Early bird conundrum

Despite 2013 proving to be the best year for private market GPs on the fundraising trail since the financial crisis, the market was still a very trying place. A recent study from consulting firm Bain & Company revealed that GPs are enduring, on average now, 18-month marathon fundraises.

One reason for the protracted fundraising periods may be that investors don’t have as much incentive to commit cash before the first close, which can scupper a GP’s marketing momentum, according to multiple market sources. Part of the reason why relates to today’s low interest rate environment.

In sum: When a fund begins investing after the first close, any LP who comes on board afterwards has to buy a slice of the current portfolio plus interest – but that interest charge doesn’t amount to much when market interest rates continue to hover just above zero.

Another thing LPs are saying is that coming into the fund late no longer means losing significant negotiating power as the final touches on the partnership agreement are being hammered out (with many using side-letters to work out certain preferred terms).

So in order to gain fundraising momentum, GPs are still finding favour with “early bird discounts” that provide first round LPs with certain fee discounts. Most times the savings come in the form of reduced management fees, but fund formation lawyers note that a few GPs are even conceding a lower slice of carry to reward early bird investors (its limited popularity is apparently due to the fact that it’s harder to work out how much the discount is actually worth until seeing the final performance of the fund).

POPULARITY WANING

A development taking place now is that the early bird discount is beginning to be seen as a sign of desperation by investors; troubling news for any GP hoping a strong first round close means stepping off the fundraising trail sooner. Despite the attractiveness of a management fee that can be up to 10 percent lower, some say the concept of an early bird discount raises questions about the credibility of the GP and its ability to raise cash. However, others say that this perception is misguided.

Jason Glover, a London-based funds partner with law firm Simpson Thacher & Bartlett, and someone considered a legal pioneer of first round sweeteners, says the early bird discount is really only a possible sign of weakness if you suddenly decide to use the discount later in the fundraising process. “In that instance you are at risk of sending a message which is ‘we are using an early bird to create momentum because we don’t already have it’, whereas at the start of fundraising it’s saying ‘I want to offer an early bird in order to speed up the fundraising process’.”

A related consideration here is the notion that the management fee is meant to cover a firm’s operating costs and not a nickel more. The fact that GPs are willing to offer a discount on a cash flow meant to keep the lights on raises questions about whether GPs are baking a profit element into the original fee price that can be negotiated away.

Then again, some sources (and not surprisingly more GPs than LPs) argue that it’s ok, and in fact a good thing, that the management fee covers more than just the electric bill and other overhead expenses.

“Investors understandably don’t want managers to get super rich from the management fee as that would create the wrong dynamic; however the idea that the management fee should only just cover costs is unhealthy and creates unnecessary instability for the manager if the market, legal, regulatory or tax landscapes should change,” says Glover. “The early bird discount is relatively small and doesn’t have a substantial impact on the P&L. Any suggestion that an early bird discount could threaten the viability of a fund manager and therefore should serve as a discouragement to investors is crazy.”

THE ALLURE OF CO-INVESTMENTS

For the most part, this emerging debate around early bird discounts has resided at the top end of the market. For now it seems this type of fee concession hasn’t trickled its way down into the mid-market, says Sam Kay, head of investment funds at law firm Travers Smith.

However, that may change. Today most smaller firms try to seal early commitments on the fundraising trail by staggering the interest charges LPs have to pay for later closings (the later you commit, the higher the charge). But “that is a stick and not a carrot for coming in early,” says Glover, who adds that carrots have proven more fruitful for GPs based on his experiences. “If the rate is set so high so as to encourage someone to come in at first closing then almost inevitably it will discourage someone coming in at a later closing or indeed coming in at all.”

First close incentives are not limited to financial discounts or penalties, adds Cathy Pitt, funds partner at law firm CMS. Pitt thinks early bird LPs will be more enticed by preferred co-investment rights and advisory board representation rather than fee reductions. Co-investment rights are quite an easy thing for a GP to offer too, says Kay. “Anyone who comes into first closing is offered the right to see co-investment opportunities.” The real question then is: can the GP execute? “If they can’t, it doesn’t cost the GP a huge amount because the GP was probably prepared to offer co-investment rights anyway knowing only a small number can go through with it,” responds Kay.

Indeed LPs are keen to capture co-investment rights “just to wave something around their committee room and say ‘I’ve earned this option for us’,” agrees Jeff Davis, a partner at placement agent Eaton Partners. Then again, Glover counters that offering preferred co-investment rights may send the wrong message to investors.

He says co-investment rights are something many LPs have come to expect in order to be on equal footing with other LPs in the partnership. Whether or not GPs will continue to offer first close incentives as the fundraising market creeps back to pre-crisis levels remains to be seen, but it is clear the current fundraising environment is rewarding “out-of-the-box” thinking.

And as incentives get more sophisticated, GPs demonstrating an acute understanding of the commercial dynamics can probably shorten today’s demanding 18-month fundraising averages.

A version of this article was first produced by our sister title, PFM (PrivateFundsManagement.net)