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What Do Private Equity Investors Want Now?

Bridget Barker - Macfarlanes LLP

Following the credit crunch and the upheavals in the private equity market, investors seem, for the most part, to have adjusted their return expectations appropriately. However, limited partners are now looking far more closely at the nature of the arrangements they have with private equity fund managers.

Bridget Barker

Bridget Barker

Fund-raising has been extremely slow over the past two years, which has given investors time to sort out their portfolios and to think about the key issues in their relationships with general partners. In particular, limited partners have been focusing on fees, team composition and the level of control they have in relation to the fund. In turn, this is leading a number of LPs to reduce the number of GPs they invest with - but often to increase the amounts of money they give to those GPs. There is also a focus on the terms set out in the Institutional Limited Partners Association (ILPA) Private Equity Principles and to what extent these should be adopted by GPs. These principles were first published in September 2009 and, following considerable criticism of them, are about to undergo a wholesale revision.

It is abundantly clear that the very top-performing GPs are still largely able to dictate terms – LPs continue to want to invest with them. Conversely, GPs whose portfolios are in trouble are finding it difficult to negotiate extensions to their fund’s investment period or to raise a new fund. GPs in the middle area are being forced to negotiate and to adjust their terms to accommodate LPs’ demands. The gap between the “good” and “bad” GPs has widened.

Fees are being scrutinised far more closely. Although, in the majority of cases, carry seems to remain at the 20 per cent level, management fees are under particular pressure and prospective investors often request detailed GP budgets. A number of managers have agreed, particularly in the light of the ILPA Private Equity Principles, to return all transaction fees to investors – so the former 80/20 split (or even 50/50 for some top performing GPs) is being eroded.

The industry has seen considerable generational change – senior managers have been moving on (forcibly or otherwise) and younger managers taking over. LPs want to know who exactly is managing their investments and how much time is being devoted to that activity. There is much more focus on key-man provisions and the procedural consequences of a key-man event.

Control rights come in a number of different forms. We see LPs expecting greater transparency – partly as a result of the ILPA principles. Investor relations teams are no longer solely active immediately prior to, and during, fund-raising. Investors want better and more frequent reporting throughout the term of the relationship. They want early warnings of problem issues or team changes. In some cases (particularly for LPs with deeper pockets) this is leading LPs to look away from the classic fund structure (where all LPs are treated exactly the same) to co-investment or discretionary management arrangements that are more tailored to suit their requirements. Having a one-to-one agreement allows an LP to have greater dialogue with the GP on investments and to negotiate tighter terms - without the GP necessarily having to give these provisions to other investors. This, in turn, raises issues of transparency and fairness in dealing between investors that need to be addressed.

Another control trigger is the ability to exercise termination rights. Fault-removal provisions have generally not changed but investors are looking more closely at no-fault divorce provisions. LPs want it to be easier to walk away – with lesser penalties if they do so. LPs are also reconsidering the role of the advisory committee. Some want to exercise more power through the committee – although this can lead to concerns that the LP is “taking part in management” and jeopardising its limited liability status. Other investors (particularly those based in North America) are increasingly concerned about liability issues and want to be less involved in decisions concerning a fund and the underlying portfolio companies.

Some investors, particularly those who are members of ILPA, have been pressing for fund terms to be changed to reflect the ILPA Private Equity Principles. These set out ILPA’s views on best practice in relation to alignment of interests, governance and transparency. The principles contain a “wish list” for best practice and were aimed at the bigger buy-out funds so many of the provisions do not fit easily with smaller or more specialised funds. Stronger GPs have fought hard to resist some of the more difficult provisions and described them as “unworkable”, but as fund-raising has been slow over the last two years many GPs have not yet had to consider whether they should adopt the suggested provisions. Some LPs, on the other hand, have stated that although the principles are useful, they will still consider investing with good managers even if those managers have not adopted some of the principles.

The key points on alignment issues were adopting a “fund as a whole” (which is the traditional European model) rather than a “deal by deal” waterfall and strengthening clawback provisions so that they are gross of tax and provide that liability between the executives should be joint and several. Both of these provisions on clawback are particularly onerous and do not reflect previous standard practice. The principles also state that management fees should “cover normal operating costs for the firm and its principals and should not be excessive” and that the GP commitment should be “substantial” and a high proportion should be contributed in cash rather than offset against management fees.

Conflicts of interest are a key focus, with the aim of prohibiting a GP from resolving conflicts independently and ensuring that conflicts are presented to the LP advisory committee. The more controversial elements of the governance section focus on no-fault removal and termination rights, requiring that a majority of LPs by value should be able to suspend or terminate the investment period at any time and that a two-thirds majority should be able to remove the GP or dissolve the fund at any time.

The principles also focus on formalising aspects of the advisory committee, ensuring that its role and operational procedures are codified and that it can go about its duties without concerns over incurring costs or, indeed, liabilities. The principles suggest that the advisory committee should have access to external legal counsel, at the fund’s expense. This reflects what has been happening in practice in relation to a number of European fund issues recently. Representatives of LPs who are members of the advisory committee are required to “participate in all LPAC meetings, be properly prepared and responsibly fulfil the duties of their role.” However, no mention is made of the potential for members of the advisory committee themselves having conflicts of interest whether through investment in different funds managed by the same GP or otherwise: in fact, rather than require them to be excluded where they are conflicted (or declare the conflict), this possibility is not mentioned and instead they should be “able to take into account their own interest in voting on the LPAC”. However, European GPs seem to have followed European standard practice and tended to excuse themselves from advisory committee discussions if they perceived any conflict of interest in their position.

Additional reporting requirements were also set out in the principles, although to a large extent these provisions have been adopted by GPs as a result of market conditions, and consequently are the least controversial part of the guidelines.

A number of GPs have expressed their dissatisfaction with the principles to ILPA and some LPs also accept that they could be improved. It is expected that revised principles will be published by the end of 2010. In particular, it is thought that they will include some “standard” wording to cover clawbacks, which may, over time, become industry standard.

All of these issues mean that we are currently in a state of flux with many LPs looking to change their existing relationships with GPs. Undoubtedly, the balance of power has swung towards LPs and there is a firm focus on the terms on which, in future, LPs will agree to invest. Going forward we fully expect to see a greater variation in terms with fewer standard ten-year “blind pool” fund arrangements and a greater proportion of discretionary management agreements and co-investment arrangements that will permit LPs to enter into more tailored arrangements with their chosen fund managers.

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