When you speak to a family office investor, you get a very particular view on private equity as an asset class. Elements that are knitted into the fabric of institutional private equity are looked at in a different – and not always as favourable – light.
For example, the idea that, having committed $10 million to a private equity fund, an LP might only see $8 million or even $5 million invested, is a turn-off.
Says one family office manager: “Our clients look at all the performance numbers that come through private equity managers, and they’re good, but they are internal rates of return; and that IRR is on potentially $1 of invested capital rather than $100.” So if a manager returns 15 percent on its invested capital, but only manages to invest half of the committed capital, then an investor’s allocation is only returning 7.5 percent.
“Why do they find that harder than institutions? Because institutions have entire teams whose job it is to do cashflow modelling and asset allocation to ensure that at all times they are fully invested. Certainly, the families we look after don’t have those resources,” the family office manager says.
Another concern is the gross-to-net spread. Fees play a substantial part in that, but as numerous reports and studies have shown, demand for the asset class is keeping them constant. For example, LPs will be paying up to 1.5 percent on committed capital to Apollo’s Fund X, which this week hit $24.6 billion in commitments, according to pension documents seen by PEI.
With demand keeping fees steady, what other levers can be pulled to narrow the spread between gross and net returns? One is the efficient use of a credit facility. Another is the greater use of cross-fund investment, mopping up the tail-end capacity of one fund with a portion of one of the next fund’s deals. Both can be viewed with suspicion by investors, but both have their uses from a capital-efficiency perspective.
Historically, private equity firms have staffed-up to be world-leading dealmakers and that has been part of the issue. In the words of our family office manager: “The IR guy or the finance guy really understands the component parts of net performance, quite often the deal-doers have got no clue about net performance.”
The data are telling. Across the last 15 years the median spread between gross and net for all buyout funds is 8.59 percent, based on a net IRR of 16.01 percent, according to CEPRES, a tech platform that allows GPs and LPs to exchange confidential performance data. Interestingly, once you include private debt, venture capital and infrastructure funds in the sample, the average spread comes down to 6.32 percent, suggesting there may be more efficient use of capital in those asset classes.
PEI this week moderated a roundtable discussion with a number of private equity firm CFOs and their advisors. As well as revealing some fascinating insights from a recent SEC examination of his firm – more on that soon – one of the CFOs said that he is increasingly being called on by prospective investors to discuss the firm’s approach to all aspects of fund management.
“It’s almost as if the investment diligence is pretty easy when you have a mature firm; show me what your gross returns are,” he said. “Really figuring out if the firm is maturing and becoming a better fund manager takes a little bit more digging and we are finding investors doing that more often.”
Anecdotally, many GPs are starting to think much harder about the issue of net performance. Those that are not may find raising capital that much more difficult.
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