Fund terms and conditions are evolving, influenced by economic and regulatory conditions, and the changing balance of power between investors and fund managers. As regulatory and compliance issues have mounted, the LPA has become almost an insurance policy for general partners.
“Limited partner agreements are a game of cat and mouse between GPs and the regulators. It’s happened as a result of big managers being fined for issues such as accelerated management fees and incorrect expense allocations,” Eamon Devlin, partner at MJ Hudson, tells pfm. “They have become more complex; for example, their length has increased by around 30 percent in the last five years alone.”
Terms and conditions have also become more flexible, although they are also more explicit and far-reaching. Provisions allowing managers to invest in businesses in which they already have an interest have been included in some cases, for example. Changes to fee and returns structures have been noted by market sources too. The straightforward two-and-20 management fee structure is still evident, but variations are now more common.
“The extent to which large investors are getting discounts is increasing, and there is more focus on post-investment period management fees, not least because funds are now being extended several times, meaning the post-investment period can be up to nine years,” Devlin says.
In terms of distributions, some funds are choosing a ratchet structure – be it 2x money for 10 percent carry, or 4x money for 20 percent carry – while others have increased carry and lowered the hurdle rate.
“Over the past six months or so we’ve seen some funds launching with hurdle rates under the traditional 8 percent,” Michael Halford, partner at Goodwin, tells pfm. In most cases, the funds have strong track records and are likely to be oversubscribed, although some come from managers with lower hurdles who are coming back to market, he adds.
“Being able to change the economic terms of the fund that are beneficial to the GP has of course been the focus. We’ve also seen lower hurdles (in some cases without catch-up) combined with higher carry rates,” Halford says.
GPs are also under increased pressure to narrow the gross and net internal rate of return spread, according to research conducted by law firm Proskauer. To do this, a number have sought to increase borrowing, which puts money to work quicker and reduces capital calls, or reused cash to get closer to 100 percent invested.
“By using borrowing, you can reduce the number of calls made to investors so their money is outstanding for less time. In addition, the fund can use the borrowing to pay expenses rather than calling capital and use income/return to pay it off. This means more capital is called for investment rather than expenses,” Edward Lee, senior associate at Proskauer, tells pfm.
And finally, more transparency – driven by regulation – around expenses has also emerged, including increased clarity on what is an expense, and whether it is assigned to the LPs or the manager.
“Previously there was some flexibility and discretion allowed for, but agreements are now more clinical,” Devlin says.