The current level of management fees was the overriding concern for almost a third of investors surveyed while the often thorny issue of how expenses are split between GPs and LPs was the second most cited concern for respondents.
And at a time when demand for co-investment opportunities continues to rise from investors seeking to increase their return on capital deployed, this provides ample proof that general partners are having to come up with more sophisticated ways of keeping everyone happy.
On oversubscribed funds, the most popular GPs may be able to get away with clauses that make few promises at the fund-raising stage. But others have promised co-investment rights pro rata to each LP’s commitment to a fund, or only the largest, or first, investors are given co-investment rights as an incentive for writing cheques. There have been recent examples of LPs receiving as much as three times their fund commitment in free co-invest.
Advisors say choosing the route to take on handing out co-investment options is going to be a big talking point on 2016 fundraisings, for everyone but the largest sponsors.
Tom Alabaster, a partner in the London office of law firm Latham & Watkins, specialising in investment funds, says: “We are seeing a much greater interest in co-investments from LPs, and increased use of them by private equity firms, and that’s for two reasons. First, it is to arbitrage the fees, so that people, over the whole of their portfolios, can get a less aggressive fee. And second, it helps the funds de-risk by putting some exposures outside the fund.”
From an investor’s point of view, there are savings to be made through co-investments, which often come with zero carry and fees, along with the added benefits of deal-by-deal investment selection. But GPs can tie themselves in knots trying to meet every investor’s demands.
“Offering co-investment is a tool that is increasingly used by some managers to support fundraising, but there are pitfalls,” says Clive Norton, partner at placement agents First Avenue. “Investors who anchor a fundraise frequently look to negotiate preferential co-investment rights, but giving away too much can compromise a GP’s position with potentially larger investors who seek to commit later on in the fundraise.
“GPs should aim to offer co-invest on a best-efforts basis, retaining control and flexibility as to the amount of co-invest they offer and to whom. Expectations will be set, and investors who are driven by co-invest will have the chance to opt out of the next fundraise if they don’t get what they expect.”
The other downside for GPs is the risk that investors will not actually be able to deliver the goods on co-investment opportunities. Many are not set up to make quick decisions about co-invest deployments.
One solution is in the structuring of new vehicles. Jason Glover, a private funds partner at law firm Simpson Thacher & Bartlett, says: “There are some investors that would ideally take up co-investment opportunities but have a huge problem in processing them. We see those investors shunning the traditional model whereby they themselves determine whether or not to take up an opportunity offered by a GP, and asking instead for a co-investment structure where there’s a discretionary pool, run by the GP, who can decide whether or not the LP should do it.”
Glover argues that can be a win for both sides. In a traditional co-investment scenario, the fund underwrites the larger equity cheque and then the GP hopes to syndicate any excess equity to the fund’s investors, with the risk that the fund ends up with a bigger exposure than originally intended if potential co-investors choose not to take up the opportunity. This structure gives the GP a guarantee that the co-investment opportunity will be taken up.
There are also more firms setting up parallel pools alongside their main funds, so that all investors who want access to co-investments can make allocations to both the main fund and a non-discretionary co-investment pool, which remains under the control of the private equity firm and is fee-free and carry-free.
Glover says: “The other change that we are seeing is that some investors, while accepting that co-investment is discretionary, are seeking reassurance that if co-investment opportunities are not made available then there will be some adjustment on management fees payable by them in respect of the fund itself. Of course, the success of such a request is to a large extent dependent on the relative negotiating position of the investor versus the GP.”