PRINT THIS PAGE The Relationship between GPs and LPs: The Stony Road to Success
02/01/2008. Source: CAM Private Equity. Ralph Westermann 
With $432bn collected worldwide by private equity in 2006, new funds raised in ever shorter periods of time and fund sizes reaching new records every year, one needs to ask what implications these developments have on the alignment of interests between GPs and LPs and on future returns and what makes for a successful partnership today, writes Ralph Westermann of CAM Private Equity.
The complexity and dynamics of GP-LP relations
The GP-LP relationship is at the heart of private equity. Ideally it can be described as a long-lasting partnership that is built on mutual trust and a fair alignment of interests between both parties. In reality the situation is far more complex and dynamic as the objectives and motivations of fund managers and investors change and are not always fully in line. Moreover each private equity fund involves one GP but multiple LPs with different performance expectations, asset allocation requirements and reporting demands. On the other hand, each LP has relationships with many GPs, each managing a variety of funds, some covering a time frame of up to 15 years. Not surprisingly this network is not always stable or free of conflict, but may come under stress, whenever there are shifts in the fragile balance of power between its participants.
The private equity boom and shifts in the balance of power
In this context, there can be no doubt about the fact that the buyout bonanza of recent years has changed partnership economics in favour of GPs and to the disadvantage of LPs. A closer look at the terms and conditions of limited partner agreements reflects these changes. Through higher fees and more carry on ever-larger funds, big LBO groups are in the position to cash in on their popularity. Some of them even achieved the status of brand names due to stellar returns from prior funds and broad media coverage of their transactions. According to data provider Private Equity Intelligence, eighteen buyout firms are currently charging their investors more than $100m in annual management fees, compared with only one company in 2000. Last year the whole industry generated a record of $18bn in management fees, of which the lion's share went to the dozen biggest companies. In comparison the carried interest, or performance fees, reached a total of $24bn in 2006. Viewed in the light of these market circumstances a growing number of investors raised the question whether fixed income by super-sized management fees will undermine carried interest, as the traditional GP incentive, and hence reduce returns because of weaker entrepreneurial GP spirit and alertness. But inspite of increasing investor unrest, LP appetite for private equity and alternative assets remains high. The latest summer survey by Coller Capital shows that three fifths (61%) of LPs plan to increase their allocations into alternatives and almost half of LPs (47%) intent to expand their private equity investments.
The GP-LP divide
Nevertheless advisory firm Acanthus observes a widening communication gap and growing imbalance of power between fund managers and investors that should be taken seriously if the indispensable alignment of interests shall not be put at risk. In a confidential survey among 200 senior LP and GP professionals across the U.S. and Europe, the study identified several key areas of misunderstanding between LPs and GPs. The Acanthus survey tackled five main themes:
- The overall level of satisfaction with the relationship between both sides
- The principal areas of concern over terms and conditions
- The ideal form and level of communications between GP and LP
- The effect of fund size on relationships
- The perceived alignment, or misalignment of interests and the general quality of the partnership
With regard to the overall satisfaction with business relations, two thirds of LPs (68%) and more than half of GPs (54%) felt that relations could be significantly improved - a noticeable increase to the prior survey. With abundant capital, LPs obviously sensed their limited weight in the partnership and got the impression that their counterparts became less concerned with maintaining good relations.
Fund terms and conditions, the linchpin of any GP-LP partnership, were the most divisive area of the survey. 80% of the investors judged that protection clauses were too weak versus only 12% of GPs. 78% of LPs believe that excessive management fees cause a divergence of interest compared to 37% of GPs. To have more "own skin in the game", 83% of investors think that fund managers should invest more in their own products. Only half of the GPs agree on this view. In general, terms are an area where the apparent ease of fundraising is causing the most friction. Whereas GPs commented that legal terms were too restrictive or not relevant, LPs were concerned about fee driven investment behaviour, fund size, sudden strategy drifts and GP personnel issues.
Could GP-LP relations be significantly improved?
Although fund managers and investors readily agree that formal and informal communications is important, they both overestimate the quality of their own approach and tend to criticise each other. Nine out of ten GPs said they communicated well on team and strategy issues but only half of LPs agreed. The split was even larger with regard to providing information on underperforming investments. 85% of GPs thought they delivered upfront and timely information on their more problematic deals, an opinion shared by only 39% of LPs. The differentiation between smaller (less than €1bn fundraisings in their latest fund) and larger GPs (more than €1bn) revealed that large GPs and LPs are increasingly aware of their mutual concerns but their relationship still remains more strained than with smaller GPs. 75% of LPs felt relations with the big players could be significantly improved; this proportion fell to 62% when asked about the smaller ones.
Finally, the survey reveals differing perceptions and worries between LPs and GPs about the overall quality of the partnership. While LPs stress that GPs prefer "dumb money" and for LPs to accept poor terms, cursory due diligence, excessive purchase multiples, high leverage, poor deal flow and generally limited LP influence, it appears that GPs are increasingly frustrated by LPs who do not understand the value creation process of their industry well enough to contribute more than just money. As one fund manager puts it: "LP organisations often lack operational business experience, creating situations where the GP needs to expend a lot of effort to explain natural fluctuations in the business environment." Furthermore GPs seem to be dissatisfied with the LP investment strategy and process. Too much herd behaviour, vague portfolio strategies, short-term involvement along with weak due diligence, negotiations and decision making were listed as sore LP points by many GPs.
Lessons learnt: What determines a successful partnership
But regardless of these, at first sight, disillusioning facts the survey also made it very clear that the GP-LP relationship can be changed for the better once people address problems openly and say what they really expect from each other. Most fundamental to how GPs and LPs interact is to recognise their mutual dependency and the necessity to build up truly long-term ties. This requires compromise, transparency and an on-going dialogue. That is why GPs must provide detailed and well-timed information to investors. It is not the success stories told that make the difference but an open communication policy and consequent corrective actions when it comes to critical investments and risks involved. LPs, on the other hand, should behave as reliable long-term investors willing to build up the necessary expert knowledge and professionalism needed to really understand the private equity business model. This includes apprehending the underlying portfolio company investments and to be able to constantly improve due diligence and decision making. Investments via fund-of-funds managers present good opportunities for LPs as the extra costs compared to direct LP investments are usually paid off by high-quality access to top performing funds and a considerable limitation of related risks.
Another crucial aspect for the success and the longevity of this relationship is that both sides bring more to the partnership than just the obvious. LP, besides their financial commitments to GPs, play a key role as an advisory board to the fund manager, often having an extra view on overall economic developments, adding significantly to the complete picture. Moreover, LPs contribute their own network and experience to the partnership, which can be an important added value for the GP. Of course this requires GPs to be open to a more active involvement of investors.
Besides a solid track record, one main consideration for LPs to invest with a GP is a strong and stable investment team, covering complementary skills and being able to invest and operate at the same time. Other differentiating factors are GP specialisation, consistency in investment strategy and style as well as a superior network and a higher degree of proprietary deal flow relative to its competitors. Additionally, LPs expect fair terms and conditions with the right incentivation, i.e. a proportion between fees and carry not undermining GP's constant search for performance. Although the agreements cannot be isolated from market realities GPs are well advised not to overstretch their better bargaining position in today's partnership negotiations as the winds can suddenly blow from a different direction. This summer's subprime crisis and credit crunch may well alter the rules of the game fundamentally and put LPs on the driver's seat again. But regardless of who is in the lead, stable GP-LP partnerships built to last will surely be those to weather the storm best.
CAM Private Equity was established in 1998. The firm has over €2.7bn in assets under management for institutional investors, family offices and private investors. For more information go to www.cam-pe.com.
The presentation was prepared for the Private Equity World Germany 2007 conference organised by Terrapinn.
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