A meaningful commitment

How much skin should GPs have in the game? For today's LPs, it's more about the relative significance than the absolute percentage.

While speaking with LPs for a special report on investor relations (see our June edition) we discovered something interesting: more and more LPs are focusing on the GP commitment during discussions about alignment of interests. That makes sense; but it's worthy of note because other variables like fees and carry have tended to dominate these discussions in the past.

One aspect of this is that the industry standard one or two percent GP commitment isn’t quite so standard anymore. Why? For starters, funds of different size, scope and strategy (not to mention popularity) tend to have different economics on fees and GP co-investments. Recent research by PEI and law firm Schulte Roth & Zabel backs this up: when LPs were asked what size contribution firms should make to their own funds ('1 percent or less'; '1 percent to 2.5 percent'; '2.5 percent to 5 percent'; 'greater than 5 percent'; or 'dollar amount is more important than percentage'), the vote was pretty much evenly split across the board.

But the other part of the story is that investors are increasingly asking for some context around the level of commitment provided. For instance, LPs are aware that some GPs are undergoing (or are on the verge of) a generational shift, meaning today’s junior partners may be the big decision-makers for the next fund. LPs recognize that these junior partners may not have the historic carry to be able to fund a particular co-investment percentage, meaning a commitment of less than one percent isn’t necessarily a deal-breaker during fundraising. Fund formation lawyers tell us they’ve seen this same logic play out with first-time teams looking to make a name for themselves.

In other words, the GP commitment is seen as one variable in achieving a certain level of interest alignment, regardless of market standards.

That's not to say the GP commitment is only heading downwards, however. Take a firm that’s done well for itself over the course of a few funds. LPs may like the fact the GP's partners are willing to pump a lot of their own cash into the next fund (and really, why wouldn’t a GP on a roll do this?). But the question then becomes: 'Is that percentage actually meaningful to the deal partners involved?' Nobody wants a GP who’s grown rich and fat (metaphorically speaking) to lose their hunger for successful dealmaking.

All of this syncs with the wider trend of more extensive LP due diligence. GPs must be prepared to have a detailed discussion about how the GP commitment was determined, and whether it really does align interests in a way that satisfies investors’ expectations.

Another important aspect of this is talking about where the money is coming from. According to market sources, LPs definitely don't want to see GPs relying on management fee waivers to fund their contribution; they want GPs to be putting up their own cash. Sometimes the GP will arrange a loan program with a bank, so the more junior partners can borrow the cash; LPs tend to be happier with this arrangement since if the money is coming from a bank, it's non-recourse to the fund and the junior partner is still on the hook.

In short: GPs need to be prepared to explain exactly why and how they are committing the amount they're committing – and be ready for some pushback if the LP doesn’t like the answer.