Why Private Equity Models Fail: The GP/LP Challenge

Private equity (PE) has long been seen as a powerful tool for driving economic growth, financial returns, and innovation. However, the PE model, particularly the plain vanilla Limited Partnership model of symbiotic General Partner (GP) and Limited Partner (LP) structure, is fraught with challenges that can lead to “trial and error” failure. This viewpoint explores these challenges, focusing on key personnel issues, the deep J-curve, misalignment of interests, and the importance of alignment between the key PE players: fundraisers, investors, and value creators. As we explain the intricacies of the PE model, we shall also use the very interesting Middle East PE ecosystem of 2005-2015 as a case study to illustrate these points.

Key Challenges in the PE Limited Partnership Model

1. Misalignment of Interests

The PE model hinges on the relationship between GPs and LPs. GPs manage the investments and are driven by the need to generate high returns – above the hurdle rate - within a short timeframe, while LPs provide the necessary capital – even in captive funds - and may prioritize steady, long-term returns. Also, PE GPs might assign a higher weight of importance to placement and management fees as part of the GP P&L as opposed to Carried Interest. This misalignment can lead to conflicting strategies and eventual failure.

Agency Cost and Mindset

The agency cost, which arises from the conflicts of interest between GPs and LPs, exacerbates this misalignment. GPs might take on riskier projects to maximize their returns, while LPs prefer safer investments; given there are other Alt/Investments to better mimic a higher risk-reward structure such as VC and even Crypto. Additionally, the mindset differences, where GPs are more aggressive and LPs more conservative, further strain this relationship. Also, many GPs might seek certain investments that elevate their branding as opposed to pure return drivers – as would be referred to as Trophy OpCos. These help elevate the brand name (equity) of the GP and funded by the LPs.

2. Key Personnel

A critical factor in the success of PE investments is the quality and commitment of - and to - key personnel. Many firms fail to invest adequately in hiring and co-growing talented individuals who can drive value creation. The lack of skilled professionals who understand both local and global markets can severely impact the performance of PE investments. Typically, this “cost-saving” approach at the PE umbrella is a major red flag and will transcend to OpCos. In short, “Cheap” PE GPs will lead to poor performance; there is no other way!

3. The Deep J-Curve

The J-curve effect in PE refers to the tendency of investments to show negative returns initially before turning profitable. However, in many cases, this curve resembles more of an L-curve, with a prolonged period of losses due to steep “learning curves” and higher-than-expected costs. This deep J-curve can deter investors and lead to premature exits, causing the overall failure of the investment. PE GPs can learn the market, industry, stage etc. at their own expense or risk!

4. Alignment of Key Players

Successful PE investments require alignment between the three pillars – aka players - of private equity: fundraisers, investors, and value creators. Fundraisers bring in the capital, investors provide the funds, and value creators implement strategies to grow the investments. Misalignment among these players can lead to ineffective strategies and poor returns. If any PE GP is seen to prioritize fundraising – at 2-3% Placement Fee – this is another red flag. Investors need to stay sharp: PE success is determined by returns and not AUMs.

Case Study: The Middle East PE Limited Partnership State 2005-2015

Unique Challenges in the Middle East

The Middle Est region is probably one of the most important financial ecosystems among Developing and Frontier markets, however, it is very different from the traditional average PE-targeted geomarkets. For people who worked in this region can actually identify that while MENA investors are among the most savvy and talented, with many very successful PE firms that have had significant global impact and outreach. Yet, the MENA region offers many limitations and challenges for sustaining a bona fide PE success story as seen in the “decade of failed promises” between 2005-2015. Below is an objective and academic attempt to identify these limitations and challenges:

1. Political and Economic Instability

The Middle East has experienced significant political and economic instability, including conflicts and fluctuating oil prices, creating an uncertain environment for PE investments. Investors are cautious, preferring more liquid assets and shorter-term investments. FX instability between pegged and floating currencies made the inevitable cross-border PE play more challenging (Egyptian Pound, Turkish Lira).

2. Family-Owned Businesses

Family-owned businesses dominate the Middle Eastern market, and they are often reluctant to sell stakes to external investors. One would even objectively say that PE-approach has never been novel to the region. Most Family Businesses have been using this model for ages before the advent of the Wall Street cliché model where siblings or trusted family friends have been acting as GPs and LPs to one another. For a plain vanilla Limited Partnership model to manage these complex family dynamics and ensuring professional governance can be challenging.

3. Regulatory and Legal Hurdles

The regulatory and legal frameworks in many Middle Eastern countries are still developing. Uncertainties around shareholder rights, contract enforcement, and exit strategies can hinder PE investments. Also, the tax system, which favors PE models in the US/EU, is still in flux whereby the gradient between carried interest, capital gains, corporate profit, etc. is still nascent and limited.

Sovereign Wealth Funds: A Unique Strength

Despite these challenges, the Middle East has a significant strength in its sovereign wealth funds (SWFs) which are among the “global best”. These funds, backed by substantial state resources, can provide the stability and long-term perspective that traditional PE models might lack. SWFs often align public and private interests, allowing for more strategic and less volatile investment approaches. Moreover, most PE firms in MENA are backed by one or more SWF as an “Anchor LP” who actually expect more than top returns from the GP. This implicit expectation might derail the initial investment mandate of the fund – besides being time and resource consuming.

Lessons Learned from Maiden PE Funds

1. Local Partnerships Are Crucial: Building strong local partnerships is essential for navigating the unique business environment in the Middle East. Local partners provide valuable insights, mitigate risks, and facilitate smoother operations.
2. Focus on Governance and Transparency: Enhancing governance structures and ensuring transparency can build trust with local stakeholders and improve investment outcomes.
3. Adaptation to Local Contexts: PE firms need to adapt their strategies to fit the local context, taking smaller stakes, focusing on government-supported sectors, and being patient with investment timelines.
4. Risk Management: Robust risk management practices are essential, including diversifying investments, hedging against political risks, and maintaining liquidity.
5. Operational Expertise: Developing local operational expertise helps drive necessary changes in portfolio companies, whether by bringing in international experts or training local talent.

The challenges facing private equity models, as particularly seen in the Middle East, can be attributed to a combination of inherent challenges in the GP/LP structure and unique regional factors. By understanding these issues and adopting tailored strategies, PE firms can navigate the complexities of - or those similar to - the Middle Eastern market and enhance their chances of success. The Value Creation Institute (VCII) focuses on providing insights and strategies to address these challenges, helping firms achieve sustainable growth and value creation in complex markets.

This viewpoint has been co-authored by the VCI Institute and its volunteering advisor and faculty member – Mohamad Chahine, a Private Equity veteran and author of various novel books on Private Equity and Value Creation.