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Bargaining 2.0

PE Manager revisits some of the year's best guest articles: In August Julian Ashworth of law firm Walkers provided an overview of concerns GPs and their investors are discussing at the negotiating table.

Prominent investors are less willing to accept industry-standard terms for funds which are of differing size and with varying levels of performance. Instead they are far more focused on ensuring that a fund's overall terms and conditions appropriately align the GP's interests with those of investors. Similarly, GPs have been prepared to consider and negotiate with prospective LPs where there is significant capital to invest.

…waterfall mechanics, GP clawbacks and advisory committee powers remain key areas of contention because they are seen as inflexible and even impractical in certain circumstances

Julain Ashworth

This general approach has complemented a perception that the pendulum of negotiating power has swung in favour of investors. It has also coincided with the adoption of the Institutional Limited Partners Association's (ILPA) revised investment guidelines which were released in January 2011.

The guiding principles of alignment of interest, governance and transparency, contained within the ILPA’s guidelines have been broadly endorsed by industry participants.  Several of the specifics, however, such as waterfall mechanics, GP clawbacks and advisory committee powers remain key areas of contention because they are seen as inflexible and even impractical in certain circumstances.

From our perspective in the Cayman Islands, where we have recognised a steady increase in fund formation activity from the leading names in the industry, the negotiation process is much more nuanced. The final specific terms of a fund are ultimately being shaped by the outcome of negotiations between investors and GPs.  As a result, the ILPA guidelines appear to be evolving into a platform for GP-investor negotiations rather than operating as a checklist for the industry.

Investors are particularly focused on due diligence at the commitment phase.  As part of the due diligence process, we are seeing investors are keen to understand, in particular, what the manager's projected budget is and how management fees are to be deployed. This exercise is undertaken with a view to minimising concerns that the manager will be inappropriately incentivised by an excessive management fee as opposed to maximising a fund's portfolio returns.

In our experience, investors have been able to gain certain concessions on transaction and monitoring fees or, to a lesser extent, on the manner in which carry is paid or clawed back and co-investment opportunities. In many instances, GPs are looking to close on smaller and more targeted fund sizes and it is difficult to move on the management fee as certain amounts are necessary in order to operate the running of the fund and to basically keep the lights on.

Investors are also focused on what succession plans are in place as well as a manager's deal flow capability and projected investment pace.  These matters may ultimately have a bearing on a fund's key man, investment strategies and period and term provisions.

These trends, and market conditions, also seem to chime with the fund formation patterns we are seeing where there is a preference towards more specialist funds, with less exposure to global macro events and with a greater emphasis on product and geography. There has been demand for funds investing in infrastructure and agriculture in Brazil and real estate, bio-pharma and life sciences in China. In traditional markets we have seen growing interest in mezzanine finance funds, commodity based investments and venture capital funds in bio sciences and life sciences. Energy and natural resources have also gained momentum in Canada.

In some respects, some of the trends which are emerging simply reflect the evolution of this industry.  A key part of the due diligence process at the commitment phase appears to be to develop appropriate working relationships between GPs and investors and to ensure there is mutual expectation as between an alignment of interests, governance, and transparency. Ultimately, however, investment decisions seem to be determined by the entire package on offer as opposed to any single or specific term which a GP may offer.

Julian Ashworth is a partner in Walkers’ Global Investment Funds Group and is based in the Cayman Islands office.