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LPs

Amid private wealth push, investors raise concerns about cherry-picking

Funds dedicated to high-net-worth clients could leave LPs vulnerable to less profitable deals compared to institutional clients.

Private equity wants to attract a new kind of limited partner: the high-net-worth investor.

As the industry deepens its foothold in products for traditional wealth management clients, participants have flagged potential byproducts of the trend, including the risk of cherry-picking.

In recent years, managers began a push beyond family offices into the wealthy individual channel. In early January, Blackstone raised $1.3 billion for its first PE fund for high-net-worth individuals. Last year, Apollo Global Management launched two semi-liquid products for wealthy investors—one focused on PE and the other on private credit.

Asset managers attract these investors with products structured to address individual investor concerns about the capital lock-ups in large-cap institutional funds.

With a typical buyout vehicle, large institutional investors make capital commitments and that capital is “called” by PE funds over the next three to four years. While LPs see periodic distributions, they consider their capital to be locked away for 10 to 12 years.

In a semi-liquid fund structure, wealthy individuals are typically offered monthly or quarterly redemptions. While there are limits to the amount an investor can pull from the fund in a redemption period, the frequency of distributions makes the fund more accessible to investors who can’t afford to keep their capital frozen for years on end.

While attractive, these structures can make new LPs vulnerable to cherry-picking—when asset managers select more profitable deals for larger institutional funds and leave the “leftovers” to individual investors, said Mina Pacheco Nazemi, head of the diversified alternative equity team at Barings.

“The allocation policies can be nebulous especially when large platforms have multiple products for different types of clients,” Pacheco Nazemi said of large asset managers’ semi-liquid products. “Is there an equitable allocation of deals to the closed-end funds as to the liquid vehicles?”

Checklist for individual investors

Pacheco Nazemi said that investors need to pay close attention to individual deals going into the funds they’re invested in and confirm that as a small retail investor they are not getting crowded out by the larger institutional clients of that manager.

But most high-net-worth investors and wealthy individuals likely do not have the institutional-grade infrastructure to ensure allocations are conducted transparently, according to Gaurav Joshi, head of EY-Parthenon‘s US wealth and asset management strategy.

This places these new LPs at a disadvantage relative to institutional investors, family offices and the ultra high-net-worth channel in ensuring that cherry-picking isn’t affecting them.

“From an allocation standpoint, the real concern from investors is that they want to be getting the best deals that they source through their process and that the traditional close-ended funds are getting the first crack at deals before they make their way into evergreen, semi-liquid funds,” said Stephen Brennan, head of Hamilton Lane‘s private wealth solutions business.

PE instates investor protections

Some firms are protecting against this risk with various policies and regulatory structures.

Blackstone’s BXPE, its fund for qualified individual investors, allocates across the scope of Blackstone’s PE platform. This means BXPE has a small amount of exposure to every PE deal the firm closes, according to a person familiar with the product.

This mechanism is part of a long-standing contractual obligation that reserves certain percentages of the returns of Blackstone funds for Blackstone affiliates and its employees. In this case, BXPE is considered an affiliate.

David Levi, head of Brookfield Oaktree Wealth Solutions, said the firm’s semi-liquid infrastructure strategy protects against any risk of wealth clients receiving the “leftovers” through its regulatory structure.

In 2019, Brookfield Asset Management acquired investment manager Oaktree Capital Management, and three years ago, the firms combined their wealth management books to create Brookfield Oaktree Wealth Solutions.

Brookfield Infrastructure Income, which includes semi-liquid infrastructure offerings for private wealth investors, is a regulated investment company. The RIC structure is largely beneficial for tax purposes, but it also requires the registered companies to have a board of directors.

This board of directors has to be even-keeled with no more than 60% of its members possessing any interest in the company.

“That board basically needs to be sure that [Brookfield Infrastructure Income] is shown every deal that’s appropriate for it. In other words, it cannot—by its regulatory structure—get ‘leftovers,’” Levi said.

Asset manager Hamilton Lane handles cherry-picking concerns with its “stringent” allocation policy, Brennan said. Hamilton Lane’s evergreen, semi-liquid PE fund sits at the top of the firm’s allocation priority list alongside other vehicles, he added.

Still, investors and consultants agreed and said the relative novelty of private market funds dedicated to wealthy individual investors has stirred concerns over transparency and investor education.

“We’re still at a nascent point in the industry, where more of the wealth channel is linking to the private markets through private equity,” Joshi said.

Featured image by Spencer Platt/Getty Images

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