Guy Hands’ View

13 January 2016

Alignment between GPs and LPs is at a low ebb

To consider where the global private equity industry is at the end of 2015, we need to consider where it started. The industry began back in the 1970s, when club deals went on to become the first private equity funds of the 1980s. In those days, deals were backed by a small number of investors, and the GPs typically invested a substantial amount of their own money in the funds. There was an almost perfect alignment of interest between GPs and LPs.

The industry now has assets of more than $3.5trn (€3.26bn), and many of the biggest players are large, global, public companies, some of which have evolved from private equity specialists into broader asset managers. What is striking about these funds today is that typically they have far less skin in the game than in the early days of the industry, often less than one per cent. And that means that there is less alignment of interest between GPs and LPs.

In the early days, the management fee (typically around two per cent) was intended to cover administrative costs and would have been a relatively low figure given the small assets being managed, so the bulk of the compensation earned by GPs was from carry (typically 20 per cent of the profit) achieved on the fund with no hurdle.

As assets have grown, the management fee has assumed much greater importance. For example, the amount of dry powder for the industry was estimated by Preqin this year to have reached more than $1trn. That means, assuming management fees of two per cent, that investors are paying more than $20bn a year on money that has not yet been invested.

The size of the management fee is often generating the wrong incentives and creating a misalignment of interest between GPs and LPs. For the GP, the management fees will continue to roll in even if money is not invested, whereas the LP will be fretting about when deals will be done. To better align ourselves with our partners, Terra Firma has therefore committed to not charge any fees on uninvested capital in our future funds.

Because of these fee issues, many investors have become increasingly sceptical about traditional blind pool funds and have started to invest more in direct and co-investments and less in blind pool funds. Many of the bigger investors such as sovereign wealth funds, endowments and pension funds have therefore built up their own deal-making capacity. It was estimated this year that while for much of its history the private equity industry was very largely based on the blind pool fund model, it is now 50-50 funds vs deals.

GPs, however, have not yet fully understood how strong this trend is. Instead, the size of funds and money raised receives far more attention from the press and GPs than the returns achieved for investors, while many firms have not yet embraced the opportunity to be more flexible in the structures they create for their investors.

The private equity industry has also followed other investment management sectors in that as it has evolved, so competition has increased and it has become more difficult to generate alpha. Increasingly, alpha is not going to be found by large firms doing similar things with “me too” funds, but by smaller, more niche players doing more difficult and more specialised things.

I spent a lot of time talking to investors in 2015, and they said that while some of their allocations to the industry will be to achieve diversifying sources of beta, they also want GPs who can generate alpha, who have a lot of skin in the game and whose fees are sensible.

Taking the approach of going for alpha creates by its nature more volatility, but over 20 years it can produce an incredible overall track record, as Terra Firma has achieved with deals such as Angel Trains, Tank & Rast and Deutsche Annington.

During these 20 years Terra Firma put almost all its own capital to work in its funds, so that we have typically been the largest investor in our own funds. Because Terra Firma has recycled that money and been successful in generating returns for our investors, we now have a considerable amount of capital to deploy. We are convinced that there will be opportunities out there in 2016. It may be in difficult or distressed situations featuring complex regulatory or political circumstances, but those are where we can often best add value and where there are the best alpha opportunities.

Going into 2016 we are looking forward to working with our existing partners and some new partners to find opportunities where we can work together to maximise alpha, either in a fund structure, joint venture or whatever works for them and us.

This article appeared in Real Deals on the 13th January.

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