New rules to the PE game
Sustained top performance means continued evolution and change. Technology became ever more accessible in the 1990s when personal computers began appearing in every home. But if you’re a tech-savvy person today, you’re not using a dial-up connection on a desktop computer. Everyone knows you can’t be successful today using 1990s technology.
Similarly, private equity players can no longer use a 1990s-era rulebook to structure funds. The world is a more complex place than it was two decades ago. There’s a different playbook now, and LPs and GPs need to keep a few things in their sights to navigate the nuances smoothly.
If you’re looking to invest in a private equity firm’s tenth fund, you are unlikely to be seeing the same terms and structures used in funds I or II. There are new considerations to take into account and a heightened interest on the part of regulators to go through fee arrangements with a fine-toothed comb. That some of the largest private equity funds can be caught off-guard by the SEC, is testament to how confusing and difficult keeping track of fees can be.
Don’t be put off by offsets
Much of what LPs will need to look out for focuses on fees and expenses, both in how they are calculated and how they are charged. Offsets to the standard charges can be a much overlooked item in the LPA.
The most common offset today is fee income earned by the general partner or associates from the underlying investments being applied as a reduction to overall management fees. These fees and offsets are important for LPs to understand and keep track of. In recent years several large private equity firms, including some of the most well-known, have been challenged by the SEC over a lack of discipline, accuracy or disclosure in allocating amounts and communicating the scale of such transactions to LPs.
It’s not uncommon to see a 100% offset of fee income generated by GPs or affiliates from the portfolio, though a lower rate is sometimes used when the core management fee is itself a lower percentage. Typically offsets are made for transaction fees, monitoring, director fees, underwriting fees and other fees such as abort/broken deal/breakup fees, and advisory fees. Items such as excess organisational expenses and the placement fees are also generally covered by the manager, or offset against management fees if drawn separately.
And about those management fees. While a 2% fee is a historic norm and common on smaller or mid-sized funds, we’re seeing a lot more variation on the commercial terms today. The standard “two and twenty” is something that is challenged, particularly in larger funds where it would make for a high absolute level of charges. Indeed this very traditional fee structure may become the almost exclusive territory of only the largest brand-name-firms who continually post stellar returns.
In an effort to make the fee-carry structure reflect current sensitivities, one option that limited partners are exercising with greater frequency is to secure rebates through side letters. Such personal terms, in cultivating the long-term relationship, can be given to preferred LPs that commit capital at a fund’s first close or to those that invest significant commitments. LPs and some regulators now routinely demand greater transparency and disclosure of key side letter terms offered across the investor base – whether on fees, co-investment opportunities or other commercial points.
Another variation we’ve seen that bears note is the way management fees are charged. Some funds charge in a more granular way, with fees based on the mix of what has been drawn and what has not yet been drawn, charging a different percentage for capital drawn vs. not. And don’t forget about the post-investment period, when fees are generally lower – and subsequently tail off.
It stands to reason…
Investors don’t want to see GPs earning the bulk of their compensation from management fees alone. The ILPA have recommended that ongoing fee levels are reviewed for ‘reasonableness’ in the context of GP operating expenses, to ensure alignment of GP and LP interests. GPs should be incentivised to outperform by their carry by their own ‘skin in the game’ rather than by their core annual fees. LPs want to ensure they have sensible operational cost coverage and are able to make reasonable profits for their manager/adviser business to withstand the economic cycle. Just as you wouldn’t buy a car without looking at how the engine is running, you will want to see how a fund manager budgets its money. GPs should expect this level of enquiry.
LPs will also expect to look at the fee and carry structure of the firm’s previous funds as well. Did the last fund hit its expected targets? If not, why wouldn’t there be some kind of inducement in the new fund to make it more attractive to investors? Were there issues with other LPs? Very often LPs exercise right of first refusal to invest in a follow-on fund. Are there an unusually large number of openings for new LP relationships with a PE fund on the fundraising circuit? If so, questions will also be asked about why previous LPs aren’t coming back? There could be perfectly reasonable explanations for this, but it could raise a red flag. Also, will you have right of first refusal to invest in follow-on funds? If not, why not?
Don’t get in over your overhead
General administrative and operating expenses aren’t usually a significant amount over the life of the fund but there are several things to note on overall costs. One is that there should be a reasonable cap on the organisation expenses. Keep track of such caps and track if, when, and how a fund has exceeded what was agreed. Also be on the lookout when there is a parallel fund, a co-investment fund or any other kind of multi-fund structure. Expenses should be drawn only from the specific vehicle where applicable but if not, then drawn equitably from all vehicles in a group if it’s a general or common expense.
Keeping these things clear from the beginning of the GP/LP relationship can avoid awkward discovery later. It’s important that both sides of the private equity fund equation work to stay current on the fee and carry practices that are becoming standard.
The fund terrain has become more difficult to navigate with more complex investment, fee, and compensation packages that seek to be equitable and fair, but can easily be confusing and frustrating. With increasing complexity comes opportunity for private equity players to embrace change and modernise their approach. There’s no better time to start than today.
Gaurav Marwah is technical director and Hugh Stacey is executive director, Investor Solutions, for Augentius.