Balance of power

The Carlyle Group co-founder David Rubenstein said during a conference in February that LPs rather than fund managers would hold the “balance of power” for the next few years, and would have to be heard out more on issues like deal fees and fund sizes. Less than three months later, events in Oregon, Utah and California have proved his prescience.

In the most recent demonstration of rising LP clout, the Oregon Investment Council drafted a set of principles it will use when considering future investments. As part of the new guidelines, GPs will be asked to reduce management fees and take carry only after 100 percent of capital, net of all fees and expenses, has been returned to the investor who has provided the vast majority of the risk capital. They also say that GPs should avoid charging transaction fees, monitoring fees and other fees to a deal or a portfolio company, and that fees earned by the GP should offset management fees and partnership expenses during the life of the fund and at the end of the life of the fund.

The OIC – which manages an investment portfolio of more than $56 billion – stressed the guidelines will not dictate how every investment is made, and that it is not going to ask its existing managers to lower fees. However, the draft is clearly an attempt to give limited partners more say over how funds are managed: one section stipulates that a majority of LPs may have the power to terminate a commitment period, remove a general partner or dissolve a fund.

Oregon’s move comes less than two months after the Utah Retirement Systems released its own set of guidelines for hedge fund terms. The $16 billion fund has proposed that management fees should cover only operating expenses, performance fees should be paid at the end of a lockup period, and managers should provide weekly return estimates and updates on how well investments are performing.

Such demands will likely not be confined to these two states, as other public pensions have expressed interest in reviewing the OIC’s draft and using it as a template for their own possible guidelines. While several GPs only a few months ago professed to be unconcerned about having to deal with issues such as management fee relief, investors seem to be pushing back much faster than anticipated.

“One of the natural questions from LPs is going to be, ‘Okay, you can’t get any deals done this year, why am I paying you a management fee?’,” said a partner with an investment group that has committed funds to over 200 managers. “That’s kind of a third-rail issue, and I wouldn’t be surprised if it becomes a deal point in fundraising. I think it is reasonable for LPs in a new fund to have some questions about whether there should be management fee relief.”

These sorts of questions are already part of the conversation for two of California’s largest investors. Joe Dear, chief investment officer for the $164.9 billion California Public Employees’ Retirement System (CALPERS), said during the annual Milken Institute conference in April that managers who could previously dictate terms to limited partners are not in the same position of strength in today’s economy.

“So now is the time to take advantage of that,” he said. “I don’t have any objection at all to paying a partner a lot of money … as long as we are all along on the ride with them and share in that gain over the long haul.”

He added that limited partners may be able the shift the power pendulum if they stick together, pointing to recent moves firms have made to appease their LPs. TPG, for example, reduced its management fees by one-tenth and HgCapital lowered its management fees for its sixth fund to 1.75 percent. During the same event Christopher Ailman, CIO of the California State Teachers’ Retirement System, said conversations are already taking place among LPs about how to better align their interests.

Part of that alignment may include LP representative groups such as the Institutional Limited Partners Association (ILPA) and UK-based Private Equity Investors Association (PEIA), which have broadened their networks and taken a more proactive role in the last few months in pushing their members’ concerns. “LPs, particularly on the advisory boards, need to start asking more questions and push GPs a bit harder,” said PEIA chair Robert Coke.

While no funds have yet agreed to permanently lower fees, more may have to consider a fee renegotiation. Either way, managers should be prepared to deal with an increasingly organised and proactive investor base.