For the longest time, the role of investors in a private investment fund, also known as “Limited Partners” or “LPs”, was exactly that – limited. They gave their money to professional fund managers (aka General Partners or GPs) and received quarterly reports on how their investments were doing.
That is now changing. A growing number of LPs worldwide are now looking to play a more active role in managing their money. LPs are seeking greater involvement than before by co-investing in companies they like, to nudging GPs into ESG & impact investing, to insisting on better governance of the GP firms, complete with stricter penalties for non-conformance.
In this two-part series, we take a look at how the relationship between LPs and GPs is changing against the backdrop of rapidly evolving investment paradigms across the world.
In order to capture more return, an increasing number of LPs now want to directly invest at an early stage in promising companies. They are looking at funds as a pipeline for deal flow from which they can pick companies to double down on, or to make a further investment. This gives them greater flexibility to choose companies they invest in, and have the potential to control their returns. And, it also increases LPs’ risk.
One way of doing this is to ‘co-invest’ in some of the companies alongside the fund in which they a LP.
This also gives them an option to invest further in the best-performing ones in the fund manager’s portfolio. LPs may also negotiate for preferential rights on subsequent investment rounds in exchange for helping the manager with the companies where they invest alongside the fund. Sometimes they commit to a greater involvement in the portfolio company.
In both situations, because investors pay lower or no fees for the additional investment, they get a higher profit on these ‘blended’ investments if the company is successful.
The question of returns and management fees
Venture capital (“VC”) is a relatively new investment strategy in emerging markets, dynamics of which are very different from traditional private equity (“PE”). For one, VC funds tend to invest in a larger number of early-stage companies with the potential for rapid growth, whereas PE funds tend to invest in a small number of mature companies. The failure rate at a VC fund is accepted at 50% or higher but is limited to 10-15% at a PE fund.
VC investments entail slower liquidity, with investment horizons of 6-8 years, while successful PE investments start generating returns in 2-3 years. Due to the different risk profiles, the expected rates of return also differ. Since PE funds have a lower risk profile, a return of 2X is often considered exciting. VC funds, with their higher risk profile, are expected to have an overall return rate of 2.5-3X or higher resulting from selected companies doing exceptionally well returning 10X or more.
The two types of funds hence, need to be managed differently. Yet their management fee and profit sharing structures are similar, often because LPs are familiar with PE fee structures, and therefore request by default.
The traditional large growth-stage and buy-out private equity 2/20 structure (2% management fee, 20% carry with an ~8% hurdle rate) does not align the interests of LPs and GPs with VC funds well enough. This is truer in emerging markets, and for most early-growth PE funds of under $100 million because it was designed for investments in mature companies and not for VC funds.
In a VC investment with a longer hold time, this model incentivizes fund managers to think short term and take fewer risks. e.g. selling an investment too early at a lower price because of the certainty of meeting the hurdle. It also incentivizes excessive risk-taking when the forecast for generating carry looks bleak. When no carry seems possible, GPs will be incentivized towards taking excessive risk — rolling the dice on risky big bets — as they are effectively playing with house (LP) money. When companies stall out in their growth, it pushes GPs to hold on to assets for longer than they should as GPs are paid management fees while they hold on to investments. This defeats the very purpose of venture capital because it is meant to bet on companies with great potential and hold on to them for as long as it takes for them to realize that potential.
This lack of alignment has also led to a tussle between GPs and LPs over management fees: LPs wonder why GPs need to be paid excessive management fees which works out to a handsome amount even if their investments don’t perform well. Do GPs have enough skin in the game?
A simpler structure for such funds would be to have a pre-defined management fee for the entire duration of the fund, defined by a year-on-year budget with heavy lifting (and therefore higher management fees) in the initial years. This way, GPs can focus on maximizing results without having to think of buy/sell decisions impacting operating revenue, or being incentivized to prematurely raise another fund.
I describe more details on this here: https://2019.capria.vc/management-fees
And for more alignment on carry (profit sharing with the GP), we have seen a number of funds use a “tiered carry” model in replacement of a hurdle.
More details here: https://2019.capria.vc/tiered-carry
The long-term story: Don’t just do no harm, do good
LPs are also actively encouraging GPs to explore sustainable investing – both environmental, social and governance (ESG) as well as impact investments aligning with the United Nations’ sustainable development goals (SDGs). They are asking GPs to go beyond assessing just the potential financial returns and consider these aspects when making an investment decision. For many LPs, it is no longer about whether a company can make money, it is about how they make money and who they impact.
ESG is primarily about reputation management and doing no harm – not investing in a company that’s going to embarrass you as an investor by doing something bad like ill-treating their workers or customers, or selling products that hurt people. Impact investment is intended to do good – make people’s lives better, improve healthcare, provide access to education, mitigate climate change, and so on.
Many GPs are ill-equipped to respond to LP requests for ESG and impact requirements. Many are now hiring and outsourcing to expert consultants to help them build compliance-oriented policies and systems to show that they can handle these requirements. This is a reasonably defensive approach, but is not sufficient. GPs need to instead think about how they can proactively build their internal team capabilities for impact and ESG management as methods for improving their investment results, not just “checking the box”. The GPs who do so, will both impress LPs and benefit from the improved financial results that come from seeing these as investing best practices.
Frankly, aspects like good governance, being non-exploitative, delivering affordable, high-quality goods and services to people who didn’t have access to them before are all good business practices that sustain a business in the long run, reduce risks and can therefore deliver higher financial returns. It’s one area where LPs and GPs can work together to make a real difference.
At Capria, we work with a network of 19 funds that have all made a commitment to both impact and ESG and are using best practices for these to improve investment results. In part 2: https://2019.capria.vc/dsa-2 we’ll talk about how a storm at one particular fund triggered a review of LP-GP dynamics and the need for better governance at investment funds.