In today’s buyer's market, LPs have more leverage in their negotiations with GPs than ever before. As they sit around the bargaining table, one change LPs are now pushing for is the management fee offset, paid for with 100 percent of “deal fees” going to the LPs.
LPs have had concerns for many years about transaction fees, which include several different types of fees GPs take out of portfolio companies, such as consulting, monitoring, M&A and even exit fees. Not all firms charge the same kinds of transaction fees, and while GPs were known to keep 100 percent of them starting in the 1990s, these days they generally give LPs 50 to 80 percent of the transaction fee to offset the management fee.
In the era of LP power, many investors would like to see that number go to 100 percent.
According to a study done by placement agency Probitas Partners at the beginning of this year, about 41 percent of surveyed LPs said 100 percent of the transaction fee should be allocated to investors in 2009. About 27 percent said an 80/20 split between the investors and fund managers is adequate and another 21 percent said the split needs to be determined on a case by case basis, or “the optimal split of transaction fees depends upon other terms in the agreement”.
Only about 9 percent said a 50/50 split between investors and mangers is adequate, illustrating a move from the fee structure that was most prevalent only a few years ago.
The transaction fee is still not the most pressing LP concern on the table. The Probitas study shows that of all the LPs surveyed, only about 21 percent said they were focusing on transaction fee splits. About 60 percent of the investors in the survey said they were focusing on the level of GP commitment to the fund, and about 45 percent said they considered the distribution of carried interest between senior investment professionals as a major issue.
But LPs have kept the issue at the forefront when negotiating terms and conditions with fund managers. HarbourVest Partners, the California Public Employees’ Retirement System and Wilshire Capital Markets, to name a few, have all said in interviews with PEO that they push for GPs to use a higher percentage of the transaction fee to offset the management fee.
Wilshire “looks at every investment case by case”, according to Jeffrey Ennis, senior managing director of Wilshire Private Markets. “In some cases, we want 80 to 20, at other times we might be more flexible,” Ennis said. “It has to do with the size of the fund, the size of the team.”
The firm also looks at the “total amount of fees”, Ennis said, to make sure there is sufficient capital to pay everyone and keep the business running. “We’re interested in total fees, paid, the amount and how that influences behavior,” Ennis said. “Our goal is to achieve the best alignment of interest we can, not necessarily to get the lowest fees possible.”
At the same time one GP who uses a 50/50 structure for the transaction fee said it’s important that LPs understand what the money is being used for and that the fee is justified.
“It’s very expensive to run [the firm],” the GP said. “Our investors are very astute and educated about how [the firm] runs. They don’t want us to change.”