Every year MJ Hudson evaluates the terms of a large, diverse and representative sample of newly-closed private equity funds where we advised either the fund manager or prospective investors. (You can find our 2017 Private Equity Fund Terms Research report here.) In this article we explain what’s changed since last year and where fund terms are headed.
Our research indicates that investor pressure on private equity fees is ebbing in the face of booming fundraising.
The headline fee rates don’t necessarily tell the full story. GPs are often willing to lower fees for particular LPs, on an individual basis and in groups defined by some special characteristic, for instance if the investor makes a big commitment, backs the fund at first closing, or re-ups from the GP’s predecessor fund. Fee discounts can be implemented in the LPA on a fund-wide basis, or they may be negotiated with investors individually by side letter. Depending on how loose the MFN obligation is, these side deals may remain undisclosed or, if disclosed, may not be made available to the investor base as a whole. The persistence of these practices makes it difficult to gauge a fund’s true fee level.
Getting the management team to make a substantial capital commitment to the fund has long been seen as the epitome of GP/LP alignment – “skin in the game”, as it’s known. In our 2016 survey, the majority of GPs invested between 2% and 3% of a fund’s total commitments. But in 2017 this dropped to between 1.5% and 2%. We also saw the emergence of something new: a small minority of GPs making zero or sub-1% commitments. It’s not all bad news for alignment. The number of GPs committing 3%-plus in 2017 remained stable when compared to 2016, whereas the number of GPs committing 5% or more doubled in 2017.
As part of their due diligence, LPs should confirm:
Even though low interest rates have persisted for nearly a decade, the long-established 8% hurdle rate continues to be iron-clad in the private equity market. Measured by capital raised, 93% of the funds we sampled reported a hurdle rate of 8%, whereas just 7% reported a sub-8% hurdle (which, in this year’s sample, was always 0%).
Our 2017 findings are nearly identical to our 2015 survey and also show a ‘market correction’ from what we found in 2016, when only two-thirds of the sampled funds sported a hurdle of 8%, although it’s true that the 2016 figures were skewed by two mega funds (accounting for $25bn in capital) famously dropping the hurdle altogether.
Back in 2016 we saw a substantial minority of funds shifting to a ‘slower’ catch-up, typically at 50%. A few funds went even further by dropping catch-up in favour of a lower, ‘hard’ hurdle rate. However, 100% catch-up has come roaring back in 2017, with 93% of sampled funds (measured by capital raised) providing for 100% catch-up. 88% of those are ‘fast’ to the GP (i.e. they distribute all post-hurdle distributions to the GP until the GP has fully caught up). The remaining 12% of funds with ‘slow’ catch-up tended to be funds with non-standard tiered distribution waterfalls.
Historically, European funds favour (LP-friendly) whole-fund carry, while American funds prefer (GP-friendly) deal-by-deal carry.
Back in 2015 we found that whole-fund carry was making inroads into the US market, yet in our 2016 sample the use of deal-by-deal surged on both sides of the Atlantic. However, the 2016 surge now looks like an anomaly. In our 2017 batch, 88% of European funds adopted whole-fund carry, a big jump from the 67% we recorded in 2016. And although deal-by-deal carry still topped the survey in America, whole-fund carry accounted for a healthy 36% of American funds in 2017, up from 20% a year before.
The deal-by-deal model is gradually evolving with enhanced LP protection. For instance, in the 2017 sample, we found that interim clawbacks feature in 71% of deal-by-deal funds. However, these interim clawbacks are mainly based on fair market value tests which leave a lot of discretion in the GP’s hands. Moreover, only a minority of interim clawbacks have multiple test dates. In our sample, no deal-by-deal fund with an interim clawback offered escrow protection, although 80% of such funds did offer personal guarantees.
Most investors recognize the need to improve the baseline of information provided by management and strengthen fee and expense monitoring. To this end, ILPA and others have been leading on the creation of uniform, standardised reporting for LPs. But because every GP and fund is different, and every LP has its own unique set of preferences, comprehensive standardisation is yet to arrive.
Transparency also suffers from the growth of LP-specific side letters that vary fund-level arrangements. Although 61% of funds report an MFN clause (up from 57% in our 2016 data), there is a growing trend to insert ‘tiers’ into not just the MFN but disclosure itself – i.e. the right to see an LP’s side letter is restricted to those LPs who have subscribed at least the same commitment.
A large majority of funds permit investors to vote the GP off the island – in our 2017 batch, 96% of funds provide for cause removal (up from 85% in 2016), while 68% allow removal without cause (up from 55% in 2016).
The increase implies that LPs are becoming more assertive. But, diving into the detailed terms, we find that the effectiveness of removal rights is often blunted by a variety of GP-friendly conditions, including:
In the last year we have seen core economics shift in GPs’ favour, with lower GP commitments, increased management fees and improved catch-ups. We think that investors’ tolerance of these trends is down to:
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