(You can find our 2017 Private Equity Fund Terms Research report here.) In this article we explain what’s changed since last year and where fund terms are headed.
Our research indicates that investor pressure on private equity fees is ebbing in the face of booming fundraising.
- The traditional 2% fee remains the market norm – weighted by capital raised, 62% of the funds raised by GPs was subject to a 2% fee, a slight increase compared with our 2016 survey. The 2% fee is popular with small-cap (sub-$500m) and large-cap funds ($1.5bn-$4.5bn).
- The 1.5% fee cropped up predominantly at a relatively small number of GPs, but their funds tended to be mega-cap funds ($4.5bn-plus). This suggests that a GP’s willingness to lower the fee level to 1.5% is commensurate with the sheer size of the overall fee, rather than any particular need to discount.
- At the “low-cost” end of the market, the number of funds charging fees of less than 1.5% more than halved between 2016 and 2017.
The headline fee rates don’t necessarily tell the full story. GPs are often willing to lower fees for particular LPs, on an individual basis and in groups defined by some special characteristic, for instance if the investor makes a big commitment, backs the fund at first closing, or re-ups from the GP’s predecessor fund. Fee discounts can be implemented in the LPA on a fund-wide basis, or they may be negotiated with investors individually by side letter. Depending on how loose the MFN obligation is, these side deals may remain undisclosed or, if disclosed, may not be made available to the investor base as a whole. The persistence of these practices makes it difficult to gauge a fund’s true fee level.
Getting the management team to make a substantial capital commitment to the fund has long been seen as the epitome of GP/LP alignment – “skin in the game”, as it’s known. In our 2016 survey, the majority of GPs invested between 2% and 3% of a fund’s total commitments. But in 2017 this dropped to between 1.5% and 2%. We also saw the emergence of something new: a small minority of GPs making zero or sub-1% commitments. It’s not all bad news for alignment. The number of GPs committing 3%-plus in 2017 remained stable when compared to 2016, whereas the number of GPs committing 5% or more doubled in 2017.
As part of their due diligence, LPs should confirm:
- How the GP commitment is being financed – management fee waivers, bank debt financing and contributions-in-kind are all suspected to reduce true alignment.
- Who is eligible to participate – across our 2015, 2016 and 2017 findings, we find that fund managers often define the GP class quite broadly, which means that a large chunk of the GP commitment may not actually be funded through the personal wealth of the fund’s own executives.
Even though low interest rates have persisted for nearly a decade, the long-established 8% hurdle rate continues to be iron-clad in the private equity market. Measured by capital raised, 93% of the funds we sampled reported a hurdle rate of 8%, whereas just 7% reported a sub-8% hurdle (which, in this year’s sample, was always 0%).
Our 2017 findings are nearly identical to our 2015 survey and also show a ‘market correction’ from what we found in 2016, when only two-thirds of the sampled funds sported a hurdle of 8%, although it’s true that the 2016 figures were skewed by two mega funds (accounting for $25bn in capital) famously dropping the hurdle altogether.
Back in 2016 we saw a substantial minority of funds shifting to a ‘slower’ catch-up, typically at 50%. A few funds went even further by dropping catch-up in favour of a lower, ‘hard’ hurdle rate. However, 100% catch-up has come roaring back in 2017, with 93% of sampled funds (measured by capital raised) providing for 100% catch-up. 88% of those are ‘fast’ to the GP (i.e. they distribute all post-hurdle distributions to the GP until the GP has fully caught up). The remaining 12% of funds with ‘slow’ catch-up tended to be funds with non-standard tiered distribution waterfalls.
Historically, European funds favour (LP-friendly) whole-fund carry, while American funds prefer (GP-friendly) deal-by-deal carry.
Back in 2015 we found that whole-fund carry was making inroads into the US market, yet in our 2016 sample the use of deal-by-deal surged on both sides of the Atlantic. However, the 2016 surge now looks like an anomaly. In our 2017 batch, 88% of European funds adopted whole-fund carry, a big jump from the 67% we recorded in 2016. And although deal-by-deal carry still topped the survey in America, whole-fund carry accounted for a healthy 36% of American funds in 2017, up from 20% a year before.
The deal-by-deal model is gradually evolving with enhanced LP protection. For instance, in the 2017 sample, we found that interim clawbacks feature in 71% of deal-by-deal funds. However, these interim clawbacks are mainly based on fair market value tests which leave a lot of discretion in the GP’s hands. Moreover, only a minority of interim clawbacks have multiple test dates. In our sample, no deal-by-deal fund with an interim clawback offered escrow protection, although 80% of such funds did offer personal guarantees.
Most investors recognize the need to improve the baseline of information provided by management and strengthen fee and expense monitoring. To this end, ILPA and others have been leading on the creation of uniform, standardised reporting for LPs. 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 growth of LP-specific side letters that vary fund-level arrangements. Although 61% of funds report an MFN clause (up from 57% in our 2016 data), there is a growing trend to insert ‘tiers’ into not just the MFN but disclosure itself – i.e. the right to see an LP’s side letter is restricted to those LPs who have subscribed at least the same commitment.
A large majority of funds permit investors to vote the GP off the island – in our 2017 batch, 96% of funds provide for cause removal (up from 85% in 2016), while 68% allow removal without cause (up from 55% in 2016).
The increase implies that LPs are becoming more assertive. But, diving into the detailed terms, we find that the effectiveness of removal rights is often blunted by a variety of GP-friendly conditions, including:
- Delay: 47% of funds deny investors the right to vote on no fault removal for some period after final closing, typically two years.
- Voting thresholds: 63% of funds require a 75% majority to trigger no fault divorce, with 21% imposing even higher requirements, e.g. 80% (and, occasionally, 85%).
- Fee compensation: 84% of funds award the GP compensation if it is removed without cause (typically calculated as a multiple of the annual management fee).
- Carried interest retention: none of the sampled funds imposed a 100% haircut. Instead, 69% allowed the GP to retain 100% carried interest in respect of investments made prior to the date of removal. A mere 10% of funds imposed a haircut (typically, 25% to 50%).
We think that investors’ tolerance of these trends is down to:
- Search for yield. In the current low interest rate environment, private equity continues to appeal to LPs looking for high absolute returns and portfolio diversification.
- Solid performance. Distributions to LPs have exceed capital calls in every one of the past six years, and it is the third successive year in which net cash flows to LPs have been well in excess of $100bn.
- LP demand. 2016 was the fourth consecutive year in which private equity fundraising surpassed $300bn; 40% of institutional LPs report their intention to allocate more capital to private equity in the next 12 months then they did during 2016.
- LP liquidity. Many LPs are very liquid as a result of continuing distributions and are reinvesting that liquidity back into its source.