This year’s LP survey is the product of four months of work, not the least of which was contacting more than 400 limited partners around the world multiple times. Most of those who agreed to take our survey are based in the United States. All agreed to fill out the survey under the condition that they not be named.
As a group, the 42 LPs who filled out our survey manage more than $1.3 trillion in assets and participate in private equity with around 700 different fund managers.
As we did last year, we asked LPs to grade the performance of their GPs in eight areas: portfolio valuation, write-downs, succession planning, management fees, carry structure, capital deployment, investment drift and communication.
We expected to find a generally more positive outlook on the private equity industry-given the higher levels of investment, the increase in venture-backed IPOs and other exits, and the fact that LPs are, according to every study that we have seen, putting more money to work in venture capital. To our surprise LPs told us in almost every area of performance that their VCs haven’t improved.
Portfolio Valuation: C
We feel like there was progress in this category despite the mediocre grade. Several LPs upgraded their outlook on how well their VCs are doing. Over the course of the year several top-decile venture firms have reminded us that they’ve always “marked to market.” That is to say, they only increase the value their portfolio companies when a third-party transaction or new investment shows an objective increase in the valuation. But, says one LP that invests worldwide, “Not all [GPs] mark to market on a timely and a regular basis.”
LPs generally believe that this area would improve with the adoption of voluntary valuation guidelines proposed by the Private Equity Investment Guideline Group (PEIGG). The normally reticent International Limited Partners Association (ILPA) endorsed the PEIGG valuation standards at its annual meeting in Chicago in September. But GPs haven’t shared the same enthusiasm.
Two LPs-one at an educational endowment another at a corporation-say that they gave GPs low grades on the issue of portfolio valuation primarily because of inconsistency among fund managers and the quality of their valuations. “Valuations are all over the board,” says one. “We can have two managers with the same investment and two very different valuations. There should be a more consistent framework for valuations.” So much for PEIGG.
Despite the fact that a few LPs told us that their fund managers have performed admirably in this regard, the majority of LPs say that their fund managers are doing only a fair job of writing down bad investments, principally from vintage 1999 and 2000 funds. This year marked the first time that a major company, United Airlines, blamed its overall financial losses for a quarter on the bad performance of private equity investments by its pension fund. United certainly has bigger problems than poor pension investments, but we think that the issue of portfolio write-downs is a Titanic-sized iceberg that will look even worse next year.
Succession Planning: C
Maintaining the franchise (otherwise known as succession planning) made a slight improvement in this year’s survey. At this time last year we heard a lot of LPs complain that senior GPs were hoarding profits and starving their junior colleagues of incentives. There was nary a peep about that this year.
But succession planning is still top of mind. “VC is a very personal business; you invest in a venture capitalist, not a pool of people,” explains one of the LPs who completed our survey.
In general, LPs are worried that the young bucks won’t be able to duplicate the performance of the old guard. “The good VCs are old, and the young ones haven’t seen the investment cycles [to understand the industry well enough],” grouses one corporate LP. An LP from an educational endowment agrees, saying that, “The upcoming partners are just less proven.”
Succession is an issue at even the bluest of the blue chip VC firms. More than one LP says he is keeping a close watch on Kleiner Perkins Caulfield and Byers. As the first and second generations at KP move on, some LPs question whether the next generation has the scientific, industry or academic credentials of the firm’s famous founders. Still, the firm’s third generation represents the cream of America’s business schools, so if LPs have concerns about KP, then second- and third-tier venture firms must remain under incredibly close observation.
LPs say that how well general partners work together is very important to them. Lucian Wu, a managing director at Henderson Global Associates, says that for his firm, “One of the key questions is whether the team has harmony, good relationships. There are firms where the partners don’t even talk to one another.” As a result, Wu says, he and his associates look closely at the dynamics of the teams running firms as one of the key determinants when they’re considering investing with a private equity fund.
Management Fees: C-
Earning a C may not be something you put on your resume, but when you’re moving from the D awarded in last year’s report, it’s worth noting. A representative of a large fund-of-funds expressed satisfaction with holding the line, and even pushing back fees over the past year to the range of 1.5% to 2.5 percent. LPs also told us that they appreciate the attitudinal change away from the hubris-ridden Internet era when “take it or leave it” was the watchword.
GPs, for the most part, are behaving in a more civil fashion toward their investors, and they are taking more care with the housekeeping issues of how and when they perform their fee calculations, LPs tell us.
Still, LP dissatisfaction remains high. “The way the fees are calculated always seems to favor the GP,” says an investment manager at an endowment. And an LP who invests globally complains that, “Very lackluster performance in the last few years forces sponsors to look at fees closer than normal. Fees for not doing anything make no sense at all.”
Andrew Lebus, a partner at Pantheon Private Equity, speaks to the frustration that LPs feel when he says, “Buyout funds are charging fees in excess of what they need. Why should a firm with four professionals charge 1.5% per annum on a $4 billion fund over five years?”
One educational endowment LP says his colleagues are at least partially to blame. “There is more competition for deals,” he says. “We should be putting some pressure on fees to remain the same or lower than previous funds, and this is not happening. The premier players are able to charge the same or more yet will face some competitive pressures. Also, return expectations have come down a bit without a commensurate drop in fees.”
LPs are realists, though. “The best funds are over-subscribed; they can charge what they want,” says Dr. Teh Kok Peng, president of GIC’s Special Investments group.
Carry Structure: C-
Perceptions about how well venture firms deal with the issue of the distributed carry was the only category that remained unchanged since last year. There has been little movement in the disagreement between the two parties because, in the words of Clint Harris of Grove Street Advisors, “The best funds are still getting 25% to 30% [carries] despite horrible returns on ’99 and ’00 vintage funds,” and the fact that their fund sizes are shrinking.
Another fund-of-funds manager tells us that he continues to discuss with GPs contentious issues such as the timing of draw downs against the carry, the amount of the pre-set hurdle that has to be earned out and whether GPs will take any distribution before all investments have been repaid.
Capital Deployment: C+
One of the most promising areas for LPs has been the improvement over the last year of the rate at which VCs are investing. In some case they have more than doubled their deal-making pace in the past year. And unlike last year, not one LP grumbled to us about a general partner getting paid six figures to manage other people’s money in bank accounts.
With venture-backed IPOs at two or three times the rate of the previous year, LPs have good reason to feel confident that their managers are going to do good things for them, as recent vintage funds foster their startups along the path to exits. Still, the grade was a C, because, in one corporate LP’s testimony to the poor rating, “Now they [VC firms] are keeping too much in reserve.”
One global LP says that capital deployment is a “tough issue, since we don’t want them to invest for the sake of getting money working unless they find something truly worth the investment. On the other hand, we always have this feeling of committed but uncalled capital hanging over our heads and the call coming right when we think it won’t.”
Some limited partners’ concern with funds deployment is based on the large size of so many funds. “We don’t believe in the multi-billion dollar funds,” says Wayne Harber, a managing director at Hamilton Lane. “There just aren’t 60 to 70 top fund managers out there. These big funds can’t place more than 10% to 15% of [the fund’s] money successfully.”
Investment Drift: B-
This was the highest score for GPs, as was the case last year. With the exception of a few venture firms that are willing to tread into unfamiliar grounds or “opportunistic” investments, most are sticking to their knitting. And that’s what LPs want to see. The overall grade fell slightly because some GPs are branching into areas that their LPs didn’t sign up for. Nearly 10% of the LPs surveyed gave their GPs a failing grade in this category, compared to none last year.
Mark Wiseman, director of Toronto’s Teacher’s Private Capital and chairman of ILPA, says of this category that he suspects that the generally high satisfaction reflects the fact that “LPs have tightened agreements [with GPs], a natural reaction to the mistakes that people made in the bubble, when frankly everybody got out of their area of knowledge.”
Asked what GPs have to do to raise their grade to an A in this most positive area of performance, Wiseman says, “It will be hard for this-or any of the areas- to ever achieve a top grade because the average performance [of the bottom 75% of funds managers] is always going to drag the grades down.”
At first glance, it looked like GPs would score higher in this category, with a 10% increase in the number of B grades issued by LPs. On the other hand, last year’s survey didn’t have a single failing grade, while this year’s had one “F.” LPs granting top marks to their VC partners diminished as well.
Frustration with lack of information has prompted some limited partners to seek out other LPs, and that has created tension with some general partners. Says one corporate LP, “Some GPs “try to keep LPs from talking to one another.”