Management fees are the biggest bone of contention for investors across the alternative asset classes.
“We see a lot of discussion between LPs and GPs on performance fees and management fee terms for infrastructure funds,” says Rahul Manvatkar, investment funds partner at global law firm Linklaters. “There is wide divergence in the market, driven by how GPs are generating returns and how that is perceived by LPs.”
The second most significant source of conflict is an unsatisfactory key-person clause – or no key-person clause at all. Investors increasingly want to see a wider group of partners fall within the key-person definition, as well as greater clarity over trigger events and remedy periods.
Other causes for concern among investors include the GP commitment. Investors have always scrutinised the level of skin-in-the-game that a manager has. This has become increasingly challenging for GPs as fund sizes have escalated – 2 percent of a $20 billion infrastructure vehicle is not be sniffed at.
Investors typically also insist on cash, as opposed to a management fee waiver, to further ensure that interests are aligned. This is also why they favour direct investment into a fund as opposed to a separate co-investment vehicle. Although these co-investment funds are not uncommon, they do represent potential conflicts if the GP is able to vary investment on a deal-by-deal basis.
Equally, some GP co-investment vehicles allow the GP to increase its commitment over time. This means the GP can increase its exposure in a positive market but remain flat in a poor market – a luxury not afforded to investors.
Hurdle rates are cited as another cause of potential disagreement in the due diligence process. These rates hit the headlines in 2018 when Blackstone proposed a 5 percent hurdle on its $40 billion infrastructure fund. This was rebuffed by several of Blackstone’s LPs. The firm nonetheless got the fund with a 6 percent hurdle, making it one of a select group of managers to break the intransigent eight percent norm.
Also ranking on investors’ gripe lists were investment restrictions, a lack of clawback provisions, the carried interest distribution waterfall and performance fees. Set-up costs and board representation policy, however, were the least controversial issues.
Transparency and disclosure
Sixty percent of LPs in alternative asset funds called on their GPs to provide greater transparency and disclosure in 2019. This marks the continuation of a trend that has been ongoing for the past few years, bolstered by a widespread crackdown that has seen the US Securities and Exchange Commission take a tougher stance on violations.
GPs have been forced to adapt their limited partnership agreements to provide greater detail on fees and expenses. Transparency around operating partners and directors’ fees, for example, has increased dramatically. However, some other fees that have historically been prevalent, particularly in private equity, such as monitoring fees, have disappeared altogether.
The growing complexity this has brought to LPAs has created a challenge for investors – how to make sure the fees they are paying actually align with the provisions of their agreements.
Several public pension plans, including New Mexico State Investment Council and California State Teachers’ Retirement System, have retained outside help to assist with this process.
The Teachers Retirement System of Oklahoma was the latest to join their ranks after uncovering at least four errors in its recent history of interactions with GPs in 2019.
However, our survey shows that the majority of investors continue to handle this matter internally. Almost two thirds report they did not plan to seek external help for fee validation over the next 12 months, and only 13 percent say they did.