For an investor in a private equity fund, the GP commitment is one of the most important terms in a limited partnership agreement. While the promise of riches in the form of carried interest ensures managers and LPs are aligned when the sun is shining, it is the GP commitment which aligns interests in stormier weather. If investors lose, managers lose too.
“The important thing to me is that they, like us, have a downside as well,” says Jan Rådberg, head of private equity at AP Fonden 1, the first Swedish national pension fund.
The accepted standard is for the fund manager to commit 2 percent of the total fund size. But some GPs are choosing to pledge more as a way of competing for LP commitments.
“The acid test in every GP commitment is around whether it’s a sizeable commitment that you would expect from a manager of their experience and wealth,” says Mark Nicolson, a partner at SL Capital Partners. “Is it meaningful to them, so it hurts if it doesn’t perform? You have to take it on a case by case basis.”
It is often not made explicitly clear to LPs where the capital for the GP commitment is coming from. If investors want to know, they have to dig themselves.
“By and large GPs do not advertise clearly during fundraising how they plan to fund their GP commitment. We will always ask during diligence because I think this is relevant and material information; it’s not always volunteered,” says Neil Harper, chief investment officer at Morgan Stanley Alternative Investment Partners PE.
“If you ask for it, you get the information you need, but it’s something that’s often not as openly disclosed as many other [things],” Rådberg says.
According to a survey published by Investec, the specialist lender, last year, managers are struggling to fund these commitments, not least because fund sizes are increasing across the board. More than half of the respondents said they didn’t currently have the liquidity to meet their GP commitment (see chart).
For the most part, it is the younger members of the team who have seen fewer fund cycles that struggle, says Investec’s Matt Hansford.
“It’s quite often that level down, investment directors, more junior partners, that have advanced their careers through the downturn. They haven’t seen that same return that the senior partners have.”
One accepted way for junior partners to fund their portion of the GP commitment is to borrow either from the senior partners or the firm itself. According to Investec, 14 percent of respondents were planning to rely on financing from their employer.
The same proportion anticipate using some form of external financing, such as the lending facilities provided by Investec. Accounting for 10-15 percent of transaction volume per year at Investec, Hansford describes such loans as “a liquidity bridge from the locked-up value in the prior fund to the new fund”.
The loan is made to the manager itself, and will then be lent again to individuals within the team. These types of facilities can raise eyebrows among the LP community. To get comfortable with teams or individuals using loan facilities, Harper’s team sometimes request signed personal statements of net worth from the main partners committing to a particular fund.
“Once you understand that, the question is whether it is acceptable or not that they’re partly funding the GP commitment in the form of a loan – in some circumstances it may be a positive, in others, evidence of weaker alignment or a risk factor to consider.”
If a partner pledges a significant proportion of his personal wealth and then takes out an additional loan to boost that commitment, that’s a strong demonstration of belief in their strategy.
However, augmenting a small personal commitment with a loan “can look like lacklustre alignment and support for their investment strategy, unless their personal financial situation suggests that a small commitment is economically meaningful to them”, says Harper.
Bank lending to individual partners within a team – where each individual is personally liable – can be seen as a positive. “We’re happier about that,” says Nicolson, “because they are leveraging themselves, and that’s a big vote of confidence; as long as they don’t over-do it, which can lead to other issues.”
According to Hansford, Investec requires each individual using one of its loan facilities to provide a personal guarantee.
“We want them to feel that they’re aligned to us. That if something did go wrong they’d be just as motivated as us to work it out.”
However, the extent to which lenders would actually pursue individual team members were the fund to turn sour, and not just recoup any losses from the fund manager itself, is unclear.
“The bank lends money to the firm as a whole, so [it has] diversified risk against a group of partners plus all the business streams of this entity. We’re not really talking about anybody’s house or car at that point,” says one London-based private equity lawyer.
“Generally those loans will be non-recoursed to your personal assets, but you do have to pay them back.”
Any loans that could have an impact on the fund itself should also be disclosed to LPs.
“Anything that has a potential economic impact on [GPs’] incentivisation, such as the way in which any loan to fund a GP commitment is secured, I think they should be informing LPs,” Harper says. “They may not always have the technical obligation under the LPA to do so, but I think as a matter of good fiduciary behaviour they should.”
Another option is for GPs to use the management fee of the vehicle itself to fund the GP commitment. “Fee waivers”, in which the manager waives the right to collect an annual management fee and instead keeps the capital within the fund itself as a GP commitment, has been under increasing scrutiny in recent years. Having been once common practice, particularly in the US, it is now much less prevalent.
“Ideally the GP commitment should be substantial, and then I think it should come from their own personal wealth,” says AP1’s Rådberg. “It should be their own money at risk and not funded from the management fee.”
But that does not stop the manager collecting the management fee and recycling it into the fund. Nicolson and Harper are in agreement that if GPs are receiving a high level of fee income, which would lead to distributions over-and-above a market-rate remuneration package, the preference would be for the manager to reinvest that back into the fund.
However, this should be in conjunction with a substantial cash contribution to avoid distorting the risk profile.
“Giving up something that you would have had in the future, but don’t yet have, is somehow a little bit easier and requires a little bit less thought for people than giving up something you’ve already got and that’s in your pocket, even though economically it comes to the same thing,” Harper says.