Contributed by Gaurav Marwah and Hugh Stacey of Augentius
The new rules of the game
Sustained high performance means continued evolution and change. Technology became ever more accessible in the 1990s when personal computers began appearing in every home. But if you’re a tech-savvy person today, you’re not using a dial-up connection on a desktop computer. Everyone knows you can’t be successful today using the technology of 20 years ago.
Similarly, private equity players can no longer use the ‘90s’ rulebook to structure funds. The world is more complex than it was and even the largest funds can be caught off-guard by regulators. LPs and GPs need to keep a few things in mind to navigate these nuances smoothly.
Don’t be put off by offsets
It’s important for LPs to pay attention to how fees and expenses are calculated and charged. In recent years, several large private equity firms have been challenged by regulators over a lack of discipline, accuracy or disclosure in allocating amounts and communicating the scale of such transactions to LPs.
It is not uncommon to see a 100 per cent offset of fee income generated by GPs or affiliates from the portfolio. Typically offsets are made for transaction fees, monitoring, director fees, underwriting fees and other fees such as abort/broken deal/breakup fees and advisory fees. Items such as excess organisational expenses and placement fees are also generally covered by the manager.
As for management fees, while two per cent is a historic norm, we’re seeing a lot more variation on the commercial terms today. The standard “two and twenty” is coming under challenge, particularly in larger funds where it would make for a high absolute level of charges. Indeed this very traditional fee structure may become the almost exclusive territory of only the largest brand-name-firms who continually post stellar returns.
In an effort to make the fee-carry structure reflect current sensitivities, LPs are securing more rebates through side letters. Such personal terms can be given to preferred LPs that commit capital at a fund’s first close or to those that invest significant commitments. LPs and some regulators now demand greater transparency and disclosure of key side letter terms offered across the investor base – whether on fees, co-investment opportunities or other commercial points.
Another notable variation is the way management fees are charged. Some funds charge in a more granular way, with fees based on the mix of what has been drawn and what has not been drawn yet, charging a different percentage for capital drawn vs. not. And don’t forget about the post-investment period, when fees are generally lower – and subsequently tail off.
It stands to reason…
Investors don’t want to see GPs earning the bulk of their compensation from management fees alone. The ILPA recommends reviews to ensure fees are reasonable and align GP and LP interests. GPs should be incentivised to outperform by their carry by their own ‘skin in the game’ rather than by their core annual fees. LPs want to ensure that funds have sensible operational cost coverage and are able to make reasonable profits to withstand the economic cycle. GPs should expect budgets to be scrutinised.
LPs will also expect to look at the fee and carry structure of the firm’s previous funds as well. Did the last fund hit its expected targets? If not, why wouldn’t there be some kind of inducement in the new fund to make it more attractive to investors? Were there issues with other LPs? Very often LPs exercise right of first refusal to invest in a follow-on fund. If there are an unusually large number of openings for new LP relationships with a PE fund on the fundraising circuit, questions will also be asked about why previous LPs aren’t coming back.
Don’t get in over your overhead
General administrative and operating expenses aren’t usually significant over the life of the fund but there are several things to note. One is that there should be a reasonable cap on expenses. Keep track of such caps and track if, when, and how a fund has exceeded what was agreed. Another is that where there is any kind of multi-fund structure, expenses should be drawn only from the specific vehicle where applicable, and drawn equitably from all vehicles in a group only when it’s a general or common expense.
Keeping these things clear from the beginning of the GP/LP relationship can avoid awkward discoveries later. It’s important that both sides of the private equity fund equation work to stay current on the fee and carry practices that are becoming standard.
The fund terrain has become more difficult to navigate with more complex investment, fees, and compensation packages that seek to be equitable and fair, but can easily be confusing. With increasing complexity comes opportunity for private equity players to embrace change and modernise their approach. There’s no better time to start than today.
Gaurav Marwah is Technical Director and Hugh Stacey is Executive Director for Augentius.