PE firms courting investors with piles of cash cut fees

These are opportune times to be holding the cash that private equity funds want.

Most private equity fund sponsors that are out raising money this year know it's an investor's market. Just ask John M. Saada, a partner at Jones Day in Cleveland who advises on private equity matters.

“Most sponsors realize that it's more important to get a fund closed than to argue with their investors,” Mr. Saada said.

Limited partners are receiving a greater share of the fees that portfolio companies pay to general partners, and they're demanding — often successfully — that GPs delay collecting any profit as portfolio companies are sold until investors are paid back their investments.

According to Preqin, a provider of information for the alternative assets business, more than 1,870 private equity funds are seeking capital worldwide. Industry experts say a combination of more funds pursuing capital and fewer investors willing to put their money into them has led to friendlier terms for limited partners.

“When everyone's pockets were lined with cash ... then Blackstone (the private equity behemoth) didn't really have to listen” to investors' desires, said Tim Milanich, director of private investments for Case Western Reserve University's Office of Investments, Cleveland.

“In the past, they'd say, 'Well, we have six people behind you that will take' an investment on our terms," Mr. Milanich said.

That's not the case any longer.

“You're not going to see private equity firm managers building houses in Hawaii because of the management fees” they collect, Mr. Saada said. “You'll see the general partners making a little less than they did in their heyday.”

Resilience Capital Partners in Beachwood, Ohio, which last month announced the closing in May of a $222.5 million fund, is sharing a greater percentage with investors in this fund, said Bassem A. Mansour, co-CEO of the private equity firm. He characterized the increase as moderate.

Linsalata Capital Partners in Mayfield Heights, Ohio, closed on its sixth fund in June. According to Eric V. Bacon, co-president and senior managing director, Linsalata held steady on its management fee, but is sharing “modestly” more of the transaction and advisory fees paid to it by portfolio companies.

“We're retaining less and less for ourselves,” Mr. Bacon said.

Besides sharing more of the fees paid to it by its portfolio companies, Resilience Capital Partners is one of a number of private equity firms nationwide agreeing to an arrangement called the European waterfall, Mr. Mansour said.

Under such arrangements, general partners agree not to collect any returns for themselves until all the capital the fund has drawn down from its investors, plus any specified returns, have been paid. The practice means fund sponsors must wait longer to receive their share of any profit.

Some general partners also are extending better terms to parties that invest before a fund's first close to attract early participation — understandable, given that the time it takes to raise a fund has doubled in the last couple years, industry insiders report.

Another change giving Linsalata's Mr. Bacon pause is that general partners more often are setting lower thresholds at which limited partners can stop providing funds for their agreed-upon commitments. The percentage of “yes” votes required to approve such an action decreased in Linsalata's newest fund, meaning fewer votes are necessary, Mr. Bacon said.

“I find that (trend) a little worrisome,” he said. “If you got into the situation that we were in three years ago where the entire financial situation was melting down ... if (the investing parties) were to have a problem of their own, suddenly, they vote to say, 'OK, let's stop.' There could be unintended situations that allow that to trigger, and it really wasn't in the best interest of the majority of the (limited partners), but it still could happen.”

Many attribute the increased popularity of investor-friendly terms to the publication in 2009 of desired best practices by the Institutional Limited Partners Association, a trade association of investors.

Mr. Bacon said the changes also are the result of the maturation of the private equity business. The terms of every new fund Linsalata has raised over more than 20 years have been increasingly favorable to its investors because there's more knowledge among investors and general partners of the various situations that can arise, he said.

Some observers say more favorable terms for investors are a lasting change. Others predict the pendulum eventually will swing back somewhere in the middle.

“I don't think it's permanent at all,” Jones Day's Mr. Saada said. “The more demand (to invest in private equity), the better leverage the general partners will ultimately have. (When) there's more money out there, they can be choosier and can negotiate.”

For that very reason, some funds haven't extended friendlier terms at all. Mr. Saada said hugely successful West Coast venture capital funds have no shortage of investors vying to invest in their next funds. Thus, they still can dictate terms and charge higher management fees.

Mr. Milanich of Case Western Reserve University agreed.

“If you're a really good venture, you can do whatever the hell you want,” he said. “If you're not a ‘have,' for the most part, you're bending over backward today just to get funded.”

Michelle Park is a writer for Crain's Cleveland Business, a sister publication of Pensions & Investments