Are you seeing much creativity on fund terms?
Christopher Schelling: There are some new structures being proposed. There are longer-dated funds, 15 to 20 years, there are some permanent capital vehicles where they’re trying to structure an evergreen fund that has the optionality to hold a private equity portfolio company forever but can sell if and when it’s the right time to do so, like a private holding company. Those are the rarities, but there are a few firms out there trying to think a little differently, and in those cases trying to reduce fees, trying to reduce transaction costs. But by and large, it’s still a standard two-and-20, five [years] and five-plus-one-plus one-plus-one model.
Has the ‘pendulum of power’ swung fully toward GPs?
CS: Everything is pushing the GP’s way. Every re-up comes with stuff the GP has pushed their way. You can walk some of those back, and in some cases, we’re not interested in investing in those funds anymore. Not only are we seeing discounts going away but premium economics in some cases, carry’s going up, we’re seeing hurdles going away – 8 percent pref to zero, or sometimes the pref is dropped to 4 percent. We’re seeing a lot of governance stuff that’s moving their way, what the limited partner advisory committee gets to actually do being eroded, fiduciary standards being eroded. We’re seeing key-man clauses being eroded – for instance, if you have two partners, your last fund could say ‘if either partner leaves, the key-man clause is triggered’; the next fund might say ‘both have to leave for the clause to be triggered’, which then essentially means you don’t have a key-man clause. We’re seeing that a lot.
That’s the big trend we’ve seen; more things are really pushing their way and we’ve got to fight to claw it back.
The $28 billion Texas Municipal Retirement System has a 5 percent target allocation to private equity that currently stands at 1 percent. Recent commitments made by the programme include €45 million to CapVest Equity Partners IV and $50 million to TPG Opportunities Partners IV, according to PEI data.
Are you still seeing portfolio monitoring fees?
CS: The practice is declining – it’s less prevalent than we think it used to be. If they’re used, we need to have an understanding around when and where they may be used. It’s definitely declining, and our preference is to never pay them. But like most other things in private equity, you don’t ever get 100 percent of what you want. We’re aware of when they’re used, we don’t have a lot of them; it would be nice to see it completely go away.
I think [accelerated monitoring fees] have pretty much gone away. The Securities and Exchange Commission has really taken a hard look at that. Certainly, for the big, publicly traded funds out there, they’ve all stopped.
How willing are you to back a fund without the traditional 8 percent preferred return hurdle?
CS: There’s very different reasons why there might not be a hurdle; one we can do, one we would be very, very hesitant to do.
If you’re a small fund and you’ve historically generated really high rates of return that have exceeded what would be a hurdle in every period, you’ve never had a hurdle, and you’re coming back to market with the same terms, your fund size is not growing, that’s one where we would consider that. A lot of venture funds don’t have and have never had a hurdle, but they make 20 percent net every year, so the hurdle doesn’t really come into play. We would consider that.
A large fund removing the hurdle that has been there in the past, that is raising a bigger fund that is going to be oversubscribed, to me the justification for removing that hurdle is not LP-favorable. It’s something that is signaling either what your expected returns are going to be going forward or you just want more economics if returns aren’t as good as you expect them to be. Both are a concern.
You’re seeing some public pensions just in principle refuse to commit to those types of funds. For us, that would be very, very low probability to get there.
What is the biggest source of frustration for you at the moment?
CS: Fund to fund sales. GPs are using current funds to buy a stake in a company held by a prior fund. It is being marketed as ‘business as usual,’ and in some cases I can understand why it is the case, but there are still potential conflicts and risks around it that I don’t love.
The general thesis is: ‘We have inbound interest in the company from a number of other entities, we don’t really want to sell all of it yet; the company could use some additional capital’ – so it’s quite common in a growth situation – ‘we have very strong visibility into revenue for the next year or maybe even longer, and so as the biggest private equity fund in this company to date and having been in it for 4 or 5 years now, we know it really well.’ There may be a third party who is putting a bigger chunk in, the prior fund is taking their position out and then the subsequent fund is buying in at the new mark. That seems to be happening quite a bit.
We have voted against it and that doesn’t make us a popular member of the LPAC to have to do that, but I think that’s our duty, to really challenge and question some of these things
I understand the reasons why – you have a lot of capital being put to work and so private equity’s increasingly buying from private equity, there is the third-party fund setting the valuation so there’s not one fund technically setting the valuation and buying from the other one, but there still is conflicts of interest in the model. You essentially have liquidity going from one fund to the next. We’ve voted against it in a couple of instances and we’ve approved it in a couple of instances.
What’s the main area of concern?
CS: Carry. In the prior fund the general partner could be realizing carry, so in those situations we’ve said ‘you’ve got to roll that carry or escrow it or reinvest it’ or something, otherwise it’s kind of a free option. We have voted against it and that doesn’t make us a popular member of the LPAC to have to do that, but I think that’s our duty, to really challenge and question some of these things. Hopefully they all work out great because we’re still invested in them, but I think there are some issues that can occur.
Do you have the freedom to invest in funds with non-traditional terms?
CS: We would consider them. There would be an educational process internally and it would still have to go through our formal recommendation process which, as a government entity, is very robust. If we think it’s the correct structure and the correct manager for those assets, we would certainly consider a perpetual vehicle, and we have, because I think it actually removes some issues. There’s no transaction fees coming or going, there’s no issue around valuation or who’s getting liquidity or who’s not. It’s just good assets that you can hold a long time. Warren Buffett says ‘My favorite holding period is forever,’ and he’s done a pretty good job, so maybe we should take cues from what he has done and see if we can replicate something similar in PE.
Christopher Schelling is director, private equity at the $28.6 billion Texas Municipal Retirement System.