Last year, the average size of private equity funds holding a final close was the highest ever recorded by Private Equity International, at $530 million, while the 10 largest funds accounted for around a fifth of all capital raised. Several funds are now in market targeting north of $10 billion in 2022. But ever-larger fund sizes do not come without challenges for both GPs and their investors.

For those seeking to raise capital, the scale of the funds being sought means not only having to ask existing investors to re-up, but also targeting new sources of money. Investors are looking for in-depth conversations, and it is wrong to assume that existing LPs will simply come into the next fund without a proper negotiation.

Jason Glover, head of the European funds practice at law firm Simpson Thacher & Bartlett, has noticed that some LPs that had enjoyed being the biggest fish in a small pond are having to adapt to swimming in a bigger pool: “There are a lot of investors that historically had a lot of power as significant investors in funds, and now find that changing.

“The mega-funds are growing at a faster rate than LPs are growing the size of their commitments, and there is a broadening of the investor base going on, which means some LPs are seeing their negotiating power has changed quite significantly. Those investors are used to having influence, and that takes a bit of managing as the dynamic has shifted.”

Meanwhile, the challenges of marshalling an ever-expanding investor base, all with different expectations and requirements, is putting pressure on advisers.

Paul Buckley, CEO and managing partner at First Avenue, a placement agent working on fundraising in infrastructure, debt and private equity, says: “The evolution of fund sizes has been quite astounding during covid, which means you have many more investors to deal with. The ability to herd the cats and negotiate terms with all those investors means the negotiating skills of your internal counsel and your external fund formation counsel become more important, particularly at first close.”

Boosting the investor base

Christopher Elson, special funds counsel at law firm Proskauer, says sky-high fundraising targets can only be met with new LPs coming on board. “Lots of big sponsors want to raise large amounts of capital, but in order to achieve that significant size increase, they may need to look beyond the existing investors in their prior funds, and creating new relationships takes time.”

Such an expansion of the investor base may mean tapping into Asian, Middle Eastern, Australian and South American sources of capital, as well as looking to retail investors and
private wealth.

“The use of the secondary market to your advantage ahead of a fundraise can help position your story even better”

Paul Buckley, First Avenue

“There is an increasing diversity in private market participants, extending beyond the classic institutional investors to include more retail platforms and high-net-worth individuals,” says Elson. “That means lawyers need to make sure they are designing structures that suit the widest possible range of market participants, while also designing a fundraising subscription process that is manageable for all different types of investors.”

That, in turn, puts pressure on fundraising timelines, says Buckley: “Managers now need to assume a longer timeline when it comes to raising capital. It may appear that these fundraisings are taking place in record time, but there is a lot of preparation and pre-marketing going on. Fundraisings are typically dated from the point of the publication of the private placement memorandum through to the final close, but we may do more than six months or a year of preparatory work before we publish the PPM.”

In today’s hot market, some LPs have been urging their GPs to push back fundraising into 2023 because they are drowning in a constant stream of re-ups from GPs bringing back
subsequent funds.

Elson says the key to a smooth process is good communication. “It’s really about careful communication on timelines, because if you surprise your LPs and come back before they are expecting it, that may lead to a longer timeline on fundraising. Where those timelines are anticipated, they tend to be more successful. On a large fundraising, it is a case of driving momentum.”

New investors also put their own pressures on timelines, says Glover. “One reason the timelines are lengthening is not because of the challenge of getting to the hard-cap, but because a lot of these newer investor types, such as private wealth managers, can take a lot longer to raise their own capital in addition to the time needed to overcome regulatory hurdles.”

False economy

Glover says it is wrong to assume economies of scale will be achieved as fundraisings get larger, with legal processes getting more onerous as fund sizes grow. “Because investors are writing bigger cheques, they are spending more time and money on lawyers and on their side letter negotiations, which creates quite a lot of challenges for GPs as they try to gain consistency with the side letter provisions that they agree to give.”

Side letters are used by GPs to grant supplemental or preferential investment terms to certain investors outside the fund’s main limited partnership agreement, and can be subject to intense negotiation. It is through side letters that the unique tax and regulatory treatment of certain investors will be addressed, typically driven by the jurisdiction they originate from.

“The tax and regulatory burden on asset managers just continues to increase, so side letters are getting longer”
Christopher Elson, Proskauer

Says Elson: “The tax and regulatory burden on asset managers just continues to increase, so side letters are getting longer, and for a sponsor it is really a case of making sure that wherever you can identify alignment between the interests of different investors, you align the provisions.”

Investors are also becoming more demanding in areas like ESG, says Glover. “The bigger the investor, the more sophisticated they are likely to be in terms of side letter requirements. Rather than being term takers, those investors want to be term influencers. They want to have a say on things like ESG policies and reporting requirements. That means there is a more onerous set of negotiations taking place.”

“LPs are all creating their own reporting platforms for ESG and are being quite specific in what they are asking for,” says Elson. “For a sponsor, trying to navigate that can be challenging, because you want to make sure you are reporting to everyone in a similar way while at the same time fulfilling the different requirements of each investor.”

Few law firms have the resources to handle such large and complex processes, which means a handful of players are getting the bulk of the work. It is also not unusual to see law firms representing multiple investors on a big fundraise, while also investing in technologies to support better processes.

“There is definitely more pressure on the legal side, so we see more firms investing in technologies that allow you to streamline that legal process,” says Elson.

“That could be intelligent trackers that allow you to monitor the stage that hundreds of LPs have got to, electronic subscription platforms or smart side letters, all of which help the GP and LP experience when committing to a large fund. We are not alone in investing in those tools and they have made a huge difference.”

Smoothing out the process

Elsewhere, advisers say major topics for negotiation on mega-funds tend to be around key-person clauses – which could involve more named individuals as funds get larger – and the scale of GP commitments.

Glover says the composition of the LP advisory committee is increasingly up for discussion. “Because investors’ influence via their percentage interest in the fund is reducing, we are seeing an increasing focus from investors on getting a seat on the LPAC. They realise that their ability to make an impact through an investor vote is more limited, so having a disproportionate vote by being on the LPAC is significant.

“That’s challenging for mega-funds that probably have at least 25 investors with more than $100 million of commitments who all expect a seat on the LPAC. But there comes a point where such a size of LPAC would be dysfunctional, so we are now seeing terms that say the top eight investors will be guaranteed a seat, for example, and beyond that it is at the GP’s discretion.”

Meanwhile, fee negotiations are increasingly challenging for mega-funds, notes Glover. “There is a greater proliferation of fee discounts taking place on the mega-funds, because of the variance of the cheque size among investors. You may have some investors coming in at $1 billion and others at $5 million, and it is unrealistic to think the fee treatment of each is going to be the same.”

Successful sponsors are putting more work in upfront to smooth fundraising processes, typically flagging early any incremental changes that they wish to make to terms. Elson advocates being proactive: “The successful approaches that I have seen are where sponsors identify a select group of terms that they want to improve and go out to investors early with a clear rationale for making a change. At the moment, a lot of priority is given to raising quickly, so to do that while winning improved terms means you do have to demonstrate clear commercial reasoning.”

First Avenue’s Buckley says it is critical for a sponsor to get its co-investment policy right and orientated to the largest LPs that will drive a successful fundraise. Many GPs are now making use of the secondaries market to inject fundraising momentum, using continuation funds or stapled secondaries to both offer liquidity to existing LPs and demonstrate track record, notes Buckley: “The use of the secondary market to your advantage ahead of a fundraise can help position your story even better.”

As platforms continue to get larger and more sophisticated, and every investor’s position on negotiations remains slightly different, a close dialogue with LPs over the longer term is more important than ever.