From aiCIO Magazine's June Issue: Limited partners, be warned...misaligned incentives may be pushing private equity firms to purchase assets they otherwise wouldn't. Benjamin Ruffel reports.
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As asset owners dive into alternatives in pursuit of outsized returns, they would be well advised to regard their private equity allocations—and private equity managers—with a more critical eye. A well-known but rarely mentioned phenomenon is occurring throughout the private equity industry in which approaching capital windows are incentivizing firms to purchase assets they otherwise wouldn’t. As most 2007 vintage private equity pools reach maturation, limited partners may need to take a closer look at what is being done with their money—and to make sure their interests are still aligned with their various private equity managers.
The concept is simple. Limited partners grant private equity funds periods in which their capital—oftentimes five-year windows—can be invested. When that window closes, any unspent money will be returned, untouched, to the limited partner. If the private equity fund does not invest that capital, they will forfeit a management fee—typically about 1.5%—that they could have earned by doing so, not to mention foregoing any slice of the profits earned therewith. As the end of the lock-up period approaches, the desire to put unused capital to work becomes more acute (understandably). From a general partner financial perspective, this is not an entirely irrational pursuit. Disregarding any long-term reputational concerns, if they don’t do it, they will have left money on the table, something managers are notoriously loath to do. However, for the limited partners investing in private equity, this situation leaves a lot to be desired.
This is a classic example of misaligned incentives. In all likelihood, private equity firms would not undertake the bulk of these deals were they not laboring under an artificial deadline. But given the way the arrangements between the firms and their limited partners are constructed, they would be foolish not to make such transactions. In 2007, institutional allocations to private equity reached a frenzied peak. Given that the standard capital window lasts five years, the next few months will, in all likelihood, bring with them a flurry of deal-making. Companies will be bought. Companies will be sold. The question is, at what cost—and what return for the end investor? And what, if anything, can limited partners do about it?
“Depending on the contract, there may be some avenues to end the fund early,” advises Brad Morrow, an investment consultant with Towers Watson. “A good example is what is known as a no-fault divorce clause, which means that if a large majority of the limited partners vote to end the fund they can stop the investment period.” However, opening that escape hatch is rather difficult and rarely occurs. In reality, it comes down to vigilance. “Limited partners need to do their homework to find out whether these deals are questionable or not,” Morrow says. Of course, no private equity firm worth its salt would admit to pursuing an unnecessary deal. As a result, limited partners should pay careful attention to deals occurring in expiring private equity pools. The later the hour, the more skeptical they should be.
Morrow cautions that in the 2007 vintage private equity funds, mostly likely “only 10% is left to invest at this stage.” However, as any good asset owner knows, 10% can be a lot. Don’t let it go to waste.