Private Equity and the Hunt for Control

The traditional method for investing in private equity – GP fund structures with 2&20 fees and ten-year horizons – leaves investors with little or no influence over how or when capital is being deployed. Investment authority is delegated to the GP; investors take on a “blind-pool” approach.

Yet recent years have seen investors seeking more control, usually with one or more of the following three priorities in mind.

Control over costs

The debates over high fees and low transparency within private equity have driven improvements, but there is still a long way to go. Investors have therefore sought alternative routes to access PE investments that curb overall leakage. As the new bfinance Asset Owner Survey reveals, 29% of asset owners have managed to bring down manager fees as a proportion of private market investments during the past three years, with larger (>$25 billion) investors and Australian pension funds experiencing greater success than their peers.

Control over deployment

This has become particularly relevant in today’s market conditions, with frustrations from some LPs about the difficulty of putting enough capital to work and concerns surrounding valuations from others. According to the Survey, more than a third of investors in PE are currently underweight versus their strategic asset allocation (Figure 2), although reasons differ by region: in Australia, respondents were more likely to be holding back “because opportunities are less attractive now”; in North America, respondents were more likely to be “actively trying to add more” or finding that “not enough capital is being called.” With slow drawdowns we see some investors looking to over-commit, but memories of 2008 are fresh in everyone’s memories: those that suffered most were those that piled in most aggressively during 2005-7. It is thus not surprising to see investors seeking to obtain more control over this aspect of PE investment in particular.

Control over investment choices

In a conventional PE fund structure, the LP’s exposure to particular deals is determined by the allocation of the fund itself. Yet investors are increasingly keen to exercise more discretion over the investments to which they are exposed – beyond the selection of the GP – such as emphasising particular sectors, strategies, geographies or characteristics.

Control over assets

A greater number of investors are now behaving more like GPs, moving down the direct investment route. This is especially prominent amongst some of the larger Canadian pension funds as well as Sovereign Wealth Funds in Asia and the Middle East. This allows the LP to have greater control over the operational and strategic direction of the companies in which they invest, as well as exit/sale decisions. The control over value creation is increasingly important to some LPs and, in a world increasingly focused on sustainable investing, this closer relationship with assets theoretically allows for stronger integration of ESG criteria. While this approach leaves LPs with no fees and carry to pay for investments, the investor will still bear substantial costs in the form of in-house staffing, legal fees, transaction costs and so forth.

In with the new, (not) out with the old

This desire to take back control has spurred the development of multiple interesting models, leading to a large rise in the volume of “Shadow Capital” in the private equity sector (defined as money that is invested outside of the conventional primary fund and FoF structures).

There has been much debate in the PE world, for some time now, on whether this Shadow Capital will end up competing against GPs directly for deals and bypassing the fund players completely. While we have seen the rise of large investors executing direct investments with substantial in-house teams, for now the traditional players are not only surviving but thriving. Indeed, many of the forms taken by Shadow Capital prove to be complementary to GPs and their fundraising efforts rather than competitive. In the vast majority of cases, these new approaches see investors working alongside GPs who have the requisite skillsets, developing their own skills over time.

In the second article within this series, we will explore four of these newer “investment routes” in some detail: separate mandates or SMAs (not included in Shadow Capital estimates), classic co-investments, “paid” or “deal-by-deal” co-investments (especially alongside fundless sponsors) and direct investments. Each of these brings different merits in terms of the four dimensions of control outlined above. However, they also each bring distinct challenges.

For success, investors must ensure that they have proper in-house resources and expertise, particularly for co-investment and direct investment. These are valuable net return boosters, but only if the investments themselves do well. It is also crucial to retain investment discipline and ensure that these newer routes do not produce negative unintended consequences. We warn LPs against engaging in so much customisation that they compromise overall execution. For example, excessive pressure on co-investment may lead the fund to deploy capital at a sub-optimal pace, or too many separate mandates might lead to an inappropriate focus on non-core investments where the GP has less expertise.

More control or out of control?

Greater discretion is fantastic, in theory. Yet control is entirely theoretical unless one has the ability and the willingness to use it.

We expect to see appetite for these non-traditional investment routes remaining strong through the near future. Yet strong implementation will be critical to success. Investors that approach these newer methods purely as a shortcut to obtaining lower fees risk shooting themselves in the foot. The rising tide of the past ten years has lifted all boats but, to paraphrase the famous expression, a falling tide will reveal who is wearing trunks.