The new rules of the LP game

Sustained top performance means continued evolution and change. Technology became ever more accessible in the 1990s when personal computers began appearing in every home. But if you're a tech-savvy person today, you're not using a dial-up connection on a desktop computer. Everyone knows you can't be successful today using 1990s technology.

Similarly, private equity players can no longer use a 1990s-era rulebook to structure funds. The world is a more complex place than it was two decades ago. There's a different playbook now, and limited partners and general partners need to keep a few things in sight to navigate the nuances smoothly.

If you're looking to invest in a private equity firm's 10th fund, you are unlikely to be seeing the same terms and structures used in the first two funds. There are new considerations to take into account and a heightened interest on the part of regulators to go through fee arrangements with a fine-toothed comb. That some of the largest private equity funds can be caught off-guard by the Securities and Exchange Commission is testament to how confusing and difficult keeping track of fees can be.

Much of what LPs will need to look out for focuses on fees and expenses, both in how they are calculated and how they are charged. Offsets to the standard charges can be a much overlooked item in a limited partnership agreement.

The most common offset today is fee income earned by the general partner or associates from the underlying investments being applied as a reduction to overall management fees. These fees and offsets are important for LPs to understand and keep track of. In recent years several large private equity firms, including some of the most well-known, have been challenged by the SEC over a lack of discipline, accuracy or disclosure in allocating amounts and communicating the scale of such transactions to LPs.

For example, two fund managers have been fined for failing to adequately disclose details of accelerated monitoring fees to investors. In each case, monitoring fees payments by fund-owned portfolio companies were accelerated prior to the companies' sale or IPO. By charging these fees prior to the event, the SEC determined the fees had reduced the value of the companies prior to their sale or IPO, which was effectively to the detriment of fund investors The investigations concluded that the managers had failed in their duty to properly disclose the information regarding the monitoring fees acceleration and were instructed to pay disgorgement amounts along with interest to affected investors and a penalty to the SEC.

It's not uncommon to see a 100% offset of fee income generated by GPs or affiliates from the portfolio, although a lower rate is sometimes used when the core management fee is itself a lower percentage. Typically offsets are made for transaction fees, monitoring, director fees, underwriting fees and other fees such as abort/broken deal/breakup fees, and advisory fees. Items such as excess organizational expenses and the placement fees also are generally covered by the manager, or offset against management fees if drawn separately.

And about those management fees. While a 2% fee is a historic norm and common on smaller or midsize funds, we're seeing a lot more variation on the commercial terms today. The standard “2 and 20” is something that is challenged, particularly in larger funds where it would make for a high absolute level of charges. Indeed this very traditional fee structure might become the almost exclusive territory of only the largest brand-name firms that continually post stellar returns.

In an effort to make the fee-carry structure reflect current sensitivities, one option that limited partners are exercising with greater frequency is to secure rebates through side letters. Such personal terms, in cultivating the long-term relationship, can be given to preferred LPs that commit capital at a fund's first close or to those that invest significant commitments. LPs and some regulators now routinely demand greater transparency and disclosure of key side-letter terms offered across the investor base — whether on fees, co-investment opportunities or other commercial points.

Another variation that bears note is the way management fees are charged. Some funds charge in a more granular way, with fees based on the mix of what has been drawn and what has not yet been drawn, charging a different percentage for capital drawn vs. not. And don't forget about the post-investment period, when fees are generally lower — and subsequently tail off.

Investors don't want to see GPs earning the bulk of their compensation from management fees alone. The Institutional Limited Partners Association has recommended that ongoing fee levels are reviewed for “reasonableness” in the context of GP operating expenses, to ensure alignment of GP and LP interests. GPs should be motivated to outperform by their own “skin in the game” rather than by their core annual fees. LPs want to ensure the GP's have sensible operational cost coverage and are able to make reasonable profits for their manager/adviser business to withstand the economic cycle. Just as you wouldn't buy a car without looking at how the engine is running, you will want to see how a fund manager budgets its money. GPs should expect this level of inquiry.

LPs also will expect to look at the fee and carry structure of the firm's previous funds. Did the last fund hit its expected targets? If not, why wouldn't there be some kind of inducement in the new fund to make it more attractive to investors? Were there issues with other LPs? Very often LPs exercise right of first refusal to invest in a follow-on fund. Are there an unusually large number of openings for new LP relationships with a fund on the fundraising circuit? If so, questions also will be asked about why previous LPs aren't coming back. There could be perfectly reasonable explanations for this, but it could raise a red flag. Also, will you have right of first refusal to invest in follow-on funds? If not, why not?

General administrative and operating expenses typically aren't significant over the life of the fund, but there are several things to note on overall costs. One is that there should be a reasonable cap on the organization expenses. Keep track of such caps and track if, when and how a fund has exceeded the agreed amount. Also be on the lookout when there is a parallel fund, a co-investment fund or any other kind of multifund structure. Expenses should be drawn only from the specific vehicle where applicable, but if not, then drawn equitably from all vehicles in a group if it's a general or common expense.

Keeping these things clear from the beginning of the GP/LP relationship can avoid awkward discovery later. It's important that both sides of the private equity fund equation work to stay current on the fee and carry practices that are becoming standard.

The fund terrain has become more difficult to navigate with more complex investment, fee and compensation packages that seek to be equitable and fair, but can easily be confusing and frustrating. With increasing complexity comes opportunity for private equity players to embrace change and modernize their approach. There's no better time to start than today.

Gaurav Marwah is technical director and Hugh Stacey is executive director, investor solutions at Augentius Group in London. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.