Private equity: the definition of an opaque asset class

At a private equity conference years ago, I sat beside a couple of trustees from a small pension fund. Nice men, highly educated and intelligent, and wanting to do their best for their members, but utterly clueless about investments.

They found the presentations by private equity managers very convincing, and presumably went back to their investment committee to explain that private equity investment was well worth the fees.

More sophisticated investors have also been convinced. These days money is pouring into private equity funds, to such an extent that managers are struggling to find deals.

But private equity is, almost by definition, an opaque asset class, with high barriers to entry and an arcane charging system that allows managers to make most of their profits from fixed fees rather than performance.

Consequently, investors have started to join forces in an attempt to level the playing field.

Some, mostly pension funds, are focused on fund investing, while others, typically family offices, are collaborating to build a direct investment capability.

Last week, Calpers, the largest US pension fund, said it was looking to cut the number of managers it uses by two-thirds, to as few as 120, and would work with other investors to build direct investment capability.

Last year, also in California, the Orange County Employees Retirement Fund put together a group of small to midsized pension funds to invest together with a fund of funds. In the UK, two local authority pension funds (Avon and Dorset) used JLT, the consultancy, to help them jointly search for an infrastructure fund manager.

"[These deals] are about bringing down the cost of fund investment and improving access to funds," says Antoine Drean, founder of Triago, the private equity fund adviser, and chief executive of Palico, the online private equity marketplace. "Some of these alliances designed to improve private equity fund investment will in all likelihood broaden into initiatives that open up direct investment opportunities for participants."

Going straight to direct investment is not always wise, as the $72bn Korea Investment Corporation found. The sovereign wealth fund said last year it would change its strategy after direct investing produced "disappointingly lower returns" than investing through funds.

The new plan is not to allocate all its private equity investments through funds, but to co-operate with other SWFs to share regional expertise.

"Who could know more of Korean projects than KIC? Who could be better versed in what is happening in Singapore than GIC or Temasek?" asked KIC's chairman and chief executive, referring to two Singaporean sovereign funds.

Because private equity investing is complex, there are many levels and modes of collaboration for investors. It is therefore likely that a broad range of pension funds and others will continue to work together to improve outcomes.

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"Clearly collaborating on a more occasional, opportunistic basis keeps complications to a minimum, though if you can successfully negotiate the thicket of political and fiduciary hurdles, more comprehensive partnerships hold the greatest potential for improving investment returns," adds Mr Drean.

Would better investment returns inevitably come at a cost to general partners, the professional private equity investors who run funds? It is hard to say, as there are also likely to be benefits.

Although larger asset allocations would probably mean tougher fee negotiations, that might be offset by the increased efficiency for GPs in bringing in bigger chunks of money.

Outsourcing by investor alliances to funds of funds would offer an opportunity, albeit one whose benefits might be undermined by lower fees.

It is better for GPs to work with a group of investors who want to co-invest than to have to team up with other GPs on particularly large investments. Ultimately, the likelihood is that increasing experience and confidence in the field will mean more institutional investors feel able to go it alone, or at least without a GP holding their hand.

To quote KIC's chairman: "Let's go together with unwavering confidence in this co-investment initiative."

Although my pension trustee friends might shudder at such grandiose imagery, I like to think they will ultimately benefit from this shift in the power structure of private equity.

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