Institutional LPs are Long-Term Oriented(ish)
Ask a CIO #30
There isn’t much to say that hasn’t already been said about the devastating wildfires in LA. It’s hard to fathom just how much has been lost.
For our LA-based readers, I hope you’re all safe and well.
This week’s question turns the spotlight on LPs.
Are institutional LPs truly long-term oriented?
Ouch. I’m sure you didn’t mean for the question to include a judgement, but I still felt it a little anyway.
Not that it would be completely wrong either. While I truly believe that institutional LPs generally invest in good faith, with a long-term orientation in mind, LPs sometimes seem to change their minds in surprisingly short order.
Mostly though, I think institutional LPs are inclined to be long-term investors. I’ll make the obvious arguments first: 1) institutional LPs typically invest from long-term (or even perpetual) pools of capital, and 2) institutional LPs, who are collectively the most active investors in private markets, understand that a long-term investment approach can be advantageous in many strategies.
But to me, the institutional due diligence process is the most convincing proof point that these LPs intend to invest for the long-term. For anyone who isn’t familiar, these due diligence processes can be and often are very long and drawn-out. An institutional LP might meet a manager and spend the next year, two years, or longer, monitoring that manager. If the LP decides to really pursue the investment, the active underwriting process is likely to then include many more meetings and requests for data, all of which could require months of additional time.1
The investment teams behind many institutional LPs are lean, and these teams, in my view, are generally not looking to deploy all those hours in service of short-term investments.2 At the outset of any new investment, everyone is aligned on the optimal outcome – a long and successful partnership between GP and LP.
So what happens next? Why do institutional LPs sometimes seemingly change their minds?
In some breakups, it really is the LP. Perhaps there was a significant change to the investment team (e.g., new CIO), which can happen more often than LPs might like to admit.3 Or, as in recent years, perhaps the LP is facing unexpected liquidity challenges. I can appreciate the difficulty of having an LP terminate a relationship prematurely for reasons outside the GP’s control.4
But in other breakups, it’s the GP. Underperformance relative to benchmarks or peer managers is probably the most common catalyst. And while it can be easy to dismiss LP decisions as performance chasing (and sometimes that criticism is fair), it’s often not the whole story.
From what I’ve seen, two managers can exhibit similar performance, yet one manager might experience far more investor redemptions than the other. The difference has tended to reflect how much trust each manager has built with their LP base. Managers that proactively and transparently communicate offer their LPs the opportunity to better understand why performance is challenged and why those challenges might be temporary.
Finally, what can look like a change of heart might instead be the LP determining that the GP no longer meets the original underwriting criteria. In these situations, LPs are likely observing changes in a GP’s investment process, team, firm structure, asset growth, etc. that are significant enough to change the investment thesis. In other words – the LP sees a case of manager strategy drift.
Thanks for joining, and as always, feel free to reach out: askacio@ivyinvest.co!
Until next week,
Wendy
If you’re an emerging GP and nobody has yet warned you about the institutional investor time frame – consider yourself warned.
Of course, there are time-sensitive investments that can arise from severe market dislocations, but underwriting an opportunity is different from underwriting a manager. In my experience, institutional LPs often prefer to pursue these one-off opportunities with pre-existing manager relationships.
Unsurprisingly, team turnover often precedes shifts in portfolio strategy or philosophy. A new CIO may prefer one asset class over another, leading to changes in asset allocation targets. Or, in the case of emerging managers, a new CIO may not be willing to offer the time for an emerging manager to prove itself.
For this reason, among others, it’s critical for GPs to diversify their investor bases. I think experienced GPs know this lesson well, but it’s a something I’ve watched too many newer managers learn the hard way.