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What is the level of negotiations between LPs and GPs in the current economic and private equity environment?
Simcha David: In terms of negotiation, the limited partners have the upper hand in some ways when LPs and general partners are courting each other during the extended due diligence process and before they even come into the fund, in part with the help of Institutional Limited Partners Association coming up with due diligence checklists. In the past, GPs may have just not wanted to answer some of these questions, but with the amount of money coming into private equity and the proliferation of private equity funds in the last decade, GPs are willing to do more in terms of courting LPs.
The LPs have also become much more sophisticated in terms of the type of diligence they request of funds. A lot of time, it’s almost like a checklist of questions. Question with regard to tax structuring are now a normal part of the diligence process. I think it’s because LPs feel they have this power as the allocators even though there’s been an increase in the allocation to private equity. They are increasingly doing more sophisticated due diligence when they come in.
Gautham Deshpande: It almost feels like there are two segments of the market. Large managers who have stellar track records are in the driver’s seat and they are in a position to negotiate better terms with the LPs or provide reduced allocation than what was originally requested. Then there’s the other side, which also represents a significant portion of the PE market. These are managers who are still developing their track records, but maybe not as stellar as [those in] the first segment. With these managers, obviously some of the LPs are driving the conversation.
How do you ensure alignment between GPs and LPs?
GD: The alignment is being created through strategic partnerships. GPs are raising their largest funds to date. You now see fund managers coming back to market almost every couple of years to raise a new fund. In these situations, managers have the investors more on their side already and don’t have to do a lot of selling for them to agree to commit to a new vehicle. On the other hand LPs are willing to provide the strategic support in return for better alpha, co-investment opportunities and better terms. The amount of time and costs LPs spend on due diligence on an existing GP relationship is significantly lesser than on a new relationship. From that perspective, strategic partnerships are really helping out. In these cases, LPs and GPs are not sitting on opposite sides of the table but are really co-operating with each other.
How has the increase in co-investments impacted LPA negotiations?
GD: Negotiations around co-investments have been driven by transparency and there is a lot of disclosure that you see in legal documents today that you probably couldn’t see 10 years ago. ILPA and the regulators have set a high bar as far as transparency is concerned. Today GPs feel that it’s in their best interest to disclose significant matters, including conflicts of interest. You see a lot of disclosure in the limited partnership agreement about allocation of fees and expenses between the Funds and the co-investors. It has significantly enhanced that part of the LPA and the private placement memorandum stack. On the other hand, side letters are the flavor of the season. Strategic and large institutional investors that come in have a side letter because investors do want transparency. Some of the side letters have requests for reporting, which is much more in depth.
How have discussions around key terms in the LPA evolved?
SD: From a tax perspective, in the management fee realm, with investors becoming more sophisticated, you at times find negotiations around the management fee. The limited partners might insist on having a mechanism in place such as a management fee waiver. Management fees in private equity funds are non-deductible expenses and this affects individual investors. For the last three to five years, it has become a little more prevalent to have a management fee waiver, where management waives the actual fee and instead takes a deemed contribution into the fund from the limited partners. From a tax perspective, you have to do them right because if they’re too aggressive, the Internal Revenue Service is not going to look at them as a fee waiver. We’ve seen that evolving.
In addition, you tend not to see pure American-style waterfalls any more – a deal-by-deal kind of waterfall without clawback.
That’s gone since the last financial crisis. Most are European waterfalls and even if you do deal-by-deal, you do have some sort of clawback at the end if the last deal goes sour.
GD: Due to the changes in tax regulation, we do see general partners becoming very innovative when it comes to charging fees and performance carry. I’m seeing increased use of the performance benchmarks. For instance, if a fund exceeds a performance benchmark, the carried interest can go up, which could compensate for reduced management fees. Management fees also go down after the initial investment period. Also, as a result of the last financial crisis, management fees after the initial investment period are benchmarked to net capital invested, which is capital invested minus capital returned.
How has the evolving secondaries market, especially GP-led transactions, impacted LPA negotiations and drafting?
GD: We’re seeing a lot of transparency around the process used for GP-led restructurings, including specific mandates to the limited partner advisory committees on what they need to do when a fund is in a situation where they have to create a vehicle outside of the fund, or special purpose vehicles, where the assets that need restructured at the end of the fund life cycle are transferred to. We are seeing a lot of disclosure in the LPA around what transparency the LPAC has. I’m also seeing GPs having a very broad mandate in how they can deal with these assets that are left at the end of the fund’s life cycle. The goal is to provide a process for LPs to evaluate these issues when they come up at the end of the fund’s cycle and empower the LPAC to act on behalf of investors’ interests.
Simcha David is a tax partner and member of the financial services group at EisnerAmper. He works with clients on the tax implications of the initial structuring of their fund entities, review of their partnership and offering documents, tax implications of various types of securities transactions, and general tax issues and planning opportunities that arise during the life cycle of a fund.
Gautham Deshpande is an audit partner in the financial services group, with more than 15 years of accounting, audit and consulting experience in the securities and investment management industries. He leads the audits of private equity funds, venture capital funds, hedge funds, real estate partnerships, alternate investment vehicles, and investment advisors.