It’s time to focus on funds economics

General partners could do much more to show that their interests are aligned with those of their investors. Concessions to suffering limited partners are long overdue, says Dominique Peninon.

Dominique Peninon is managing partner of Access Capital Partners. This article was first published in EVCA Network News, issue 7, December 2002.

Both the venture capital and buyout funds continue to show, each at their own pace, a steadily declining NAV, due to the combination of two factors: price adjustments and the impact of management fees. As a consequence, from a communication standpoint, they are giving investors a rather negative signal at a time when they work hard to add more value to portfolios.

Taking venture first, there are serious concerns about the quality of portfolios. Even though most portfolio companies have already cut costs to a minimum, delayed investment and taken other necessary measures, they will inevitably need further financing at a time when venture capitalists are not especially keen to re-invest. Syndicating a funding round today has become quite a challenge, even for top quality firms.

Of course, valuations are critical, but the vast majority of VCs have already spent a lot of time and effort restructuring their portfolios, applying all the well known recipes: anti-dilution and ratchet clauses (which have their limits), liquidation preference, renegotiating prices and milestones with entrepreneurs. Beyond mistakes on pricing or deal selection, they often did a great job.

Unfortunately, this work does not show up in valuations: investors just see mark-down after mark-down, not to mention the write-offs. And not enough attention is being paid to the end result: dilution. Venture capitalists that are still able to keep funding their best portfolio companies are increasing their holdings to the detriment of other shareholders who cannot.

Buyout funds suffer another syndrome. By and large they invested carefully during the last two years, expecting a decrease in entry prices or anticipating an economic downturn that would affect the performances of portfolio companies. Most have solid portfolios, although they often value them overly conservatively, failing to show valuation changes and to give a fair market value. They could at least integrate acquisition debt repayment and take EBIT/EBITDA changes into consideration.

Improving fund terms and conditions

But in many ways, the valuation issue is a red herring. Investors would do well to pay more attention to fund economics above quarter on quarter changes in value. The impact of management fees is responsible for a good portion of NAV decline. Management fees are based on commitments not on drawn-downs. Few would question the need for the management fee. But it is still worth examining the piling of fees, the shape of the management fee curve, the magnitude of transaction/syndication fees, compensation packages and staffing levels.

These items have been discussed for years, with very little attention from GPs, who were clearly benefiting from a sellers market and were not listening. The situation has changed quite dramatically since then, with a major concern today about performance, both in terms of cash multiple and IRR.

Adjustments have to be made, which requires some willingness from GPs to co-operate. The alignment of interest between LPs and GPs remains a true asset of private equity and it would be a pity not to exploit current market conditions to demonstrate that this asset class is much more responsive than others.

A few measures can be taken, that could seriously improve the overall performance of funds.

First of all, funds should invest 100 per cent of commitments, i.e. re-inject the equivalent of the management fee. To be fair, this might turn out to be somewhat theoretical for the worse performing funds because it means recycling some of the exit proceeds (more difficult to find in today’s environment). However, it can make a tremendous difference, because often merely 80 per cent of an investor’s commitment to a fund is actually put to work.

Second, every effort must be made to modify the impact of the management fee by offsetting it against transaction and syndication fees. Again, this leads to greater alignment of interest as more money is invested, leading to more capital gains and more carried interest.

Some efforts need to be made by the most “expensive” funds or by the ones who have increased considerably the size of successor funds often without incurring additional expenses at a similar rate. The longer holding periods in the current environment also mean more management fees.

Changing the shape of the management fee so that it is more progressive, declining faster over time and reduced as soon a new fund is started would be welcomed by investors. Deferral of payment of the management fee when possible (it improves the IRR) would be another step in the right direction.

The potential impact of such improvements can be shown by comparing two private equity funds with terms and conditions that are representative of today’s market standard:

 
Fund A
Fund B
Fund size
100
100
Management fee
2% of committed capital, declining after the commitment period to 2% of net invested capital
(minus the cost of realisations)
2% of committed capital, reduced to 1.5% after the commitment period
Commitment period
5 years
5 years
Transaction fees(2% of acquisition cost+ 1.5% syndication fees)
Offset against the management fee
No offset
Carried interest
20%
20%
Hurdle rate
6%
6%
Gross return assumption (with a 20% casualty rate + a 4 year holding period)
2.5x
2.5x
Re-investment
Limited to the cost of realised investments in compensation of management fees
(100% of capital is invested)
Excluded
Net multiple to investors
2.10
1.86
Net IRR to investors
19.13%
18.14%
Carried interest
27.40
21.50


The analysis reveals a significant gap between gross and net performance in the case of Fund A where interests between GPs and LPs are badly aligned. It shows that reasonable terms and conditions coupled with the ability to compensate for the negative impact of the management fee by limited re-investments can really make a difference. In this case it is an improvement of 13 per cent on the overall return in multiple terms. Interestingly enough, the GP is much better off as well, with a significantly higher carry (+27 per cent) because of the higher overall multiple.

A more balanced relationship

Throughout the asset class, the transition from a bull to a bear market has already been reflected on the portfolio level, now it is the turn of the limited partner agreements. Investor friendly terms such as those described above will guarantee a more balanced LP/GP relationship over time, focusing even more the GP’s attention to long term value creation rather than short term fee income.

Investor friendly terms such as those described above will guarantee a more balanced LP/GP relationship over time, focusing even more the GP’s attention to long term value creation rather than short term fee income.