Powerful general partners setting the terms again

Ever-shifting balance now puts LPs at mercy of strongest managers

The private equity balance of power is starting to shift in favor of the strongest general partners, leaving limited partners with less negotiating clout, industry insiders say.

Until the 2008 financial crisis, general partners pretty much set the rules, leaving most limited partners little say on terms, including on fees and expenses, when they committed to funds. Then fundraising got harder, and even the most popular private equity managers had to accept investors' demands for lower fees and expenses and a greater degree of transparency.

Now, the highest-returning general partners are regaining the upper hand.

“Certainly, the pendulum has swung more toward the GP compared to 2009,” said Kevin Campbell, managing director and portfolio manager in the private markets group at fund-of-funds manager DuPont Capital Management, Wilmington, Del. The firm was spun out from the pension management division of DuPont's pension plan in 1993.

It's easier to raise capital now; funds are raised more quickly and general partners have more influence on terms, he added.

Indeed, some private equity funds are closing very quickly, with access to much more capital than they need. Instead of holding several fund closings — giving general partners the ability to invest the capital commitments before the final close — a number of firms are having “one-and-done” closings. Because there are asset owners willing to invest on those terms, the GPs have little reason to give in to limited partners demanding changes to fund terms.

For example, Veritas Fund Management in August held a first and final close at $1.875 billion for its latest middle-market private equity fund, after just three months of fundraising. And private equity real estate manager Iron Point Partners LLC in November closed the Iron Point Real Estate Partners III LP at $750 million, well above its $450 million target.

And KPS Capital Partners LP held a first and final closing last year of its $3.5 billion KPS Special Situations Fund IV, above its $3 billion target. It was KPS' third oversubscribed institutional private equity fund, according to a statement from the firm at the time.

Said DuPont's Mr. Campbell: “I've seen the pendulum of power change positions several different times during the last 15 years,” where private equity fund terms are determined by the GP and sometimes they are more influenced by the LP.

Strong-performing managers that retain the same team and the same investment strategy used when they earned their strong returns have the most influence over fund terms, Mr. Campbell said. These managers also are raising a fund that is similar in size to their last fund and they have a “good investor base,” meaning investors who routinely commit to their funds, he said.

These managers are having no trouble raising capital, he said.

Data from Preqin, London, showed half of the 185 private equity funds that closed in the third quarter of 2014 exceeded their fundraising targets.

Some are increasing their negotiating clout by getting large capital commitments from sovereign wealth funds before the first close, enabling them to give other interested institutional investors a take-it-or-leave-it deal, said Stephen L. Nesbitt, chief executive officer of Marina del Rey, Calif.-based alternative investment consulting firm Cliffwater LLC.

Sovereign wealth funds that will make commitments before a fund's first close are the Abu Dhabi Investment Council, Alaska Permanent Fund Corp., China Investment Corp., Kuwait Investment Authority and New Zealand Superannuation Fund, according to Preqin.

And other general partners are finding new investors.

New group of investors

Executives at Vista Equity Partners, Austin, Texas, acknowledged they raised Vista's largest-ever fund — $5.775 billion — in part by turning to a new group of investors including the pension funds of U.S.-based multinational companies, large endowments, foreign corporate pension plans and foreign sovereign wealth funds.

Not all private equity managers first go to sovereign wealth funds.

“The strong GPs are still able to get what they want,” said Alicia Cooney, managing director and co-founder of Monument Group, a Boston placement agent. “Weaker GPs won't be in business unless theygive LPs what they want.”

The group perceived as strong contains those managers whose funds are raised quickly and are oversubscribed.

“It's a combination of high-quality returns and high-quality investors and a modest fund size,” Ms. Cooney said. “You put all that together and you get a GP who is in control.”

In the race for control over fund terms, the bulge-bracket, brand-name firms could be at disadvantage due to their size, she said.

The big PE firms “want to raise very, very large funds still because they want to invest in the very, very large deals and there is a place for them in the market,” she said.

This means that some brand-name firms, including KKR & Co. LLC, offer more limited partner-friendly terms than some of the smaller private equity firms. For example, KKR offered a performance hurdle for the first time in its history when it raised KKR North America Fund XI LP in December 2013. The hurdle requires KKR to return 7% to limited partners before the firm can receive its 20% share of net profits, said documents filed with the Securities and Exchange Commission.

By comparison, the management fee for KPS Capital's latest fund is lower than the typical 2%. But the firm is charging carried interest of up to 30%, when 20% is typical.

Some in the industry think that the recent scrutiny by the SEC of the fees and expenses charged by private equity firms could help limited partners regain some ground in negotiations with general partners. n

This article originally appeared in the December 8, 2014 print issue as, "Powerful general partners setting the terms again".