Grove Street Advisors - Case Answers

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GSA’s compensation structure is also designed to add value. The firm charges a fee lower than the industry average which is reduced by increments, equating to roughly half of a typical fund of funds’ fee overall. To earn carry, GPA must meet a performance hurdle of 18%, aligning GPA’s interests with its clients (Rhodes-Kropf and Leamon 2010).

QUESTION 3.

Alternative strategies for GSA

GSA has three alternative strategies available. These are as follows:

- Target smaller clients.

Firstly, GSA could target smaller clients and broaden their sources of funding by establishing a ‘co-mingled fund of funds’ (Rhodes-Kropf and Leamon 2010, p.12). By partnering with a private bank, GSA could gain access to funds from high net worth individuals and other smaller entities, which would otherwise be unable to meet their $100 million minimum investment.

However, this approach has several drawbacks. GSA may face potential conflicts of interests if the opportunity to invest with a desirable GP arose. The fund of funds has clear allocation guidelines, while GSA may also be incentivised to selectively choose GPs so to beat its hurdle rate for particular funds. Furthermore, market flows into these mixed investment vehicles has been declining meaning benefits are limited (Rhodes-Kropf and Leamon 2010).

- Diversify across geographies and asset mix.

Secondly, GSA may attempt to diversify across geographies and expand its asset mix, in turn allowing it to further customise a client’s PE program. While the fund of funds has reasonable global coverage, GSA could continue to build-out expertise across emerging markets (EM) economies with the aim of establishing a local presence in these markets (Rhodes-Kropf and Leamon 2010).

Given the uncertain economy, expanding into mezzanine debt and/or venture lending may also prove prudent, considering debt has seniority over equity. According to the 2009 Prequin Global Private Equity Review (cited in Rhodes-Kropf and Leamon 2010) mezzanine debt offers investors a higher IRR at a lower volatility than funds of funds. However, this would necessitate GSA to form new GP relationships over a period of time.

- Target larger LPs and build scale.

Thirdly, GSA could target larger LPs and build scale to be seen as the leading customised fund of funds provider. By taking advantage of the growing demand for custom PE products in a post-GFC market, the fund of funds could attempt to capture clients such as large sovereign wealth funds, particularly those in Japan and the Middle East.

However, such a strategy would prove costly and require additional resources for back-office operations required to perform due diligence. The fund of funds may also encounter issues of size, namely the ability to fully invest these large mandates with their current base of GPs, meaning GSA may be forced to allocate capital to larger GPs with lower returns.

Final strategy recommendation

It is recommended GSA pursues a strategy of diversifying across geographies and asset mix in the short to medium term. This approach allows the fund of funds to capture additional sources of alpha while reducing its risk profile and differentiate itself in an increasingly crowded industry. GSA should prioritise defending market share (i.e. it is by far easier to keep existing clients than to find new customers) and build additional capabilities to justify its higher fee structure than competitors.

Over a medium to long term horizon, it is recommended GSA aims to capture larger LPs, in particular sovereign wealth funds. Once a certain scale is realised, larger LP mandates can be incorporated into GSA’s business model without a significant impact on operations or comprising on GP selection. Applying both approaches allows GSA to build its range of customised solutions and maintain market positioning while achieving sustainable growth in assets under management in the long run.

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REFERENCES

Kaplan, S. and Schoar, A. 2005, ‘Private equity performance: Returns persistence and capital’, Journal of Finance, vol. 60, no. 4, pp. 1791-1823, viewed 18 March 2017, [Wiley/Wiley Online Library/10.1111/j.1540-6261.2005.00780.x]

Rhodes-Kropf, M. and Leamon, A. 2010, Grove street advisors: September 2009, HBS No. 9-810-064, Harvard Business School Publications, Boston.