New cycle, new challenges

For many in the private equity industry, the issue of aligning interests has traditionally focused on the performance fee model and the make-up of a fund’s distribution waterfall, which encompasses the management fee, the preferred return, the carry model and the carry percentage. In aggregate, these elements seek to incentivise the manager to outperform a predetermined benchmark return over the life of the fund (that is, producing an alpha return as opposed to the market’s beta return profile), and align the GP’s interests with those of its LPs by rewarding the alpha return.

The following sections discuss the central economic terms that are designed to generate GP/LP alignment, as well as the non-economic provisions in the LPA that seek to monitor ongoing alignment and address any misalignment.

Management fees

Management fees have historically varied between 1.5 percent and 2.5 percent, with smaller funds typically inhabiting the top end of the range. Designed to cover the operating costs of the manager during the life of the fund as it sources and makes investments, more emphasis is now being placed on how exactly these fees are deployed.

A 2.5 percent fee on a first time fund can be justified on the basis of start-up costs and overheads, but when it is being levied on fund number five or six, investors have started to question how much of the (often sizeable) revenue stream is actually being used to cover overheads and what proportion is simply providing additional income to managers. In terms of alignment, the risk is that generating such fees becomes an end in itself rather than a means by which carried interest is achieved. This is especially true in larger funds or zombie fund situations.

Above a certain fund size the gap between the amounts needed to cover ongoing operational expenses and the amount actually being received as annual fee revenue diverges very quickly.

Adapting fee structures to deal with LP pressure on manager remuneration is nothing new. For instance, the practice of offsetting transaction fees against the management fee has changed significantly over the last decade with an 80 percent to 100 percent offset now the accepted market standard. With this in mind, greater focus on understanding the real cost base of the GP should enable investors and managers to reach agreement on the appropriate level at which to set ongoing fee levels.

Preferred return

The preferred return acts as a measure of beta, providing a hurdle over which the fund manager is required to perform before receiving carry. Set at 8 percent per annum for the vast majority of private equity funds, this return rate was structured to mirror the ten-year US Treasury rate at the end of the 1980s. This was widely accepted at the time as the appropriate baseline for ‘riskless investment’, yet that same rate fell below 6 percent in 1998 and has continued its downward trajectory (it was 2 percent as at the third quarter of 2012). Therefore, there is little to suggest that the original rationale for the use of 8 percent as the industry standard should still apply in 2012. For a vintage 2012 fund, is it appropriate to use a preferred return based on a historic benchmark? If we are taking it as an approximate long-term expectation of public equity returns, perhaps there is a more relevant benchmark to use. Another consideration is whether, in a difficult macro-economic environment, the use of a single preferred return, which fails to differentiate between a disastrous GP returning say 1 percent and a below average GP that returns 7 percent, is really an intelligent or appropriate tool for alignment or incentivisation.

One reason for its continued use may simply be the fact that attempting to reduce a ‘market standard’ benchmark may be seen as an admission of failure on the part of a GP. In the current climate, any perceived underperformancewill be quickly picked up by investors and competitors alike.

There are various ways that the industry can apply new thinking to the preferred return. One option would be to draw from experiences in the hedge fund world and compare performance to a beta benchmark of wider market performance. Another option may be the use of an incremental, graduated preferred return whereby managers receive a pro-rata share of carry over different hurdle levels. Lower hurdles, for example, would provide lower carry entitlements.

In either case, the aim of providing an ‘all weather’ incentive for the whole life of the fund must be the central driver of any change.

The carry model

Carried interest models can be divided along geographic lines – the European fund-as-a-whole model and the US deal-by-deal model. Despite the efforts of the Institutional Limited Partners Association (ILPA) and its Private Equity Principles, deal-by-deal remains the primary model in the US. In Europe, 88 percent of GPs continue to use the fund-as-a-whole model, which has also proved more popular in Asia and the rest of the world.

In the deal-by-deal model there is no backdating of carried interest earned in the early years of the fund; the emphasis is instead on outperformance in individual deals rather than consistent performance across the portfolio throughout the life of the fund. That is not to say that the deal-by-deal model overplays quick returns at the expense of longer deal horizons, but rather it places greater incentive on individual deal performance when compared with the back-ended fund-as-a-whole model.

In Europe, the more risk averse fund-as-a-whole model has sought to fully repay investor money prior to the allocation of carried interest. This approach sees GPs’ performance being rewarded only once investor money is no longer ‘on risk’. This risk averse approach to performance fees can also be seen in the increased focus on ever more stringent escrow terms and ‘super-hurdles’.

For a global industry to have two completely different incentivisation models apply purely on the basis of geography is an odd situation after three decades, especially as other fund terms are substantively the same across different geographies. While the end result may not be that different for LPs, it has a real impact for fund management teams. From an LP’s perspective, the ultimate question is how much money is returned to them. Under each model, this should be the same at the end of the life of the fund. For managers, however, the question rests on the timings of cash flows and the ‘reward time horizon’. Under a fund-as-a-whole model, members of the management team are required to wait longer for carry returns and are more dependent on the aggregated performance of the management team rather than individual performance. Under the deal-by-deal model, the opposite is true.

While there is a clear move in the industry towards fund-as-a-whole, there has yet to be a comprehensive, statistically argued justification for why it is actually better for LPs. This is likely to merit further study, especially given the strength of the long-term returns from US private equity funds and their repeated outperformance compared to the public market indices, NASDAQ and the S&P 500.

The headline 20 percent carried interest rate has been a central element in the limited partnership model since the industry’s inception. Entrenched by its use in the ‘model outline fund structure’ for the 1987 memorandum of understanding with HM Revenue & Customs, the UK tax authority, on the tax treatment of gains from private equity, the percentage has not changed in three decades.

Yet in the current 2012 fundraising cycle, the headline figure has come under increased scrutiny from a number of different angles. When coupled with the 8 percent preferred return, the inherent economics of a GP’s financial incentive to manage a fund remain the same now as they were in 1980s, despite fundamental changes in the industry and macroeconomic landscape.

Top performing managers have in some cases sought to address questions regarding fees in their recent funds; management fee, preferred return and carry rates have all been amended in an attempt to more closely match fund terms to individual investors’ investment risk/reward profiles. Bain Capital, for example, has reportedly offered LPs three different fee structures in its latest fund:

  • a ‘market standard’ 1.5 percent management fee, 20 percent carry, and 7 percent preferred return;
  • 1 percent  management fee, 30 percent carry, and 7 percent preferred return, and
  • 0.5 percent management fee, 30 percent carry and no preferred return. 

The key issue, however, is whether a multiple fee structure misses the point. While the different options may provide for easier matching with investors’ risk/reward profiles, it is debateable whether it actually makes for greater alignment of interest. As commitments are aggregated across the fund and deployed by the same management team, one fee arrangement will inevitably incentivise the manager more than the others. This encourages an investment approach targeted at that fee model to the detriment of the others. In turn, this may result in the very activity that the lower risk/lower reward investor was trying to avoid. Alignment with one type of investor may be at the expense of creating alignment with all others.

In other related asset classes, there are early indications that a move towards differing performance fee models is under way. Drawing on experiences in the infrastructure space, for instance, where longer investment horizons (typically 20 years) and graduated performance fee structures are the norm, some within the private equity industry are advocating the introduction of more nuanced carry arrangements to improve alignment. Offering lower preferred return rates to trigger lower carry entitlement may, for example, help to address the significant misalignment which can occur in underperforming funds. To illustrate the point, the introduction of a 10 percent carry entitlement between 1x and 2x capital returned, with a 30 percent  entitlement over 2x capital returned, may do more to help to incentivise managers than a blunt 20 percent carry entitlement over an 8 percent  preferred return.

GPs adopting this approach would be the exception rather than the norm and the pace of change, even in a difficult fundraising environment, is slow. Received wisdom suggests that few managers have the past performance or predisposition to allow them to fundamentally alter their traditional fee models. Empirical evidence suggests that while there is an appetite among GPs, and some LPs, for change, it is a majority of larger institutional investors that shy away from new fee/incentive
arrangements. The reason for their hesitancy could be explained either as a consequence of an unwillingness to deviate from the models they understand or a reluctance to countenance the fact that, in many cases, alignment is not effectively achieved for new funds by employing old models.

GP commitment

The GP’s own ‘skin in the game’ – that is, the amount of money that it is willing to put into the fund itself – has become a real point of alignment pressure. LPs want to see that GPs have their own money on risk in funds, so that they share in any potential downside as well as the inherent upside provided for by carried interest.

This pressure has seen the more traditional 1 percent GP commitment rising to 2 percent and above. However, to focus on headline rates may be to miss the crux of the issue. While a larger GP commitment, funded by diverted management fees or carry from previous funds, does provide a tangible financial inducement to GPs to perform well, the management team that have to remortgage their homes to fund a 1 percent commitment have arguably much more to lose if performance falters. That GP’s desire to see the fund outperform is probably disproportionately higher than the LP’s and some would argue that the alignment of interest weighs too heavily against the GP. The end result will be a constant drive to maximise value for the fund – the overarching aim of GPs and LPs alike.

LPs want to see the same hunger amongst GPs that drove them to outperform in previous funds repeated in a new fund and the easiest way to achieve this is to place a GP’s own money and financial security at risk.

GP removal

One much negotiated, though little used, term of the LPA is the GP removal clause. Seen by many as the nuclear option when misalignment between a GP and its LPs reaches a critical juncture, the traditional approach of attaching onerous compensation conditions and high investor vote thresholds has militated against its use in all but the rarest of circumstances.

Commonly drafted as a ‘for-fault’ or ‘no-fault’ removal, with correspondingly arduous voting thresholds, the option of a ‘no-fault’ removal has always been viewed as somewhat academic. Aside from the effort required to mobilise a sufficiently large proportion of the investor base to meet voting thresholds, considerations of market reputation and ongoing relationship management have been cited for the under use of the power accorded to investors in the LPA.

However, with a growing number of funds testing the traditional alignment model, recourse to the GP removal clause may become more necessary. When undertaken as part of a wider restructuring of the manager and its funds, the possible upside of introducing a new management team may, on balance, outweigh the effect of shorter term compensation requirements and the cost of continued misalignment.

This extract is taken from PEI’s The LPA Anatomised (see