Longer-dated funds: the shifting return focus of private equity

Macfarlanes' Christopher Good examines how such vehicles should be structured in order to maximise incentives while managing return expectations.

With news that CVC Capital Partners is raising its second longer-term fund, GPs and LPs have again been considering the pros and cons of this approach.

There is certainly demand from investors for a longer-term product, and a number of other larger houses – including Carlyle and Blackstone – either already manage a longer-term fund or have plans to raise one. Interestingly, BlackRock has announced plans to raise a similar fund as well, and since 2015, the EU has been promoting a new regulatory framework for longer-term investment funds focussing on private assets and infrastructure.

It is not surprising that investors look at this with real interest. They have been frustrated by transaction fees on both sides of a deal when one GP is forced to flip a performing asset – which still has room to grow – onto another private equity fund (where the same investors may also be LPs); and at having to extend durations for funds and pay extended fees where the intention was originally for a 10-year term.

Christopher Good

For their part, some GPs find longer-term funds attractive because they allow them to invest in businesses whose return profile would have been too low for their flagship fund (the return profile is likely to be lower – a typical target might be an internal rate of return of around 15 percent, rather than, for example, 20 percent for the same house’s flagship buyout fund).

The longer duration also means that the GP has time to sit through a downturn and invest into operational improvements, rather than sell at the wrong time. Given the extra time, and fewer frictional transaction costs, some commentators think that despite a lower return target, a longer-held fund would still outperform a standard fund. For example, Bain & Company’s Global Private Equity Report 2018 concluded that long-hold funds had the potential to generate double the post-tax investment multiple of a typical buyout fund over a 24-year period.

The commercial arrangements for the longer-term fund, and how it does its deals, will need to be slightly different from the typical “10+2” private equity fund in the following ways:

  • Given that the return profile is likely to be lower, the management fee will also tend to be lower than the flagship buyout fund.
  • The GP will only be able to partner with certain types of LPs – those that have a genuine ability to sit passively and patiently to wait out a 20-year fund duration. These investors are more likely to be sovereign wealth funds and very particular family offices, rather than the more typical mix of private equity investors, including funds of funds, that have their own structural return and time constraints.
  • The GP needs to demonstrate that, while it now has the benefit of not being forced to sell a portfolio company at the wrong time, it still has the discipline to know when to sell rather than hold.
  • Given that carried interest will be locked up for longer and there will naturally be changes in personnel to manage over that longer time period, the GP needs to show LPs that it can incentivise its own internal teams and manage transitions over the duration of the fund’s longer life when there is turnover in key positions.

The incentive issue is even more pressing at the portfolio company level. Management teams at that level may need to see that there is something equivalent to an exit opportunity along the way – even for an asset that has a longer hold period. Typically, managers won’t be keen to sign up to business plans that only pay out on an exit that is six, seven or more years away.

This may impact the good and bad leaver terms on the management team’s equity, which may be more favourable to leavers than would otherwise be the case on a more typical private equity deal. Some of that technology can come across from infrastructure investors, family offices or sovereign wealth funds that have a history of making longer-hold direct investments and have therefore already worked their way through the incentive issues.

Of course, the “10+2” model will still be very popular, and longer-dated funds are not going to displace it as the common model. Investors, by and large, prefer their capital back sooner rather than later and most GPs see the longer-hold approach as a complement rather than a replacement to their existing buyout strategy. But for an industry where sponsors have tended to dictate terms to investors rather than vice versa, it is encouraging to see more GPs innovate in response to the market and start to think about patient investing.

Christopher Good is a London-based partner at Macfarlanes who focuses on private funds, fundraisings and investor negotiations, spin-outs, incentive structures and primary and secondares fund transactions. He is a member of the Association of Partnership Practitioners and sits on Invest Europe’s working group on legal and regulatory affairs.