For many in the private equity industry, the issue of aligning interests has traditionally focused on the performance fee model and the make-up of a fund’s distribution waterfall, which encompasses the management fee, the preferred return, the carry model and the carry percentage. In aggregate, these elements seek to incentivize the manager to outperform a predetermined benchmark return over the life of the fund (that is, producing an alpha return as opposed to the market’s beta return profile), and align the GP’s interests with those of its LPs by rewarding the alpha return. However, there are also other important tools in the LPA, such as GP commitments and non-economic provisions (such as GP removal), which seek to ensure ongoing alignment.
Management fees have become more varied with greater scrutiny on GPs’ budgets and where the management fee income is going. For so-called ‘mega-
funds’, fees are now commonly 1.5 percent or less, while smaller funds have been able to secure fees as high as 2.5 percent where strong investor demand and tight budgets justify it. Ultimately, management fees are designed to cover the operating costs of the manager during the fund’s life as it sources and makes investments, and more emphasis is now being placed on this.
A 2.5 percent fee on a first-time fund can be justified on the basis of start-up costs and overheads, but when it is being levied on fund number five or six, investors have started to question how much of the (often sizeable) revenue stream is actually being used to cover overheads and what proportion is simply providing additional income to managers. In terms of alignment, the risk is that generating such fees becomes an end in itself rather than a means by which carried interest is achieved. This is especially true in larger fund situations where a 2 percent fee on, for example, Blackstone’s $18 billion Fund VII raised in 2015 would equate to $360 million of fees without generating any return for investors.
For a global industry to have two completely different incentivization models applied purely on the basis of geography is an odd situation after three decades
At the other end of the spectrum, where managers struggle for operating income against a backdrop of LP best practice terms, the previous practice of managers deriving supplementary fee income from retained transaction fees has changed significantly over the last decade or so with managers increasingly agreeing to offset 100 percent of such fees. However, here the existence of a bifurcated market can be seen with some sought-after smaller managers able to negotiate retaining a percentage of such fees in order to keep management fees in line with market standard. Ultimately, aside from the supply/demand dynamics of a bifurcated market, a greater focus on understanding the real cost base of the GP should enable investors and managers to reach agreement on the appropriate level at which to set ongoing fee levels.
The preferred return acts as a measure of beta, providing a hurdle over which the fund manager is required to perform before receiving carry. Set at 8 percent per annum for the vast majority of private equity funds, this return rate was structured to mirror the ten-year US Treasury rate at the end of the 1980s. This was widely accepted at the time as the appropriate baseline for ‘riskless investment,’ yet that same rate fell below 6 percent in 1998 and has continued its downward trajectory (it was below 2 percent as at December 2017). Therefore, there is little to suggest that the original rationale for the use of 8 percent as the industry standard should still apply in 2018. For a vintage fund, is it appropriate to use a preferred return based on a historic benchmark? If we are taking it as an approximate long-term expectation of public equity returns, perhaps there is a more relevant benchmark to use.
Another consideration is whether, in a difficult macroeconomic environment, the use of a single preferred return, which fails to differentiate between a very poorly performing GP losing money and a below average GP that returns 7 percent, is really an intelligent or appropriate tool for alignment or incentivization. We are seeing some movement away from the standard 8 percent preferred return, with Advent International having negotiated the removal of their preferred return in 2016 and CVC reducing it to 6 percent in their Fund VII, which closed in 2017.
Aside from simple reductions, there are various ways that the industry can apply new thinking to the preferred return and carry structure. One option, which is being increasingly introduced by strong-performing managers, is to use a ratcheted carry based on incremental levels of overall performance. These mechanisms are designed to incentivize further on the upside more than factor in potential downside. However, there have been cases where managers have accepted a higher preferred return than 8 percent in return for increased carry percentages.
The carry model
Historically, carried interest models have been divided along geographic lines: the European fund-as-a-whole model and the US deal-by-deal model. The reason for this geographic division originates from the tax treatment of carried interest. US managers are taxed on the value of accrued carry whereas European managers are only taxed once carry is distributed, meaning that US managers have needed to receive carry earlier to meet tax liabilities. However, following continued efforts by the Institutional Limited Partners Association to create best practice private equity principles, there has been a significant industry shift towards the European fund-as-a-whole model. Eighty percent of more recent US funds are now implementing the European model with Europe maintaining a similar split.
“In many cases, alignment is not effectively achieved for new funds by employing old models”
The reason ILPA and other investor industry bodies have encouraged this change is largely because, in the deal-by-deal model, carried interest distributions are made to managers on the basis of individual portfolio company performance with no backdating of carried interest earned in the early years of the fund. This can lead to situations where managers may outperform in early deals and receive carried interest before underperforming in later deals, and therefore requiring carry payments to be clawed back. Clawback liability is a notoriously gray area and, despite the now more common use of escrows, LPs prefer to avoid potential uncertainty and relationship damage from arising by sticking to the more risk-averse fund-as-a-whole model. This European approach sees GPs’ performance being rewarded only once investor money is no longer ‘on risk.’
While the end result may not be that different for LPs, it has a real impact for fund management teams. From an LP’s perspective, the ultimate question is how much money is returned to them. Under each model, this should be the same at the end of the fund’s life. For managers, however, the question rests on the timings of cashflows and the ‘reward time horizon.’ Under a fund-as-a-whole model, members of the management team are required to wait longer for carry returns and are more dependent on the aggregated performance of the management team rather than individual performance. Under the deal-by-deal model, the opposite is true. For a global industry to have two completely different incentivization models applied purely on the basis of geography is an odd situation after three decades, and it is therefore not surprising that the industry is at last coming close to having a consistent model.
While geography no longer delineates when the different models are utilized in the carry model, the reason that the industry has still not moved 100 percent to whole-fund carry, points once again to the dynamics of today’s fundraising market. As manager preference tends to be for deal-by-deal carry when possible, it is not surprising that we see some high-performing and sought-after managers able to negotiate and implement at least hybrid carry structures with a portion of deal-by-deal alongside a whole-fund percentage.
Their negotiations may also be helped by the lack of a comprehensive, statistically argued justification for why the fund-as-a-whole model is actually better for LPs. This is likely to merit further study, especially given the strength of the long-term returns from US private equity funds and their repeated outperformance on a 10-year-plus basis compared with the public market indices, NASDAQ and the S&P 500.
The carry percentage
The headline 20 percent carried interest rate has been a central element in the limited partnership model since the industry’s inception. Entrenched by its use in the “model outline fund structure” for the 1987 memorandum of understanding with HM Revenue & Customs, the UK tax authority, on the tax treatment of gains from private equity, the percentage has not changed in three decades.
In 2017, the headline figure remained very much the same despite moves by various groups, including Bain Capital, to introduce optionality to investors around fee structures that toggle between management fees, preferred return and carry percentage. More topical currently is a push by top-performing managers to introduce so-called ‘super carry’, or simply a higher carry percentage with a higher preferred return.
GPs adopting this approach would be the exception rather than the norm and the pace of change, even in a strong fundraising environment, is slow. Few managers have the past performance or predisposition to allow them to fundamentally alter their traditional fee models. Empirical evidence suggests that while there is an appetite among GPs, and some LPs, for change, it is a majority of larger institutional investors that shy away from new fee/incentive arrangements. The reason for their hesitancy could be explained either as a consequence of an unwillingness to deviate from the models they understand (or at least their internal investment committees can easily approve) or a reluctance to countenance the fact that, in many cases, alignment is not effectively achieved for new funds by employing old models.
The GP’s own ‘skin in the game’ — that is, the amount of money that it is willing to put into the fund itself — has become a real point of alignment pressure. LPs want to see that GPs have their own money on risk in funds, so that they share in any potential downside as well as the inherent upside provided for by carried interest.
This pressure has seen investors increasingly scrutinize GP commitment levels over time. The original 1 percent GP commitment is now rare, and the very notion of percentage has become a less relevant measure as investors have become more focused on what it represents as a proportion of manager net worth. Ultimately, a management team whose members have to remortgage their homes to fund a 1 percent commitment arguably has much more to lose if performance falters than a manager contributing 2 percent from prior fund management fees and carry distributions. There are numerous cases of managers contributing a 2 percent commitment that have come under pressure for this very reason. However, the GP’s desire to see the fund outperform is arguably disproportionately higher than the LP’s, and therefore perhaps the alignment of interest weighs too heavily against the GP at times.
Ultimately, LPs want to see the same hunger among GPs that drove them to outperform in previous funds repeated in a new fund, and the easiest way to achieve this is to place a GP’s own money and financial security at risk.
One much negotiated, though little used, term of the LPA is the GP removal clause. Seen by many as the nuclear option when misalignment between a GP and its LPs reaches a critical juncture, the traditional approach of attaching onerous compensation conditions and high investor vote thresholds has militated against its use in all but the rarest of circumstances.
Commonly drafted as a ‘for-fault’ or ‘no-fault’ removal, with correspondingly arduous voting thresholds, the option of a ‘no-fault’ removal has always been viewed as somewhat academic. Aside from the effort required to mobilize a sufficiently large proportion of the investor base to meet voting thresholds, considerations of market reputation and ongoing relationship management have been cited for the under-utilization of the power accorded to investors in the LPA.
However, with a growing number of funds testing the traditional alignment model, recourse to the GP removal clause may become more necessary. When undertaken as part of a wider restructuring of the manager and its funds, the possible upside of introducing a new management team may, on balance, outweigh the effect of shorter term compensation requirements and the cost of continued misalignment.
Increased pressure on non-economic terms
As a consequence of the regulatory environment and more stringent accountability requirements to their own stakeholders, LPs are focusing more and more on the operational terms in LPAs.
One area that has come into sharp focus in the current fundraising cycle is the question of transparency. There is a trend across the financial services sector in developed economies for greater transparency in the wake of the global financial crisis that struck in 2008-09. Calls for greater regulation and improved transparency are the watchwords of governments, regulators and investors alike. Nowhere has this had a more direct impact than on the private equity sector.
For example, LPs’ demands for increased information rights have grown to unprecedented levels. LPs want more frequent and more detailed reports than ever before, not only driven by their own desire for oversight, but also by the demands of regulators and their own investors. Private equity as an asset class is inherently a long-term investment strategy. Yet recent trends among regulators and investors to impose reporting requirements on illiquid fund managers, which are more suited to liquid investments, are putting significant pressure on private equity managers. The idea of buy-and-build private equity mangers having to effectively ‘mark to market’ assets within their portfolios on a quarterly basis runs counter to the idea of an illiquid investment held for up to 10 years. And an overemphasis on quarter-by-quarter performance is potentially detrimental to a portfolio and to private equity managers more generally.
It is, therefore, critical to ensure that reporting requirements are addressed comprehensively in the LPA and in individual LP side letters. With increased regulatory pressure showing no sign of abating, the need to find a workable balance between investor expectations and what the manager can realistically provide on an ongoing basis, without it having a detrimental impact on the fund or its portfolio, is vital. Ultimately, this may prove to be a balancing act that can only be effectively achieved with wider dialogue between regulators and the industry as a whole.
This is an excerpt from The LPA Anatomised (2018), published by Private Equity International, and available for purchase here.