Let’s talk terms

What’s changing? What’s new? Justin Storms, partner, and Emily Harmsworth, counsel, at Linklaters discuss what’s in fashion in today’s marketplace.

Emily Harmsworth

The art of successfully negotiating the terms of alternative investment fund documents lies in finding balance between the rights and obligations of general partners and limited partners throughout the relatively long life of these funds. While certain key economic terms such as fees and carried interest will always remain a focus of attention and negotiation, other factors also drive the evolution of fund terms, including changing regulatory regimes, macroeconomic conditions and other market pressures and developments. In that light, what terms have been on the minds of GPs and LPs in the latest fundraising round?

The increasing use of credit facilities is a hot topic that would be hard to miss, as low interest rates have created an opportunity for GPs to drive value and returns using leverage. Fund terms have evolved substantially on this topic in recent years, and what were traditionally short-term borrowings of 30 to 90 days are now quite often permitted to be outstanding for a year or more (and in some cases for unlimited duration). Greater flexibility with respect to the terms governing fund borrowings has enabled greater creativity in how subscription credit facilities are being used. In addition to continued use to bridge capital calls and smooth cashflows, subscription credit facilities can also support borrowings to backstop lower tier borrowings and bridge distributions as well as to support more permanent gearing where permitted by the relevant fund documents. Given the expanded scope and scale of fund borrowings, the relevant provisions of fund documents (including with respect to guarantees of the indebtedness of portfolio companies or other parties) have become far more detailed and the subject of much more bespoke negotiation among different funds and sponsors. Interestingly, the evolution of greater flexibility and creativity with respect to fund borrowings has been driven not only by GPs but also by LPs seeking to moderate the administrative demands of increasingly large fund portfolios and certain segments of the LP community who recognize the potential value that can be captured by leveraging the strong creditworthiness of an institutional investor base. This view is of course not shared by all LPs (or all GPs for that matter), which can result in difficult negotiations with multiple, non-overlapping interests involved.

LP reporting is another area that has seen substantial developments in market practice in recent years. In an effort to provide for more standardized reporting to LPs, the Institutional Limited Partners Association has published and continues to update templates and guidance for periodic LP reporting along with capital calls and distribution notices. Many LPs have adopted internal policies requiring funds in which they invest to report in accordance with some or all of the ILPA templates and guidelines as a condition to making new commitments. On its face, the adoption of a standardized set of reporting templates is just as attractive to GPs as it is to LPs, in that it should provide for reduced transaction costs up front (in negotiation) and on an ongoing basis (including with respect to service providers, who become familiar with standard terms) and greater consistency across multiple products provided by a GP. In practice however, the exceptions to the rule tend to undermine these desired economies of scale and scope, as both LPs and GPs inevitably seek bespoke additions to or modifications from the templates and guidelines. Moreover, whereas LPs and GPs might previously have negotiated at length regarding the substance of reporting provided, there is increasingly a focus by both sides on the form and manner of reporting. It remains unclear whether the laudable goals of ‘standardized’ reporting will be realized absent more universal agreement within the LP community regarding what reporting is acceptable and within the GP community regarding what reporting will be provided.

Changes in LP reporting have been driven not only by ILPA standards and LP requests, but also by regulatory scrutiny. Regulators generally, and the Securities and Exchange Commission in particular, have made it clear that full and fair transparency is key to the relationship between GPs and LPs, with a particular focus on expenses and fees charged to or otherwise borne by the fund and its LPs. This focus has led to increasingly detailed provisions, including the definition of fund expenses, the manner in which expenses are allocated among different entities, the types of fees that may be charged to portfolio companies and the manner in which those fees reduce (or don’t reduce) management fees.

Beyond the key developments described above, we note that the approach to LP excuse provisions has shifted, with GPs retaining greater discretion to agree to excuse rights with LPs beyond true legal prohibitions. These rights drive greater disclosure as well, particularly where excuse rights could be viewed as indirectly modifying a fund’s investment policy (eg, avoiding investments for which a large investor holds an excuse right).

Justin Storms

Hybrid/multiple waterfalls incorporating both ‘whole-fund’ and ‘deal-by-deal’ components are seemingly all the rage these days in European fundraises. While they add operational complexity for GPs, they also enable a sponsor to remunerate more junior members with earlier carry payouts without having to convince LPs to accept a wholesale change in waterfall methodology.For LPs, it is interesting to consider whether the application of different waterfalls among the investor base may result in them having diverging interests with respect to decisions put before investors or the LP advisory committee during the course of a fund’s life.

We have recently seen a number of funds that have offered multiple currency classes. While this optionality can certainly be attractive to LPs, multiple currency funds are highly complex operationally and can result in highly divergent investment experiences and returns for LPs as well as entitlement to carry for GPs. Undoubtedly for this reason, we have also seen funds that previously offered multiple currency classes cease to do so, or do so only on a vehicle-specific basis (ie, using multiple single currency parallel funds).

Finally, key person, succession and ownership provisions remain front of mind for GPs and LPs alike. As has been widely publicized, there is a much more active market for stakes in GPs, with investments coming both from large institutional investors as well as funds established specifically for this purpose. LPs are therefore increasingly focused on ring-fencing ownership within a specified group of individuals and/or entities to ensure the right people remain involved in the fund and that they are appropriately incentivized. Furthermore, in something of a generational moment, a large number of GPs are addressing the need to prepare for the future, build out their bench and provide for transition of firm leadership. Material changes to these provisions, which are of core importance to both GPs and the LPs, can be the most hotly negotiated provisions during the course of a fundraise.

As noted at the outset, evolutions in fund terms are often driven by the environment in which a fund is raised, which is clearly true for many of the developments described above. Whether these terms remain in focus or attention shifts to new ‘hot topics’ will of course depend on shape of the world in which those terms are negotiated. 

This article was sponsored by Linklaters and first appeared in the May issue of pfm