How sophisticated are LPs in reviewing GPs?
Are they able to see through inflated/high valuation marks? Do they test valuation levels of non-exited portfolio companies?
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Ignore the title, have been in an LP seat for a little while. Can tell you that while some LPs are marginally more sophisticated than others when it comes to the assessment of valuations, it very rarely makes or breaks the commitment. Often comes down to things like relationships/co investment offered etc.
Surely bad performance must lead to bad fundraising - especially for new commitments?
You are absolutely correct with a couple of caveats. I think where the statement holds true is really in the middle/lower middle market, where the co-investment/platform construct is not as strong; in other words, tougher to keep justifying a 50m commitment to a 12% IRR manager when you are getting very limited co-investment flow (allowing to generate stronger returns on a blended basis). Having said that, you still see LPs giving GPs some benefit of the doubt for at least 1/2 funds (if the performance tanks). The large cap space is different in that the likes of Blackstone will always raise pretty chunky funds (albeit may have to scale down) due to the co investment/platform benefits that larger LPs benefit from. More broadly, you are parking your capital for a while so it takes 3-5 years before over/underperformance comes through. Even then, if a GP has an early exit/liquidity event, the returns could appear inflated for longer (which is why NAV loans is such a hot topic in the LP community).
The first thing a sophisticated LP will do when reviewing a new manager is a MTM on their existing portfolio to see how true the unrealized returns are.
With their own peer groups etc? Challenge is that firms manipulate their own analysis to back up existing marks..
Public comparables MTM
Have always wondered about what actually goes on behind their closed doors. Moral hazard at its finest.
Yes agree. Also given limited long term incent..
Most pensions have bonuses tied to performance, at least where I live. FoF have carry, FO have carry or long-term incentive plans. May not be pure carry like PE but if your book is outperforming whatever metric is determined you get paid more.
This 100% varies by LP and there is a massive spread:
Great answer. Would add one nuance on ME sovereign wealth funds: they would all like to think they are smart allocators but the reality as I understand it from a classmate who works at one of the big ones is they are centuries behind the European and Asian SWFs in terms of financial sophistication, investing talent and organization.
A lot of nepotism throughout and money is invested based on relationships / access (e.g. Jared Kushner but he is the worst example) much more than it is based on market track record.
My experience is that public plans and endowments (particularly Yale) tend to be the best to have as partners.
True -- but being a great partner isn't the same as level of diligence/looking through marks. My general experience is that E&Fs are preferred parties because they are sticky capital (don't trade out after a Fund III like some FoFs, actually have a commitment plan like some procyclical family offices, unlimited time horizon etc.). They also tend to more willing to pay premium fees, can catalyze a fundraise etc.
Said another way, an elite ivy might be 1) low maintenance 2) anchor and catalyze your fundraise 3) not to be onerous on terms 4) be patient over time time -- these are all different than intensity of marks / beating you up on quarterly valuations.
I'll offer a somewhat different perspective here -- at the very core of a primary commitment is ultimately making a qualitative judgement call on the ability of a manager's new fund to outperform a target return you have in mind. And therefore there are hugely varying opinions on what constitutes a sophisticated LP and what isn't -- as much as GPs can game their portfolio valuations, LPs can also game their projections of past fund returns even if they do a rigorous secondary style underwriting for a GP's past funds. Do LPs genuinely have enough information on hand to form an informed view of what a company's true value should be? Probably not -- they could pick a wrong comps set too, deal leads can pick an optimistic comps set, they can argue that GPs realize deals with multiple uplift, it goes on and on and the point is that ultimately whatever analytics that LPs do drive a qualitative opinion that the deal lead (more often than not) has already taken a call on before any of these numbers are run.
Certainly the FOFs, SWFs, and large institutions may spend a lot of time underwriting past funds and claim to know portfolio companies inside out, going through the strenuous pain of doing so. Does that really improve decision making? Or do you end up picking funds that on average, turn out to be precisely that -- average -- for a multitude of reasons? More often than not, this is exactly what happens. Some people who work for GPs say they are spinning models and tweaking and tweaking stuff to spit out an IRR that the partner wants to be able to bring a specific deal to IC. This happens all the time as well with LPs.
At the same time, some family offices have done incredibly well over a long period of time by getting the basics right (team, strategy, performance, market), and have managed to consistently make the right judgement calls -- which emerging team to back, which strategy will outperform over the next decade, when to get out of a fund, and so on, despite the lack of "rigour" in decision making. Are they just lucky? Is luck even differentiable from being good in primary underwriting if so much of it is qualitative? Lots of institutional LPs (even extremely well known, high profile, and high paying ones) may not perform as you may expect of their team's calibre and rigour for various reasons, which are way too many to list.
I realize I have become incoherent here but I guess to sum it up -- I think rigour doesn't necessarily mean testing portfolio marks and doing lots of modelling work. This could be rigorous but it may or may not inform rigorous investment decision making.
Thank you. I guess that the ability to generate returns for the last two funds would be (somewhat) a predictor of the next funds return and a way to evalute the strategy. At least if it was my money, I would prefer that the old LP guy had to show why he gave which GP money - rather than gut feeling (i.e. Giving it in a very biased way).
Data shows a muddy picture of what you said on persistence of returns in PE, it exists a little bit (much more than public markets) but doesn't mean as much as many think/want it to. The thing I have seen and there is some data coming out on this is that as fund sizes increase dramatically performance falls off substantually. The why of this is all over the place from MPs already making a shit ton of $ and just mailing it in, to having to hire larger teams who may not all actually be all-stars like the MP once was, luck (see last 15 years for many funds, right place right time), strategy changes as fund size grows, GP just gets fat off the management fee and carry doesn't even matter to the higher ups. Can go on and on here.
There's also more and more data coming out about how Fund I/II's can meaningfully outperform benchmarks with the top quartile in this bucket smashing large peers. Obviously the bad Fund I's are generally bottom quartile and worse but most halfway smart LPs can talk to a manager in this space and know within 30 minutes if they're even worth talking to again (meaning bad performers are easy to weed out). The smartest groups (as above poster mentioned, nimble/lean family offices and small E&F) hunt in this space heavily and don't even consider funds over a few billion dollars even despite being able to write $25-50mm checks. At the end of the day you're analyzing someone's ability to generate returns and the things that really matter are hunger, alignment and prior experience. This is why, IMO, Fund 1-2 can crush is you get people jumping from larger firms at 35-40 years old where they have run plenty of deals but want to own a large portion of a GP/carry (albeit at a smaller scale today). They have to make it work from a carry perspective so motivations are higher than just peddling away at whatever MM/UMM firm.
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