New York law firm Barnes & Thornburg sought out to measure LP and GP expectations through a survey of 125 limited partners, fund sponsors and service providers, revealing an alternative investment industry in flux.
The online survey spanned hedge fund, private equity, credit and venture capital organizations and provided a sense of shifting expectations and mindsets spawning from a changing economic landscape. “GPs, especially less experienced ones, will have to find innovative ways to attract LP dollars and address concerns about ESG and succession planning,” said Kerry Potter McCormick, partner in Barnes & Thornburg’s Private Funds and Asset Management Group. “At the same time, stakeholders on all sides of the deal table will need to make sure they’re getting the right risk-reward balance while making preparations to adapt to inevitable shifts in the markets.”
One of the key findings was that as exits slow and portfolio valuations decline, liquidity restrictions have placed added pressure on LP cash flow with 75% of those surveyed saying they expect changes in fund terms that will be more beneficial to LPs going forward. These include investment period extensions, changes in GP commitments and no-fault divorce clauses, among others. Perhaps more notably 72% of respondents expect to see a change in distribution of fund proceeds. This would include changes in distribution formats and changes in waterfall provisions.
According to McCormick, GPs are now having to “woo” LPs with better economics and transparency whether it is co-investment opportunities, fee discounts, enhanced visibility for purposes of portfolio monitoring. She added that the trend is likely more advantageous for larger GPs with more product lines that have the flexibility to work closely with LPs on terms.
Notably that transparency for LPs doesn’t mean the same level of disclosure for all LPs, McCormick said. A number of leading institutional investors have expressed concerns with a proposed SEC disclosure requirement.
According to Barnes & Thornburg, if the new requirement is implemented it will curtail the customized transparency many allocators have become accustomed to via side letters. Larger institutions have expressed concern that the new rules would dissuade GPs from providing any side letters.
McCormick added that some LPs are asking for redacted copies of the actual side letters rather than the traditional MFN compendium that is usually provided following a final closing.
“Transparency is important to LPs, who are really focused on getting the best deal they can in this economic environment, especially when their capital will be tied up for 10 years or longer. GPs will likely increasingly see just how important transparency is.”
GP/LP misalignment
Disclosure and transparency are just two areas of increased discrepancy between managers and investors. More than half of LPs said fundraising was GPs’ most pressing issue, while only 24% of GPs said the same. Meanwhile, 42% anticipate investor growth in the coming year, while only 30% of LPs expect an increase in the number of fund managers to which they allocate in the coming year.
When it comes to discipline in investment management, only 56% of LPs believe GPs will show more discipline, while 71% of GPs say they will maintain greater discipline this year. This may translate into increased focus on the pace of deploying capital or use of leverage.
Other key findings
- Succession planning is highly valued by LPs, yet only 41% of GPs have such plans in place.
- Cryptocurrency is a risk many are still willing to take. Most respondents — particularly private equity and credit managers — say the current state of the cryptocurrency market has significantly impacted their company in a negative way. Yet even as regulatory scrutiny picks up, the majority are still considering or actively deploying capital in the space in 2023.
- Life sciences has plenty more investment potential. Though investment in life sciences has cooled slightly, more than half of respondents focused on the space see gene therapy, precision medicine, artificial intelligence/machine learning, and cell therapy as key opportunities.
- Real estate PE funds draw interest despite softening economy. Though such funds may experience difficulties when compared to pre-2022 levels — due, in part, to the shift to work-from-home and real estate capitalization rates — opportunities abound. For instance, roughly the same number of respondents call rising interest rates an opportunity as those who view it as a challenge.
