Trumped-up terms? Does it pay to be an American GP?
Although managers on both sides of the Atlantic broadly adhere to certain core principles, there are some distinct differences between the two, which are often geared in the GP favour when looking at the U.S. market. Such differences span both economic and governance provisions, and also extend to other aspects of the fundraising process, including the standard structures adopted by U.S. managers.
1. Distribution waterfall
U.S. private equity funds have historically used a more GP-friendly deal-by-deal (American-style) waterfall, whereby the manager can access carry much sooner, whereas European funds have used a more LP-friendly whole-fund (European-style) waterfall. On both sides of the Atlantic, however, there is an increasing trend towards the use of hybrid waterfalls, where a portion of proceeds is distributed on a deal-by-deal basis and another portion is distributed on a whole fund basis, albeit the whole-fund model still remains very much the benchmark in Europe.
2. Clawback and escrow mechanism
As a quid pro quo for LPs accepting deal-by-deal waterfalls as the norm in U.S. funds, it is commonplace for additional investor protections to be incorporated into the fund documentation. For U.S. funds, this can be seen through the inclusion of clawback mechanisms, and in particular interim clawbacks, which operate on multiple test dates, from the end of the investment period through to termination of the fund. In the European fund context, the standard position is for the clawback provisions to operate on termination only, but to be supported by an escrow of a portion of the carry. Conversely, as stated in the MJ Hudson 2017 Private Equity Funds Terms Research, only 14% of funds sampled which utilised a U.S.-style deal-by-deal waterfall included some form of an escrow protection.
The other principal protection afforded to LPs investing in funds adopting a standard U.S. deal-by-deal waterfall is the inclusion of guarantees. 71% of funds sampled with a deal-by-deal waterfall supported the GP’s obligation to return excess carry with guarantees, according to the MJ Hudson 2017 Private Equity Funds Terms Research. Delving further into the detail of the Research, 80% of such guarantees were from direct or indirect members of the GP entitled to receive carry distributions from the GP, whereas only 20% were from the sponsor’s parent undertaking. For funds adopting the European-style whole-fund waterfall, the inclusion of guarantees is far less prevalent, in view of the alternative protections afforded to LPs through the nature of the waterfall itself and the much greater use of carry escrow mechanisms.
4. No fault GP removal
Historically, European funds have offered greater LP protections than their counterparts in the U.S.. For example, removal without cause is typical for European funds, but far less prevalent in U.S. fund terms – of the U.S. funds sampled as part of the MJ Hudson 2017 Private Equity Funds Terms Research, less than one third provided for a no fault removal. Most U.S. funds will alternatively have a provision providing for no fault termination of the fund. Whilst this provides some degree of protection to LPs, it still does not allow LPs to remove the GP for poor performance and continue the fund with another GP.
5. GP commitment
One major difference between American and European funds is the funding of the GP commitment through a management fee waiver. This mechanism has been largely absent from European fundraising but is widely used in the U.S.. With this mechanism, the GP will elect not to receive all or a portion of its management fee and the amount ‘waived’ will instead be deemed contributed to the fund to satisfy its commitment obligation. The primary aims of this mechanism are for the sponsor to avoid taxation of management fee income at the normal income tax rate and to allow it to tap into future income to assist with funding. This is a controversial mechanism, as it begs the question whether the management fee is serving its true purpose given that the GP commitment should be provided up front rather than later on through accrued fee income. In July 2015, the IRS indicated that it may challenge the validity of this mechanism. There have been some reports and informal comments that the IRS is targeting this in audits, but no official guidance or legislation to date. In the meantime, this mechanism is still widely used in the U.S. and waived amounts range anywhere from 10 – 50%.
In recent years, the SEC has increasingly focused on fees and expenses charged by U.S. private equity fund managers. As a result, U.S. fund managers are responding with greater disclosure and transparency around fees and expenses in fund documents. For example, U.S. managers will often expand the list of partnership expenses in their fund documents from previous vintages to be far more comprehensive. This is an area of particular scrutiny with larger fund managers that have multiple product lines and are therefore exposed to greater risk in allocating expenses amongst multiple funds. In contrast, European regulators have not yet focused on this issue to the same extent, which in turn has led to much ‘leaner’ descriptions of fees and expenses charged in European fund documents.
In both the U.S. and Europe, the key takeaway is to ensure that the fund manager is using a tax efficient entity that maintains the limited liability of LPs. U.S. private equity funds are typically structured as Delaware limited partnerships or Cayman Islands exempt limited partnerships. To accommodate the tax structuring needs of LPs, many funds will contain parallel vehicles for UBTI, ECI and CAI sensitive LPs. In contrast, there is much greater variety found across European structures, given the array of legal and regulatory systems throughout Europe. European private equity funds will often be domiciled in Luxembourg, the UK or the Channel Islands. More regional funds may use a local structure, for example a French or Scandinavian fund may use the limited partnership regimes in its own country.
8. What to expect in the year ahead
It is no surprise that terms have been very GP friendly for fund managers on both sides of the Atlantic given the buoyant fundraising market of recent times. This past year we have seen fund sizes increase, in particular for larger and more established managers, and a consolidation of GP relationships by a number of LPs. We expect that fund sizes will continue to creep up over the year ahead and in any case until there is a correction in the market. In negotiating with private equity fund managers in this tricky and uncertain market, it is key for LPs to be aware of the key market differences in the U.S. and Europe to ensure that they are negotiating on the most important points in respect of which they can gain meaningful traction.