LP Intel – December 2018

Private Equity Fund Terms – 2018’s Key Takeaways

MJ Hudson recently published its latest annual survey of private fund terms. We examined a large, diverse sample of closed-ended funds in the private equity, infrastructure, real estate, venture and private debt sectors, where we have advised either the fund manager or a prospective investor.  Here are six key takeaways for LPs:

1. Fee rates are falling

The traditional annual management fee of 2% of committed capital remains the most common fee level  – charged by around two-fifths of the sampled funds.  But those funds accounted for just 8% of the capital raised by the funds in our survey, compared to 62% in our 2017 funds survey.

By contrast, funds charging a 1.5% management fee scooped 59% of commitments. This suggests that large-cap funds are taking advantage of scale to reduce their fees, typically to around 1.5%. For mega-funds, in particular, the sheer magnitude of the capital commitments flowing in allows their sponsors to maintain (or even increase) aggregate fee income, even while cutting the headline percentage.

Nearly 12% of the sampled funds charged fees in excess of 2%, but they raised only about 3% of commitments.  Most of the funds in this bracket were venture capital funds, but their investment strategy is unlikely to have on its own determined the level of fees, if only because they were also, invariably, small- or mid-cap funds, which, because of their smaller capital base, have less scope to cut the headline fee rate.

2. Special deals are proliferating

Almost a quarter of the funds in our survey have systematic fee discounts written into their LPA.  The rise in the popularity of discounting has been nothing short of dramatic – by comparison, fewer than 5% of the funds in last year’s survey offered systematic discounts.

Discounts are typically linked to objective metrics.  The most popular metric is the size of an investor’s commitment, which is used by 54% of the funds in our latest survey, either as a criterion on its own or else in combination with the investor being an “early bird” (i.e., joining the fund at its first closing).

The LPA is not the only forum in which GPs and LPs can agree discounts.  Some large investors negotiate discounts with the GP on an individual basis, which typically end up in investor side letters.  Depending on how comprehensive the fund’s MFN obligation is, these individual discounts may remain undisclosed or, if disclosed, will seldom have to be extended to the investor base as a whole.

Only 54% of the funds in our 2018 survey even have an MFN clause in their LPAs.  That doesn’t mean that the remaining 46% are MFN-free, since many investors in those funds will negotiate MFN rights in their side letters, but it highlights the rising prominence of investor-specific terms in the funds industry, which in turn makes it more difficult for LPs to amass the necessary information to usefully compare funds.

Of those funds in our sample which had an MFN in their LPAs, 30% are “tiered”, i.e., the ability to request the benefit of another investor’s side letter conditional on the requesting investor committing at least the same amount of capital as the other investor.

3. The hurdle is intact

Despite a decade of low interest rates and a couple of big name managers eliminating the hurdle from their waterfalls, most funds still choose to include one, and it is usually at the traditional 8% level.  75% of the capital raised in our latest survey was committed to funds with an 8% hurdle.  This is down on the 93% recorded in last year’s survey, but up on 66% in the 2016 survey.

It’s still rare to encounter funds without a hurdle.  Only 4% of capital was committed to funds with no hurdle (compared to 7% in last year’s survey).  Rather than dispense with the hurdle altogether, a small but growing number of funds are pitching sub-8% hurdles – they attracted around a fifth of committed capital in this year’s survey.

4. Carried interest is evolving, albeit slowly

There is a trend to experiment with more innovative carry structures.  For example, 17% of sampled funds employed ratchets, which benchmark the carry percentage to aggregate investor returns.  Another model, floated by a small number of prominent PE firms on both sides of the Atlantic, is to let investors select from a menu of fee and carried interest mixes, with higher carry percentages offset by lower management fees.  That said, the market standard of an 80/20 split of profits (after returning investors’ capital) remains intact for now.

Historically, UK/European-based funds tend to use (LP-friendly) whole-fund carry, while U.S.-based funds favour (GP-friendly) deal-by-deal carry.  The competitive balance between the two forms of carry has yo-yoed in recent years, although the data from our latest survey indicates that funds in the two main markets are conforming to type: 80% of UK/European-domiciled funds opted for whole-fund carry, compared to only 36% of U.S.-domiciled funds.

5. GP commitment levels are strong, but read the small print

MJ Hudson’s market surveys over the last three years show that the average GP commitment, as a share of total fund commitments, now tends to surpass the traditional 1% benchmark, often by quite a degree.

In our latest survey, one-third of funds have a GP commitment in the 2-3% range, and a further 35% have GP commitments of 3% or more (and, in about half of these funds, it was at least 5%).  Only a quarter of the funds surveyed had GP commitments below 1.5% (about half of whom were sub-1%).

In principle, the higher the GP commitment percentage, the more closely aligned the GP should be with its investors’ interests.  But LPs should always beware of the detail.  Certain other features are important to making sure that the alignment is genuinely reinforced.  From an LP perspective, the GP commitment should be (1) subscribed in cash, rather than by way of management fee waivers, (2) invested in all of the fund’s investments, rather than on a discretionary or selective basis, and (3) predominantly subscribed by the GP’s key executives, preferably funded out of personal assets.

6. Offsets are ubiquitous, but, again, read the small print

The object of a fee offset is to limit the aggregate fee load in a fund, by deducting transaction, monitoring, break-up and other fees (which the GP and management team earn from the fund’s portfolio companies) from management fees.  The idea is that management shouldn’t “double dip” on fees at different levels.

A stonking 92% of funds in our survey have an offset, 98% of whom set the offset percentage at an LP-friendly 100%. But, as with most fund terms, the detail is important.  Even with an ostensible 100% offset, there will be some fee leakage if it is not drafted to be all-encompassing.

Offsets often do not cover the remuneration of GP team members serving as directors of portfolio companies, or fees charged by specialist consultants who work with the GP on some or all of the fund’s investments.  A few managers have developed close relationships with consulting firms, which become (and may even be advertised to prospective investors as) essential to the manager’s value creation effort.  In that case, LPs may reasonably query whether these consulting fees should be met by the GP out of its own management fees.

Our LP Unit, via a team of highly experienced lawyers, focuses on LPs’ interests in relation to co-investments, primaries and secondaries. Few law firms offer a one-stop solution for LPs’ needs
across the primary, co-investment and secondary sectors, with a sufficient depth of legal and market experience to devote across all such sectors. MJ Hudson is different. Our LP Unit works to
enhance GP / LP alignment on every primary and co-investment opportunity reviewed and negotiated, as well as acting for buyers and sellers on direct and indirect secondary transactions and for investors on fund restructurings.