Clockwise from top left: Mallika Nair, Kristin Varela, Amy Resnick and Courtney Nowell.
Institutional limited partners seek to find the best asset managers as their general partners and to achieve strong alignment with them on several issues, including fees, transparency, exits and conflicts of interest.
In a recent CIO webinar, institutional LPs discussed what they expect from their managers and how their relationships with their GPs are changing.
Webinar speakers included Kristin Varela, CIO of the New Mexico State Investment Council; Mallika Nair, senior director of investments at Fordham University; and Courtney Nowell, a partner in Morgan Lewis’s global investment management practice.
Watch the full webinar here:
Driving Operational Value
Despite recent headwinds for private markets, institutional investors still highlight their importance in a portfolio. For the $1 billion Fordham University endowment, alternatives make up slightly more than half of the portfolio, while the New Mexico State Investment Council is pacing up its deployment into the asset classes.In order to achieve the illiquidity premium, LPs are increasingly looking for managers who can outperform and provide operational value.
“While we do believe that there are headwinds for private markets, we do think that they earn their way in the portfolio, but we recognize that there is a significant amount of capital out there and competition, … so we are much more cautious and believe that in order to continue to deliver outsized returns, we really have to parse out who has been able to drive operational value and who will continue to be able to,” Nair said.
Private markets are an important part of driving the value of New Mexico’s sovereign fund, Varela noted—the fund is aiming a 35% target to alternative investments.
“‘Does it pay to be this complex?’[is] the first question any of our investments should answer … ‘Is this the best opportunity set?’ And for a CIO sitting in a total portfolio capacity, considering whether or not we should lock up our capital … or if we should [seek] a very simple passive beta exposure—that is the first question that we are asking our team to attest,” Varela said. “When you’re underwriting your opportunities, are you comparing them to very simple investable strategies?”
Varela also noted that NM SIC seeks to partner with the best managers available, noting that the fund seeks to form strong long-term relationships with a handful of larger managers. The most important question, Varela asked, is if their managers can be strategic partners for the fund.
“We’re no longer looking for just access to the fund; we are looking for an extension of staff, we are looking for resources beyond our capacities,” Varela said. “This portfolio is $70-plus billion and growing. The investment team … is smaller, relative to our peers. We need all the help we can get, and the scalabilities and efficiencies—we also want to make sure any of our partners [share] that same goal to achieve … [the] mission that we have.”
Varela noted that for many years, just being in the markets meant that it was easier for managers to outperform. With current headwinds in private markets, however, allocators need to be more selective to identify managers who can continue to outperform and support the operations of their LPs.
Getting the Best Fees
The asset-owner speakers discussed how they work to get the best fees and other terms from their managers.Given the Fordham endowment’s size, fees on private funds are an important topic. Nair noted that fee terms are trending in the favor of asset managers, but the fund does what it can to negotiate favorable rates.
“We really do try to push our managers when we can, but we are cognizant of our size and our limitations,” Nair said. “We try to lean in and push when a manager is trying to upgrade their fees or change them, because I think we have a higher chance of success, rather than trying to have a manager walk back fees and carry terms.”
Nair noted that Fordham works with other institutional investors and consultants to ensure the university is getting the best possible fee terms from its managers. She also said that the endowment has had success in fee negotiations with managers with whom Fordham has long-term relationships, highlighting the importance of prudent manager selection.
Varela added that if there is more consistency in what LPs are asking for, GPs are forced to listen. She encouraged asset owners to engage in “LP networking and find like-minded investors you can work with.”
Nowell also said that in the age of artificial intelligence, asset manager expenses are evolving.
“Everyone is aware of the six pages of disclosure of expenses as is, typically expected and requested by the regulators,” Nowell said. “But what is being added to that giant list is getting a little interesting. Things like AI, things like cybersecurity, how is that being allocated between funds? If this is a manager with platforms upon platforms, how are they allocating those expenses?”
Varela also highlighted the importance of getting transparency from managers.
“We are really pushing a lot of pieces of this, but alignment really comes down to: It’s not just fees; it’s governance, it’s transparency, it’s engagement and, for us, it’s influence,” Varela said.
Extensions, Continuation Vehicles and an Exit Slowdown
As private equity exits have slowed in recent years, the use of continuation vehicles to increase the longevity of private funds has increased.Nowell noted that continuation vehicles have become well-established liquidity tools, rather than used as a way to shed old investments that LPs did not know what to do with. Nowell also said that many smaller LPs. Particularly those that are not on an LP advisory committee, often are not at the table when a GP is considering a continuation vehicle. As those on the LPAC are notified first, smaller LPs—those not on the committee—have a much shorter timeline—often two weeks—to decide whether or not to stay in the continuation fund.
Questions the smaller LPs should ask, according to Nowell, include: “What are the terms being offered to the cornerstone investors? What are the terms being offered to the new money? Even if they are not cornerstone investors, is it different than what is being offered to you as a potential [rollover] investor? Who is approving, who is valuing, who is checking the valuation? Or is it just a ‘trust me’? Because sometimes it is. What are the fees being charged in the new vehicle, and what’s happening with the carry?” Nowell asked.
Valera added that from an allocator’s perspective, many underwriting teams need to make sure they understand everything going on in the legal documents of continuation vehicles.
Nair noted that allocators are being far more conservative when it comes to stress-testing assumptions about where returns are being generated.
“We’re assuming longer times to liquidity, I think we are also asking different questions, [and] we are paying more attention to how managers have acted during this [low liquidity] period as we think about going forward and what our investments look like, whether we think about re-ups,” Nair said. “We’re diving [into] much more, not just on the pacing level, but on the individual fund level and manager level, and thinking, ‘Have they overpromised and underdelivered? If so, what are the reasons for that?”
Nair also highlighted the importance of managers who provide transparency when things are not going well and that act as partners with their LPs.
What Retail Capital in Alts Means for Institutional LPs
The panelists also discussed the influx of retail and defined contribution capital that is being encouraged into alternative investments, including private equity and private credit. LPs are worried that the new investors may not have the best terms or the most education on these products.Varela added that transparency in pricing—many retail investors and retirement plans are seeking more transparent pricing for private credit and private equity funds, including daily pricing—will not be a bad thing, but said she is worried about the implications of a wave of retail money for LPs.
“Institutional investors have made a tremendous amount of progress to get more LP-friendly terms,” Varela says. “If we’re not careful and there is a huge pool of less-discerning capital out there seeking double-digit returns, what we might find is all of the advancements we made in those term, governance and alignment negotiations start to erode.”
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