A calculated change?

Economic terms for private equity investments are evolving, but are today’s agreements the new norm?

Private equity investments may be alternative, but in the past their terms and conditions were fairly standard. As the asset class grew, and investors and fund managers alike became more sophisticated, fee structures and costs began to shift.

Low interest rates and a wider economic malaise have also played a part in the evolution, and the typical limited partner agreement today now looks fairly different to those signed 10 years ago.

US fund managers have been changing their carry terms. Just over one-third of funds in a sample taken by law firm MJ Hudson have adopted the European whole-of-fund approach in the past 12 months, up from 20 percent the previous year. In Europe, the majority of funds continue to offer whole of fund carry.

The transition to the European model is expected to continue as a result of investor pressure, a number of fund formation lawyers told pfm. The Institutional Limited Partner Association also supports the transition and is likely to continue pressing the matter with its members.

Hurdle rates

There has been a small move toward lower hurdle rates, but law sources are divided over the origins of the trend. One says it was a US phenomenon transitioning to Europe, while others say it is a more general shift. “We are seeing some changes in hurdle rates generally. However, the rates are relatively consistent between the US and Europe,” Edward Lee, senior associate at Proskauer, says.

Large fund managers with strong track records are predicted to continue to employ low hurdles, but for the majority the traditional 8 percent is likely to remain in place, law sources agree.

Management fees
The average management fee has risen, with the number of funds charging 2 percent increasing over the past year, and a 1.5 percent fee applying to fewer funds, the MJ Hudson data show. But the increased incidence of management fee discounts and side letters mean it is difficult to gauge a fund’s true level of fees, the firm says.

“Investors are becoming more attuned at negotiating their fees and are focusing more on the details rather than just the headline percentage rate,” one lawyer tells pfm.
Higher management fees will remain acceptable to investors for as long as interest rates remain low and the asset class continues to outperform the public markets, law sources agree. But regulatory scrutiny and more savvy investors are likely to dampen any further hikes.

“Regulators in the US and Europe are keeping an eye on fees, managers have to ensure transparency,” the lawyer says.

Co-investment fees
Fees charged on co-investments vary, but are generally half those paid on a regular private equity fund commitment – between 0 and 1 percent compared with 2 percent – MJ Hudson’s research found. These lower fees have continued to fuel investor appetite for co-investments.

One fund lawyer says GPs have become a victim of their own success in terms of co-investments and forecasts an end to zero fee era. “GPs want to make money from these opportunities, there’s going to be upward pressure on fees within three years,” he says.
Many factors influence the terms and conditions attached to a private equity investment. The agreements made today reflect current economic conditions, the relative performance of the asset class and the strength of the relationship between fund managers and their investors. These are likely to evolve, meaning future terms and conditions will do, too.