It is no longer better together for private equity institutional investors, says Neuberger Berman’s Joana Rocha Scaff, as separate accounts begin to replace funds of funds.
Managers tasked with building private equity portfolios are living through an adapt-or-die moment.
In prior decades, private equity programs often were implemented through commingled funds of funds, but in recent years there has been a rise in mandate customisation, using separate accounts and strategic partnerships.
A 2015 private equity survey by research company Preqin indicates that almost 30% of investors are considering separate accounts, while a 2014 report found more than half of the fund of funds managers offer separate accounts to clients.
Key points
1. Discuss whether your fund could benefit from customising its private equity
2. Interrogate your providers’ readiness to manage separate accounts
3. Consider how customised mandates will complement existing arrangements
Why seek customisation?
The most important driver in seeking a tailored account is the flexibility to exercise greater control over programme implementation and the ‘rules of the game’.
Through a separately managed account an investor can control the pace of capital deployment or comply with internal criteria in areas such as responsible investment.
The way investors use this flexibility will depend on their starting point. Some will have no existing exposures and start with a clean slate.
Others might hold a disjointed combination of large-cap buyout funds; small, often relationship-driven domestic funds; and funds of funds they want to rationalise.
Usually the customised account provider will need to understand the existing exposures and design a completion program.
In the first scenario customisation is a way to build the ideal portfolio; in the second, it is a way to fix a suboptimal portfolio.
Investors can determine their desired level of interaction with program implementation.
Those in the UK or Switzerland, who may be liable for investment decisions, often prefer to set parameters upfront and delegate the specific investment selection.
Managers tasked with building private equity portfolios are living through an adapt-or-die moment
Others embrace the flexibility to get involved with investment selection.
Investors with limited staff often look to outsource completely, while those with larger teams may outsource in specialist areas so they can concentrate on core strategies; in doing so they can enhance their own network through their separate account providers’ relationships and deal flow.
Three is the magic number
Experience suggests that while two separate account providers can work well, three begins to create an administrative burden for the investor.
Managing three funds of funds is easier: for the investor, customisation is a trade-off between portfolio efficiency and administrative complexity.
Customisation brings more complexity for the account manager too, with unique legal, accounting, tax, administrative, reporting and risk-management requirements alongside bespoke portfolio design.
It is crucial to have well-defined internal rules and policies to address potential conflicts among separate accounts and commingled funds.
It might seem odd to add and customise services when surveys suggest fees are the main obstacle to allocation and alignment of interests in private equity. But a big-ticket customised mandate offers scope for fee negotiation.
This is one reason separate accounts tend to be bigger in size than pooled fund commitments: on average $250m (£161m), according to Preqin; sometimes in the billions; rarely less than $100m.
One commonly cited frustration is management fee charged on capital commitments waiting to be deployed in the early stage of a program.
A bespoke structure might involve a net asset value-based fee, with the investor essentially paying nothing on uninvested capital.
For a Swiss pension fund, for example, whose regulator focuses on total expense ratio, this makes a private equity allocation much more practical.
Moreover, fees paid to the account can be offset through the manager’s ability to leverage its platform to negotiate terms with underlying general partners and to access more fee-efficient co-investment and secondary opportunities.
Customisation often means managers doing more for less, but they will benefit from scalability once the investments in people and infrastructure have been made.
In any case, no one can fight such a strong trend; those who fail to adapt could face a far from certain future.
Joana Rocha Scaff is managing director and head of Europe private equity at Neuberger Berman
