In part 1: https://2019.capria.vc/dsa of this two-part series, we explored the changing dynamics between Limited Partners (LPs), private fund investors, and General Partners (GPs), private fund managers, in an investment fund. In part 2, we look at how a significant event has resulted into LPs driving accountability from GPs, and GPs responding with restructured operations for responsible and result-oriented decision-making.
In 2018, Dubai-based investment firm Abraaj Capital collapsed following allegations of fraud against its founder and senior leadership. Many high profile LPs were the hardest hit because of mismanagement or misconduct on the part of the Abraaj. Understandably then, LPs began to look at ways to protect themselves against criminal and negligent acts committed by their fund managers.
The result is the ‘Abraaj Effect’, literally a term now being used by LPs to describe new terms that they are demanding when they invest in a fund – a deterrent against mismanagement by way of adding new preventive and punitive clauses to investment agreements.
These range from new, more transparent disclosure norms and stringent rules around governance, communication, and even valuation, including harsher penalties for fraud and other malfeasance committed by GPs. Some agreements even allow LPs to more easily fire GPs and recover any profits given out to GPs as part of profit-sharing, to get their money back. But has this gone to far and is it fair to GPs?
Increasing risk awareness
LPs are now more aware of the risks that GPs face. As a financial institution with lots of money under management, a fund faces serious cybersecurity risks to protect the funds and confidential information. This needs to be actively managed by GPs to ensure that the firm is safe from the increasing number and sophistication of online attacks.
Another is related to reputational risk. LPs want to know who their co-investors in a fund are. The last thing an LP wants is to be featured in a media publication as being a co-investor in a fund alongside someone with a dubious reputation. This means a GP is responsible for carrying out KYC (know-your-customer) process before accepting an LP’s fund commitment. Of course, many LPs want to protect their privacy too, and so there is some conflict to manage. Internal transparency however, is a clear requirement. GPs are going to have to start asking harder questions and LPs are going to have to be more disclosing of their identity including beneficial ownership.
The third risk arises from the way investment decisions are made. Traditionally GPs evaluate a company’s potential, the team, assess market conditions, risk and make an investment. Today, this method is being challenged by using insights derived from big data analytics related to the target company, sometimes without even meeting the team in question.
Rocket Ship, a VC firm inSilicon Valley, uses their proprietary data analysis and algorithms to select, or at least shortlist businesses, they want to invest in. Other funds have followed suit. Which begs the question: how important is this? Does it work? Does it give GPs using big data a certain edge over others that don’t?
Beyond risk mitigation to active governance
LPs are also going beyond risk mitigation to actively evaluating day-to-day governance at GP firms to bring them in line with global best practices. The issue is that there are multiple different conflicting viewpoints on how governance should be structured at PE and VC funds.
The global private institutional LP standard for VC funds is that the GP’s leadership team (usually the firm’s partners) should be the only investment committee (“IC”) members making all strategic business decisions due to their closeness to the entrepreneurial ecosystem, and hence take on complete accountability for decision-making. Additionally, the Limited Partners Advisory Committee (LPAC), comprised of some of the largest LPs in a fund, should approve conflicts and certain other limited decisions (not including regular investment decisions) previously agreed to in the fund documents.
In emerging markets, the vast majority of LPs for VC funds are development financial institutions (“DFIs”) such as the International Finance Corporation, individual or family group investors, local businesses and institutional investors. They often require a fund’s IC to have either a minority or even a majority of independent members in order to provide more guidance to, or even control over GP’s decision-making. And sometimes these LPs require many more decisions to be approved by the LPAC. The cynical viewpoint is that these LPs don’t “trust” the GP fully, and this helps them get more comfortable by putting additional “adults” in the decision room.
We have developed a governance approach that brings the best of these two IC member construction intents together by creating a third governance body called the General Partner Advisory Board (GPAB).
The GPAB is a group of highly engaged advisors, with a modest compensation, who advise the IC on a broad range of topics including fund strategy, investment decisions, people issues and more. Their role however is limited to being advisors only and don’t have a fiduciary responsibility or a binding “vote”.
We have implemented this to great success with Unitus Ventures, our early-stage India venture fund. With our GPAB, we have an amazing brain trust of 8-10 diverse and experienced senior advisors whom we share our ups and downs with and who in turn, give us invaluable counsel. Ultimately the firm’s partners are the only votes on fiduciary decisions and the “buck stops with us partners”. While owning the complete accountability for investment decisions, we also get the benefit of more independent, trusted perspectives. The GPAB group hence complements the GP-Partners-Only IC and the (modestly scoped role) LPAC for an improved overall governance approach.
A challenge for the investment community today is to find the right balance between protecting the interests of LPs while providing GPs the freedom they need, to be accountable for the fund investment results. Instances like the collapse of Abraaj have seen LPs take a more active role in ensuring that funds are managed better, risks are proactively tackled, and that if deterrents do not work, there are reasonable consequences to committing wilful wrongdoing. Getting smart and diverse people appropriately advising a GP is always a good objective and can lead to responsible and result-driven investment operations.