The cost of restructuring a fund

This article is sponsored by WithumSmith+Brown.

Trending in a fund near you: Restructuring. As one of the most viable end-of-fund-term solutions today, more and more LPs are being presented with GP-led proposals in the quest for more liquidity by extending the potential upside of a portfolio. While fund restructuring is becoming widely accepted, it does not lend itself to a “one-size-fits-all” approach. Extending its life is not as simple as it sounds, particularly when it comes to fees and expenses.

With the steady rise in the number of funds now extending beyond their original lifecycle, market practices are still developing. In this year’s pfm Fees & Expenses Benchmarking Survey, respondents shed some interesting light into how they plan for and implement the restructuring process, which seems to be more of a “we’ll cross that bridge when we get to it” approach than a consideration at inception.

When properly conceived and implemented, and in the right situation, a restructuring can solve many end-of-term concerns or create a whole new set of problems. Here are some of the key findings from the survey in two of the most contested areas: fund extensions and co-investments.

Fund extensions

There was a clear split in the LPA stipulations for fees and expense arrangements for fund life beyond the extension periods. Almost half of the 90 respondents to the stipulation-related question indicated they planned to continue with the same or an amended extension period in the LPA, but that was outnumbered by the 51 percent who said they would negotiate the handling of fees and expenses at the time of the extension. While the former lays the groundwork for success, the latter “wait-and-see” approach can be dangerous. When the fund reaches the end of its term and still holds a significant portfolio, opinions among all interested parties will no doubt vary regarding management. While this practice was not assessed in the 2016 survey, it is safe to say that a lack of vision early in the process could yield negative outcomes – from a failed transaction and significant expenses to angry investors and regulatory scrutiny – if fee and expense arrangements are left open for negotiation at the time of the extension.

Fund restructuring

The survey also asked about LPA stipulations for costs relating to potential fund restructurings. Once again, a majority – 52.75 percent or 48 of the 91 respondents to this question – indicated “no,” this would be decided at the time of restructuring and submitted to LPs for approval with the rest of the terms. Even more interesting, almost one-third of the respondents stated they have not indicated whether these costs would be handled by the management firm, the fund, split between the two or decided at the time of restructuring. In essence, the plan is no plan at all. Once again, while we lack comparative survey data from 2016, those funds without clear-cut stipulations are living dangerously, given the mounting velocity for restructurings.

The rise of co-investments

About three years ago, this practice gained tremendous traction and has not demonstrated any signs of slowing down. With almost 87 percent of the respondents replying affirmatively to co-investments, it is expected that these transactions will continue to grow in popularity among both private equity investors and private equity fund sponsors. Not only will this trend continue, it will most certainly accelerate in the foreseeable future.

Structural issues

Of 81 respondents who answered the question of how they structure their co-investments, more than half (55.56 percent) indicated they structure them as separate entities 100 percent of the time, which falls slightly below the 2016 survey results (58.82 percent). While those saying they did this 80 percent of the time recorded a bump from 7.35 percent in 2016 to 9.88 percent in 2018, the “50 percent” and “less than 50 percent” categories dipped from 8.82 percent  and 25 percent two years ago to 7.41 percent and 17.28 percent today, respectively. So what does all this mean for future trends? One cannot overlook a common theme mentioned by the 10 percent that answered “other”: direct investments.

Contentious charges

Broken deal expenses are a hot, contentious topic for co-investments. There was a straight divide here between the 40 percent that answered co-investors had responsibility “if the co-investment entity has been formed” and “No, the broken deal expense is a fund expense.” Despite this “standoff,” the numbers also indicate an abandonment of two previously held overriding philosophies: co-investors are responsible because it is part of their interest in co-investing and they are not responsible because each co-investment deal that closes is charged a fee. The former is down 13.14 percent from 2016 while the latter declined by 3.62 percent. Since restructurings are a firm management tool for the GP, it is critical to establish the parameters for these expenses, including those related to broken deals.

Downward trend

There’s an undeniable reduction in the levying of management fees for co-investment vehicles. The following responses all declined between 2016 and 2018:

• The respondents charging a fee that is equal to the management fee that is paid by the fund fell 4.56 percent.
• The respondents charging a management fee which is less than the management fee that is paid by the fund declined 6.97 percent.
• There were 7.21 percent fewer respondents charging carried interest equal to the carry payable by the fund

In contrast, there was a 17.55 percent surge in organizational and/or set-up fees and a 6.61 percent bump in charging carried interest which is less than the carry payable by the fund. One important note: 93 respondents skipped this survey question – prompting analysts like myself to wonder why and what this could mean.

Creative thinking to the fore

For fund restructurings, creativity, consideration and careful analysis are essential elements. These form the foundation for optimal results as this practice becomes even more entrenched in private equity.

Industry-wide, fund restructurings are being driven by these key factors:

• Soon-to-be 10-year-old funds with portfolios valued at billions of dollars
• Sophisticated secondary investors with abundant capital
• Fundraising challenges among some sponsors
• In 2018, it is more the rule rather than the exception for fees and expenses and costs of restructuring to be negotiated when the event occurs. As post-recession funds come to their end of life, perhaps we will see a new wave of stipulations incorporated into LPAs to address these very conditions.

Not all end-of-term funds are suited for restructuring. And not all end-of-term funds signal the end of a fund’s life. When properly conceived, planned and implemented, restructurings offer a more favorable solution than the once traditional routes.