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Editor’s Letter: Have the courage to walk away

I had one of these debates the other day with my colleague Sam Sutton about the recent column in Bloomberg written by Naked Capitalism’s Yves Smith, the pen name of Susan Webber, who has quickly become one of the major media critics of private equity.

Webber argued that public pensions should be barred from investing in private equity if they can’t monitor private equity managers on their own. She was responding to a letter sent in July by state treasurers and comptrollers representing many of the largest public systems in the country asking the SEC to force private equity firms to be more transparent around fees and expenses.

“One can only conclude that the state and local officials are trying to shift responsibility to the SEC for their own failure to perform their fiduciary duties,” Webber wrote.

Chris Witkowsky
Chris Witkowsky

I agree with this argument to a point: Public systems hold ultimate power over a GP if they don’t like terms — they can deny the GP their money.

But Sam argued it’s not so simple: Public pensions face pressures that force them to commit to managers with terms they might hate, but with strong performance. They need private equity in the portfolio to help them hit their targets so they can meet obligations to retirees. It’s a tough position to be in.

Webber’s point is that public systems, which collectively represent the bulk of money raised by the private equity industry, can force GPs to comply with their wishes. If they want more information about fees and expenses, demand it. If a GP decides not to comply, don’t commit capital. Pretty simple solution.

Most systems have not been willing to take this step, however. The fundraising numbers tell the tale. Last year was the strongest fundraising year for private equity since 2007. Private equity, including buyouts, growth, distressed, co-investments and mezzanine, raised about $206 billion, according to data from Buyouts. The peak was in 2007, when private equity raised $300 billion, according to Buyouts.

These days, LPs are parking more money with fewer GPs — a strategy many big systems like the California Public Employees’ Retirement System and the New York City Retirement System — have pursued. Cutting down the number of manager relationships makes private equity programs more manageable for public systems, which are frequently under-resourced.

These factors — strong fundraising targeting fewer managers — have created an environment where a lot of money is chasing only a handful of managers. LPs develop a herd mentality as they stampede toward the same funds. Managers in this position can set the terms they like, and if one LP walks away, others will step in.

It’s a concerning dynamic, not only because of the risk of expensive economic terms or loose governance rights, but also because of the high-priced deal environment. Too much money is flowing into a hyper-expensive market, making it imperative that managers find deals off the beaten path, away from auctions where bids can soar.

All of this considered, LPs should simply walk away when they don’t get terms they like. If a GP has no reason to negotiate, it might be best to skip that particular vintage and see how that manager does. Oregon has done this, and CalPERS for several years has negotiated hard and formed customized relationships with some big shops, getting the economics they want in exchange for big checks.

Smaller systems also need to have the courage to break from the pack. I’m not suggesting they try to time the market, but they can dig harder and find unknown managers that are hungry and will work on terms that make sense.