Improved GP/LP alignment through stronger fund governance

The last year has seen unprecedented investor interest in private equity since the global financial crisis, with record fundraising levels and many LPs signalling their intention to increase allocations to private equity.

However, the number of funds that closed in 2016 decreased when compared with previous years – LPs appear to be investing more capital with a smaller number of proven and well-known GPs, with the largest funds accounting for a greater proportion of overall fundraising.

What impact has this had on fund terms since the previous edition of this report, published in April 2016? Does this mean more GP-friendly terms, with LPs willing to accept weaker protections in order to gain access to these funds?

The data does show lower GP commitments and increased management fees (see Section 3). But, as always, there is a balance to be met - outside of economic provisions, Sections 4 and 5 show many GPs are committed to offering other ways to meaningfully align GP/LP interests through fund governance.

Pro-GP movements in core economic terms?

GP Commitments: counterintuitively, LP pressure on GP commitment has softened

  • majority of GPs making 1.5-1.99% commitment c.f. 2016 report data which showed majority of GPs making commitments in 2-2.99% range
  • 2017 data suggests that GP commitment is becoming less prominent than other factors in investors' GP evaluation process

Management Fee: 2% dominates

  • number of funds charging 2% has increased c.f. 2016 report data, being the dominant fee level by both number of funds and capital (with 62% of capital in 2017 sample attracting 2%)
  • 2% dominates small cap funds (<$500m) to large cap funds ($1.5bn-$4.5bn)

Catch-up: 100% is back ... and it's fast

  • 100% catch-up near ubiquitous, with the vast majority of funds reporting it as fast to the GP

But...

Distribution Waterfall: Whole-of-Fund carry dominates Europe and making inroads in North America:

  • European Funds: 88% of sampled European funds offer whole-of-fund carry
  • North American Funds: 36% of North American funds offering whole-of-fund carry c.f. 2016 data which showed only 20% of North American funds offering whole-of-fund carry

Hurdle Rate: 8% rate still presides

  • even though low interest rates have persisted for a number of years, 8% hurdle rate continues to be iron-clad in the private equity market
  • 93% of sampled funds report a 8% hurdle rate

And (albeit with some caution)...

Deal-by-Deal Enhancement: interim clawback features

in 71% of deal-by-deal funds. However:

  • mainly based on pro-GP FMV test and only a minority of interim clawbacks have multiple test dates
  • emphasis still on getting carried interest out to the GP (and, ultimately, to the fund executives):
    • in our sample, no deal-by-deal fund with an interim clawback offers carry escrow protection, with 80% of such funds offering guarantees as an alternative to escrow restrictions on carry distributions to the GP
    • this raises questions as to the credit worthiness and enforceability of such guarantees

Innovations in Carried Interest.

20% share of a fund's profits arguably remains the general market norm for carried interest. However, our data shows some GPs offering alternatives to the traditional "20%" carry model. At Section 3, we detail some of those variations.

These alternative carry structures suggest that carried interest, properly designed, is a formidable tool to align incentives between the GP and its LPs. Reforms to the taxation of carried interest that are expected on both sides of the Atlantic this year may lead to yet more disruption of the old certainties of "two and 20" model, traditionally an integral part of a private equity fund manager's compensation arrangement.

Stronger fund governance.

When combined with an understanding of why LPs appear willing to tolerate certain pro-GP economic movements, the continued overall gains in fund governance paint an encouraging picture of improved GP/LP alignment.

Compared to the 2016 report findings, there is a strengthening in fundamental investor protections such as key person event, GP cause removal and no-cause removal clauses and MFN disclosure. This edition also reports on the prevalence of management fee offsets and restrictions on raising successor funds, these also being important investor protections.

  • Key Person Event: incremental improvement in key person protections:
    • 87% of funds (up from 86% in 2016 data) report automatic suspension of investment period
    • 81% of funds (up from 80% in 2016 data) report automatic termination of investment period
  • GP No-Fault Removal: 68% of funds (up from 55% in 2016 data) have a no-fault removal right
  • GP Fault Removal: 96% of funds (up from 85% in 2016 data) have a removal for cause right
  • MFN Disclosure: 61% of funds (57% in 2016 data) report an MFN clause
  • Management Fee Offset: 93% of funds reduce the management fee by transaction fees received by the GP and its affiliates
  • Successor Funds: 93% of funds restrict the GP's ability to raise a successor fund during the investment period

MJ Hudson's Fund Terms Research 2017 can be downloaded at https://www.mjhudson.com/wp-content/uploads/2017/05/MJ-Hudson-PE-Fund-Terms-2017.pdf

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.