisations, but also that such themes and specialisations make a good fit with the area they operate in. Economic headwinds in the country in question can make a huge difference."

As funds-of-funds have their own investors, they are forced to simultaneously juggle the agenda and demands from their own LPs with those of the GPs they have invested in. Striking a balance can prove tricky at times, Bödtker says: "Our position is quite interesting in that we need to be prepared to offer something to both sides, negotiate terms and conditions with GPs as our own LPs do the same with us."

As the entire institutional investment universe seeks to reduce fees, fund-of-funds have been kept on their toes in terms of keeping their model relevant and valuable. Many have found their best hope for survival lies in staying small and fee-flexible. Life lines have emerged through focusing on the small- and mid-cap spaces – where the amount of players and, consequently, the need for a funds-of-funds offer is greater – and on keenly-priced individual mandates.

Family offices
The relationship between family offices and private equity funds has intensified in recent years. While in the past, wealthy individuals have often quietly committed their cash to funds, they seem much more involved nowadays. Greg Harris, a senior investment manager at Matiland, who advises family offices on their investments, observes their largest appetite is for mid-market funds run by accessible teams. Family offices, like all other investors, are trying to generate strong returns in a stifled economy and private equity is a way to achieve this. "Private equity is a way to do that but it involves not being able to get your money when you need it and returns being somehow unpredictable. So it's profitable, but you need to plan ahead for it to work," says Harris.

Joerg Sperling, managing partner at Alpina Partner, has family offices among his LPs and values the increasing professionalism shown by them: "Nowadays they know exactly what they want and are very well organised. Those changes came about because they are trying to have more exposure to the assets."

The accessibility to GPs and portfolio companies is essential to a developing strategy and philosophy, in which family offices seek to be investors in funds as well as co-investors. Daniel Koppelkamm, principal at Jadeberg Partners (formerly Mountain Cleantech) sees these investors being more proactive: "Nowadays, family offices want exposure to deals. I would say that over the past one-and-a-half years this became more popular. They first co-invest with a partner and later by themselves." Jadeberg has recently co-invested with Belgian family office PE Group. The growth investor sought a partner for its acquisition of a €6m minority stake in Antwerp-based software company MCS. It found the family office to be a suitable partner with local knowledge.

Besides the co-investment trend, family offices are increasingly demanding stronger reporting. While Harris praises improving quality of reporting on the side of GPs, among the individuals who manage large family fortunes there seems to be a new generation with new requirements. They not only want their investments to generate large returns, but also bring returns for society at large. "Measuring impact is increasingly important for investors," says Koppelkamm. "They want social and environmental returns and ask GPs to report on non-financial performance."

Pension funds
Pension fund managers often top the industry's worldwide LP rankings, and keeping them close is a bet that always pays off in the long run, says Activa Capital's Diehl: "Pension funds have a long-term vision not only on asset class performance, but also on relationships. The entry barriers are quite high, but once you're in, they tend to be very loyal investors." Activa, which recently concluded fundraising for its third vehicle, has raised 31% of its capital to date from pension funds.

And the feeling appears to be mutual. "We like private equity. In a difficult global environment, generating a strong alpha is critical for pension funds and the asset class has proved its worth at that," says Simon Moss, partner at Hermes GPE, which manages the investment portfolio of BT's pension scheme.

Although BT's appetite for private equity is here to stay, Moss reveals that swelling valuations and leverage ratios have sparked a need for greater control over exposure to the asset class: "In the early 2000s, we could take blanket exposure, we didn't have to be creative about the fund portfolio that we built. Today, extracting the alpha is much harder than before, we need to choose more carefully the private equity niches where there's still good value."

As part of those changes, the LP is moving away from large-cap funds and into smaller, sector-specific vehicles. In addition, co-investment has become a key strategy; half the funds raised for the new £1bn investment programme will be allocated to co-investments. According to Moss, a way to reach that target is by being pro-active with deal sourcing: "It's a bit of a reverse marketing with GPs. We try to generate as much dealflow as possible, we track about 200 deals a year on the co-investment side, of which 10-15 end up crystallising."

While pension funds are one of private equity's biggest supporters, given the nature of their capital, they are also the most likely to push GPs on emerging corporate trends, including ESG. According to Anna Follér, a sustainability manager at Swedish pension fund AP6, poor ESG can even be the basis for the LP to turn down a fund. Fortunately, GPs have responded well to this pressure. "Pension funds are one LP that is pushing factors like ESG very high on the agenda. If you want to attract their money, you need to have a solid strategy in that respect," says Activa's Diehl.

Another top concern among pension funds is fee transparency. Having recently met Ruulke Baagijn, the private equity head at Dutch pension fund PGGM, which announced a plan against fee-opaque GPs, Hermes's Moss echoes her calls for concerted action: "It is critical that LPs speak as one on this, but the problem is our community is always divided." The thriving fundraising scene is not helping things either; cash-rich LPs are turning a blind eye to unfair terms to guarantee their place in the strongest performing funds. "There have been some ludicrous cases, yet people are still signing up. During certain times of the cycle, it all becomes ‘take it or leave it' and GPs are playing on this to really push terms."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• LPs
• Fundraising
• LP selection series
• Top story