The key to building a successful LP-GP partnership is to put trust on top. Bronwyn Bailey, Vice President, Research and Investor Relations at American Investment Council describes the evolving relationship between LPs and GPs since the financial crisis, and why transparency and trust-building helps strengthening the relationship.
The relationship between a private equity fund and its investors is the core of the investment business. In blunt terms: If a fund’s customers, the limited partners (LPs), are not satisfied they will take their capital elsewhere. Maintaining good LP relations is key to a firm’s future fundraising.
The LP-GP relationship has evolved over the last ten years, which has strengthened the partnership between general partners (GPs) and their investors. In my role at the American Investment Council, I have heard from members’ Investor Relations professionals about LPs’ changing expectations on transparency, reporting, and responsible investment. While meeting investor inquiries can be time-consuming, better communication fosters a stronger relationship, as it does in most relationships. The AIC will continue to work with our members to ensure they have the resources to foster strong relationships with their fund investors.
The latest stage in the evolution of the LP-GP relationship in private equity has its roots with the financial crisis. Because the crisis produced a scarcity of capital resulting from sharp drops in real estate and equity values, investors seeking to invest in private equity funds during the recession and the first year or two of the recovery often commanded relatively better economic terms. GPs who communicated with their investors during the crisis about the changes in the health of their portfolio companies and relative valuations were often rewarded with more loyal LPs.
New regulations, namely the Dodd-Frank Act, were passed in response to the financial crisis. The Dodd-Frank Act required private equity firms with over $150 million in assets to register with the Securities and Exchange Commission (SEC) and be subject to periodic examinations of their processes and procedures. In response to the new regulatory regime, firms implemented stricter compliance policies and hired consultants and internal experts to ensure that they were incorporating best practices. The result is that private equity became a more regulated industry with robust governance practices.
As fund distributions reached record levels and fundraising volumes continued to grow, the influence of LPs on GPs’ practices continued. Indeed, with greater exposure and more years of investing in private equity, many LPs became more engaged in the analytics of their funds and sought more detailed information. During this time, the SEC began conducting the first presence exams for private funds and focused on areas such as fees and expenses, cybersecurity, and valuations. As a result, many LPs began to ask their funds more questions on these topics. These inquiries elicited more conversations between GPs and LPs, such as specific calculations that produced return metrics and company valuations.
Most GPs would agree that better reporting leads to better retention of LPs.
In response to LPs’ demand for more information, the Institutional Limited Partner Association (ILPA) published a template for fee reporting. This detailed spreadsheet has been adopted by many LPs and AIC members. The bar has clearly been raised on LPs’ expectations about transparency and information flow. As service providers rise to the challenge of automating a secure flow of customized information from GPs to LPs, data transfers will become less burdensome. Most GPs would agree that better reporting leads to better retention of LPs.
It is interesting to note that requests for greater detailed reporting has concentrated more on private equity funds, rather than venture capital. In fact, most data inquiries come from larger investors, particularly pension funds, which face their own transparency pressures from the public. Smaller venture funds with mainly US-based investors have not seen similar requests for data access from their LPs. It is possible that these discussions have not yet hit the venture space but are on their way.
The answer? Partnership built on trust.
The evolution of the LP-GP relationship has matured along with the private capital asset class, which grew from about $1 trillion in 2003 to almost $5 trillion at the end of 2017. As with most long-standing relationships, fund managers have built trust with their investors by satisfying expectations around communication.