PE Fund III is a US-based mid-market private equity firm. It is currently seeking to raise $500 million in LP commitments. Before officially launching, PE Fund III meets with current and prospective investors in order to gauge interest and obtain valuable information regarding investors’ commitment timelines and high-level changes expected to be requested by investors to the terms of PE Fund II.
PE Fund II, which raised $500 million in LP commitments, has a promising portfolio of investments and potential for strong investor returns. While Fund II’s IRR is in the first quartile for its vintage year based on unrealized gains, it has not experienced significant liquidity. Moreover, in these pre-launch meetings, PE Fund III learned that its anchor investor from PE Fund II, a US public pension plan, has decided not to commit to PE Fund III. PE Fund III has, however, received strong initial interest from another prospective institutional investor (Lead Investor).
Lead Investor has indicated a willingness to participate in the first closing of PE Fund III. In return, Lead Investor is seeking to play a substantial role in shaping the fund’s terms and to obtain special ‘early-bird’ incentives for participating in the first close.
Special ‘early-bird’ incentives often include a reduced management fee and/or carried interest arrangements, and preferred co-investment rights. Note that the fund sponsor will need to work closely with fund counsel to consider whether one or more ‘early-bird’ incentives being provided to only some investors should be disclosed to all of the other investors prior to their admission to the fund to comply with current regulatory guidance.
When offering ‘early-bird’ incentives, it is essential for fund sponsors to strike the right balance between the operational needs of the firm and meeting the demands of both early investors and later investors. Holding a strong first closing is perceived to be important because of the signal it sends to other investors. Offering early-bird incentives is one way to nudge potential investors that otherwise may be holding out until PE Fund III’s portfolio begins to develop.
However, despite a strong first closing, PE Fund III faces the risk of alienating investors that simply are unable to make a first close and may have a difficult time turning down special incentive requests from returning and new investors alike at later closings. We have seen many instances where fund sponsors offer early-bird incentives to potential first-closing participants in order to gain momentum and critical mass, yet later have a difficult time holding the line with investors at subsequent closings who request similar discounts.
After extensive negotiations with Lead Investor and discussions with returning investors, PE Fund III has crafted a potential solution — a modest management fee break to all investors that invest in the first closing (or perhaps within 60 days thereafter) and make a commitment equal to or greater than a specified amount. This proposal meets the request of Lead Investor and leaves the door open for additional investors to reap the benefit, so long as they participate in the first close and commit a substantial amount to PE Fund III.
Alternatively, given the difficulty in holding the line that many fund sponsors face, PE Fund III may want to consider simply agreeing to a tiered management fee. A tiered management fee would provide a discount to Lead Investor while creating flexibility with respect to other large investors that cannot meet the target date of the first close. It may also appear more transparent as it would be available to all investors rather than being a special side deal for only certain investors. If PE III Fund pursues that course, it should be prepared to consider requests to aggregate commitments of LPs advised by the same investment manager or consultant for the purposes of the tiered management fee.
PE Fund III is also considering whether to provide Lead Investor with priority rights for co-investment opportunities. Institutional investors commonly request to be given a priority over other investors with respect to co-investments. Co-investment arrangements are attractive to LPs because they can put additional money to work, typically on a reduced fee and/or carry basis.
Granting co-investment rights as an incentive can be attractive as it does not directly impact the fund sponsor’s management fee or carried interest. In addition, the existence of co-invest dry powder may allow the fund more flexibility to consider investments that are larger than it might otherwise have been able to pursue for the fund. However, fund sponsors should closely analyze potential commercial risks and conflicts of interest associated with providing special co-investment rights. The sponsor needs to decide whether it wants to give up its freedom to choose its co-investment partners on a case-by-case basis. Importantly, fund sponsors need to take into account the relatively short time frame in which opportunities become available and must be acted on. The fund sponsor needs to disclose to all LPs, before their admission to the fund, the existence of any arrangements that provide preferential co-investment rights to some but not all LPs, as per guidance from the Securities and Exchange Commission. In addition to such disclosure, the fund sponsor also needs to develop and disclose the rules around expense sharing among co-investors and the fund (including for transactions not ultimately consummated) to the fund investors. Fund sponsors granting rights to a co-investment deal allocation should consider carving out co-investment rights from the fund’s most favored nation provision allowing the sponsor to offer rights to a limited number of early closers and other strategic investors.
After further meetings with additional prospective investors, PE Fund III has noticed a recurring request for a fundamental change from PE Fund II — a shift in PE Fund III’s waterfall structure from a North American waterfall to a European waterfall.
Under a North American waterfall, carried interest is calculated and distributed on a deal-by-deal basis and carried interest is earned by the fund sponsor as soon as it begins to generate profitable exits from disposed fund investments, so long as losses from unprofitable deals are recouped and a preferred return hurdle (usually 8 percent) is exceeded. By contrast, under a European waterfall, carry is calculated at the fund level, and no carry is paid to the fund sponsor until all previously drawn down capital has been returned (plus any preferred return). Ultimately, the amount of carried interest earned should prove to be the same under either waterfall.
Prospective LPs have expressed concerns over the difference in timing and risk between the two waterfalls because the sponsor is much more likely to receive carried interest early in the fund’s term under a North American waterfall. As a consequence, they are concerned that it is much more likely that adjustments will be needed at the end of the fund’s life to ensure that the sponsor did not receive more carry than it was entitled to under the waterfall, creating a complicated clawback process that can create tension between the fund sponsor and the LPs.
A fundamental change to its economic terms could have a material impact on PE Fund III. Changing the waterfall is likely to result in lower amounts of carry being distributed to the individual partners of the fund sponsor in the early years of the fund’s term. As a result, PE Fund III could find itself less competitive than its peers with respect to recruitment and retention of talent. Younger investment professionals may need assistance meeting capital calls on their GP commitment if carried interest distributions are not made to them on a deal-by-deal basis. Moreover, if prior funds are not yet providing liquidity, despite their strong unrealized performance, delaying the stream of carried interest proceeds through a ‘fund-as-a-whole’ model could incentivize the sponsor to liquidate investments earlier than it normally would in order to reach the carry tranche of the waterfall earlier.
Relying on a clawback to ‘right’ an ‘early pay carry’ can put significant pressure on the relationship between a fund sponsor and its LPs
On the other hand, relying on a clawback to ‘right’ an ‘early pay carry’ can put significant pressure on the relationship between a fund sponsor and its LPs, and LPs need to be mindful of the costs and potential credit risks of enforcing a clawback. In addition, fund agreements are typically drafted in a way that repayment of carry takes actual or hypothetical tax payments into account, which can reduce the amount of proceeds LPs ultimately receive from any clawback. From the fund sponsor’s perspective, it is not ideal to force its own partners to pull out their wallets in order to fund a clawback, especially if it means chasing departed partners to fund their share of a clawback.
For all of the above reasons, there is significant risk that the proper amount of carry may not be returned in a clawback scenario.
When advising funds that are negotiating such a fundamental change to the economic deal, we often initiate the discussion by reiterating that this portion of the negotiation should be considered ring-fenced from negotiations regarding any additional items on an investor’s request list. Ring-fencing the discussion permits a negotiation on the merits of this fundamental change rather than a give and take on other items. As an initial matter, there are a number of items to which a fund sponsor can point to support their case, or at least provide some comfort to the prospective LP. For instance, a history of conservative distribution management may alleviate fears that LPs will be left with underperforming investments, which have little chance of generating investment proceeds after carried interest was paid out on successful investments early in the fund’s term. In addition to pointing to its current practices, PE Fund III can consider a few alternatives to switching to a European waterfall to help alleviate the prospective LPs’ clawback concerns.
The fund could set up escrow accounts with significant reserves to cover potential clawbacks. Release from the escrow accounts could be tied to passage of time and/or a net asset value tests, on which carried interest is released to the individual partners only once PE Fund III has demonstrated that the value of investments being carried in the portfolio is sufficient to support subsequent distributions of the fund and is likely to preserve the economic deal between the LPs and the GP. From the sponsors perspective, large amounts of distributions otherwise payable to the sponsor sitting in escrow earning an unattractive interest rate is not ideal.
Interim clawbacks, often tested both at specific intervals (such as after the seventh anniversary of the Fund’s first capital drawdown) and on specific events such as a key-person event or once a fund is unable to meet a NAV test, are becoming increasingly common.
Interim clawbacks may not be a perfect solution for either party. From an investor’s perspective, many of the same clawback concerns remain — it may be done on a net-tax basis, investors have to trust that investments are being properly valued, written down or written off, and it may prove difficult to ultimately collect the full clawback amount. From PE Fund III’s perspective, it is still not desirable to force its partners to take money out of their wallets in order to true-up with investors. Nonetheless, an interim clawback can serve as a compromise position between retaining a North American waterfall and moving to a European waterfall; LPs are not forced to wait out the entire term of the fund in order to receive a true-up and fund sponsors keep the American waterfall.
PE Fund III could also consider proposing changes to the guarantee that each carry recipient signs up to upon receiving a piece of the carry. The typical guarantee structure provides for liability on a several and not joint basis. A guarantee of a partner that has passed away or is locked in bitter divorce proceedings is of little comfort to LPs. As an alternative, PE Fund III could offer up that its senior principals (or a creditworthy corporate entity) will serve as a backstop (perhaps up to a specified cap) in the event individual partners of the fund sponsor are unable to fund the clawback.
With the substantial negotiations regarding the distribution waterfall in the rear-view mirror, PE Fund III is now focusing on rounding up investors and reaching its first close.
We typically advise fund clients to set an aspirational, yet realistic, first-closing date in order to get prospective investors in motion and working towards a set date. It is important to make sure the timeline fits the schedule of lead investors. When seeking commitments from new investors, in addition to its stable of return investors, negotiations can be an ongoing display of divergent interests among the various prospective LPs. There can be a significant clash of geographic preferences and customary practices, both with respect to prospective investors and their respective counsel. Moreover, each subset of investors has its own unique needs. PE Fund III could field multiple requests to change a specific
We typically advise fund clients to set an aspirational, yet realistic, first-closing date in order to get prospective investors in motion and working towards a set date
provision, such as excuse and exclusion rights. An Employee Retirement Income Security Act investor’s request may be completely different to that of a bank-sponsored investor’s or a government plan’s request. In addition, funds of funds may seem to make inconsistent requests based on the divergent interests and preferences of their own investors. Fund sponsors should resist the temptation to respond to investor requests until a substantial number are received so that general themes and outliers can be identified.
Negotiating with multiple investors can prove to be a delicate balance. Even with a promising track record and a strong showing by returning investors, it can be difficult to hold the party line, particularly as market norms for certain terms shift. Therefore, it is important to develop consensus among investors. At this stage – as opposed to ring-fencing fundamental changes – the important theme is to develop consensus by emphasizing the totality of a deal. From PE Fund III’s perspective, line-by-line ‘Is this market?’ negotiations with each investor can be time-consuming and lead to a partnership agreement that may be viewed as both an administrative burden and a disadvantageous baseline for a successor fund. One strategy is to be responsible to the governance and transparency concerns highlighted by ILPA and regulators while resisting revisions to core economics. Business-level conversations may be helpful in pinpointing an investor’s substantive concerns versus ‘check-the-box’ ministerial exercises.
Navigating to a first close and a successful fund launch can be a long and arduous process in this environment. Active engagement with its investors from the pre-marketing stage through to the fund’s launch, as well as creativity and flexibility on terms, can lead to a better alignment of interests and the long-term success of the fund.