‘Devil is in the detail’ on LP-GP alignment – report

GPs have more skin in the game, according to a survey by MJ Hudson – but whose skin is it?

Private equity managers are committing more to their own funds, according to research from law firm MJ Hudson.

In the latest instalment of its Private Equity Fund Terms Research 2018 report, the firm looked into how the alignment of interests between LPs and fund managers is safeguarded.

“The closer the alignment of interests between the investors on one side and the managers on the other, the less likely it is that a conflict will occur. Alignment is primarily achieved by way of economic arrangements,” the report noted. “The golden rule is that the managers should not benefit before their investors.”

Last year 62 percent of funds had a GP commitment of less than 2 percent; this year that figure is down to 31 percent.

The survey found that 33 percent of funds had a GP commitment of between 2 percent and 2.99 percent – up from 7 percent of funds in 2017, but down from 44 percent of funds in 2016. Meanwhile, 18 percent of funds had a GP commitment of between 3 percent and 4.99 percent, and 17 percent had a commitment above 5 percent – down from 24 percent in 2017.

However, an increasing number of funds had a GP commitment of below 1 percent – 13 percent in 2018, up from 7 percent the previous year and 0 percent in 2016.

In the survey, MJ Hudson found investors prefer the GP commitment to be paid in cash, rather than through management fee waivers. On the whole, LPs must take on the task of finding out how the GP commitment is funded themselves; only one quarter of the LPAs of funds MJ Hudson reviewed this year expressly stated whether the GP commitment would be paid in cash or not.

While GP commitment is perhaps the most powerful method by which GPs can align their interests with LPs, it is not the only way; the report noted management fee offsets, change of control provisions and successor fund provisions all play a role.

“Without proper alignment between fund managers and their investors, the performance of a fund may not be matched by the returns for its LPs,” said managing partner Eamon Devlin. “Clearly, this is damaging for LPs, but it is also a problem for GPs that take a long-term view on their investor relationships.”

Of the funds surveyed, 92 percent offer a transaction fee offset; of those, 98 percent provide a 100 percent offset.

But, as the report notes, the “devil is in the detail”: all fees received by managers in relation to fund activities should be offset – including transaction fees, monitoring fees, set-up fees, directors’ fees, advisory fees, and break-up fees. But this is not always the case, with directors’ remuneration a common exclusion.

“GPs now have more ‘skin in the game’ but, often, the GP commitment in larger funds is funded by a management fee offset, which severely reduces the actual and real impact of a team investing in its own fund – or it is borrowed from a bank,” the report noted. “Either way, LPs need to ask the question: whose skin is it?”

Almost three-quarters of funds include a change of control provision, requiring investor consent for any transfer of other ownership or control of the GP’s interests in the fund. In addition, 84 percent of funds have successor fund provisions to help LPs avoid paying two sets of management fees to the same firm.

While alignment between LPs and GPs has improved, some areas of concern remain. Partner Edyta Brozyniak, who led the research, noted a recent trend towards removal of hurdle rates and continued use of deal-by-deal carry. Both harm alignment. While there has been a reduction in the management fee rate at the larger end of the market, the adjustment has not been in line with how much fund sizes have increased, meaning for some firms the management fee can be a “substantial profit centre”.

The erosion of most favoured nations clauses is also leaving LPs with less visibility on terms, potentially creating inequality within the LP base.