Over the past two decades the closed-end fund structure (CEFS) has become the standard model for investing in venture, buyout, distressed debt, mezzanine, private real estate, and even PIPE investments. At the core of the CEFS is a model that allows talented, flexible, entrepreneurial teams (general partners) with deep domain expertise to make private investments and to share a portion (around 20 percent) of the profits upon exits. Day-to-day operation, administrative and other overhead expenses are taken care of by management fees (around 2 percent) on committed capital. This dual compensation structure (fees and carried interest) works quite elegantly; it has promoted the much sought-after “alignment of interests” between investors and general partners.
However, starting in this decade the CEFS began to be stressed when fund sizes started getting beyond the $1 billion mark. It was easy to do the math: at a 2 percent management fee on committed capital the GP’s interests weren't aligned with the LPs’ interests anymore. The fee income stream overwhelmed the carry as the dominant factor in the GP's economic calculation. It was a “win-win” situation for the GPs, while it was a “mostly lose – only occasionally win” proposition for the investors. The alignment of interests was eventually completely eliminated as fund sizes ballooned, to over $20 billion in some cases. Clearly, there was no motivation to generate carried interest when the GP could earn over $400 million in management fees annually, other than as a factor in perpetuating their franchise – failure to achieve a return above the hurdle doesn’t bode well for the raising of a successor fund. Nevertheless, relying on a GP to ignore the lure of certain, munificent short-term economic gains for uncertain long-term business considerations is problematic for investors.
Making matters worse, as the 2-and-20 CEFS became a standard across all funds, negotiation over several other terms and conditions in the limited partnership agreement started to move against the LPs. Some of the more egregious such term trends are as follows:
1. Standard of Care: From negligence to gross negligence to no standard of care at all;
2. Deal-by-deal calculation of carried interest;
3. Transaction and other advisory fees being charged at the portfolio company level;
4. Catch-up provisions which basically eliminated the impact of a preferred return or no preferred return at all, and
5. Indemnification of the general partner in spite of material breach of the limited partnership agreement.
This is a perverse result, reflecting the shift in the balance of negotiating power away from LPs towards GPs. In essence, GPs took advantage of investors’ urgent requirement for alpha and several institutional investors piling into the private asset class at the same time. It is perhaps understandable that they did so, but the result has been both time-inefficient as well as and suboptimal from a resource allocation viewpoint.
Consider the case in which the opposite might have happened, that is, if the legal, administrative and operational terms of the agreement had become codified while the CEFS economic structure became more responsive to market forces and competition. It is clear that the private equity market would thus allocate capital and resources more efficiently; there would be less expenditure of time and expense haggling over terms if consistent industry standards and practices were adopted, while an increased focus on performance and the economics of the fund would lead to the operation of familiar market forces: rewards for good deal selection and superior execution, elimination for underperformers.
With the start of the current economic downtown and the concomitant halt of the private equity juggernaut, however, the balance of power has begun to swing back to a more balanced, market-based outcome. While some pundits have been quick to proclaim the demise of the private equity asset class, others have offered valuable suggestions on reforming the private equity industry and restoring the alignment of interests between LPs and GPs. The most constructive proposal for change has come from The Institutional Limited Partners Association (ILPA), which recently proposed a set of guidelines that should become standard across all CEFS. It is capital- and time-efficient to make all limited partnership agreements ILPA-compliant, and I strongly feel that the private equity asset class would benefit tremendously if it were to operate under a consistent set of guidelines for the CEFS administrative, operational and legal frameworks.
What ILPA didn't address specifically, however, was the issue of excessive management fees, the root cause of the misalignment of LP and GP interests. The key to correcting this inefficiency is improved, readily accessible information. In that context I am proposing a Size/Management Fee/Carried Interest (SMC) ‘tag’ to create a clear point of differentiation by which LPs can compare GPs. The SMC tag should be an industry requirement prominently displayed in the private placement memorandum. This tag would show fund size and management fees as absolute numbers, and carried interest as a variable dependent on the track record of the fund. For example, the SMC of JAMBOG Fund I could be “250/20/10 percent” which indicates a fund size of $250 million, a management fee of $20 million across the entire life of the fund, and a 10 percent carried interest. If JAMBOG Fund I is successful, then JAMBOG Fund II could be tagged “350/25/15 percent”, Fund III could be “500/30/20 percent” and Fund IV could be “600/30/22 percent”.
This SMC tag would bring rationality and transparency to management fees; LPs would be able to immediately evaluate the fee load on the fund. I wonder how many LPs would have signed up for Mega Buyout Fund V if the SMC tag read “20,000/3,300/20 percent”! That however is exactly what happened in the not-too-distant past. As discussed before, the carried interest in a fund that earns over $3.3 billion in management fees is virtually meaningless; the GP is deep in the money even before the first inning has started. An SMC tag would bring private equity in line with the pricing of every other product or service in the world, as opposed to one price (2/20) across all private equity funds.
Ultimately, the basic idea of SMC tag is to reinstate the fundamental premise of the CEFS, which is that the management fees should only cover the daily operations of the GP, while the carried interest (above the preferred hurdle) being the key motivation for larger capital gains. The management fees should be expressed as an absolute number and shouldn't be presented as a percentage of fund size, since fund size is not directly correlated with the regular operations of the business. In effect, GPs are unfairly capturing all benefits of the increasing returns to scale in fund operations. Also, like every other business in the world, GPs should be able to differentiate against their competitors by charging a carried interest that the open markets will accept. A 20 percent carried interest shouldn't be a given “rule”; some track records should earn 25 percent while others should be stuck at 10 percent until they are either able to earn a standing in the market place that rewards them with a higher percentage, or go out of business.
The SMC tag, along with ILPA guidelines compatibility, would be a smart step in improving the negative (locust!) image of the private equity industry asset class and will ultimately serve to enhance its longevity.