The chief investment officer of a big fund of funds explains why top-quartile performance is no longer enough.
Erik Hirsch is the chief investment officer of Hamilton Lane, a US-based provider of investment-management services to investors in private markets. The firm manages more than $33 billion and advises on an additional $191 billion. He spoke with McKinsey’s Aly Jeddy and Bryce Klempner in April 2015.
McKinsey: Given Hamilton Lane’s size and breadth, you see as much or more of what’s happening in private equity than perhaps any other limited partner [LP]. Let’s start with your view on the most significant changes taking place in private equity.
Erik Hirsch: To me, the most interesting evolution is in the expansion of private-market strategies. In the past ten years, we have rapidly evolved from an industry that was simply vanilla or chocolate to one that now is Baskin-Robbins, with 31 flavors. It wasn’t long ago that LPs could choose either venture capital or buyout, the chocolate or vanilla options. Sure, there were fringe strategies—growth equity, mezzanine—but the world was largely made up of only two flavors. Today, there are many more, and they continue to evolve.
One obvious implication for LPs is that it’s much easier to pick funds when you only have two flavors. This year, I would estimate that Hamilton Lane will review 650 to 700 institutionally sized funds. To source and review that volume, institutional investors need substantial resources. Participating in this asset class successfully with small teams and single offices is very challenging.
Another implication is much greater flexibility in portfolio construction. General partners [GPs] and LPs can now have a real discussion about how to use the private markets to achieve objectives for returns, risk, duration, exposure, and getting the balance right in a way that they couldn’t ten years ago.
McKinsey: So the LPs’ selection risk has increased. Does this mean that the GPs’ track records have become less relevant?
Erik Hirsch: It does and it doesn’t. Comparing track records is easier when you’re evaluating vanilla and chocolate. The comparison is much clearer. But as the world has evolved and become more complicated, not every GP fits in a neat bucket. And let’s be honest—GPs often don’t want to fit in a neat bucket; they want comparisons to be hard to make. And so calculating track records and truly understanding peer groups is harder today. The good news is that we have more data on this asset class, and it is increasingly accessible, though we have a long way to go.
McKinsey: At Hamilton Lane, you see a lot of that data.
Erik Hirsch: Yes. But data is still a great challenge for the industry. If you consider that the returns of private versus public markets are well documented and that private markets have outperformed public ones through multiple cycles, you would expect that allocations would be rising rapidly. They are not—they’re rising only slightly. So you have to ask, why does the average LP allocate less than 10 percent of its portfolio to private equity [PE]? One reason is that PE has been very data constrained. That makes ranking, benchmarking, and decision making difficult for investors.
McKinsey: Do you see that changing?
Erik Hirsch: Yes, but not quickly. One reason is that in some cases, we’ve created the problem. Many people like the fact that data is private. Lots of people don’t want to live in a perfectly efficient world, because lots of people make a living from inefficiencies. Some GPs have reveled in the lack of transparency, and some LPs have too. Someone’s managing those fourth-quartile funds, and someone’s investing in them. Not everyone wants to see all of that brought into the light of day.
There are also some practical challenges in evaluation methods and knowing how to compare strategies. Other asset classes have managed to figure that out in far less time than PE, however, so I think the change is inevitable.
McKinsey: What other challenges are holding back LPs?
Erik Hirsch: One has to do with duration. PE is known to be a fairly long-term asset class, but the data suggests that it’s even longer than people think. The life of most funds is not 10 years, as we expected; on average, today it’s 12 to 14 years. That’s a meaningful difference and certainly gives some LPs pause about locking up capital for that period of time.
Another issue is liquidity. The secondary market continues to grow, and LPs are using it for liquidity and, increasingly, for portfolio management. But this is an inefficient system that by nature produces a discount in net asset value. Add the friction costs associated with completing a transaction, and these are real stall points for a lot of LPs.
McKinsey: You noted that private markets have outperformed public markets over the long haul. Do you see that performance continuing or changing?
Erik Hirsch: I see it continuing. The asset class has some real advantages over the public markets—control, tight alignment of interests between GP and management, operational toolboxes that can be brought to bear. The outperformance isn’t random or erratic. It is significant and it is consistent over long time frames.
McKinsey: So is there ultimately a trade-off between the scale and the returns of this asset class?
Erik Hirsch: The issue is really more the supply of transactions. Deal volume is shrinking. Deals come from just a few channels—the classic private owner selling to a private-equity firm, PE firms selling to other PE firms, public companies or divisions going private. “Take privates” have historically been a meaningful part of deal volume but today represent virtually none. Private-equity practitioners view the public markets as very fully priced. Even in this leverage environment, and even with the tool kit to improve businesses, practitioners are still not doing these deals. So while purchase prices in private markets are going up, most GPs would tell you they still think that private-market multiples look more attractive than public-market multiples.
So to me, the question around scale is really more about supply, not whether more capital makes the industry efficient and thereby automatically lowers performance. When you look at the classic channels—US and European buyout funds—we are at a supply–demand imbalance today, so more capital makes that worse, not better. When you look at why the industry has been growing so much, it has not been buyouts. Back to our ice-cream analogy, it’s really been the arrival of all the new flavors of asset classes, plus new geographies. That’s where you’re seeing a lot of the growth. You’re not seeing it in just another US midmarket buyout firm. That market is relatively flat, and some firms are disappearing.
McKinsey: If developed markets are flat, what is your prognosis for emerging markets? Most LPs we speak to think that while these look exciting and dynamic, historically the returns have not justified the risk. How do you see that evolving?
Erik Hirsch: No question, that’s what this has been historically. You can certainly find numerous exceptions, but as an asset class, emerging-market PE returns have been disappointing. You have not been rewarded for the risk, and in some cases you have not been rewarded, period. Emerging-market funds have underperformed relative to funds in the US or in Europe, and when you factor in currency volatility, geopolitical risk, et cetera, it’s even worse.
Will that change? A lot of LPs flock to emerging markets believing that as public markets go, so go the private markets. The data suggests that’s not true. The factors that create good public markets are often very macro, and that’s not at all true in private markets. Good GDP growth, rising employment rates, a maturing demographic, or the expansion of the middle class may cause positive public-market reactions, but they may not alter the fundamental behavior or nature of an individual business.
For that performance to turn around, you need a few things to happen. One, you need to grow the talent base as managers continue to mature and expand. That’s a very positive thing and will certainly help returns. Second, culturally, you’re beginning to see more openness to control buyouts in emerging markets. Deal volume has largely been a growth-equity story to date, and as an asset class, that’s never been our strong suit. Private equity often does best when playing a much more hands-on, active role in managing businesses, using all of the tools in its toolbox. But a lot of emerging markets have not been as receptive to that for cultural, structural, and tax reasons, among others. That is beginning to change, which will also help. The third piece is that currency hedging as a tool is more commonplace. It’s more cost efficient, and GPs are becoming more adept at using it. That will help take out some of the currency risk.
All of those are good factors. You’re also starting to see fund-raising decrease in a lot of those markets. Ironically, one of the things that help returns go up in our asset class is when fund-raising drops. Over the past ten years, performance in emerging markets has been relatively disappointing, so fund-raising has decreased, which I think is going to prove, over the next cycle, to be a very good thing.
McKinsey: You have mentioned the GP tool kit a couple of times. Do you believe that active ownership can produce real, differential value for LPs? And if you see financial engineering and operational improvements as the first sets of tools, what do you think is next?
Erik Hirsch: I do think active ownership is real when it’s done well. As an industry, though, it would be grossly unfair to say that everyone does it well and that everyone has the resources; they don’t. There is a huge gap in the level of resources that each firm has and how firms actually utilize them. People have prognosticated that the dispersion of returns would shrink as our asset classes grew, to which we at Hamilton Lane loudly say: That’s not going to happen. Too much of the value creation is about what you do with the business after you buy it, not what you paid for it or how you sourced it. The data suggests that is still the case.
So then the question arises of what comes next. I think the tool that’s beginning to come on—and it’s ironic that it’s coming on now and didn’t sooner—is portfolio-construction techniques. A lot of GPs were investors first and portfolio constructors second, if at all. It was “find good deal, do good deal; find good deal, do good deal.”
Today, among the elite firms, I’m seeing a lot more time and attention spent on managing the internal rate of return [IRR]. They’re thinking more about the timing of cash flows, how assets get assembled, using tools like lines of credit as funding mechanisms—thinking about being a portfolio manager, not just an investor. That’s becoming another tool for GPs to further enhance and differentiate performance.
McKinsey: Not all IRRs are created equal—some GPs take on more risk to achieve the same result. To what extent are LPs differentiating among returns by level or type of risk?
Erik Hirsch: It varies by LP. A surprising number don’t have the tools or the resources to think through that, because the data required to do so effectively is pretty significant, and not every GP is racing to provide it. But the theory is absolutely right. It’s one of the reasons a firm like ours can add real value: we have the tools, the data, and the resources to go and figure all that out. So for us, that is a key criterion, and we spend a lot of time tracing every dollar of gain to understand where it came from. It could come from multiple expansion, from earnings growth, from leverage, or from some combination. Tracing that gain is a key part of our due diligence. Then you can begin tracing the gain in portfolio decisions—how much came from timing, from sector weighting, from IRR-enhancement tools. You begin to draw the full picture by tracing back each of those underlying pieces.
But as an industry, frankly, I think we’ve done a pretty lackluster job at either rewarding or punishing risk and risk management. There has just been a fairly exclusive focus on returns and not enough focus on the broader picture.
McKinsey: Continuing with that line of thought, what are some of the greatest misconceptions LPs have about private equity, and what do you see as GPs’ greatest misconceptions about LPs?
Erik Hirsch: It’s probably easier to start with the latter. Most GPs are not particularly good students of their own asset class. For their portfolio companies, they know chapter and verse about the competitive environment, but they tend to know very little about other GPs. This is somewhat understandable as data is hard to come by, and good data even harder. But very few GPs seem to think about the world that way. They have grown up believing that if they do a good job and generate a top-quartile return, they should and will be funded by LPs.
GPs forget that we’re in a world of a few thousand fund managers, so even the top quartile is still a really big pool. A typical Hamilton Lane client invests in six to ten funds a year. Last year alone, screening out all the noise, we saw 630 fund managers that could work for an institution, raising funds of at least $100 million. So if you allocate to six to ten funds, you’re investing in 1 to 2 percent of the total asset class. If a GP’s sole pitch is that it’s in the top quartile, that isn’t exactly compelling.
McKinsey: So does that mean the top decile is the new top quartile? Or that being in the top quartile is now just table stakes?
Erik Hirsch: I think it means some of both. It also means that LPs are becoming more sophisticated about portfolio construction. The LPs’ portfolio-construction approach used to be “find GPs I like, back them, keep backing them, keep finding new GPs that I like, and back them too.” Those LPs then woke up after several years and realized they had 200 funds, many with duplicative strategies, similar returns, and similar risk profiles. So now they’ve diversified for the sake of diversity.
The other reality is that the asset class is becoming more expensive to manage. LPs’ legal bills are all going up because they’re dealing with more amendments, more fund extensions, and so on. We all want more data, but getting, tracking, and storing more data is also expensive. The more funds you do due diligence on, the more it costs.
So LPs are thinking about how to limit the number of GPs. They are doing new things, like secondaries. Ten years ago, an LP selling a big part of its private-equity portfolio meant that something bad was happening in its organization. Today, secondaries are becoming much more of a portfolio-construction tool. Some LPs today will do a secondary sale if the returns look right, then turn around and redeploy that money elsewhere. Portfolio management is changing.
Most LPs today are not making the decision to invest simply because of the returns number or the benchmark. Top quartile is a start, but the LP is then going to have to move quickly to questions like what this is going to do for the portfolio and the bigger and better questions: “Do I need this? What is adding that next GP doing for us? Is it providing diversification that we have lacked? A different type of cash-flow stream? A different type of risk or return profile?” If the answer is none of the above, the LP is just adding costs to its portfolio management and getting little in return.
This is one reason you’re seeing relationships between some GPs and LPs expand. It’s better for the LPs to have fewer partners that can do more for them. And some of the GPs are taking advantage of that—through bigger strategic partnerships and separate accounts.
McKinsey: What services do LPs value most today?
Erik Hirsch: Mainly, it’s having one GP that invests across multiple strategies. With such a partner, LPs are diversifying strategy and returns, but doing so with less friction cost because there’s only one partner to manage.
McKinsey: To what extent do you see LPs beginning to insource capabilities? Is there a tension in expanding GP relationships while bringing capabilities in-house?
Erik Hirsch: Bringing capabilities in-house is more spoken about than actually done. Very few LPs are truly equipped to execute as a GP would using in-house resources. For most, cost remains a real challenge; it is tough for them to attract and retain the right talent. Add all the other resources required—multiple offices, operating partners—and this is a difficult model to replicate well. Some will, that’s inevitable, but this will be the exception, not the rule. The resource gap is growing wider. GPs are adding more resources every day. So the challenges of replicating that model are increasing.
If there’s a tension, it’s closer to “What have you done for me lately?” The LPs’ expectations of the biggest bang for the buck continue to rise. There are more demands being put on LPs by constituents and boards, and they in turn relay those pressures back to the GP. Transparency is chief among those pressures. Ask GPs which costs have risen fastest in the past few years, and they’ll tell you that it’s back-office and investor-relations personnel.
McKinsey: This falls under the broader rubric of GPs becoming institutionalized. Where do you see them making progress and where are they struggling?
Erik Hirsch: The dispersion in the level of professionalization and institutionalization is vast and will stay vast for a long time. GPs have to make a real choice whether to professionalize or not—not all GPs believe they need to do this. Overall, the trend is a good one because while people chafe at increased regulation, it does bring increased professionalization, and LPs benefit from transparency, disclosure, and better access to information.
The flip side, though, is that this adds a lot of costs for LPs, who need to build out their infrastructure. You can’t track your private-markets portfolio today in all of its detailed glory using Excel and some notebooks. You need to invest in real technology and in the personnel for managing it or to outsource it to a provider. Either way, that’s a real cost. I think the outcome is going to be better, but it’s not free.
McKinsey: What new kinds of LPs are entering the private-equity asset class?
Erik Hirsch: We see new LPs every day. A surprising number just hadn’t gotten around to investing in the private markets earlier. Sometimes, they were not investing because of misperceptions, and they entered as those misperceptions were cleared up. Some in the media still say you could replicate the return stream by simply levering the public markets—which is completely false. Others say the only way to make money is by slashing jobs and slashing costs. That too is simply not true.
New pockets of capital are also arriving from different geographies. The question of how to package this asset class effectively for the high-net-worth or retail channel has not yet been solved but inevitably will be. That will be good for new capital flowing in, but it does make us ask whether the asset class can absorb all the capital. Institutional investors need to think about whether they will be seen by GPs as an attractive source of capital in the future if GPs have unfettered access to the retail market.
McKinsey: As that plays out, how do you see the power dynamic shifting between GPs and LPs?
Erik Hirsch: You can imagine a world in which the retail code is cracked and funds are packaged and sold freely so GPs have essentially unlimited access to capital. Retail investors have historically been less demanding because they’re fragmented, with no lead voice demanding transparency or meetings. That market has been very cost insensitive relative to the institutional channel. As a GP, this world probably looks much more attractive to you than the institutional world.
But this retail world is also prone to class-action lawsuits. It opens you up to public scrutiny that perhaps you don’t have today, and distributing and managing the capital base is expensive. What emerges is likely not going to be either extreme, but today it’s not clear what that reality will look like. The institutional investors need to understand that although to date public pension funds and sovereigns have been the loudest and most important voices in the room, things may not stay that way forever.
McKinsey: Let’s talk about the ecosystem surrounding GPs and LPs. What is the outlook for funds of funds and investment consultants over the next five to ten years?
Erik Hirsch: It’s very fluid. There’s a real difference between a service provider like ourselves and a simple fund of funds. To me, the fund of funds−only world is challenged because institutions want high levels of customization. Funds of funds, by their very nature, are more one size fits all. If the retail market thrives, that will probably be good for funds of funds. For the small-market investor or for the retail investor, this may be the only option.
The environment for broader service providers like us is different. Adding another layer of cost is never seen as a good thing, so we have to prove our value. Again, back to our ice-cream analogy, it is more complicated than ever before to navigate through all the flavors and to choose wisely and to assemble them in the proper way. And the resources needed to do so are higher than ever before.
Then there are all the other supporting pieces. You want to be active in the secondary markets because they are a good portfolio-management tool; you need resources to do that. You want to do coinvestments; you need resources. You want to track and analyze the massive amount of data that we’re demanding and expecting; you need resources. We have those resources, but the clients’ expectations go up every day. We try to stay one step ahead.