Fund managers, regardless of their investment strategy, have bowed to certain limited partner demands in response to a tighter fundraising environment in post-crisis years.
However, focusing the lens to only examine the key terms and conditions written for emerging market-focused funds reveals investors and managers engaged in a more subtle balancing act, observes Debevoise & Plimpton partner Geoffrey Kittredge, in an interview with PEM.
Historically speaking, emerging market funds have always tended to offer more favourable investor terms, notes Kittredge, a private equity fund specialist. Development finance institutions operating under relatively strict commitment standards, less established fund managers and the higher risk-return profile in emerging markets have all contributed to these LPs’ negotiating position he elaborates.
However, in the post-crisis years the key business and legal terms of emerging market funds have experienced some trends more particularly than other target geographies. As evidence Kittredge points to a study carried out by Debevoise & Plimpton which examined around 40 emerging market funds raised during 2004 to 2007 (or pre-crisis) and 40 funds raised between 2008 to 2010 (or post-crisis) pulled from its in-house database.
In general the study shows emerging market GPs mimicking the standard 2 percent management fee and 20 percent share of profits (known as carried interest) used by other fund types. And while a slim majority of the emerging market funds raised post-crisis still provide LPs the European-style waterfall distribution model of returning all capital and a preferred return before distributing any carry, there was some movement by post-crisis funds toward a US-style of distribution where carry is calculated on a deal-by-deal basis.
A shift in transaction fees was also revealed by the study, a strong area of focus for emerging market investors says Kittredge. “Investments in emerging markets use relatively less debt financing and more often take minority positions in companies”, which can make it more difficult to charge investment banking-like fees to portfolio companies. Roughly three quarters of post-crisis funds allocated at least 80 percent of transaction fees to the benefit of fund investors, in contrast to approximately two-thirds of pre-crisis funds which did the same.
Some movement regarding investor protections was also revealed by the study. Emerging market funds raised pre-crisis provided for GP removal without cause more readily than the funds raised in the post-crisis years, although that may simply reflect the fact that fewer “first time” funds were raised in the recent period, says Kittredge.
Exploring the causes
There are countervailing forces at work in emerging markets, explains Kittredge. “A hearty investor appetite for returns from the faster growing emerging market economies is beneficial for GPs and can help push fund terms in their favour. However the comparatively higher risk profile of less proven markets means that institutional LPs still proceed with caution.”
Increased LP demand for emerging market funds is understandable when considering these geographies proved more resilient to the “Great Recession” (in part due to having less exposure to the banking meltdown). Meantime investors have witnessed the significant (and proven) growth potential exhibited by Brazil, China, India and other regions and don’t want to miss the boat. Over half (57 percent) of investors in emerging markets anticipate further increases in their allocations in the next two years, according to the 2010 EMPEA/Coller Capital Emerging Markets Private Equity Survey. Moreover 77 percent of LPs surveyed say they expect their emerging market stakes to provide returns north of 16 percent. Just 29 percent said the same for their global private equity portfolio.
However investor appetite for certain emerging markets has been suppressed by the challenge of finding experienced GPs—cited as one of the top barriers to first time investment in Africa and Latin America by survey respondents. LPs also remain sensitive to emerging market legal regimes and business practices, adds Kittredge. “Consequently LPs often negotiate a number of terms and conditions that provide investors with greater visibility into the activities of the fund and checks on the authority of the
Even the most successful GPs are likely to negotiate the terms of successor funds primarily around the periphery, and not challenge the fundamental alignment of interests that persists
Common checks include restrictions on investments in oil, gas or other strategic natural resources prone to state intervention; and more active advisory committees to monitor conflicts of interest under the partnership agreement.
At any rate fund managers are developing a track record in these regions and the prospect of a wave of money coming their way over the long term should not cause GPs to become arrogant, muses Kittredge. “Even the most successful GPs are likely to negotiate the terms of successor funds primarily around the periphery, and not challenge the fundamental alignment of interests that persists. Terms in emerging market funds have historically tilted toward the investor friendly side of the spectrum and there’s an expectation they will not veer radically in the opposite direction.”