Misalignment of interest

A new study shows alignment of interest between LPs and GPs weakening as larger funds demand juicier management fees. By Andy Thomson.

Larger funds mean longer investment periods, and longer investment periods mean bigger management fees. That is one stark conclusion to be drawn from the third Annual Review of Private Equity Terms and Conditions by Zurich-based alternative asset manager SCM Strategic Capital Management.

Ralph Aerni, head of private equity, SCM

The survey of 235 private equity vehicles that came to market in the first nine months of 2005 found that 60 percent of these funds stated an investment period of five years and 22 percent more than five years. A four-year investment period, which was market standard throughout the 1990s, was stated by just ten percent of the funds in question.

Moreover, the start of the investment period – which traditionally has been the first closing in the vast majority of cases – is now showing signs of slippage. In last year’s equivalent survey, the number of funds starting their investment period at the final closing rather than the first had risen to 35 percent – this year it has climbed to 44 percent. In real terms, given that the time period between the first and final closing can often be around 12 months, this equates to a year’s extra management fees.
According to SCM, the combined effect of longer and more deferred investment periods on the funds surveyed is an average increase in the management fee of somewhere between ten and 15 percent.

On top of all this, the survey also found commitments made by GPs to funds on the decline. The proportion of management teams committing more than one percent of total capital is now just over 50 percent: a fall of about ten percent compared with the previous year. No wonder that, in the words of the survey’s authors, the findings “may lead some investors to conclude that the alignment of interest is weakening in an industry that is both growing and maturing”.

Nonetheless, not all the findings will put LPs in a mood of despondence. On the issue of corporate governance, for example, GPs are found to be doing rather well. The survey noted the almost universal adoption of LP advisory boards (99 percent of funds reviewed) and key man provisions (94 percent). The latter have assumed a fresh importance, given an additional finding of the survey that the size of GP management teams are not increasing in line with the larger funds they are raising: in other words, LPs remain reliant on a small clutch of key individuals with ever-greater firepower to wield.

Other key findings of the survey included:

· 20 percent carry and hurdle rate remain industry standard: Over 90 percent of funds apply 20 percent carried interest and 80 percent include a hurdle rate (which is set at 8% for 55 percent of funds reviewed).

· Deal-by-deal carry almost absent from Europe: Deal-by-deal carry, employed by 54 percent of US funds, is used by just four percent of those based in Europe. 86 percent of European funds have to return all paid-in capital prior to receiving carry, while nine percent must return all committed capital first.

· Between 10-20 percent the limit for one deal: In 70 percent of funds, the maximum amount of fund capital that can be invested in a single deal is between 10-20 percent. The limit is 10-15 percent in 34 percent of cases, and 15-20 percent in 36 percent of cases.

· ‘Removal for cause’ almost universal: ‘Removal for cause’ provisions, allowing investors to terminate a fund or suspend investments in the event of a breach of contract, wilful misconduct, bankruptcy and other defined events is now standard in 95 percent of funds.