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Dissecting private capital investment performance and comparing returns to public markets

Posted by on 14 October 2021
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Sophisticated limited partners are increasingly determined to analyze and understand private investment performance on their own terms. However, their resolve may bring some new challenges for general partners. In this paper, Northern Trust’s Clive Bellows, Head of Global Fund Services, EMEA, and Kimberly Evans, Head of Private Capital Fund Services, North America consider how LPs regard the performance of their GPs.

It should go without saying that performance is one of the most important metrics to Limited partners (LPs). A survey by Eaton Partners found that a fund manager’s track record is the factor that carries the most weight for 72% of LPs who are looking to make a new investment. Track record surged far above other factors like fees and terms and ESG considerations.1

When it comes to analyzing the performance of their GPs, LPs are looking deeper at a couple of specific angles:

  • After fees and carry, did I receive the returns I had hoped?
  • Did the investment outperform public markets?

As an asset servicer of large, sophisticated LPs and GPs, we see both sides of the relationship, including the increasingly in-depth additional analysis LPs ask us to perform on their alternatives portfolios. Our perspective of the evolving LP helps us to shape the viewpoints we can bring to GPs, as many seek to understand what’s driving an influx of LP data requests and how they can stand out amid a private capital manager landscape that’s exploding with competition.

True to LPs’ growing emphasis on transparency, they will take the measures needed to understand each of these perspectives, even if this requires additional requests of their manager or even outside assistance. GPs will naturally be wary of protecting the intellectual property of their investment strategies as they accommodate LP requests, but there are ways to work with their investors and strengthen relationships while still safekeeping their secret sauce.

Inside LPs’ Views on Fund Performance

LPs establish a program allocation with the intention of realizing outperformance of public markets. The outperformance is defined in the total plan investment policy and is an expected percentage over an index. According to values set by our performance measurement service clients, the expected premium ranges from 2% to 6%. In LPs’ manager research phase, they often seek out GP peer comparisons, such as vintage year universes, to look into elements such as speed of funding and value realization in addition to IRR (internal rate of return) comparative performance.

Even with strong performance, LPs are seeking to understand how the manager created value. Thirty-nine percent of LPs take the most sophisticated route of measuring performance – turning to a combination of IRR, multiple on invested capital (MoIC), and public market equivalents (PME).2

This considerable portion of the LP community taking such a cohesive approach to performance analysis is an indicator of the growing proficiency of private capital investors and their efforts to fully understand a GP’s fund metrics. LPs quantify if the premium was achieved using public market equivalence metrics applied at both the program level and partnership by partnership.

Fintechs have taken note of LPs’ proficiency in the private capital space and GPs’ need to support the growing degree of complex LP data requests. As a result, software solutions are beginning to emerge targeting the monitoring of value creation across a portfolio. For example, a platform may aim to track performance against initial investment goals and value creation objectives, such as replacing a CFO or adding 20% to sales staff, resulting in more thorough and customized reporting available to LPs.

Why the intensifying efforts to dig into GP performance?

This phenomenon can be attributed to a couple different reasons. For one, LPs show no sign of abandoning their allocations but are attuned to shrinking premia and sensational industry think pieces questioning if private capital can deliver as it has in the past.

In addition, LPs use true value creation analysis to separate out financial engineering effects (leverage) in order to understand true alpha, and what operational improvements drove that alpha. While the “value bridge” – a calculation of EBITDA (earnings before interest, taxes, depreciation and amortization), multiples and net debt to determine created value – has traditionally served as the go-to model for understanding how value is created by a GP, this approach is falling out of favor due to certain limitations, and LPs are mindful of this. For example, standards of performance vary depending on the particular growth strategies funds are focused on, from venture capital to buyouts to impact investing and beyond. GPs also look at each company independently and won’t necessarily have a standard model to assess performance across the whole portfolio, let alone with other GPs and their investments, making comparison of manager value drivers even more difficult.

We also can’t forget that as the GP field grows and LPs face more manager options for their private capital investments, they naturally feel the need to examine and justify the partnerships they have and performance they receive from their existing private capital managers.

This is a snippet of Northern Trust’s article, Dissecting Private Capital Investment Performance. The full article can be accessed here >>

A proven partner to some of the world’s most successful and innovative investment managers, Northern Trust has over 30 years’ experience administering the full spectrum of investment strategies for clients around the globe. Northern Trust are Gold Sponsors of the upcoming IM|Power event in Monaco, 20 - 22 October.

1 Eaton Partners, “LP Pulse Survey Results”, December 2020.

2 eFront, “LP Proficiency Survey”, March 2019.

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