No gain without pain

More than ever before, LPs have an opportunity to demand a remoulding of formerly intractable terms and conditions within private equity partnerships. But carried interest is not among the most despised features of the standard private equity fund – far from it. Instead, it's the GP commitment and a related term, the management fee, which are being seen as targets for reform.

Not to worry: carry is still seen as central to the private equity partnership. LPs believe it fundamentally aligns the interests of GP and LP. If I make money, you make money. There may be negotiations around the timing and order of carry payments, but almost all limited partners believe that a disproportionate percentage of overall profits should go to GPs.

But the management fee: now there's a term that is about to get an overhaul, and not only in the predictable percentage-of-commitments metric.

Over the years, industry participants have lost sight of what the management fee is for. It started out doing what the name advertised – paying for the costs of running the firm that managed the fund. But it has since become a creator of wealth for the GP. At the height of the private equity boom, the management fee became such an accepted part of the private equity business model that certain IPO-minded private equity firms were touting this revenue stream as a key attraction for buying shares in their private equity franchise. The notion that limited partners might someday rethink these fees was never highlighted.

The issue of management-fee-as-wealth-generator would be neutralised if it weren't for a related deficiency in current fund formation practice – namely, the weak GP commitment sometimes referred to as “skin in the game”.

Carried interest continues to maintain its support because it aligns interest on the upside. Management fees are now under attack because, without a material capital commitment from the GPs themselves, there is no aligned interest on the downside. A GP in charge of a huge fund stands to earn an outrageous fortune on carried interest if things go well. And if things don't go well, he'll do just fine collecting what's left over from the management fees. Heads we win, tails you lose.

The way around this is for the GP to put enough money on the line such that the management fees don't come close to recovering the loss. Hence, a new rule of fund formation that has been suggested to me by more than one reform-minded market participant: the GP commitment must always be more than can be earned back by the GP through management fees.

At the core of this term is a common understanding that a GP, whose fulltime job is to man age the private equity fund in question, should have a material amount of his or her own capital on the line. The fund should not represent merely a comfortable diversification of as sets for the GP, but a concentrated bet on the next 10 years of investment opportunities, with the success of said fund hinging on the skills of said GP.

“A GP who argues that he shouldn't bet a disproportionate percentage of his net worth on the next fund should not be awarded the ability to collect a disproportionate percentage of its upside”

Nothing focuses the mind on performance more than the threat of personal loss. A GP who argues that he shouldn't bet a disproportionate percentage of his net worth on the next fund should not be awarded the ability to collect a disproportionate percentage of its upside.

GPs who don't have enough money to meet this demand have a few options. There are fund formation mechanisms that allow a GP to convert management fee income into GP commitment over the life of the fund. It is likely that the tax treatment of this approach will become less favourable in the US under the current administration. But tax inefficiency isn't a good enough reason to shun this LP-sponsored long-term transfer of wealth.

GPs can also simply reduce management fees, or agree to spend more of it in the service of investment activities. They can also reduce the size of the fund and double down next time around with the winnings of the first effort. A G P who doesn't have the confidence to agree to this risks losing the confidence of prospective LPs, who today are increasingly impatient with being treated as if ploughing cash into a private equity fund is a privilege be stowed upon them by all-knowing general partners.