Like gravity, hypocrisy,
And the perils of being in 3-D
And thinking so much differently
It’s easy to forget just how young the private markets are as an asset class. With the exception of private real estate, you could argue that the industry has existed for little more than a decade or so. I’m always struck at how those of us who live and work in this universe view it as established and robust; yet, spend some time with investors who aren’t as familiar with private markets investing and you realize that most of the industry is barely ready for prime time. That’s particularly true when you look at the asset class from an institutional framework perspective.
We are to the investing world what Millennials are to the workforce: Supremely confident in our ability to rule the world, while the rest of that world looks at us with bewilderment as we dismiss so many basic skills and experiences as irrelevant. Private markets mavens that we are, we view “the rest” as dinosaurs of a bygone age. Liquidity? Bah, who needs it! Risk metrics? Hah, mere trifles when returns are all that matters. Benchmarks? Don’t bother us with baubles for mere mortals. Succession planning? Why, everyone knows PE is the ambrosia that confers immortality.
All jokes aside, today’s topic is a crucial one and yet receives little attention within our asset class, despite being an increasing area of focus for those operating in other industries. I’m talking, of course, about the operational infrastructure and robustness of the private markets’ participants, particularly those in private equity. Ok, ok, don’t groan just yet; I haven’t even started.
Operations – the nuts and bolts powering private equity’s cash and data flows – has not traditionally been an item of focus for some good and some bad reasons. The good reason (if we can call it that) has to do with the structure of private equity investing, which inherently makes operational risks far less consequential than what you might find in the public markets or in hedge funds. One of the ingenious features of PE investing is that LPs don’t give GPs all of their money on day one of investing with them. I’ll admit, the capital calls and distributions give rise to a host of operational headaches for LPs: Keeping track of everything, determining return compared to anything else in which you invest, understanding what you’re sending money for and why you’re getting it back. For better or worse, all of those elements contribute to part of the headache of investing in private equity. And yet it’s those very elements that dramatically diminish the likelihood that a GP could ever pull off another one of those Madoff-style Ponzi schemes that periodically bedevil the hedge fund industry. Or, that a GP could mess up its back office in such a catastrophic way that no one knows where the money or assets are. PE’s very structure provides a semblance of risk mitigation for investors.
Whew, we’re safe.
Increasingly, however, risk managers, CIOs and even some of us within the industry are asking some shockingly basic questions to which we’re receiving unsatisfactory answers: Although the structure of the industry may limit risk, does it eliminate it altogether?
As private markets investing becomes a larger part of portfolios and as general partners become larger entities, shouldn’t operational analysis become at least a small part of investment analysis? Isn’t there both some investment risk and, perhaps more importantly, some reputational risk if a GP or LP becomes operationally suspect and errors or outright misrepresentations occur?
The reality, as someone succinctly framed it to me, is that this asset class has very low standards of operational diligence coupled with low expectations of institutional standards. Ugh. That is a very sad, albeit accurate, assessment of the current state of our industry. Some of this is due to the relative immaturity of this investment arena itself. As an asset class, we’ve successfully achieved size and scale rather quickly, and yet the infrastructure simply hasn’t kept pace. But I believe the more problematic factors at play here are the general lack of recognition of the issue and the fact that most GPs and LPs are parsimonious when it comes to spending money on something that doesn’t directly benefit them today. They don’t want to spend the money, especially on back-office “stuff,” unless they absolutely have to. And, the absence of something having gone horribly wrong means that the “have to” hasn’t happened. But do we really want to wait for something to go wrong? (On this one, let’s watch what we do, not what we say; so the answer is probably, “yes.”)
If something were to go wrong, what would it be exactly? Why does this matter at all? Let’s think about it from the LP perspective. In what other area of investing do you simply either take for granted or take the investment manager’s word for:
- Effective implementation of the investment strategy;
- Ability to provide information and transparency that is both timely and accurate;
- An infrastructure and process that protects from losses due to fraud, both internal and external;
- An infrastructure that is effective in meeting ever-expanding regulatory requirements around the world; and
- Policies and procedures that appropriately address conflicts of interest.
These are just an obvious few of the many operational items you should think about in any investment. Let me also state the obvious: You’re investing in blind pools from which you can’t easily get out, so if you don’t know the answer before you commit, learning it from the process of being an investor is going to be a very frustrating experience. The LP response has generally come in two forms: One, ignore it. That’s a pretty good choice, especially if you buy into the school of thought that what you can’t see can’t hurt you.
The second response has been to force much of the responsibility onto the general partner community. In this scenario, the attitude seems to be: “This should be your problem, so go ahead and meet these 10 requirements that are on some templated check-the-box form and we’re all okay.” Let’s leave aside for a moment the fact that, depending on the LP, the GP world is generally confronted with hundreds of variations on which boxes to check. (Most of you reading this have probably seen the checklists that qualify as “operational due diligence”; we could probably all agree that, from the perspective of someone outside our industry, they’d appear lacking if not outright embarrassing.) The GP also has to contend with the fact that many LPs don’t know or don’t care what the cost of any number of their “requirements” might be; instead, they simply ship them over as if they are all equally important and have been equally thought through in the process. Historical behavior seems to suggest that many of the players in the PE game have determined that back office controls and processes don’t really matter, and, in many cases, the conversation has become mere lip service to best practices. It would be great, and easy, to blame general partners for this state of affairs. There is no question that many – dare I say most? – general partners fall far below the proverbial bar of operational best practices. In fairness, perhaps most don’t need to worry too much about it. After all, the overall risk is small and, bluntly, their limited partners don’t seem to care.
They may say they care, but they really don’t. Still, general partners, in the aggregate, will eventually come around to spending more time and effort on the operations side. They’ll have to if only because the complexity of their businesses, their reporting requirements and their regulatory requirements, will force them to spend the time and money as they continue to grow. But, that will be a long process and, for investors, is really a race between reaching a point of sound operational basics and a point where something bad happens, whether intentional or unintentional. I’m going to bet that most won’t win that particular race.
Nope, the real blame here lies with the investors, the limited partners. LPs spend a great deal of time, enabled in so many cases by ponderous pronouncements from ILPA, telling the GPs how they should be run, how they should do this and that, all with an aim toward creating operational and investment best practices.
Now, as I said before, the risks in private markets investing are generally less than they are in other areas, but, people, they’re not zero.
But, when pressed, most LPs would be unable to clearly communicate what controls, if any, their various fund managers have in place; how they are ensuring that their GPs are acting in accordance with the terms of their partnership agreements; what specific procedures and protocols their managers have in place to mitigate potential conflicts of interest.
Alas, dear readers, in this regard, it’s the LPs who don’t want to spend the time and money to figure out whether their investment managers meet any of those standards. It’s the LPs that fail on the most basic level of their own operational robustness. They’re the players not ready for prime time. Risk managers must look at our world and cringe. Now, as I said before, the risks in private markets investing are generally less than they are in other areas, but, people, they’re not zero.
Understanding and analyzing operational risk costs money, however. I look at our own efforts in this area and the ways in which we’re advising LPs on how to think about operational due diligence. Many investors simply don’t know where or how to start.
Great investment analysts are generally not great operational analysts; accounting or regulatory experience is required. Some LPs might be conducting what they believe is sufficient, high-level manager diligence; but doing this well means taking a deeper dive, it means spending money. This is a resource choice, whether you pay someone like us, or someone who does this as an area of expertise, or you hire someone internally. That just hasn’t proved to be something most LPs want to pay for today.
There’s much talk of resource constraints among LPs, and those constraints are real in many cases. But investing in your operational infrastructure – or choosing not to – is nevertheless a choice that needs to be made. There are costs associated with choosing to invest in the private markets, and all LPs must subsequently decide where they will spend their dollars or euros or yen. We have seen this story many times and, to date, it generally plays out the same way: Money will be spent on attending an annual meeting, or diligencing a deal, or doing a co-investment. Those activities are cool and fun and exciting. Spending money on better data or an operational diligence item is boring. Plus, if even one other LP in the fund or deal being assessed has a resource like Hamilton Lane involved, then that investor is already spending the time and money on the operational due diligence and I’m good by proxy, right?
Maybe you are and maybe you’re not. I get asked all the time what will stop the flow of money into alternatives. There are the usual suspects, none of which I really believe:
- Returns will go down. Yes, they will, but do you really believe they will be lower than the public markets over any reasonable time frame?;
- The asset class will stay too expensive and people will stop paying the money. Yes, it will remain the most expensive asset class and, yes, some people will leave it, but, no, as long as net returns remain better than other places to invest, alternatives will remain attractive;
- A bear market will decimate returns. Yes, it will and the flow into alternatives will slow as it will into all assets, but when would you rather be buying private assets, in a downturn or in a bull market? If you’re not sure, we did a pretty cool analysis of this very question in our Market Overview last year.
The sleeper suspect relates to operations. What happens to the attractiveness of alternatives if there is an operational blowup at a GP, particularly one that impacts a number of LPs? Even if the monetary loss or damage is relatively small, what about the reputational risk? I worry about that. Alternatives in general and PE in particular, have benefitted from the view, accurate up until now, that the risk of blow up at any GP is small; that the risk of serious accounting or regulatory problems is small. What if that perception changes? Do you really want to be in a set of illiquid investments with boards and trustees and constituents questioning the basic operational soundness and integrity of those investments? Probably not.
Here’s my advice: Spend the money, spend the time, and figure out what operational risks you want to take. Hell, first spend some time figuring out what operational risks you have. Even that might be a major first step for many investors.
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As of July 24, 2017