LPs Move Back into the Driver’s Seat –

Did you hear that? It’s the voice of the limited partner . . . getting louder.

Over the relatively short period of time that alternatives has been considered a valid asset class by most investors, the upper hand has shifted back and forth between LPs and GPs. In the past, GPs have been able to satisfy their LPs on an individual basis, sources say, with a phone call here and an update there. But faced with disappointing fund performance, lack of deal flow, a tough exit market and a recession, GPs’ leverage in the relationship has grown smaller, their independence has been threatened, and the situation is looking more onerous. LPs are raising questions and demanding answers, and they’re banding together to get what they want.

“We’re talking about a lot of money here,” says one institutional investor who admits to getting more involved with the private equity funds in which his group has invested. “In a down economy, money is on everybody’s minds. We’re just trying to be more aware of where ours is going and how it’s being used. That’s not saying we don’t trust the fund managers, we just don’t want any surprises.”

Indeed, LPs are working to eliminate the surprise factor. Rallying together seems to be their first step. The Institutional Limited Partners Association, a previously obscure group informally founded in 1993, has moved to the next level, says Rick Hayes, the newly elected chairman of the organization, as well as senior investment officer at the California Public Employees’ Retirement System. Formerly a small group that only met once a year, this quarter ILPA held its first elections and recently ratified proposals for the organization’s structure, mission statement and ability to collect dues. Once representing about $12 billion in private equity investment, the group now has 300 members on its roster, some from the same institutions, and represents $150 billion of capital put into private equity funds last year. Hayes estimates that the organization speaks for approximately 80% of the institutional investors that participate in the alternative asset class.

Now that’s an important group with a powerful leader. After all, Hayes oversees the $20 billion alternatives investment program at CalPERS, which has become less and less of a silent limited partner in the past two years, taking ownership positions in firms including The Carlyle Group and Thomas Weisel Partners. The institution also made the news earlier this year when the public discovered CalPERS’ fund performance numbers online, even though they had been posted there for more than six months, but later took them down when legal confidentiality agreements came into question.

The display of the performance numbers, however, popped the top on a can of worms that has slowly been opening as more investors have become interested in private equity funds – the issue of transparency, which ILPA plans to address.

“There’s a mystique around alternatives, and I think [the CalPERS] situation was the beginning of a straight-up analytical approach to alternatives as opposed to the black box approach,” says Chris Oberbeck, a managing director at Saratoga Partners.

Other related issues ILPA has put on its docket include increasing communication among all players in the private equity arena and setting standards. The fact that different general partners calculate returns in different ways weighs heavily on the minds of LPs. More open communication will lead to a more consistent way of reporting, thus bringing about more transparency and the ability to share and compare information, Hayes says.

On a more timely note, with the state of the economy, LPs are going as far as questioning how aggressively their GPs are managing their current portfolios. Several have mentioned a once-a-month update to keep them informed. But GPs sources say that’s not likely or feasible.

“Of course if all our LPs demanded such a thing [as a monthly report], we’d have not choice but to do it, but, man, that would be tough depending on how detailed of a report they would want,” says a GP at a multi-billion dollar fund. “Maybe a quarterly report would be a good compromise.”

At least one issue, LP/GP terms, is not a point of contention between the two parties. With a couple of exceptions, including Bain Capital and Dubin Clark, the 80%/20% terms have been industry standard and will most likely continue to be.

Steven Klinsky, a former Forstmann Little partner who broke away to start New Mountain Capital last year, closed out his fund in the third quarter. He says LPs never expressed concern over terms, not even the 2% management fee, indicating their satisfaction with the industry standard. Other recent fund raisers agreed that the term percentages are not likely to change, but the way the management fee is used is coming into question.

Limited partners are interested in further aligning private equity professionals’ incentives with their own and are encouraging GPs to stop paying employees such large salaries out of the management fees and start letting them in on the carried interest instead. LP sources say using management fees to boost salaries is a perversion of the intention of the fee, arguing that it should instead be used on analysis put into investments.

Hayes says the alignment of LP/GP interests, and all that comes with that, will be the focus of ILPA. Many voices together will no doubt get more attention than one.