LP Series: Our Views on the GP/LP Relationship

LIMITED PARTNER ARTICLE SERIES

Our Views on Fund of Funds Investing – An Article Series 

OUR VIEWS ON THE GP/LP RELATIONSHIP

The GP/LP relationship is highly compelling and worthy of discussion in the context of this article series. For both GPs and LPs, there is a lot of money and time at stake. The ten-year duration of the traditional venture model (setting aside extension years), combined with standard seven- and eight-figure commitments, demands that the relationship is unquestionably solid. Until an LP has invested in several funds, or the GP has raised several funds, the relationship is often an afterthought or is assumed or taken for granted as a united endeavor. It is our view that the relationship is of utmost importance and is, in fact, the determining factor of a second commitment. 

It is our view that the GP/LP relationship is composed of and supported by three pillars: trust, transparency and alignment. These three elements are interdependent and if all three remain strong, they support the strength and durability of the relationship. 

Trust

In our view, the relationship forms the basis of our commitment to a new fund — and the first requirement of that relationship is trust. The many weeks spent in due diligence are almost always preceded by several years of acquaintance and fund following. Due diligence is simply our process of determining that our trust is correctly directed before we commit. 

• We have become familiar with the team, their funds and portfolios over the course of time, and due diligence allows us to check our perceptions against data-room reality. 
• We want to know the team well enough to trust that they will keep improving the team. 
• We are looking to know investment and post-investment behaviours enough to trust the GP will continue to improve the process. 
• We want to understand the path to exit and trust the GP will elevate Internal Rate of Return (IRR) and Distributed to Paid-In Capital (DPI) to levels reflective of upper-quartile performers within the fund term. 

Deeper trust strengthens the relationship.

Transparency

Quality reporting and timely distribution of material information to LPs is the hub of transparency. We have had the particularly good fortune of having some GPs that are exemplary in this regard. In cases where we have been LPAC members, we have fielded many calls from GPs who seek feedback as matters arise, understanding that proactive disclosure reinforces transparency. Appropriate disclosure includes major decisions the GP is considering, and this often includes amendments to the LPA. LPA terms require amendment on occasion; having advance notice of the change request and ahead of the LPAC meeting provides time for consideration, questions, discussion and builds the relationship as transparency is an evolving trait. 

Greater transparency strengthens the relationship.

Alignment

In its most clinical sense, the alignment between GP and LP is codified within the terms of the LPA — the rules of play. GPs that invest off thesis, dedicate material time away from the business of the fund or engage in inappropriate activities breach the LPA and harm alignment. GPs that maintain both the letter of the LPA and the spirit of the document maintain alignment. LPs also weaken alignment through inappropriate behaviours such as disclosure of confidential information, ghosting on verbal commitments or attempting to seek preferential LPA terms to other LPs. Remaining aligned supports the notion that we are all on the same team here, with the same goal and the same outcome. But it is more than just winning and losing together. Alignment is also found in the GP that generates higher fees from a larger successive fund and uses those fees to improve the team, the value-add platform, the back-office, etc. That GP opted to forego the immediate personal fee gain to better the investment vehicle for the GP and LP of the next fund. This GP is building a machine much larger and better than themselves, which tends to result in a long series of high-performing funds. We seek alignment of terms for our existing relationship and a tangible investment in bettering the investment vehicle for us all. 

Deep, multifaceted alignment strengthens the relationship.

SummaryWhile there may often be intentional maintenance to support the three pillars, delayed or incomplete maintenance devolves into the minimum effort of reporting obligations, supplying necessary tax information and LPAC data dumps. But isn’t making money what really matters? Returns performance is part of trust as the GP executed on plan and, while important, it isn’t everything. If returns were great on the last fund but we do not agree on the next fund thesis, we’re out of alignment and the relationship suffers. The relationship that survives and has been supported by trust, transparency and alignment nearly always results in continuation. In the context of the GP/LP relationship, that continuation means additional and often greater sums of investment. On occasion, the GP and LP may realign after a brief period of conflict and potentially issues of transparency can be rectified. Trust, however, once damaged is almost never fully regained in this dynamic and the relationship is thereby altered or terminated. It is not a coincidence that a great GP that provides attractive returns and builds LP relationships staked in a foundation of trust, transparency and alignment finds little issue in capital attraction.