TRICKY FOR LPS TO EVALUATE: Seemingly Straightforward Positive GP Characteristics
The tone of a fundraising GP or placement agent visibly and audibly changes when these individuals believe their product truly embodies or delivers what LPs have historically sought, yet it still fails to gain the expected traction. Even the most even-keeled sponsors find it difficult to hide their frustration and agitation when they believe perennial LP worries, such as the GP’s “alignment with LPs”, “decision-making processes”, “operational value creation”, and “strategic approaches to deal management”, have been effectively addressed, but LPs are still not forming avenue-winding queues to commit capital.
When such grievances are brought to my attention, usually in an off-the-record manner, my empathetic but blunt response is “it is not that simple”. The brutal truth is that, for better or for worse, an analyst’s job is to analyze, so seemingly slam-dunk characteristics tend to be assessed for nuance not readily visible to the naked eye. Below, I provide some examples of seemingly straightforward positive GP characteristics that GPs would be shocked to learn are not necessarily definite indicators of what LPs desire.
- A very large GP commitment: The typical GP commitment is between 1% and 3% of a fund’s committed capital. A GP commitment in the 4% to 10% range will undoubtedly make investors pay attention. However, I have seen some GP commitments of 15%, 20% or even 25% of a fund. These albino tigers make it a point to lead all marketing exploits with this fact – this makes sense because very few GPs can (or want to) dedicate so much of their own capital to their funds, so why not broadcast it if you can? GPs with very large GP commitments tend to be surprised when LPs don’t fall over themselves to invest because these GPs believe the alignment concern is more than resolved with a bigger-than-usual GP commitment. On the other hand, an allocator has to unpack this large GP commitment in several ways. What is the significant GP commitment compensating for the lack of? What adverse (risk aversion, over-aggressiveness, etc.) behavior can this high GP commitment induce? How is this GP commitment structured? Is the large GP commitment from a concentrated source, and how does that incentivize or disincentivize other team members? Getting clear, convincing, galvanizing answers to these questions can take longer than GPs expect.
- Consensus decision making: Most GPs want to show LPs how collegial their internal culture is. Senior team members typically broadcast humble personalities and an all-inclusive but rigorous organizational ethos. A key part of any LP’s due diligence endeavor is understanding a GP’s process of finding, selecting, assessing, and finally consummating deals. The thoroughness of processes executed by GPs from the large-to-narrow end of the deal funnel is a critical data point for most LPs. To emphasize team cohesion and democratic inclusivity, many GPs tend to express the need for 100% consensus for deals to get through. On the surface, this can (or in many cases, is) a fantastic way to ensure broad organizational conviction and foster an all-hands-on-deck mindset in tough times, as well as the sharing of praise in good times. GPs should be aware that some LPs may view an overly collegial work environment as one that discourages dissent and breeds groupthink. LPs have learned that in many situations where mechanisms are not deliberately designed to encourage dissenting voices, consensus tends to favor the decisions of the most senior and influential person who has the loudest say regarding compensation.
- An in-house (captive) operating partner team: As the recognition of the uplifting effect “quantitative easing” had on private equity over the past 15 years increased, so did the legitimate (and marketing) use of operational prowess as a tool for adding value. Many GPs now have an investment operations function to assure investors of their ability to add value to holdings beyond financial engineering. In-house dedicated operating partners have become a familiar part of GP organizational structures. Although most LPs have logically fallen for the “operational capabilities” bait, there is still some debate about which format works best. Is it better to have in-house functional staff focusing on areas such as sales, pricing, talent, digital transformation, etc., who are deployed into portfolio companies? Or is it more effective not to assume a one-size-fits-all market environment, and instead have a fluid roster of semi-captive operators who can be deployed on an as-needed basis with increased precision to specific companies within specific sectors? GPs who have an operations function within their organization may be thinking that all bases are covered, but prospective LPs are usually thinking of things from a myriad of angles.
- Vertical integration: In private investing, vertical integration usually means that a GP controls multiple stages of the business operations of its portfolio companies. Effectively, the GP has brought functions typically outsourced to external partners in-house. Vertical integration is often marketed as beneficial due to its potential for higher cost containment, deal monitoring, risk management, vested interest, control, and economies of scale. LPs generally don’t refute the positive attributes of vertical integration but tend to want to understand better areas in which this structure could cause adverse behavior. Establishing a vertically integrated investment approach has several drawbacks, including the cost of implementation, the potential for not excelling in every function (a lack of focus), a feed-the-beast mentality (disincentivized to exit deals), limited flexibility, etc. It is crucial that, despite the positive aspects, GPs give LPs a nuanced and carefully considered explanation of how their version of vertical integration addresses the presumed drawbacks.
After reading this, a cynical GP could conclude that when dealing with LPs, “ we are damned if we do and damned if we don’t”. That is fair, and I empathize with your frustration. So what do LPs want? Do we expect a magical, infallible, mythical investment creature that has the pinpoint perfect alignment, has a Saint Peter-like decision-making process, has operating partners custom-built for every deal, and has a unique form of conflict-free vertical integration? Yes! But we know that does not exist. Ultimately, I believe LPs seek the ability to clearly describe a GP in a manner that is as devoid of spin and marketing as possible. We aim to capture the essence of a GP. GPs can facilitate this process by exhibiting transparency and illustrating self-awareness. LPs know that no GP is 100% perfect but retain the right to pick what “flaws” they can live with.
