In for a penny… or a pound?

The GP commitment is not typically a negotiated term, but LPs nevertheless feel it speaks volume about a GPs willingness to put his best ideas into the fund. By Rob Kotecki

When general partners commit their own money to a fund, LPs consider this to be more than a mere number. The GP commitment is a sign that the fund managers are putting at risk their own capital alongside that of their investors. In doing so, the risk, along with the reward, is shared among LPs and GPs alike.

But risk, like beauty, is in the eye of the beholder, and so different LPs have different expectations when it comes to GP commitment. A GP group about to form a fund should consider this important question – what factors do LPs consider in judging whether a given commitment adequately aligns interests?

According to professionals who advise GPs on fundraising, an important first consideration is often the longevity of the firm. First-time funds often don't have the resources for a sizable commitment, so limited partners expect a minimum commitment, along the lines of 1 percent of the capital raised. The key question is, should the fund falter, what does the worstcase scenario mean for the financial well being of the individual GPs? The answer to this will vary between a partner raising his first fund, and someone raising his sixth.

Bonnie Plunkett of Wayne, Pennsylvania-based placement agent Alternative Investment Source notes: ?The standard commitment is 1 percent, however we believe most LPs expect something more along the lines of 2 percent to 3 percent as a minimum, and certainly higher with more experienced groups.?

If a firm has raised several funds, the partners have likely reaped the rewards of multiple realizations. A firm's longevity demonstrates skill, but implies a substantial net worth for all the partners as well. In that case, LPs demand a level of commitment that would inspire a veteran to sustain the level of performance evident in past funds. Often veteran GPs will promote the size of their contribution as part of the marketing of the fund, but that commitment needs to represent a significant portion of the partner's net worth before genuinely catching an LP's attention. For example, LPs have been impressed with a personal capital commitment from J. Christopher Flowers to his latest JC Flowers & Co. fund – a $200 million commitment to a fund with a roughly $6 billion target, according to reports.

Incentive structures
For a startup fund, the net worth of the individual executives is scrutinized far less, with the exception of executives moving over from marquee firms. Their legacy may serve as an asset in attracting investors, but it also raises the bar for what constitutes an extraordinary commitment to the fund. However, LPs are not only sensitive to the total commitment to a fund, but also concerned with how that commitment is structured amongst the firm's members.

Often older partners will assist junior members of the team to fund their share of the commitment, but Paul Denning, founder of San Francisco placement agent Denning & Co., explains that such assistance shouldn't be reflected too strenuously in how the profits are shared. ?If the resulting carry structure starves the returns for the four junior executives who will be responsible for the fund's health, their interests may be seen as inadequately aligned with the success of the fund,? says Denning.

Limited partners want to know that compensation is commensurate with responsibility. ?Cliff vesting? clauses that inhibit partners from earning any returns if they should leave the firm prior to the end of a fund's term sometimes give LPs pause. After all, a GP may be just as highly motivated to make investments that will produce carry for him or her long after he or she leaves the fund.

GPs who operate in emerging markets might be subject to different expectations of what a legitimate GP commitment might be. ?There's some willingness for limited partners to be flexible on terms and conditions with firms venturing into new geographies,? says Al Samper, a placement agent with Juniper Capital.

Venturing into new geographic regions, such as Latin America, often involves bringing aboard new professionals with relevant local expertise but less experience with private equity, so in many ways, emerging market funds have the feel of a younger shop, even with veterans on staff. Add the administrative cost of softening the beaches and developing a presence in a given region, and the perception of the GPs' commitment expands beyond the traditional definition. LPs appreciate that access to emerging markets may involve greater risk and effort, but few are willing to waive the GP commitment entirely.

Synthetic commitment
What if a new firm has a real challenge in raising the base commitment? One placement agent reports clients raising the 1 percent among friends and relatives, with some regional banks coming through on rare occasions. A more complex solution that has nevertheless become more common over the past several years is diverting management fees to feed what becomes the GPs' commitment to the fund.

Under this scheme, the fund's management fee is waived in exchange for additional capital being drawn down at each call, which represents the GP commitment to the fund. LPs have mixed views of this arrangement. ?This often means that limited partners are paying a portion of the management fee up front as the capital calls typically happen in the early years of the fund, whereas the management fees are normally spread across the fund's full lifespan,? explains Larry Rowe of the law firm Ropes & Gray. ?And it's hard to escape the fact that it's essentially a no-interest loan to the firm.?

The upside for LPs of such cashless commitments is that the general partners rely exclusively on the fund's performance for their compensation, which is no small risk for a partner, given the duration of the investment process. If a partner lacks the net worth to raise the minimum commitment, the potential of years without income has to be a daunting prospect. But the risk may have an upside beyond the short-term solution of funding a commitment. Robert Burke of law firm WilmerHaleexplains, ?Waiving the management fee can provide a very tax efficient structure. By waiting for the compensation to come as part of a realized investment, the management fee isn't taxed as ordinary income but as capital gains.?

A tax advantage certainly better compensates the partner for risk, but it hardly diminishes risk. The other negative for waiving a management fee is a message about value that gets conveyed to some LPs. Paul Denning warns, ?I advise my clients against waiving management fees. If you're providing a quality product, it should be worth the fees to properly administer it. If you're willing to do that for free, what does that say about how you value your contribution??

Essentially, the GP commitment can become a marketing issue if LPs feel it comes up short. ?We don't believe the commitment is a marketing tool by itself, but it can raise questions for an LP if they feel the GP can handle a higher percentage,? says Plunkett.

The track record of the team and the industry or geographic focus of the fund are the core issues, but a paltry commitment can generate enough doubt to make the difference between firm x and y if they have comparable investment strategies. ?We always suggest our clients align their interests with LPs by putting forth their most substantial commitment from the start,? explains Plunkett, adding, ?It's not a term that gets negotiated.?

When LPs pass on a fund, they rarely offer feedback with the degree of detail that would address such a line item, and how it factored into their decision, so it becomes all the more vital to open with the strongest possible commitment. What makes a particular commitment ?strong? however, might boil down to certain intangible qualities. Denning says, ?If the LP knows and trusts the partner, either through a prior relationship or their track record, they'll be more inclined to be flexible on issues such as commitment level, and assume that interests are aligned.?

And that's precisely what makes a GP's commitment so difficult to define with a hard and fast number, as it deals with the LPs' perception of what's at stake for the partner. And in the case of so subjective a view, it is all the more vital that the commitment remain consistent with the image the firm is touting. Is it a young and hungry fund making its entrance or an established player looking to outperform? A clearly communicated identity, may, in the end, prove the most compelling argument for the structure and level of any GP's commitment.