Investors in private equity funds expect the general partner to make a commitment to the fund itself, primarily to align interests with the limited partners (if the GP also has money at risk, it is likely to take more care when investing). Both the amount of a GP’s commitment and the structure by which it makes that investment can vary a great deal from fund to fund. The Institutional Limited Partners Association’s Principles state that a GP should make a substantial equity commitment to the fund.
The size of a GP’s commitment is often heavily dictated by the size of the manager itself. A new start-up manager, for example, is likely to have less cash to invest than a larger more established private equity house. Often the commitment is set as a certain percentage of the fund, rather than a fixed amount.
Many investors prefer the GP to make its commitment directly into the fund, but it is not unusual for the GP to set up a separate co-investment partnership, which will invest alongside the fund. Some contention can arise around the flexibility this separate vehicle has to vary its commitment to any particular investment. Sometimes, the GP’s co-investment vehicle has the flexibility to increase its commitment over time. This can cause some contention with LPs as it is seen to give the GP an opportunity to increase its participation in a good market, but keep it flat in a bad one, although the intention is usually to allow the GP to increase its commitment as and when it realizes investments, or receives carried interest, from an earlier fund and to increase its alignment with LPs.
The ILPA Principles state that a GP should make its commitment in cash, rather than through a waiver of the management fee.
In Europe, the Alternative Investment Fund Managers Directive can, in certain circumstances, also affect the method of funding the GP commitment. The GP commitment is ultimately made by the personnel working at a GP, but they often do not have cash available to make a sufficient commitment. In order to address this issue, a GP either lends the money to the relevant personnel itself or it arranges a lending facility with a bank to cover the cost of the commitment. This is significant in the context of the AIFMD because its remuneration provisions impose certain deferral and other requirements to be attached to variable remuneration. Guidance from the European Securities and Markets Authority on these remuneration provisions states that a co-investment commitment by the GP should fall outside of these requirements, provided that, to the extent it is made by personnel through means of a loan from the GP, that loan must be repaid in full before any amounts are paid to those personnel. This may impact the structuring of any facilities set up to finance a GP commitment to the extent that the GP wishes to ensure it falls outside of these rules.
This is an excerpt from The LPA Anatomised (2018), published by Private Equity International, and available for purchase here.