Limited partners’ patience is wearing thin. They are sick of spending time negotiating fund size reductions and exercising clawback clauses with their venture fund partners. Those are the kind of gripes that LPs voiced at a San Francisco meeting of the International Business Forum in June.
Charles Froland, a managing director with General Motors Investment Management, set the tone for discussion by urging fellow limited partners to revisit their allocation to private equity funds-specifically the risk vs. return of venture funds. “There are a variety of opportunities for LPs in the high-risk arena other than venture capital,” he said. It was not quite a threat, but it was certainly threatening.
The LPs on the panel included Barry Gonder, a general partner with Grove Street Advisors, Panda Hershey, an investment officer with the California Public Employees’ Retirement System (CalPERS), Christopher Reilly, a portfolio manager with the Colorado Public Employment Retirement Association (CoPERA), Judith Elsea, a managing principal with Knightsbridge, Tim Legesse, an investment officer with the Indiana Public Employees Retirement Fund, Frank Fernandez, a senior portfolio manager with the State of Florida, and Ronn Cornelius, a managing director with Pacific Life Insurance.
Based on GM’s analysis, LPs’ expectations of a 20% return from venture funds are unrealistic. In fact, less than 50% of all venture funds provided a higher return than the public markets, according to Froland. He said his analysis evaluated all the contributing factors to the success of a venture fund. The key factor for high returns is not diversification, geography, industry or even stage. It’s manager selection, he said.
However, as ironic as it is, no two managers are looking at the venture investment situation the same. CalPERS upped its allocation in private equity to 7% from 6%, while CoPERA, which puts 11% of its $7 billion private equity allocation into venture, is sitting on $1.8 billion in uncommitted capital and is reducing its commitment to venture capital. The Florida State Alternative Investments program, which has 5% of its $90 billion allocated to the class, hopes to commit $500 million to $700 million more to venture funds over the next three to five years.
Whether LPs are going to invest more or less, over-subscription into top-tier fund becomes a problem. Add in the European LPs and you have an even bigger excess issue. Moreover, although LPs all want in to the best funds, that hasn’t stopped them from criticizing their venture counterparts. The LPs griped about the obvious problems that are plaguing the industry: too much dry powder, the loss of confidentiality due to public disclosures and plain bad investments. LP managers are confronting these issues under mounting pressure to improve returns.
As a result, LPs have shifted from their prior sotto voce approach toward a very direct and audible admonition. And while first-time and second-time funds are in for especially close scrutiny, LPs are now carefully studying every fund they invest in. One deciding investment factor for LPs these days is how much money the GPs have personally committed to a fund. The LPs on the panel said that they are willing to suffer losses that parallel general market upheavals, but they want the partners to share in their pain, as measured by a GP’s personal bank account. Cornelius said he felt that the time is up for those GPs who have “called into work-rich.”
Another LP complained of the difficulty he has in sitting down to negotiate with a GP who owns four houses and six cars, while he, as a public service employee, is managing the money of tens of thousands of much less well-off individual pension holders. Another made it clear that LPs are not interested in merely lining up to make another generation of GPs rich enough for early retirement; most certainly not at a time when they are having ongoing difficulties enforcing clawback rights.
The LPs also said they want to know more than the track record of IRRs for every fund. They want to know who is responsible for which investments, how individuals are being compensated, and whether a few GPs are keeping all of the rewards for themselves while under-compensating younger staff who will end up leaving as a result. Legesse said LPs want to know “whether you [the VC] are merely a privateer,” that is just trying to snatch and run, or “whether GPs want to build a franchise.”
If all of those very direct remarks weren’t clear enough, Pacific Life’s Cornelius added that if a GP is not meeting the terms of a partnership agreement, he isn’t afraid to sue. “I have a lot of attorneys…” if a GP is objecting to the fact that I have elected not to respond to a capital call, he said.
The general mood is still civil, but just barely. Legesse acknowledged that venture capital is vital to the private equity class, but that “the terms of deals are shifting in favor of LPs.”
Connecticut Turns PE Back On
The State of Connecticut Retirement Plans & Trust Funds is back in the private equity market, after a prolonged period of retreat, scandal and litigation. Although no official announcement has been made, both the general partner and limited partner communities are buzzing over the state’s recent decision to hire David Scopelliti as head of private equity investing. He fills a position that has sat vacant for more than three years, and he already has begun selectively looking at new fund commitment opportunities.
“I know David well and think he is terrific,” says William Dawson, a partner with Wellspring Capital Partners, a New York-based buyout firm that cites Connecticut as a limited partner in its new fund. “He has a private equity and banking background, and is a strong addition to the Connecticut team.”
Scopelliti also is the first principal investment officer to manage the private equity asset class since Michael McDonald left in early 2000. At the time, new Connecticut Treasurer Denise Nappier had imposed an informal moratorium on new private equity investments, stemming from both her general unease over high-risk investments and some troubling private equity scandals related to former Treasurer-and current prison inmate-Paul J. Silvester.
Since then, the $18.5 billion pension system has made few commitments to either new or follow-on funds from either buyout of venture capital firms. In fact, it garnered its greatest amount of industry press by pressuring private equity firm Crossroads Group to distribute certain funds into Connecticut coffers and by going to court to recoup losses related to investments in New York buyout firm Forstmann Little & Co.
“I’ve been working on private equity in my spare time, but it’s great for us to have a full-time resource,” says Susan Sweeney, who was named chief investment officer of the Connecticut pension system last spring. “It was a very competitive process that started 14 months ago. We got over 1,000 resumes.”
Scopelliti most recently served in senior operating positions at both U.S. Business Exchange and Student Transportation of America, before which he was executive director of leveraged lending with CIBC World Markets and a managing director of merchant banking with ING Barings. He says that he’s excited by the new position, and that he has no concerns over Connecticut’s complex reputation within private equity circles. “I’ve had long, exhaustive conversations about the situation here, and am very comfortable,” he says.
Both Scopelliti and Sweeney say that the pension fund will maintain its 11% allocation to private equity and that it will continue with its policy of not divulging underlying asset data related to its general partnership investments. The system does, however, release GP performance data, including internal rates of return, during its public meetings.
The state of Connecticut is advised by INVESCO on all private equity matters and historically has invested in such firms as Mohr, Davidow Ventures, New Enterprise Associates, Welsh, Carson, Anderson & Stowe and Lexington Partners.
– Dan Primack
Disclosure Issue Hits Yale
In a letter filed with the Securities and Exchange Commission in late June, Yale University’s employee unions allege that the university violated federal securities law by failing to report its position in some companies controlled or managed by members of its investment committee.
While the charges made in the letter focus on a publicly traded Texas oil company, Aviva Petroleum, Yale’s pattern of investing with groups tied to Yale’s inner circle also taints its $1.84 billion private equity portfolio, claims Anthony Dugdale, a research analyst with New Haven, Conn.-based union Federation of Hospital and University Employees.
He points out, for example, the connection between Sutter Hill Ventures founder Len Baker, a 1964 Yale grad who sits on Yale’s investment committee. Soon after Baker joined the committee in 1990, Yale made its first commitment to Sutter Hill, the union says. Additionally, by making introductions, Baker was the gateway for Yale’s $10 million commitment to Changwei Ventures and its investment in Golden Gate Capital’s buyout funds, the union claims.
In a similar situation, Josh Bekenstein, a 1980 Yale grad and the founder and managing director of Bain Capital, has sat on Yale’s investment committee while Yale invested with Bain, the Union claims.
Baker did not return calls seeking comment and Bain had no comment.
Yale denies that there is any conflict of interest. “Members of the investment committee would not participate in an investment decision that would create a conflict of interest or the appearance of a conflict of interest,” says Yale University spokesman Tom Conroy. “The university has made all required disclosure and reports to the SEC.”
For the unions, disclosure is an issue of employee rights, although union members do not need to contribute to the pension plan in order to receive retirement benefits.
“We’re just trying to figure out what they’re doing with all our money,” Dugdale says. “We want to make sure our pension is rock-solid, and if there’s nothing to worry about, [the investment committee] should be up-front about [its holdings].”
Yale and its 4,000 union employees have been locked in contract negotiations for 18 months, and things have gotten increasingly contentious at the bargaining table. The union wants representation on the endowment’s investment committee in order to gain more oversight into its pension fund. Barring that, the union is seeking greater disclosure of the performance of all of Yale’s investments. In November, the Connecticut State Attorney General took the unions’ side in a letter to the university urging it to add transparency to its investment portfolio.
Private equity accounts for about 17.5% of the university’s $10.5 billion endowment.
– Carolina Braunschweig
CalPERS Plans for 04
As the state’s fiscal year draws to a close, the California Public Employees’ Retirement System (CalPERS) is mapping out an investment strategy to carry it through the next fiscal year. The pension fund’s investment committee met recently to outline a plan that calls for less new commitments to private equity funds and aggressive pruning of its $6.7 billion private equity portfolio.
Like most private equity investors, CalPERS has been dogged by falling returns in its private equity portfolio. Since making those numbers public in March, it has come under increased public scrutiny by pensioners watching the value of their retirement funds fall. CalPERS is backing away from making more private equity investments in a negative economic climate and will make the active management of its 350 partnerships a priority for the fiscal year that began July 1.
Not only has CalPERS’ private equity staff undertaken the task of doing a comprehensive portfolio review over the next fiscal year, it also plans to develop proactive monitoring tools for early problem identification and resolution and explore new benchmarks. In its report to the fund’s investment committee, CalPERS’ investment staff blamed the tough economy and global instability for the poor performance of its portfolio companies, a situation made worse by dormant public equity markets that do not welcome new issuers and a credit crunch.
As of Dec. 31, 2002, CalPERS’ private equity portfolio had active commitments worth $19.6 billion. Since the program was initiated in 1990, it has generated a 9.5% return.
– Carolina Braunschweig
MassPRIM Fights Venture Probe
The $28 billion state of Massachusetts Pension Reserves Investment Management Board is actively objecting to the requests made by state Attorney General Thomas Reilly that the board release information on the returns of its private equity investments, according to published reports. The board has refused to disclose information on the investments, saying the data are “trade secrets” and could potentially compromise future investments if released. However, State Treasurer Timothy Cahill has stated that he does not oppose releasing “general figures” on these investments.
“We met with the attorney general’s office earlier this week and talked to them about our desire to find a middle ground,” says Karen Scharma, a Cahill spokesperson. “Right now we are in the process of talking with the fund’s general partners One of the major concerns is that by disclosing the information we will be in direct violation of confidentiality agreements.” Attorney General Reilly’s office did not respond to phone messages.
Reprinted with permission of Investment Management Weekly.