Breaking up is hard to do (with a General Partner)

In a recent article in The Financial Times, Harvard Business School Professor Josh Lerner closed his discussion on the performance of portfolios of private equity partnerships by noting:

But a large portion of the differences [in the performance of private equity portfolios] seems due to simply superior decisions about funds to invest in, and which relationships to terminate.

As a participant in the secondary private equity market, I was immediately drawn to Professor Lerner’s somewhat euphemistic notion of terminating a relationship. There are essentially two ways to terminate a relationship with a private equity fund. First, the investor can sell an interest in the secondary market and use the cash received to reinvest in a different fund. Alternatively, an investor may chose to not renew with a General Partner and over time the individual partnership will become a smaller percentage of the overall private equity portfolio. Historically, most long-term investors in private equity have taken the later approach, though there is no reason that it needs to remain the status quo. Indeed, we are increasingly finding large institutional investors seeking to sell a portion of their Limited Partnership interests to maximize returns. Choosing whether to terminate a relationship via a non-renewal or sale can be a difficult choice. Here are some key considerations for the investor.

Advantages to using the non-renewal method

Arguably the simplest way to terminate a relationship with a General Partner is to not recommit to the next fund. I liken this approach to an “underweight” rating in a public equity fund. Assuming the investor continues to add to their private equity holdings, over time, the relative amount invested with the terminating General Partner will approach zero. Early distributions from the General Partner will further accelerate this process. The primary advantage to this method is that there is no associated transaction costs associated with doing nothing. In a different asset class, studies of public market performance have shown that the performance advantage of a mutual fund manager is often lost eliminated by trading and other market frictions (for an example of academic work on mutual fund performance see: Mark Carhart (March 1997). “On Persistence in Mutual Fund Performance“. Journal of Finance 52). One could argue that the same advantage should also be true for private equity.

An additional advantage to using the non-renewal method that is unique to the private equity asset class is the perceived benefit of being seen as a long-term investor through the good times and bad. Given that top-performing General Partners are often oversubscribed, being seen as a “good Limited Partner” may be one of the few differentiating factors. Nevertheless, as the secondary market has developed, the stigma once associated with selling a private equity fund interest has greatly diminished. Most General Partners now recognize that secondary transactions are part of the landscape and can be used as a tool for their own benefit.

Advantages to using the secondary market

The primary advantage to using the secondary market to terminate a private equity relationship is the resources (both financial and human) that can be redeployed by virtue of a sale. While not-renewing with a fund often appears to be the less expensive option, this fails to account for the time which the Limited Partner must invest to monitor and manage the fund investments. As most institutional investors in private equity are extremely resource and personnel constrained, a secondary market transaction can often benefit the investor by focusing on the most promising private equity investments.

Secondary transactions can also be extremely useful when the anticipated exits from the fund are difficult to predict. A Limited Partner may find that a fund has investments that may lead to multiple extensions to the life of the fund. Waiting for the fund to terminate on its own may simply take too long to be acceptable. Finally, if a fund is particularly troubled, a Limited Partner may find that the fund in question consumes a disproportionate amount of time for minimal upside. In this case, a secondary transaction is nearly a perfect fit.

Making the choice

There is little reason that a Limited Partner choosing to terminate a relationship should not consider both the non-renewal method and the secondary market. The particulars of the situation will determine the choice that will provide the most immediate and long-term benefit to the General Partner.