Unless you happen to have been residing on another planet for the last year or two, it's surely impossible not to know that, when it comes to LBO fund economics, the balance of power these days rests firmly with the GP rather than the LP. That's a given. What still has the power to surprise, however, is just how far in the GP's favour the pendulum has swung.
Many casual observers appear to hold the view that the terms and conditions typically found in LBO funds' limited partner agreements are in a condition of stasis. Take the management fee, for example, where funds from the merely large to the mega-large are able to demand an annual management fee ranging between two percent for the former and 1.5 percent for the latter. While these parameters have been set in stone for the last few years, and continue to be considered de rigeur, those on the frontline of fund formation say they mask some interesting – and less instantly observable dynamics.
There is, of course, the simple point to be made that the 1.5 percent charged annually for the very largest funds has remained constant while the size of those funds has grown exponentially. For the coterie of US LBO funds in the process of concluding $15 billion-plus fundraisings, it is indisputable that while the fee percentage may still be the same as that applied to prior funds, the economics have changed enormously.
But even this is only part of the story, since fund formation lawyers say that in some cases the headline fee – widely assumed to be static let's remember – has in fact been heading north. Jason Glover, Londonbased partner and head of the private funds practice at law firm Clifford Chance: “We have seen funds in the €1 billion-plus bracket charging 2 percent and multi-billion funds charging 1.75 percent. 1.5 percent is only right at the top end now. There are funds which, a few years ago, would have been regarded as big and therefore charged 1.5 percent, that are now charging above 1.5 percent and in some cases up to 1.75 percent.”
The cases referred to by Glover provide some evidence that GPs have never had it so good. Not only are funds getting ever larger on a quantum basis, but some are even tempting their investors into parting with a bigger fee on those larger amounts – a heady combination.
But while one inevitable consequence of this is a collective wringing of hands in the limited partner community, GPs are in a position to point out that it stems from a straightforward case of supply and demand. Certain LBO funds have attained brand-name status on the back of stellar returns from prior funds. Is it not perfectly logical that would-be investors should be forced to pay a little extra for access to the industry's star performers?
True to an extent. But the force of the assertion is weakened a little when you consider the words of warning that attach themselves to all financial products and services: namely, that past performance is not necessarily a guide to future performance. Viewed in this light, investors arguably have every reason to worry about whether super-sized management fees will serve to undermine carried interest, the traditional guarantor of GP incentivisation.
Such concerns are expressed by Ray Maxwell, London-based managing director at Invesco Asset Management and long-time investor in private equity funds, who says: “One issue that is always high on investors' agenda is carried interest and the incentive that it offers. It seems to me that carry is becoming less and less important, and investors are bound to ask whether this means the entrepreneurial spirit is being diminished.”
However, Glover points out that it's difficult to envisage a normal situation in which the management fee would become anywhere near as significant as the carried interest. He provides the example of a €3 billion fund charging a 1.5 percent management fee and retaining one-third as profit. This profit equates to €15 million per year, which might be around €85 million over the life of the fund taking into account the step-down at the end of the commitment period. But, assuming that the fund includes carried interest at 20 percent, then the carry equates to a whopping €900 million on the assumption that the fund makes a profit of €4.5 billion, or 2.5 times cost.
STACKING THEM UP
Few would argue with Glover's contention that, in the above example, carried interest loses little or none of its motivating power. But other industry professionals say that viewing one fund in isolation overlooks the growing phenomenon of “fee stacking”, which appears to be at the heart of many investors' fears that their interests have become misaligned with those of fund managers. In other words, some of today's largest buyout houses are also broader asset managers with large families of funds embracing many different geographies and strategies.
It seems to me that carry is becoming less and less important, and investors are bound to ask whether this means the entrepreneurial spirit is being diminished
Commenting on this development, Kelly DePonte, a partner at San Francisco-based placement agent Probitas Partners, says: “The most senior managers get fees from all of these funds and the total amount involved can be staggering. It means that they have more of an asset management focus than a focus on individual investments in any one fund.”
DePonte also returns to the point about past performance being no guarantee of the future. “Remember,” he cautions, “that if the bubble bursts, carried interest might start to become irrelevant and it's the management fee that will then start driving management decisions.” For anyone tempted to think that the buyout boom will continue unabated, it's perhaps instructive to think back to the venture boom and bust of the late 90s/early 2000s and consider how many struggling funds from that period ended up with an unhealthy focus on stringing out their fee income.
All of which said, it is widely acknowledged that fund managers have motivations that go beyond simply extracting the best possible economics for themselves. In conversations, US buyout firm Hellman & Friedman is cited as one GP that has prided itself on a large management commitment to its funds, thereby putting as much skin in the game as possible (a source close to the firm says this was as much as 15 percent of the total in its earlier funds). LPs also retain the belief that for many fund managers the desire to complete successful deals is based as much on self-esteem and the desire to safeguard the future of the business as it is on cold, hard profit.
But while such noble motives undoubtedly exist, it would be wrong to view limited partners as passive creatures that have come to rely solely on the altruism of GPs for reasonable terms and conditions. Even in the testosterone-fuelled fundraising market of today, where the most sought after funds are heavily oversubscribed within weeks of their official launch (if not sooner), investors will not readily concede that there's no room for negotiation. Lawyers say many LPs are demanding more than the traditional one percent of total commitments from GPs (many of which are now agreeing to commitments of between two and five percent).
And that's not the only example of LP boldness at the negotiating table. Glover says that the speed with which GPs have been returning to market for successor funds has exacerbated the tendency to fee stacking. In light of this, investors are more inclined to request a lower management fee on the overlap between prior and successor funds where there are still significant commitments to be made from the prior vehicle.
Tussles are also still taking place with respect to transaction fees charged to portfolio companies. The most aggressive GPs are pushing for a 50/50 split, whereby half the fees go to the GP and half to the LP; while LPs are keen to get 80 percent or even 100 percent of the total. Lawyers say compromise positions are increasingly being reached, with 60/40 or 65/35 splits being seen for the first time. Not something that could easily be described as a victory for LPs, but at least a sign that they are not prepared to cave in completely to the most aggressive demands.
We're in a cycle in which everything GPs do turns out right, and it breeds a little arrogance and short-sightedness
Beyond terms and conditions, LPs have been exerting influence in other ways. For example, DePonte says that in recent years an increasing number of investors have requested fee schedules and budgeting information on the basis that, if they're forced to pay more to access a fund, LPs at least want to know precisely how their money is being allocated. Well, that's the theory at least. “Some provide that information and others don't,” says DePonte.
In terms of the way in which funds are structured, there have been some attempts to align interests between GP and LP better. For example, Maxwell is chairman of Magnolia China Energy & Media, a new private equity firm focused on the Chinese market. The firm's debut offering does away with the preferred return in order to increase the incentive offered by carried interest by making it available earlier in the fund's life. It's a development that's good for the LP, says Maxwell, because “GPs will try to sell businesses quickly and possibly sub-optimally just in order to eradicate the preferred return”.
Another private equity vehicle that introduced an innovation to the market was the second fund raised by Stockholm-based Altor Equity Partners, which closed on €1.15 billion in February 2006. It's not as if the GP needed to spice up its terms in order to lure investors in: the fund was raised almost entirely from existing backers in the space of just a few months. Nonetheless, it offered these investors the option of a lower management fee in exchange for a higher level of carried interest payable to the manager.
But where the Altor fund gives investors if not better terms then at least a choice, other GPs appear keen to exploit their position of strength to the full. Glover speculates that Europe is close to seeing LBO funds where carried interest increases as certain performance hurdles are reached – with perhaps as much as 30 percent kicking in once a big profit gain has been delivered.
In the US, DePonte has noted “two or three” examples of midmarket funds demanding a premium in order to stay mid-market. By way of illustration, he refers to a hypothetical firm that raises $500 million for its prior fund but has demand of $2 billion for its new fund. The firm might agree to hard cap its new fund at $800 million – in exchange for a higher rate of carried interest. DePonte explains the rationale thus: “What they're saying is that they're foregoing the management fee they would have got for raising a larger fund. Therefore, they deserve more carry for staying small.”
Such reasoning is a clear indication of the strength of GP bargaining power in the LBO market, as well as the extent to which alignment of interest between GP and LP may be under threat. Says DePonte: “We're in a cycle in which everything GPs do turns out right, and it breeds a little arrogance and short-sightedness. People start to ask whether cycles still exist or whether a fundamental change has taken place.”
The last time such questions were asked was during the venture boom, when people began talking of a ‘paradigm shift’. If that experience is anything to go by, expect to see evidence sometime soon that cycles may deceive – but they never disappear.