David Turner, Managing Director, Head of Private Equity for The Guardian Life Insurance Company of America
David Turner was the chairman and a speaker for iGlobal Forum's Alternative Private Equity Structures event in New York. He has been an institutional buy-side PE investor since late 1970s, engaged first in project finance using combinations of public/private growth capital and financial incentives to support entrepreneurs and private SMEs. Later, David acted as a direct equity investor in same enterprises utilizing permanent pension fund capital. He also became a "wholesale distributor" of pension fund capital by investing in closed pool primary funds and "early market" separate account special situations. David then became a GP and led a boutique FoF business before starting the internal Guardian PE business in 2007 and continuing to support select primary fund GPs in parallel with direct investing and special situation separate accounts.
Q: Why are GPs currently creating portfolios filled with a variety of different companies when most returns only derive from a few?
A: GPs are incentivized to raise funds which invariably turn out to be larger than their respective "AA quality deal" opportunity sets. They are allowed the opportunity by willing LPs who are required and motivated by their mandates to chase higher PE allocations in the chronic low interest rate environment. This is the fundamental "misalignment" of interests. I have had candid conversations with some GPs who would rather be much more selective and focus 100% of their competitive edge skills and 95% of their time in what they do best: investing in, owning, and adding value to a small handful of highly selective companies (no more than 4-5 great opportunities at a time). Instead, they each have to manage new and legacy portfolios of 15+ at a time, with the top 1/3 outperforming the rest by wide margins. In recent years, many mid-market PE portfolios we review have taken on lumpy "VC like" or "barbell" return profiles.
Q: How do you propose we improve the current model to account for the overpriced and underproductive capital?
A: To save the current closed pool model from eventual extinction, (or extend its diminishing shelf life) a few fundamental practices need the full commitment from both GPs and LPs. We need much higher hurdle returns to earn carried interest, 3.0X - 3.5X net cash on cash basis vs. modest IRR and portfolio value test. Shorter investment periods of no more than three years with a mandate to return uncommitted capital being a default vs. negotiated term would also help. GPs also need to eliminate all deal fees so there are no misdirected and unproductive residual economics to quibble over, creating a competitive edge for GPs to be more management friendly when buying companies in a market over-saturated with capital and PE managers. Management fees should be entirely budget based and fund only the working capital needs to support a tightly focused and shorter term GP business plan.
Both GPs and LPs are making good progress on LPA T&C alignment and a greater share of LPs are stepping up to their fiduciary responsibilities by re-upping with fewer lower median GPs. The fully funded and active secondary market with pricing transparency for both buyers and sellers acts as a "safety valve" to relieve some pressure for LPs suffering from the effects of overpriced and underproductive capital. However, the current secondary market alone can't overcome the performance and cost of capital drags which resulted from we LPs making bad decisions to invest with lower median managers in LPA contracts with minimum term lives of 12-13 years. Private equity continues to need more tough love and "Darwinian capitalism."
Q: What innovative structures is Guardian already using with progressive GPs?
A: To date, Guardian has structured three separate account investment programs to gain access and exposure in key, strategic PE segments otherwise difficult to achieve on our own even with an experienced, albeit small internal team. These structures themselves are not particularly innovative, but have been successful and achieved the original objectives: 1) We achieved quicker NAV build up and earlier liquidity at favorable economic terms with a co-investment separate account partner; 2) Leveraged limited time resources to gain access to top emerging market GPs by partnering with a highly experienced EM specialist partner; and 3) Opportunistically leveraged deep network contacts to acquire deeply discounted assets with "prized" GPs through an innovative structure with a sophisticated, like-minded institutional partner. Very likely more special situation needs will be addressed in a similar fashion by partnering with a small select number of innovative partners.
Q: How will “club collaborations” change the face of the current market?
A: Modern, post WWII PE started as a series of club deals between mostly high net-worth families and owners of private enterprises who needed relief from capital gains taxes and still sought extraordinary investment gains. Club deal investing has continued on through to this day, albeit far below most institutional radar screens and certainly below most institutional investors’ abilities to efficiently deploy capital. Many mainstream institutional PE investors are governed by fairly strict investment policy mandates, governance requirements, rigid execution practices, and frankly, lack deal level experience and sensibilities. Some notable exceptions are a handful of new age sovereign wealth entities, who through sheer size and scale are able to invest in highly experienced management teams, cast a global footprint and custom design specific investment solutions for needs which center around wealth management, strategic business and political alignments, economic development for their constituencies, etc.
On a more micro scale, individual investors, both active and passive, with long-histories of successful investing with one another on a deal by deal basis, continue to do so. Corporate carve outs and GP spin outs are sources of new "club-deal" arrangements many of which morph into conventional closed pool funds, but some will remain club deals as long as reliable capital is available. Club deals by definition are the domain of individual entrepreneurs, growth company executives, and investors without rigid capital management rules and will not be the major impetus for "changing the face" of the current market. In my opinion, five years from now, club deals as a share of the overall PE market may grow, but will remain immeasurably minute.
Q: Do you think the proposed structure will be a successful change, even with the informality to the process?
A: Success will be measured one outcome at a time. There have been and will be many more interesting experiments with innovative structures, including "institutional grade" club deals. One very plausible and practical approach will be for one, two, or no more than three sophisticated investors, operating under limited liability protections, to acquire or otherwise own and manage their own GP manager(s), set investment strategy to directly address their specific, or common, portfolio needs, and actively direct and oversee investment activity as majority shareholder members of a board of directors vs. minority limited partner "advisory" members in today's typical syndicates. This corporate structure would set a 2-3 year business plan with economic incentives and operating terms structured and tailored to meet circumstances similar to structuring a PE investment in a private company. In various iterations of this arrangement, investors could create an "all in" investment strategy where each deal is invested pro rata or "opt-in opt-out discretionary" on a deal-by-deal basis.
I hesitate to use the term model, but this arrangement, in theory, benefits GPs with so-called conventional models by relieving them of having to build a partnership enterprise in which success is defined by continuously raising capital and exists fundamentally to support itself. This frees the self-proclaimed "true deal guys" to just "do deals." It benefits LPs by allowing them to make more specific risk allocation decisions, pursue high potential growth opportunities and customize and fine tune portfolio construction and duration, both key components of risk mitigation. On average, up to 40% of management fees paid to each partnership go to fund operating and firm maintenance overhead expenses. Replicating this unproductive use of fees across dozens and even hundreds of partnerships in one portfolio magnifies the drag on performance. In this arrangement, the LP owner(s) of the captive GP manager(s) can agree on and budget for necessary investment firm expenses and achieve economies of scale through volume purchasing of consulting, investment banking, accounting, legal and administrative services, etc.
Unlike investing in a blind pool, one size does not fit all. Any new, innovative structures by definition will need to be tailored to fit specific circumstances of individual investors. When recognizable models and standardized practices begin to emerge, in my opinion, it will be time once again to rethink the definition of innovative.