Every year, MJ Hudson surveys the terms of a large, diverse sample of recently closed private equity, venture capital, growth capital, infrastructure, real estate and private debt funds, on which we have advised either the fund manager or a prospective investor. In our first article, we looked at shifts in fund economics – fees, hurdles, carried interest. In this article, we examine the impact on GP/LP alignment of recent changes in fund terms.
Why does alignment matter?
Because the manager has broad authority to run the fund, investors rely on the manager acting in their best interests, and to generate the returns that the investors have sought with them. This can be enhanced by aligning the manager’s economic interest in the fund with its investors’ interest.
The simplest mechanism to improve alignment is what is colloquially known as “skin in the game” – when the fund manager’s executives make capital commitments of their own to the fund, in effect putting them into an investor’s position.
This “GP commitment” was traditionally 1% of total fund commitments, which originated as a U.S. technical point. MJ Hudson’s market surveys over the last three years show that the average GP commitment now tends to surpass the 1% benchmark significantly. In our 2018 survey:
- one-third of funds have a GP commitment in the 2-3% range;
- 35% of funds have GP commitments of at least 3% (and, in about half of these funds, it was at least 5%); and
- only a quarter of the funds surveyed had GP commitments below 1.5% (about half of whom were sub-1%).
Successor funds tend to have higher-percentage GP commitments, at least when compared to first-time funds. This may be because emerging managers simply have less personal wealth to draw on to finance big cash commitments, compared to the industry veterans running long-established firms.
In principle, the higher the GP commitment percentage, the better the GP/LP alignment should be. But one should always reckon with the detail. Certain other features are important to reinforcing alignment. From an LP perspective, the GP commitment should be:
- subscribed in cash, rather than by way of management fee waivers;
- invested in all of the fund’s investments, rather than on a discretionary or selective basis;
- mainly subscribed by the GP’s key executives, if possible.
Management fee offset
The object of a fee offset is to limit the aggregate fee load in a fund, by deducting transaction, monitoring, break-up and other fees (which the GP and management team earn from the fund’s portfolio companies) from management fees (which the GP receives directly from the fund’s investors via capital calls). The idea is that management shouldn’t ‘double dip’ on fees.
Offsets are now ubiquitous in the industry: 92% of the funds we surveyed include one, and 98% of those set their offset percentage at an LP-friendly 100%. But the devil is in the detail. Even with an ostensibly 100% offset, there will be some fee leakage if it is not drafted to be comprehensive.
Common exclusions include directors’ remuneration (paid to GP team members serving on the boards of portfolio companies), and fees charged by specialist consulting firms who work with the GP on all or particular investments. Some managers develop close relationships with consulting firms, which become (or may even be marketed as) important to the fund’s value creation process, but the consultant’s fees are surplus to the GP’s own management fee.
Change of control
Another way to solidify GP/LP alignment is to lock the management team in for the long term – the fund’s life or, at least, its investment period.
74% of the funds we surveyed imposed a change-of-control restriction, which requires the management team in place at closing (or specific key executives) to hold an agreed percentage of the economic and voting rights in the GP. Any transfer that would cause them to fall below the percentage threshold requires investor consent.
The threshold varies from fund to fund – it may be a simple majority, 75% or more. It will often encompass not just the ownership of the GP / manager / investment adviser, but also individual entitlements to receive carried interest distributed by the fund.
84% of the funds we surveyed bar the manager from raising a successor fund until the end of the current fund’s investment period or, if earlier, once an agreed percentage of commitments (usually 70-75%) has been invested, allocated or reserved by the manager.
As with many fund terms, the detail needs to be analysed. It is rare for the percentage threshold to be linked to a hard benchmark of “invested capital”. For instance, it may also include amounts reserved for future investments, contingencies or ordinary running costs. If the language is general enough, the manager will retain considerable discretion over when the fund hits the successor fund threshold.
“Establishing”, “raising” and “marketing” a fund can be nebulous concepts, as shown by the variety of meanings ascribed to these terms by various European and U.S. regulatory agencies. “Closing” a successor fund or “charging management fees” are less open to interpretation, but they still allow the manager to complete most of the work of raising a successor fund without breaching the letter of the restriction.
The manager is also often free to raise a new fund if it does not have the same investment policy as the current fund (i.e., is not a direct competitor), but this can still have the effect of drawing managers’ time and effort away from the current fund.