When Private Equity GPs Play Favorites

If you’re the heavyweight LP with discount fees, great. But what about everyone else?

Blackstone had more capital rolling in via separate accounts and custom vehicles than its massive commingled funds as of early 2015, COO Tony James said in an earnings call. 

“We’re much more in the business of creating special vehicles for LPs [limited partners] that want certain things,” James told listeners. Those “things” could include shortened redemption periods, lower management fees, greater transparency, co-investments, and access to assets that don’t fit within a typical commingled structure. 

Private equity firms across the board have been seeing—and meeting—rapidly rising institutional appetite for special arrangements, Preqin data have shown. 

But doesn’t mean commingled fund investors are getting a raw deal, according to an in-depth analysis by Yale Law School’s William Clayton. 

Why give a top-notch opportunity to LPs paying discounted fees, for example, unless it’s unworkable in the main fund?“Most forms of preferential treatment enabled by individualized investing create new value for the preferred investors who receive the favored treatment, rather than appropriating that value from non-preferred investors,” Clayton found.

Most value-additive perks of separate-account investing wouldn’t be reaped at all if these structures ceased to exist, he argued. Why give a top-notch opportunity to LPs paying discounted fees, for example, unless it’s unworkable in the main fund? 

That high-conviction deal also would also contribute to a firm’s track record in a commingled fund, Clayton noted, but has little fundraising upside in a side vehicle. 

“The value of pooled-fund track record thus serves as a strong source of protection for pooled-fund investors,” he added—possibly to the extent of favoring them over separate accounts.

LPs’ desire for some control over allocation decisions has been another major driver in the custom-vehicle boom, Clayton wrote. Commingled fund investors have essentially none, beyond their initial allocation choice. Co-investments empower LPs in way that’s impossible if they’re one of dozens or hundreds of institutions, where reaching consensus would be impossible in practice. 

While the trend of customized private-equity vehicles doesn’t meaningfully conflict with commingled investors, Clayton argued, it’s hurting asset owners as a whole in one major way. 

“An interesting side effect arises out of the growth in individualized investing: The fact that the incentive for broad coordinated action among private equity investors weakens as investors’ interests become more individualized,” the author found. 

When many of the most powerful asset owners have negotiated acceptable fees and transparency via special arrangements with private equity firms, the fight for fair universal standards may be left up to those least able to win it. 

Read William Clayton’s research paper, “In Praise of Preferential Treatment in Private Equity,” published March 16.  

Related: Taking the Guesswork Out of PE Fees & PE Investors Should ‘Temper’ Their Expectations