Fees are the biggest bones of contention between limited and general partners, according to Private Equity International’s annual survey of LPs.
Fifty-one percent of limited partners cite management and performance fees as the top area of disagreement when conducting due diligence.
“The management fee is really the big area where LPs feel there isn’t adequate alignment, because the managers are collecting the management fee whether they actually perform or not,” says Howard Beber, partner and co-head of the private investment funds group at Proskauer, the law firm, in Boston.
The headline fees are usually expressed as an annual percentage levy on funds committed. These are typically 1.5 percent or a little below for the multibillion dollar buyout funds, and up to 2 percent for midmarket funds, says Nick Benson, partner in the funds team of Latham & Watkins, the law firm, in London. “There is a bit of downward pressure on headline fees, because limited partners would not be doing their job if they didn’t try to push them down,” says Benson. However, he notes that oversubscribed funds are able to resist this downward pressure
Stephen Carre, head of advisory and project management at the UBS private funds group in New York, offers another perspective. “Limited partners want the overall package of terms to make sense for the platform,” he says. “If they’re looking to commit to a first or second-time fund, for example, it may not make sense to negotiate the headline management fee rate as investors appreciate the fund manager needs capital to attract the best talent to deliver on the investment proposition.”
Market observers say that rather than worrying about the headline rate, LPs are sometimes concerned about other fees, such as those charged to portfolio companies by the investment principals for giving operational advice to portfolio companies.
This is an area in which LPs have in recent years lobbied hard and successfully. When Beber of Proskauer began as a funds lawyer 20 years ago, this was rarely discussed. But over the years, LPs have raised this as a major alignment concern, he says. Gradually, the split between the manager and fund has moved more in favour of LPs – to the point where, in many cases, all of these fees offset the management fee rather than forming an additional cost for LPs.
An issue closely related to the concern about fees is limited partner concern about the structure of the distribution waterfall – the way in which capital gains from the fund are shared between limited and general partners. Eighteen percent of LPs regarded the structure of the carry distribution waterfall as the biggest source of disagreement.
Friction over fees is an issue across much of the asset management industry; however, the concern over how much of the fund managers’ own money is committed is idiosyncratic to the private equity industry. Idiosyncratic it may be, but LPs often place a fair amount of emphasis on this. Although general partner commitment is the top priority of only 4 percent of LPs, 25 percent place it as second priority, and 44 percent place it among the top three priorities – making it the third most common concern overall.
What matters in due diligence
The track record of general partner performance is a “critical” part of the due diligence process for 72 percent of LPs, a higher score than for any other issue. In second place is “investment thesis and style drift”, regarded as critical by 62 percent.
Commenting on this question, Adam Turtle of Rede Partners says LPs are looking for two qualities: “Consistency and replicability.” He adds: “Limited partners want to understand the replicable aspects of performance that will deliver outperformance over the long term.”
Stephen Carre of UBS concurs: “The question of investment repeatability is important: did the fund manager achieve their investment returns through their own skill and planning, or was there a big element of luck?” To make these judgements, he says, many investors carefully review investment committee memos and tap their own contacts.
What are LPs looking for, as they conduct these investigations? Turtle notes managers often have particular strategies which they implement across portfolio companies. For example, one manager may buy domestic leaders in a particular sector, which can be expanded through buying equivalent firms in other countries.
The amalgamated business is sold on at a higher price than the entry multiples paid by the general partner, since the new company is bigger, more stable and, as Turtle puts it, “more strategically interesting”. This strategy can be checked backwards – through seeing whether the general partners stuck to it with a previous fund – and forwards – by interviewing anyone at the private equity firm who is involved with the fund to check their understanding of the strategy matches everyone else’s.
Consistency and replicability are bound up with fund size, which Mounir Guen, Hong Kong-based CEO of MVision, the fund placement agent, regards as the most common single area of disagreement. LPs worry, he explains, that a larger fund can imply less exciting investment opportunities. “If you double fund size, you could lose half of your investor base, because the original investors will only put money in funds of below $1 billion,” says Guen.
The issue of general partner commitment is more complicated than first appears. “The key from an LP’s perspective is that it is a ‘meaningful’ amount,” says Beber: enough of the general partners’ wealth to provide meaningful “skin in the game”, as he puts it. LPs’ notion of what is meaningful has, however, become fussier over the years. Twenty years ago, “it was pretty standard that the GP put in 1 percent, and that ticked everybody’s box,” says Beber. “Nowadays that doesn’t tick many boxes.” He thinks that most LPs look for a GP commitment of between 2 and 5 percent, with anything higher than that “an advantageous marketing point”.
The fourth most common priority among LPs at the due diligence stage is the key person clause. This specifies who the key people in the fund are, and suspends the fund’s investment period if these people cease to spend most or all of the time in the fund. It is put in the top three by 32 percent of them, and even placed first by 9 percent.
The key person clause is bound up with the issue of succession planning – always an important issue, but one that is particularly key at the moment when many people who started in the early years of the industry are stepping back and appointing newer people to manage funds in their place, says Adam Turtle, partner at Rede Partners, the placement agent, in London. But Turtle thinks that LPs often “respond positively to succession – they don’t want the same team to be around forever”. To put it another way, LPs do not baulk automatically at succession; instead, “they are focused on good succession versus bad succession”.
LPs were asked also about the quality of marketing. For private equity, 18 percent thought that marketing documents rarely met investor requirements, and only 36 percent felt they regularly did so. Turtle says Rede Partners involves itself in marketing documents for all clients. Its reason: “I don’t think the quality of marketing documentation in the broader market is always that great.”
The survey also asks whether conditions have moved more in favour of limited or of general partners. It finds 42 percent of LPs feel conditions have become less in favour of general partners over the past year, with only 13 percent thinking general partners have gained power against LPs. This tallies with the analysis of market observers who have seen greater strictness about offsets.
But Mark Yusko, CEO and CIO of Chapel Hill, North Carolina-based Morgan Creek Capital Management, is sceptical that his fellow LPs have really gained the upper hand in negotiations over terms when it comes to high-performing general partners – or whether they really greatly care. His experience is that the best managers tend to offer less advantageous terms than those with worse performance, and LPs accept these. Conversely, “if you demand a fee reduction and they give it to you, what does that say about the quality of the manager?”