Expert Interview: LP Perspective on Fund Selection

When it comes to investing in private equity (PE) funds, the Limited Partners (LPs) play a crucial role in shaping the success of the investment. LPs, who are typically institutional investors such as pension funds, endowments, family offices, and high-net-worth individuals, bring significant capital to PE funds. However, their role doesn’t stop there—they are instrumental in selecting funds that align with their strategic objectives, risk appetite, and long-term investment goals.

In this blog, we will explore the LP perspective on fund selection through insights and expert advice, diving into the key factors that influence an LP’s decision-making process when evaluating private equity funds. We’ll also feature valuable perspectives from industry professionals, highlighting their considerations and strategies.

What Do LPs Look for in a Private Equity Fund?

Selecting a private equity fund is a critical decision for LPs, who must carefully evaluate various factors to ensure the fund aligns with their investment goals. Here are the top elements LPs consider when selecting a fund:

1. Track Record and Experience of the General Partner (GP)

The experience and track record of the General Partner (GP) are often the most important factors in fund selection. LPs need to be confident in the GP’s ability to source, execute, and manage investments effectively. This includes:

• Past performance: LPs want to see a strong historical track record, including the fund's ability to achieve consistent returns, successfully exit investments, and manage risk.
• Expertise in the sector: LPs seek GPs with deep knowledge and experience in the sectors or industries in which the fund invests. Whether it’s technology, healthcare, or energy, expertise in specific sectors can enhance the GP’s ability to identify high-potential opportunities.
• Reputation and trustworthiness: LPs also evaluate the GP's reputation within the investment community, including their relationships with portfolio companies, co-investors, and other stakeholders.

Daniel Kylander, an experienced professional in the private equity space, emphasizes the importance of having "a strong relationship built on trust" between the GP and LP. Trust is critical, as LPs rely on the GP’s expertise and integrity to manage their investments effectively.

2. Investment Strategy and Alignment with LP Objectives

LPs are highly focused on selecting funds that align with their investment strategy and risk profile. Key considerations include:

• Fund focus: LPs assess whether the fund’s strategy aligns with their broader portfolio goals. For instance, if an LP is looking to gain exposure to emerging markets, they will prefer funds with a focus on high-growth regions.
• Risk tolerance: LPs must evaluate the risk profile of the fund, including the level of leverage, the nature of the portfolio companies, and the expected volatility of returns. Some LPs may prefer more conservative funds with lower risk, while others may be comfortable with higher-risk funds in exchange for higher potential returns.
• Target returns: LPs typically have specific return expectations, such as a minimum internal rate of return (IRR). GPs must demonstrate how their strategy is designed to achieve these returns over the life of the fund.

3. Fund Terms and Fee Structure

The terms and fee structure of a fund are critical considerations in the LP’s decision-making process. LPs typically evaluate:

• Management fees: LPs want to ensure that the management fees (typically 1.5%-2.5% per year) are reasonable compared to the market and align with the GP’s incentive to generate strong returns.
• Carried interest: LPs also examine the carried interest arrangements to ensure that the GP’s interests are aligned with their own. The typical carried interest for a GP is 20%, but LPs will assess whether this is appropriate for the level of risk and expected return.
• Hurdle rate: The hurdle rate is the minimum return that the GP must achieve before receiving carried interest. A higher hurdle rate may indicate that the GP has confidence in their ability to generate strong returns, which can be appealing to LPs.
• Liquidity provisions: LPs want to ensure that the fund has a clear exit strategy, which might include IPOs, secondary sales, or other liquidity events. Additionally, LPs may look for co-investment opportunities or mechanisms for partial liquidity in longer-term funds.

4. Transparency and Reporting

Transparency is a key factor in building trust between the LP and GP. LPs need regular and detailed performance reporting to monitor their investments and ensure the fund is meeting its targets.

• Regular updates: LPs prefer funds that provide clear, detailed reports on performance, portfolio companies, market trends, and financials. Frequent communication fosters trust and ensures LPs are well-informed.
• Access to information: Some LPs also seek funds that provide access to real-time data and offer transparency in terms of fund operations, governance, and management decisions.
• Governance structure: A strong governance framework ensures that the GP acts in the best interests of LPs, and that decision-making is aligned with the fund’s stated objectives.

5. Portfolio Fit and Diversification

LPs look at how a potential private equity fund fits within their broader portfolio. Diversification is a critical aspect, and LPs often seek funds that provide exposure to a variety of industries, stages, or regions. For example:

• Industry diversification: Some LPs seek funds that invest across multiple sectors to reduce risk and create a more balanced portfolio.
• Geographical diversification: LPs may also look for funds that operate across different regions to capture growth in emerging markets or hedge against regional economic risks.

LPs might also consider the level of co-investment opportunities, which can allow them to invest more capital directly into specific portfolio companies, diversifying their exposure and enhancing returns.

Navigating the Macro Environment: The Role of External Factors

Macroeconomic shifts, such as changes in interest rates, inflation, and geopolitical risks, have a significant influence on private capital markets. LPs need to assess how these factors affect fund selection and the underlying investments.

• Interest rate changes: Rising interest rates can increase the cost of borrowing and affect the valuation of portfolio companies, particularly in leveraged buyouts. LPs need to evaluate how a fund’s strategy can adapt to these changes.
• Economic cycles: During periods of economic downturn, some private equity funds may struggle to generate returns. LPs may look for funds with a defensive or counter-cyclical strategy that can perform well during market volatility.
• Geopolitical risks: Geopolitical tensions, such as trade wars or regional conflicts, can affect the performance of international investments. LPs may prioritize funds with a diversified geographic focus or those with exposure to stable markets.

Expert Insights: Perspectives from Industry Leaders

An interview with Daniel Kylander, an industry expert with years of experience in the private equity market, sheds light on what LPs should prioritize when selecting funds. According to Kylander, "The most important aspect for LPs is trust. Building a strong, transparent relationship with the GP is essential for long-term success. It’s not just about numbers, but about understanding the GP’s values, how they make decisions, and how they navigate challenges in the market."

Kylander emphasizes that LPs should also ensure that the GP has a deep understanding of the sector they’re investing in. The most successful funds are those led by GPs who have not only a strong track record but also a profound insight into the industries they target.

Conclusion

Selecting the right private equity fund is a nuanced decision for LPs. It involves careful consideration of the GP’s track record, the fund’s strategy, terms, and the broader macroeconomic environment. By focusing on factors such as fund performance, alignment with LP objectives, transparency, and diversification, LPs can make informed decisions that align with their financial goals and risk tolerance.

Navigating the complexities of private capital investments requires a mix of due diligence, market awareness, and trust in the GP. For LPs, the ability to adapt to macroeconomic changes and choose funds that align with their broader portfolio strategy will continue to be a critical element of successful investing in the private capital space.

FAQs

1. What should LPs prioritize when evaluating a private equity fund?
LPs should prioritize the GP’s track record, the fund’s investment strategy, alignment with their objectives, fund terms, and transparency in reporting.

2. How do interest rates impact private equity investments?
Higher interest rates increase borrowing costs, which can affect the structure of deals and impact the valuation of portfolio companies, especially in leveraged buyouts.

3. Why is diversification important in private equity fund selection?
Diversification reduces risk and allows LPs to gain exposure to various sectors, geographies, and stages of investment, improving the overall stability of their portfolio.

4. What role do geopolitical risks play in fund selection?
Geopolitical risks can affect the stability and growth of portfolio companies, especially those with international operations. LPs may seek funds with diversified exposure to mitigate these risks.

5. How can LPs ensure they select a fund that aligns with their investment goals?
LPs should evaluate how the fund’s strategy aligns with their risk profile, return expectations, and long-term investment objectives. They should also assess the GP’s understanding of the market and sector in which they are investing.