To give a sense of how private equity and venture capital fund terms are evolving, MJ Hudson regularly surveys the terms of new funds coming to market.
This article is a digest of the key findings from our 2016 report and considers how things have changed since our 2015 report.
Average fees remain broadly stable at 2%, although there is continued downward pressure on management fees for larger funds. In any event, it is becoming harder to gauge a fund’s true level of fees, because of:
- Management fee discounts being offered to select investors, typically ”early bird” investors (i.e. first-closers), investors making big commitments, and as a reward if an investor in the manager’s predecessor fund re-ups into the next fund.
- The growth of investor-specific side deals that either remain undisclosed or, if disclosed, are not available to the investor base as a whole.
Diving into the 2016 sample data more deeply:
- The number of 2016-vintage funds charging a flat 2% remained broadly static when compared to our 2015 sample.
- There was a big rise in the number of funds charging 1.75% concomitant with a reduction in the number of funds charging 1.5%.
- None of the funds in the 2016 sample set fees exceeded 2.5%.
- A number of low cost (i.e. sub-1.5%) funds emerged in 2016, whereas 1.5% was the lowest percentage reported in our 2015 sample.
There are signs of a reversal in the recent trend for managers to put more ‘skin in the game’.
Though perceived as the epitome of GP/LP alignment, counterintuitively LP pressure on GP commitment in 2016 has soften when benchmarked against our 2015 findings. In 2015 we found that GPs had to make bigger commitments than in older funds, ranging from 1.5% of total commitments to 5% or more. In contrast, nearly all of the GP commitments in our 2016 survey were in the 1-2% range; fewer members of the 2016 class of GPs had to commit more than 2%.
This suggests that GP commitment is becoming less prominent than other factors in investors’ GP evaluation process. If this trend away toward proportionately smaller GP commitments continues into 2017, investors with alignment concerns may try to temper it by looking at:
- How the GP commitment is being financed. This would lead to greater pushback against some of the more GP-friendly models available, e.g. management fee waivers, bank debt financing, or contributions-in-kind.
- Who is participating in the GP commitment. In both our 2015 and 2016 samples, fund managers often defined the GP class quite broadly – so a large chunk of the GP commitment may not actually be funded through the personal resources of the fund’s own managers.
Even though low interest rates have persisted for years, the customary 8% preferred return has long been iron-clad in the PE market. In our 2015 sample, 93% of funds had an 8% hurdle, and just 6% offered a lower hurdle or none at all.
But during the course of 2016, hurdle rates began to crumble under significant pressure from GPs. At the top end of the market, Advent International made news by dropping the hurdle altogether from its latest fund, which nonetheless was still oversubscribed. In our 2016 survey, less than two-thirds of private equity capital raised featured a hurdle of at least 8%.
Many GPs that don’t already have 100% catch-up in their funds find it difficult to convince investors of the fairness of 100% catch-up. There has even been some movement in the opposite direction, with a substantial minority of funds in our 2016 sample moving to a ‘slower’ catch-up, typically at 50%. A tiny minority of funds have gone further, dropping the catch-up altogether in favour of a lower, ‘hard’ hurdle rate.
When it comes to carry distribution models, the 2016 research shows that the choice is usually determined by the geographic home of the fund manager:
- Most U.S. funds continue to use deal-by-deal carry structures, which are GP-friendly because individual investments can get into carry much more quickly, even if the fund does not perform well overall.
- In Europe, funds generally implement whole-fund carry structures, where carry is calculated on the fund’s returns as a whole.
There is no clear economic rationale for this longstanding difference between American and European funds. ILPA, the investors’ trade group, actually recommends whole-fund carry. But our 2016 research reveals that, for U.S. funds, the distinction may be hardening – when contrasted with our 2015 data, we see that more U.S. funds reported a deal-by-deal carry structure. The two sides of the Atlantic just seem to have evolved different market standards that are exceedingly change-resistant.
Transparency remains a major concern for LPs. ILPA has been leading on the creation of uniform, standardised reporting for LPs, to improve the baseline of information provided to every LP and strengthen fee and expense monitoring. But because every GP and fund is different, and every LP has its own unique set of preferences, comprehensive standardisation is yet to arrive.
Transparency also suffers from the growing prominence of investor-specific side letters that vary fund-level arrangements. Although general disclosure of side letters and, to a lesser extent, MFN rights have long been offered by private equity funds, there is a growing trend to insert ‘tiers’ into not just the MFN but also disclosure itself – i.e., the right to see an investor’s side letter is restricted to those investors who have subscribed at least the same commitment. Our 2016 sampling shows that this particular trend has strengthened.
85% of LPAs in our 2016 batch have provisions allowing the GP to be removed for cause – essentially the same as in the 2015 sample.
However, only 55% of LPAs in the 2016 batch gave investors the right to remove the GP without cause (compared to 66% of the LPAs in our 2015 sample). If this trend persists into 2017, it would represent a substantial shift in GPs’ favour. Whereas a no-fault divorce just requires enough investors to vote for it, removal-for-cause provisions are often hard to trigger in practice and may be contingent on court judgments that can take years to fight and win.