Creating a precedent

The challenge:

Private debt as a standalone asset class has welcomed sustained growth over the past few years. This has led private debt fund managers to create ever new strategies and signaled the arrival of more entrants to the market. But, with competition greater than ever in a relatively young asset class, how does one go about setting the fund terms for a first time fund?

Ed Hall and Duncan Woollard’s response:

Practice has moved on over the last 12 months or so. In the early days of the current private debt market fund managers, whether from a hedge fund or private equity background, would usually seek to raise a fund primarily from their existing client base and following the terms of their prior funds very closely, often with significant success. Investors have got more sophisticated now, they appreciate that the standard structures from other assets classes don’t necessarily fit here and they know what terms are being offered elsewhere in the market. In many cases they simply will not sign up to a 2 and 20 structure.

However, there is some flexibility in terms even amongst funds of a similar type, for example whether to price with a higher hurdle rate and full catch up, or a lower hurdle rate with no catch up, so some thought needs to go into this at the start of the process. There is also a balance to be struck between pushing for strong terms on the basis of a high target return expectation and not looking unrealistic. Fundamentally, investors rarely choose a fund on price alone and will normally suggest more acceptable terms if they otherwise like the manager’s overall strategy and approach. What can trouble them more is overstated or unrealistic return expectation, whether or not these are being used to justify a certain fee level. This approach can be a deal–breaker.

It is important to focus on what the goal of the manager is too. Many fund managers in this space are not focusing on carried interest primarily but instead upon building significant assets under management from their platform and establishing a variety of different vehicles for different investment strategies.

With any new fund manager a great deal of work goes into crafting the structure and terms at the start. This is because the question of how to set the terms is even more important for a first-time manager. In these cases there is often a more complicated track record and relationships with investors may be less developed and so the risk of an investor ‘walking away on terms’ is greater. In these circumstances first-time managers may be more conservative with the terms they go out with.

This is true both in relation to the headline terms (fees and carry) but also for other important terms (e.g. key person, GP removal, clawback) where it is important to demonstrate to the market that a manager is commercial and understands the market standard positions. We tend to spend a great deal of time walking them through our market analysis and where they can place the fund compared to their competitors;

Often first-time funds seek one or two cornerstone investors and discuss/negotiate terms with them before taking the fund to the wider market. This can be more of a collaborative process than a standard investor negotiation and can help to ensure that the terms are both appropriate and defendable (as well as providing a manager with an important base-level of commitments to kick-start their fundraising). Even where there isn’t a cornerstone there is often an element of road-testing with prospective investors before the fund is launched.