THE ANNUAL REVIEW 2010 - PEI Media

private equity annual review 2010 pa g e 81
t e r m s & c o n d i t i o n s
Terms tug of war
The push-pull between fund managers and investors over
terms and conditions may not have been as dramatic as
some assumed, finds Nicholas Donato
Limited partners’ rising negotiating power
on terms and conditions was discussed frequently
in 2009 and 2010.Tougher fundraising
conditions, more GPs needing to
replenish dry powder and LP-friendly terms
and conditions guidelines released by the
Institutional Limited Partners Association
were all said to have given LPs the upper
hand in many cases.
But a study released last year by New
York-headquartered law firm Debevoise
& Plimpton found there had been no
“substantial shift” in terms in the past five
years. The study examined more than 200
buyout funds globally, comparing the key
financial and legal terms of funds that had
final closing prior to the financial crisis, with
those closed post-crisis.
“LPs and their advisors are vigorously
negotiating fund terms these days, in many cases
citing the ILPA [guidelines] to support their
arguments,” the report acknowledged, adding
there was, however, little evidence of an overall
industry-wide shift of power towards LPs.
The study measured nine key economic
terms of buyout funds: the timing of
carried interest distributions; carried
interest percentages, preferred return
rates; management fees both during and
after the investment period; sharing of
transaction and other fees; joint and several
guarantees on GP clawback provisions;
interim clawback provisions; and after-tax
calculations on clawbacks.
On most demands, including the timing
of carried interest distributions and carry
points, little concession was found to have
been made on the part of GPs.
giving way
LPs did however gain ground on a few
issues highlighted by ILPA – most notably
on transaction and management fee reductions
or offsets.
The Debevoise study found many GPs
gave way on management fee “step downs”,
which had been long-demanded by investors
who argue that reduced management fees
after the wind-down of a fund’s investment
period reflect lower operating costs.
Large funds raised after the crisis – those
of $2 billion or more – had post-investment
period management fees of on average 1.1
percent. Those raised before the crisis charged
a fee of 1.24 percent. For smaller funds, the
post-crisis funds charged 1.73 percent in
management fees after the investment period.
Pre-crisis funds charged 1.81 percent.
Concessions were also made on the
handling of fee offsets, which occur when
a GP reduces or cancels management fees as
a result of receiving income from break-up
fees, transaction and/or monitoring fees
Show of strength: GPs and LPs in
2010 continued to negotiate hard
on terms
charged to portfolio companies.
Also found more prevalent in post-crisis
funds were more LP-friendly clawback
provisions, which allowed fund investors
to recover money in the event GPs receive
too much carried interest – such as when
managers receive carry on successful exits
early in the fund’s life. In noting ILPA’s
recommendation that GPs should make any
necessary clawback payments within two
years, as opposed to waiting until the fund
completes its last exit, the study revealed
16 percent of the sample funds now provide
for the provision compared to the lesser
10 percent of funds offering the provision
raised during the boom years.
While many GPs have given in to LP
demands on fees, however, it may not be
enough. For instance the California Public
Employees’ Retirement System (CalPERS),
a trendsetter in the LP community in terms
of negotiations with fund managers, has
indicated it may push for incentive-based
fees rather than flat management fees.
Should that proposal become policy,
there will no doubt be further friction
between LPs and GPs on the fee front. But
is that such a bad thing? After all, a leaner,
hungrier group of smart, hardworking
managers who merit their fees is good for
the industry as a whole – not just CalPERS.
The squeaky wheel complaint from LPs of
GPs growing fat on fees gets jettisoned and
instead there is an unambiguous alignment
of interest. No more “heads I win, tails you
lose” as one fund formation lawyer recently
put it to PEI. n