Fund terms: Facilitating consensus

For private equity firms that previously raised capital in 2007 and 2008 and are now coming back to market, the current fundraising landscape might look like an entirely different world.

Investor due diligence is substantially more rigorous and deliberations are protracted. Many institutional investors have gravitated to only the most established and proven managers. Others have left the alternative investment asset class altogether, shrinking the pool of available capital. Consequently, we are left with a bifurcated market – top-tier fund sponsors are raising capital with relative ease while a majority of managers face an uphill battle to raise their funds.

Furthermore, active institutional investors have organized around a set of principles released by the Institutional Limited Partners Association (ILPA). The ILPA principles, developed with a goal of further aligning interests between general partners (GPs) and limited partners (LPs) and promoting transparency, have also had a substantial effect on negotiations between the parties with respect to certain key terms.

Given these circumstances, fund sponsors may find negotiations with prospective LPs to be challenging. While this case study is not meant to be modeled after any one fund in particular, we believe that it is an experience that many private equity funds may be facing in today’s market.

BACKGROUND

PE Fund III is a US-based middle 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 many significant liquidity events. Moreover, in these pre-launch meetings, PE Fund III learned that 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 a prospective European institutional investor (Lead Investor).

THE CHALLENGE: SPECIAL TERMS FOR LEAD LPs

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 preferred co-investment rights. 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 in the current extended fundraising environment 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 the 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 not able 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.

FEE BREAKS

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 who invest in the first closing and make a commitment equal to or greater than a specified amount. Such a 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.

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. PE Fund III could also consider aggregating commitments of LPs advised by the same investment manager or consultant for the purposes of the tiered management fee.

PRIORITY CO-INVESTMENT RIGHTS

PE Fund III is also considering whether to provide Lead Investor with priority rights for co-investment opportunities. Co-investments have become increasingly common and popular and are often contemplated and authorized by a fund’s operative documents.

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. However, fund sponsors should closely analyze potential risks before granting blanket approval for co-investment rights. For instance, does the firm want to give up its freedom to choose its co-investment partners at its own discretion? Will the fund sponsor be able to properly allocate deal opportunities among multiple investors? In answering these questions, fund sponsors need to take into account the relatively short timeframe in which opportunities become available and must be acted on. Fund sponsors granting rights to co-investment deal allocation should consider carving out co-investment rights from the fund’s most favored nation provision, allowing a sponsor to offer rights to a limited number of early closers and other strategic investors.

NEGOTIATING ECONOMIC TERMS

After further meetings with prospective European 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 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. Yet for LPs, there is a significant difference in timing and risk. Fund sponsors are much more likely to receive carried interest early in a fund’s term under a North American waterfall. As a consequence, 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 – 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 tremendous effect on PE Fund III. Changing the waterfall would likely 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. Moreover, where prior funds are not providing liquidity, despite their strong unrealized performance, delaying the stream of carried interest proceeds creates a disincentive to align manager fees with operating costs. Investors are concerned when fund sponsors turn management fees into a source of profit rather than the necessary amounts to run the engine of the management company.

From the perspective of the LPs, the recent economic turbulence has put the potential difficulties of clawbacks of carried interest front and center on their radar. Forcing a clawback 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 in situations where there has been a departure or retirement of partners. 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 that 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.

For example, 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 or a net asset value (NAV) test, 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. Although current interest rates are low, there is some economic inefficiency in leaving the amounts in escrow idle.

As another alternative, PE Fund III could consider proposing changes to the guarantee that each carry recipient signs up on 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.

Resident in the Boston office, Robin Painter is co-chair of corporate department and global co-head of the private investment funds group at Proskauer. This was an excerpt from a chapter in PEI's The LPA Anatomised, available HERE.