Every year, MJ Hudson surveys the terms of a broad sample of recently-closed private equity (PE), venture capital (VC) and growth capital funds, where we have advised either the fund manager or a prospective investor. In our last article, we looked at the shifts in core economic terms (fees, hurdles, carried interest) revealed in our latest survey. In this article, we examine key fund terms affecting GP/LP alignment.
Because the GP has broad authority to operate the fund, LPs depend on the GP acting in their best interests, and not primarily for its own advantage. However, there are aspects of the GP/LP relationship where the parties’ interests are not inherently aligned. This has led to the development of mechanisms which purposely encourage closer alignment.
One such mechanism is to oblige the fund’s executives to subscribe capital commitments of their own to the fund, which ensures that management has “skin in the game”. GP commitments are ubiquitous – all the funds in our 2019 survey have them – but in our 2019 survey they ranged from as little as 0.1% of the fund’s total commitment to as much as 16.7%. The traditional benchmark is 1%, but the average has been trending upwards in recent years. Nearly 70% of the 2019 cohort of funds sported a GP commitment of at least 1.5% – and in half of those it was 3% or more. Funds with a GP commitment below the 1% benchmark are becoming something of a rarity: they represented just 3% of the funds in our 2019 sample, compared with 10% the previous year.
Alignment is improved if the GP commitment is made directly in the fund (typically this is through a pooled vehicle controlled by management) and then drawn down on a uniform and proportionate basis alongside the other investors. By contrast, if the team can selectively invest in underlying deals, that could weaken the parties’ economic alignment by differentiating their exposure to risks in the underlying portfolio.
To optimise alignment, investors generally prefer GP commitments to be paid up in cash, rather than by way of management fee waivers. Only 23% of the funds in our latest survey expressly allow the use of fee waivers to fund the GP commitment.
Larger GP commitments, by raising the management team’s exposure to the risk of future under-performance, are generally considered to boost alignment. But, as a side-effect, they may also raise market barriers for first-time managers, who are less likely to have built up the personal net worth to comfortably fund a substantial GP commitment, compared to long-established firms with a history of successful funds.
Management fee offset
The purpose of a management fee offset is to limit the aggregate fee load on investors. This is achieved by deducting, from the fund’s management fees, an agreed percentage of any other fees that the management group receives from or with respect to the fund’s portfolio companies, e.g., transaction, monitoring and break-up fees. The general principle is that management shouldn’t ‘double dip’ on fees.
Offsets are now pervasive in fund LPAs: 95% of the funds we surveyed include one, and 92% set their offset percentage at an LP-friendly 100%. But even at the 100% level, it is common for GPs to negotiate carve-outs from the offset, e.g., directors’ fees received by team members who serve on portfolio company boards, or fees charged by specialist consulting firms engaged by the GP to work on portfolio investments.
Some managers have close relationships with consulting firms, which become (or may even be promoted as) integral to the GP’s value creation process, but their consulting fees, if not explicitly captured by the offset, would be treated as operating expenses of the fund, and thus be payable out of investor commitments or fund returns.
94% of funds in the 2019 survey prohibited the GP from transferring its general partner interest in the fund partnership without investors’ or LP Advisory Committee consent. 74% of funds mandated some form of restriction on the ability of principals to transfer their economic or voting interests in the management firm absent investors’ or LPAC consent. 69% of funds restricted team members’ ability to transfer their carried interest entitlements without investors’ or LPAC consent. These are all examples of ‘change-of-control’ provisions, whose purpose is to ensure that the group they backed initially remains substantially in charge over the long haul.
The detailed operation of change-of-control provisions varies from LPA to LPA. Occasionally, any transfer of interests is prohibited without the requisite consent. More commonly, transfers are permitted (i.e., won’t require investor consent) so long as they fall below an agreed aggregated threshold, which may be as restrictive as 10%, as loose as 75%, or some compromise point in between. Similarly, the duration of protection varies: from an LP’s perspective, ideally the whole life of the fund; alternatively, it may expire after the fund’s investment period. The LP agreement should be clear on the consequences of breaching the change-of-control, e.g., treating it as equivalent to a key person event or making it a cause event entitling investors to vote for GP removal.
The overwhelming majority of funds now include some form of successor fund restriction in the LP agreement governing when the manager is free to close a successor fund. The restriction will typically apply for the duration of the original fund’s investment period or, if sooner, once an agreed percentage of commitments has been invested, allocated or reserved by the manager. In nearly three-quarters of the funds in our 2019 sample, the agreed proportion was at least 75%; a further 16% of funds fixed it at 70%.
Successor fund clauses aim to ensure that management doesn’t become unduly distracted by fundraising activity for investment vehicles. They also reinforce the effective priority of the original fund in the allocation of deal opportunities during its investment period, subject to available capital commitments. Once the manager starts to accrue management fees from a successor fund, LPs in the original fund will want to ensure that there is a corresponding step-down in management fee rates in their fund.
The potency of successor fund restrictions can be hard to gauge on nominal percentage alone. The baseline also matters. It is uncommon in today’s market for the percentage threshold to be based solely on a hard benchmark of “invested capital”. Instead, it may include amounts reserved for future investments, contingencies or ordinary running costs. If the language is broad enough, the manager will retain considerable discretion over when the fund hits the successor fund threshold.
There is also considerable variety as to what exactly is being restricted: “establishing”, “raising” and “marketing” a fund are somewhat nebulous concepts, as shown by the variety of meanings ascribed to these terms by different European and U.S. regulatory agencies. “Closing” a successor fund or “charging management fees” are more precise terms, but they still allow the manager to complete most of the groundwork in raising a successor fund while stopping just short of formal closing, without breaching the letter of the restriction.
The successor fund clause often only restricts the creation of new investment vehicles with a similar investment policy to the current fund. But as management groups seek to grow their franchises by launching new strategies and products, these may fall outside of the successor fund clause and yet still have the effect of engaging executives’ time and effort away from the original fund.
You can download Part II of the 2019 MJ Hudson Fund Terms Survey here.