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Time for action?

As an investor, it's no use complaining about the lack of transparency in private equity or unfair terms and conditions unless you're prepared to do something about them.

No matter what they may be saying at the moment, private equity professionals have had it pretty easy. Current problems with portfolio companies may be testing the mettle of some of even the most experienced venture capitalists, but life isn't that hard for them - for the moment at least. They are working in an area about which many of their investors know very little. Either that, or private equity is such a small proportion of many investors' portfolio, that spending much time on monitoring it might detract from other asset classes. Put this together, and you get a pretty undemanding set of investors committing to private equity.

Faced with such undemanding investors, the private equity industry has been able to get away with some distinctly unusual - and some might say questionable - practices. How many other asset classes rely on a manager's own interpretation of his past performance? Where else would you find a situation in which a pension fund suing a fund manager can end up footing the manager's bill because it has indemnified him against class actions? There are plenty of others you could add to the list.

Tough times
But, with private equity managers facing the toughest fund-raising conditions they've seen for a few years, the balance of power is beginning to shift. Some investors are starting to make their voices heard and are encouraging their peers to do the same. This trend was particularly apparent at the recent SuperInvestor conference in Paris. Chief executive of Hermes Pensions Management, Alastair Ross Goobey, grabbed the headlines by attacking the level of fees charged by private equity professionals. He may have upset some people in the industry and he may also have used selective data to back up his arguments, but the point is a valid one. For firms to be charging up to 2.5 per cent as a management fee on top of any performance-related carried interest seems excessive, especially in the light of the fact that very few deals are being completed at the moment. In the current environment, many limited partners are effectively paying a management fee for their general partners to do little but wait and see.

The complicated nature of terms and conditions in private equity fund investing is, to some extent, to blame for the prevalence of this and other ‘unfair' characteristics of the market, according to Standard Life's Jonny Maxwell. ‘There has been blood on the streets as robust private equity names have crumbled. And yet this state of affairs has been met by limited partner inertia. The reason for this impotence and lack of action? It's partly down to the tons of legal work involved in buying private equity fund investments.' Still, said LGT Capital Partners' Ivan Vercoutere, investors shouldn't rely on their lawyers to get it right. ‘Terms and conditions are so important. They are critical because you are going into a contract that will last for 12 to 15 years. Investment committees should spend much more time on terms and conditions and yet I know some institutional investors who are scared to question their general partners.' Friends Ivory & Sime Private Equity's Sheenagh Egan agreed, saying that she was ‘appalled' at the tiny amount of negotiation that limited partners do.

Neither should limited partners rely on other investors to negotiate for them. ‘The saddening aspect is when I make perfectly reasonable comments about terms and conditions and GPs tell me that I'm the only person who has mentioned it,' said Maxwell. ‘When I then talk to other investors, they expect you to champion the cause for them. Legal agreements are like a toothless dog - it would be useful if people decided to use their teeth again. We need to work together, to collaborate.'

Come together
And that's exactly the point. Unless limited partners can join forces to change ‘unfair' terms, then they will make little progress. This isn't about limited partners ganging up on private equity managers; it's about investors coming together to protect their investments and their interests. If all investors refused to sign terms that allowed general partners to cream off carried interest before returning any money to limited partners, the practice would most likely end. If investors shared information they had on funds, you might find that some of the self-appointed ‘top quartile' performers suddenly fell to the bottom of the pile.

This kind of collaboration would be hard to make happen on an ad hoc basis. What is needed is some kind of forum for institutional investors to air their views and talk about what they expect from their private equity managers. The US already has an association of limited partners, why doesn't Europe?

The time is absolutely right to set up such an association. With the fund-raising climate as it is, general partners are likely to be much more receptive to negotiating contracts that are fairer to limited partners. The people most likely to join and lead are fund of funds - people whose main occupation is private equity fund investing - and their numbers are swelling in Europe. After all, it is up to them to protect their investors' rights and capital.

These investors wouldn't be leading a revolution - there will always be a premium to pay for access to the best funds and exerting too much pressure might encourage some of the star managers to leave. Instead, they would be ensuring that private equity evolves and matures into the type of industry that investors feel comfortable committing their money to. That would mean a less easy ride for the private equity industry. It would also give investors much more say about what happens to their money. Isn't that the way it should be?

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SuperInvestor was organised by ICBI. For more information on its conferences, please visit www.icbi-uk.com