The Advisory Board Love-In?
by Arbor Square Associates
I attended a small IR conference at the end of last year, and the IR executive of a very large, well-known GP told the room that one of his partners had recently suggested that the firm was so deeply held in the affections of its advisory board that were one of the partners to vomit on a board member’s trousers, far from being disgusted, they’d probably treasure them. Classic!
I must say, having interviewed advisory board members of a good number of GPs over the years, it is indeed a very interesting relationship. The feedback you receive about a GP from its long-standing advisory board members understandably tends to be much more detailed and nuanced than that of non-advisory board members, bringing to bear the context of a privileged relationship that often stretches back over multiple funds and cycles. What’s more, as our IR executive’s anecdote suggests, feedback does often tend to be more positive, as if buying in to a firm’s model again and again over successive funds, and being closely involved in the evolution of that GP, cements a deeper-seated commitment amongst those LPs – what you could characterise as the phenomenon of the ‘loyal investor base’. Part of me does wonder how much this loyalty is driven by a kind of ‘confirmation bias’ (i.e. the tendency of people to favour information that confirms existing beliefs and hypotheses), or by straightforward risk adversity (the ‘IBM’ argument), or even by the simple fact that personal relationships of mutual respect develop between GP and LP, and that this might well affect the objectivity of one’s judgement – a kind of emotional as well as financial buy-in. I also wonder about the extent to which this phenomenon stifles the evolution and regeneration of the industry, with the same ‘safe’ brands receiving capital, often at the expense of newer, hungrier teams. Indeed, I was speaking to an old hand in the institutional investor community last night who suggested that he’d love to launch a fund-of-funds that only backed new managers and limited its longer-term support up to a second fund, but no further. With a decent proportion of 2005-07 funds unlikely to make carry, and a growing acceptance of ‘deal-by-deal funding’ amongst LPs it’s arguably a great time for talented deal doers to get out and build the next generation of brand name firms.
Anyway, back to the topic in hand. I do also think that the privileged position of advisory board members gives them a unique perspective, and a much deeper understanding of a GP’s value proposition. While performance is ultimately king, the team that delivers that performance is what really matters in private equity and the more an LP gets to know that team, the better. Spending more time watching a GP in action, working through issues at the advisory board, being party to the strategic development of a firm helps LPs to build confidence in that GP. It engenders a deeper understanding of how a GP’s mind works; how they gel as a team; who the dominant characters are; who the next generation will be; what lessons have been learnt from past mistakes; and ultimately where the true value (and the risk) lies. It’s no wonder that existing investors, and advisory board members in particular, are often the first (and sometimes only) point of call for prospective investors undertaking reference calls on a new manager during fund due diligence. Or that advisory board seats are so highly valued.
Loyal advisory board members are therefore a fantastic asset (and key advocate) for GPs, with their well-rounded, longer-term perspective. But they can also lull a GP into a false sense of security. While those LPs closest to a firm might be able to stomach a higher than optimum level of volatility in the wake of the financial crisis, or be willing to support a new strategic initiative, the wider investor base, and prospective investors, might not be so understanding or supportive. They may cry ‘strategy drift’ and disappear into the ether when they are approached with a new fund. So loyalty is really great for the GP (if not necessarily for the industry), and a GP’s advisory board can provide an unparalleled insight into a GP’s key strengths. But as our IR executive’s anecdote so colourfully illustrates, you might not want to rely solely on your best friends when you’re looking for an honest, balanced view of your firm.
Arbor Square Associates