There is no shortage of commentary about the value created by general partners of private equity funds. However, much less consideration is given to the value added by limited partners (LPs). And yet such is the complexity of managing a portfolio of private equity funds, and such is the range of sophistication in how LPs approach this challenge, that the LP value creation dynamic ought to be a major consideration.
eFront’s LP Proficiency Survey – the largest of its kind ever undertaken – assessed the core functions of private equity LPs across 10 distinct areas. eFront canvassed 179 investors – from high net worth individuals to major pension plans globally – on all major aspects of the investment process, from managing liquidity expectations and position-monitoring, through to negotiations and performance-benchmarking.
While investors perform very well across a number of key metrics, their sophistication score sits below half marks in six of the ten skill categories studied. LPs performed particularly poorly in negotiation, where more than a third focus on very simple negotiating points. Meanwhile, just a tenth seek a segregated account or the option to make the final decision on capital deployment.
The results should act as a call to arms for underperforming investors. While it is fair to say that, in general, limited partners perform well across key competencies – with funds of funds and pension funds being the leading performers overall – there is clearly room for improvement across all investor types. This survey could therefore act as an effective benchmark against which LPs can track their progress.
Best and worst
Looking at the poorest performing areas, in reporting and information exchange, there is significant variation in sophistication. The largest proportion of LPs (45%) passively accept GP information and do no detailed analysis of NAV or distributions – which should potentially be of concern – while only 17% of the respondents in the survey reported that they employ the use of platforms that collect and streamline this type of report.
LPs received their lowest score, meanwhile, in position monitoring, where more than half of investors (53%) use the simplest form of monitoring. This exposes potentially significant shortcomings in how LPs monitor and track their investments in private equity funds. Meanwhile just 15% exploit integrated systems that pair proprietary data with third-party sources, enabling sophisticated analysis. The data underlying the highly proficient approach to keeping track of positions and exposures has only become available recently and has been reserved for early adopters, perhaps explaining the low scores.
On the positive side, conversely, LPs appear to be highly proficient at determining the appropriate private market allocation. This competency has the least divergence among the investors, and the fewest low scores, with just 8% of investors passively following their peer group to determine allocations. Indeed, no pension fund or fund of funds respondents followed this least sophisticated strategy.
Performance measurement, meanwhile, is the area of greatest proficiency among LPs – perhaps unsurprisingly owing to the central nature of this element of investors’ activities. More than 85% of respondents to the survey use sophisticated methods, determined as either a combination of IRR and multiple on invested capital, or a combination IRR, multiple on invested capital and the use of public market equivalents. Meanwhile, just 14% of respondents follow the least sophisticated process, using a simple IRR calculation to measure performance.
Risk measurement was the third-strongest category for investors, but the way they measure risk varies greatly. This may indicate that there are no clearly established benchmarks in this competency area and that self-assessment choice depends on the internally defined benchmarks within each organization. Almost a third of respondents devise a simple metric which is equivalent to public market volatility; almost a quarter use Value-at-Risk methodology and track correlations between values of different positions in portfolio; and 46% take a comprehensive and rounded approach, encompassing specific metrics and extraneous risks.
Economies of scale
Overall, this survey provides – for the very first time – clear insights into the way investors carry out key investment tasks on an ongoing basis. The self-reported nature of the results could be a concern – bringing with it the potential to assume that respondents would be tempted to inflate their own sophistication. Indeed, it is possible that there is some confidence bias in the results, but overall the very mixed nature of the results would suggest that the majority of respondents have tried to give objective answers.
Equally fascinating is how different investor types vary in sophistication. It appears that, on average, larger investors perform better than smaller ones. The intuition behind the size effect is that large institutions are able to invest more in best practice, reaping the benefits of economies of scale, as the cost of operations per dollar of AUM is smaller than for relatively small investors. The survey does confirm this intuition for most investment practices, but while there is inevitably an advantage for larger players, this is by no means the case across all competencies.
Interestingly, geographical location of limited partner institution also affect the investment practices in which the organizational capabilities are the best employed. North American funds are showing the most advance level in the private equity portfolio construction process, while their European counterparts set a high priority for the manager selection process, position monitoring and reporting.