Few need reminding that the recent upheavals in the world's financial markets have had a profound impact on the world's private equity markets ? and this most definitely includes private equity fund raising. General Partners [GPs] at private equity firms are having to travel further and work harder to capture the commitments they want from Limited Partners [LPs]. And it's much more likely that a new fund raised today will end up with capital commitments significantly below initial expectations. The heady days of 1999, when a fund could take its pick of investors eager to climb aboard the private equity bandwagon have gone. Such enthusiasm has been replaced with a reservedness on the part of experienced as well as novice private equity investors that some would call frustrating reticence, others sensible caution.
Offering investors a guaranteed return is a bold move
This changed fund-raising environment has also meant that the fund documentation process has been effected, or as Marwan Al-Turki, partner and Chair of the European Financial Services Group at Baker & McKenzie in London puts it: ?We've seen a return to something approaching orthodoxy in fund terms?. Whereas GPs were able to extract particularly favourable terms from investors during those aforementioned heady days of two years ago, there has now been a return to what many LPs would regard as a more equitable arrangement. In particular, the two hardiest of the perennially negotiated clauses to a fund document ? the carried interest and management fees ? are no longer skewed, at least in the opinion of investors, towards the GP.
Carried interest and management fees
Carried interest, the split of the net profits between the GP and the LPs from realised investments made by a fund over its life, has by tradition been calculated using a ratio of 20:80 between GP and LP respectively. Carried interest structures can vary significantly though. One key question for instance is whether the LPs must receive their entire capital committed plus an appropriate return (typically eight per cent) back ? called the preferred return or hurdle ? before GPs get a look in. In the US it is far more common to see carried interest splits take place on a deal by deal basis ? something that has yet to gain much of a foothold in Europe. There's also the ?catch-up? mechanism that GPs are unsurprisingly keen to see documented, where they receive an increased percentage of the carried interest after the fund has covered the capital commitments and hurdle for the LPs. The most popolar catch up is for the 80:20 to be reversed to 20:80. This ensures that the GP receives his full 20 per cent allocation on the entire carried interest of the fund sooner rather than later.
Management fees are the charges the GP can allocate to the fund (as opposed to the General Partnership) not only upon set up but also during its life. The management fee percentage usually tapers after the investment phase of the fund (typically the first five years). These fees have become a bugbear for some LPs who feel that the typical percentage initially allocated to cover these of around 2 per cent of a fund's committed capital is excessive. Some LPs complain that the percentage has not been reduced sufficiently as fund size has increased, although a recent survey revealed that funds over $500m in size were on average charging 1.7 per cent as opposed to 2.3 per cent for sub-$500m funds.
Both LPs and GPs confirm though that the recent changes in the terms found in fund documentation do not signal a fundamental shift in the balance of power between the two negotiating sides. That said, cautious investors are taking longer to conclude these discussions and it also seems that General Partners are today more prepared to offer, let alone accept, terms that suit more Limited Partners more often. This can even, it seems, extend to guaranteeing a minimum return to a fund's LPs: it is alleged that a recent fund document agreed by one of the largest US buyout funds included a clause undertaking to deliver a return of at least 20 per cent on capital committed. As a UK GP fresh from his fund's first closing commented: ?That's a bold move ? or should I say suicidal??
?The lawyers don't fully understand what they've pasted in?
Such an undertaking is just one, albeit remarkable, instance of how the negotiating of fund terms and documentation must inevitably progress. Both sides are going to be working together for many years ? a fund's life may stretch to a decade and certainly its investment phase will last for up to five years ? so it is in everybody's interest to agree terms that both sides can live with. As another GP who also declined to be named and who has just closed a special situations fund said: ?If you manage to get away with a nifty bit of wording in the documentation it will only return to haunt you. If it bites, your investors get pissed off and you've landed yourself with some disgruntled LPs who will probably not touch your next fund ? or at least tear into the next set of terms with a vengeance.?
That same GP thinks that sensible fund terms are a key component to how GPs should be regarding their LPs: as shareholders. ?You need to give them clarity from day one: reporting methods and timing, the role of the advisory board, the measures taken if key partners at the firm leave, these are all in the fund documentation and should give investors all the comfort they need? he says.
Lessons from America
The growing experience and knowledge of all parties involved in the negotiations is driving the clarity and coherence of private equity fund documentation. And much of this is driven by the participation of US funds, advisers and investors. In the United States, private equity funds have learnt to produce extensive fund documents that address the situations they've had to work through in the past. Likewise, private equity investors in the US have learnt what to expect ? and what to stipulate in a fund's documentation. Perhaps the most extreme instance of this is CalPERS, the California state pension scheme, that delivers a many-paged set of guidelines to prospective private equity funds stipulating how the fund documentation should be presented and the terms therein.
In Europe, the fund structuring and documenting process is different. Some consider it a result of inexperience: Al-Turki at Baker and McKenzie remarks on the frequency that one set of documentation language used for one fund can resurface in another – and another law firm's – documents. ?And it often is clear, due to the complexity of the provisions, that the lawyers don't fully understand what they've pasted in. This is particularly evident in provisions dealing with allocation of investment proceeds among partners.? he adds.
Others suggest that the European approach to fund terms and documentation reflects a difference in mindset, arguing that US LPs are far more forensic in their approach and expect to have all eventualities covered in the fund document, whilst European investors are more interested in getting comfort on the key clauses. Whatever the reasons, many feel that fund documents originating in Europe have given far more discretionary power to the GPs, although US lawyers are predicting that a tightening of terms and language is inevitable. ?Bust-ups and melt-downs are all great learning experiences: get a few more LPs defaulting on their commitments for instance and we're bound to see tighter wording in the documents? says one. As more US investors participate in European funds and more US private equity funds distribute their fund documents to European investors the advisers involved in these negotiations predict that the language and terms to become more homogenous.
As private equity as an asset class becomes increasingly interesting to a broader range and larger number of investors, it is going to be vital that a fund's documentation can accommodate the needs and expectations of different types of investors – from the pension fund to the High Net Worth Individual (HNWI). At present many feel that the documents are so highly negotiated and hence distinctive, the possibility of producing a ?one size fits all? set of documents is unrealistic. Market conditions, though, as well as new laws, for instance those contained in the recently enacted Financial Services and Markets Act 2000 in the UK, make it easier and more tax-effective for HNWIs to invest in private equity and mean that a growing number of funds are keen to see fund documentation become more streamlined. ?If I can get all my LPs onside with the fund document without spending weeks and tens of thousands of dollars with the lawyers I'd be happy? says one US GP who has actively marketed funds to an international audience of investors, ?but at the moment we will still be spending $500,000 on legals for a big buy out fund and will still be negotiating for longer than planned.?
Stealth increases in the carried interest
The typical so-called ?carried? or ?promoted? interest in profits allocated to the GP is around 20 per cent, a number which has been blessed by common usage for many decades. Every now and then, a fund manager negotiates a performance bonus in terms of staged increases in the carry if the fund does particularly well. Nonetheless, the 20 per cent figure can reasonably be called the norm. Once that number is established, however, the question insiders go on to debate is ?20 per cent of what?? There are at least two ways of defining ?profits? for this purpose. The conventional way is net profits as of the end of each measuring period, no less often than annually, measured by conventional accounting standards. Thismeans income and gains realised by the partnership, minus partnership expenses, including the management fee. It should be noted that the management fee is a big item [typically two per cent] , particularly since it is ordinarily measured against committed capital. Thus, given that the typical partnership, during most of its existence, has 50 per cent or less of its committed capital actually at work in portfolio investments, the management fee, in fact, is closer to a 5 per cent annual charge against capital actually ?in the ground.?
To illustrate the results of the conventional carry system, if the partnership in a given year has net realised gains of $10m and the management fee is $1m, the GP's ?carried? or ?promoted? interest in that gain is, for the sake of simplicity, $1.8m – 20 per cent of $9m.
In recent years, however, the more popular funds and their counsel have tinkered with the definition of ?profits,? defining the same as meaning, and only meaning, gains and losses from the sale (or deemed sale in the case of an IPO) of harvested portfolio securities. Partnership expenses, including management fees, are not taken into account. Thus, in the simple example cited above, the GP would get an extra $200,000 – $2m versus $1.8m – allocated to its capital account. When you take a first look at the fund documents, it will appear that the carried interest is the old reliable 20 per cent. However, once you get into the definition of ?profits,? you realise that, at least measured against the historical regime, the carried interest has been jacked up to somewhere around 23 or 24 per cent, without anyone explicitly saying so in the term sheet or in the allocation sections of the partnership agreement.
Stealth adjustments to the management fee
Intense negotiations can ensue with respect to certain less obvious elements of the management fee calculation. First, one starts with the proposition that private equity funds are expensive to manage – more expensive, obviously, than managing a portfolio of public securities. The professionals must be paid salaries, there are always operational expenses (rent, heat, light, telephone, etc.); often quite extensive travel expenses as the partners go coast-tocoast or across oceans for board meetings and due diligence; consultants' fees (and this can be a big number if experts are needed for special due diligence); legal and accounting fees and so forth. Another large item expense, if it is part of the mix, is a fee to a placement agent who assists in the fund's initial capital raising process. The trick is to figure out whose pockets to invade in order to satisfy these charges.
The simplest part is the salaries and benefits to the GP's employees alongside rent, heat, light, telephone and other secretarial and office expenses. That number is, conventionally, covered by the management fee. Two categories of expense are, however, specially treated: the fees and expenses of a placement agent and organisational expenses. It has become relatively routine for representatives of the lead LP to reject responsibility for the payment of placement agent fees. All or a significant portion of a placement agent fee, according the LPs, should come out of the pockets of the members of the GP, on the theory that the placement agent is an agent of, and only of, the GP. The LPs should not be tagged with the responsibility for hiring an agent whose job is to contact the LPs and solicit their investment. And, if the GP must swallow the entire placement agent fee, the members either have to dig into their own pockets or to live on, say, half rations (i.e., to concede 50 per cent of the management fee to the placement agent) for the first two or three years of the partnership's existence. A subtle way, however, for the GP to get around that problem (or at least part of it) is to negotiate a generous cap on organisation expenses. Let us say that cap is $750,000 for a $100m venture capital fund. If the legal fee is, say, $250,000, fees to accountants relatively trivial and the travel and expense of the fund's sponsors, say, $50,000 to $100,000, that can leave as much as $400,000 to pay a placement agent. The fact is that, even though the agreement ostensibly says the LPs are not paying the placement agent, if the GP can fit all or a portion of the placement agent's fees under the organisational expense cap, then it is unusual for the LPs to deny the GP that privilege.
There is also the so-called management fee offset, which exposes another pocket for revenue and/or expense reimbursement: the portfolio companies themselves. With buyout funds particularly, and sometimes with venture capital funds too, the portfolio company will cough up fees for various activities, fees which, unless intercepted, will wind up in the pockets of the members of the GP. That said, directors' fees for serving on the board of portfolio companies, the cash element thereof anyway, is usually not paid to those directors who have been nominated by the VCs as it is all part of their job. But warrants are freely given to directors and, on occasion, to the directors who are representing the financial partners of the portfolio company. Those warrants can entail big individual payoffs of between $250,000 to $500,000 when the company goes public.
In the buyout universe, Kohlberg Kravis Roberts was famous for developing very significant fee income from its portfolio companies, for a variety of services. The question is where those fees belong. The management fee offset system suggests that, if the members of the GP are making money off the portfolio companies then those fees belong to the fund itself and not to the individuals. For tax reasons, fees cannot, or should not, be taken directly into fund revenues; however, it does appear that the tax issues go away if the amount of the fees are used to offset the management fee. This is an item which varies inversely with the desirability of the fund. If the fund is a ?trophy fund,? and therefore oversubscribed, there may be no offset against the management fee and members of the GP keep all the revenues from their portfolio. For a first-time fund though, the offset is usually 100 per cent.
Further, responsibility for partnership expenses, other than those explicitly covered by the management fee, is often a subject of intense debate amongst insiders, particularly so called ?dry hole? or ?broken deal? expenses. Dry hole expenses refer to the expenses the partnership incurs in doing due diligence on investments which are not ultimately made. If the investment is made, of course, the preliminary expenses (preparation of the term sheet, trips to the company's headquarters, due diligence, consultant fees) are usually capitalized and added to the cost of the investment. If the partnership goes well down the line and yet ultimately elects not to make the investment, nonetheless the preparatory expense can be a big number. And the issue is whether the GP is responsible, out of the management fee, or the expense can be charged directly to the partnership.
The GP typically argues that it should not be inhibited from doing full due diligence on each likely investment and then, at the last minute, if something comes up which makes the investment look questionable, feeling free to pass. Accordingly, the issue is often resolved by the partnership absorbing dry hole expenses if, and only if, the investment gets to the point that a term sheet is circulated. If the inquiry process entails only sifting through business plans back at the GP's headquarters, then those expenses come out of the management fee.
Joe Bartlett is a senior partner at Morrison & Foerster LLP in New York. He is also the Founder Chairman of the Board of VCExperts.com, the premier US website for entrepreneurs and professionals in the venture capital industry