Felix Zwart: Investing without control over the destination
This column was originally written in Dutch. This is an English translation.
By Felix Zwart, Director of Research at the Dutch Association of Private Equity Firms (NVP)
Private equity requires patience, but social norms are changing rapidly. As an investor, how do you maintain control over funds that were set up in a world that no longer exists?
Fourteen years ago, all a pension fund had to do was sign a commitment to a private equity fund. The fund manager’s (GP’s) ESG policy was exemplary by the standards of the time: an exclusion list, a PRI endorsement, and a neat paragraph on corporate social responsibility. Sometimes the fund had already made investments and you were jumping on a moving train, but more often it was a blind pool: you were committing capital to a strategy and a team, not to specific companies. That’s not a design flaw; that’s the model.
Fourteen years on, the world has changed beyond recognition. Issues that weren’t on any checklist back then now dominate the front pages and parliamentary debates: digital sovereignty, strategic autonomy, the question of who is allowed to own a country’s critical infrastructure. The Mexican attempt to take over our KPN was, in those years, still a political curiosity, not a policy issue. Meanwhile, somewhere deep within the portfolio, that vintage holding still remains, heading for an exit that should have taken place long ago.
For a pension fund worth several hundred billion, having a direct view of every holding is an illusion. Behind the hundreds of fund investments, spread across the globe, lie thousands of portfolio companies. Moreover, the fund documentation explicitly places the steering wheel in the hands of the GP.
This does not, however, leave the investor (the LP) powerless. The toolbox has, in fact, been well stocked in recent years. The ILPA investors’ association recommends setting out ESG expectations in side letters, utilising a seat on the LP Advisory Committee (LPAC) and requiring reports on material ESG incidents within the portfolio; Invest Europe provides reporting guidelines and questionnaires that also serve as benchmarks during the term of the investment. But a fair-minded observer will see that these are merely rights to information and persuasion, not control. The LPAC advises; the side letter, at most, requires reporting; the real lever of power only comes into play years later – namely, by withholding support during the next fundraising round. In the current fund, the LP remains a passive provider of capital. And that is precisely the model. In this way, the investor can invest in a more diversified manner at relatively lower costs. Otherwise, the LP would be better off investing directly in companies itself.
The investor’s passivity is further reinforced by the company structure. That same fund contains dozens of other LPs, some of whom hold fundamentally different views. Some US pension funds operate in states where taking ESG factors into account now entails legal risks. A GP who accommodates his Dutch LP thereby risks a conflict with his Texan one. One fund, one policy, thirty clients with thirty different social navigation systems.
Meanwhile, the framework itself is also changing. Views on what is socially desirable now shift faster than a fund’s term. What was uncontroversial at closing has become a reputational risk at exit. No due diligence can anticipate that fourteen years down the line.
So what is the lesson? One school of thought says: press ahead with ‘know your asset’. More data, more monitoring, getting involved at an earlier stage. But that is costly, and it creates an expectation of control that legal reality cannot fulfil. Anyone who claims to know everything will be judged on everything they miss. The other school of thought says: accept the consequences and invest more passively, more liquidly and more transparently. But those who avoid illiquid investments forgo returns – and, crucially, the influence that comes with ownership.
Both schools of thought have a point, and everyone is free to make their own choices in this regard. What helps? Make your role clear to the outside world. Whether you’re the co-driver or sitting comfortably in the back seat, one thing remains certain in both cases: you can influence the course, but you can never control the destination.