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Keep laying those golden eggs

Terms and conditions in private equity investments are outdated and unfair. General partners make money no matter how well – or poorly – they invest limited partners' money. Isn't it time for more innovative and equitable agreements between the two parties?

Over the past ten years we have seen little innovation in the terms and conditions contained in limited partnership agreements. Why? Part of this is because general partners have been adept in neutralising action by limited partners to change terms. This has been due to the weight of less discerning money that has been thrust into GPs' coffers. When we have brought to the attention of general partners certain irksome clauses, we have been greeted with the response that we were the only limited partner to have raised those points. When you speak to other experienced investors it becomes clear that this has been an effective ploy to ‘divide and rule'. Equally, during a period when markets were roaring, investors focused more on the excess of net returns over public market comparables.

Today we face a more difficult environment. Gross returns are continuing to decline substantially and more investor attention is being paid to the impact of those terms on net outcomes. It is instructive that most private equity managers display their record on a gross basis and leave the investors to calculate the net returns.

It is hard to avoid fees and incentives in all walks of investment, but in the case of private equity, fees and incentives appear to be excessive relative to risk. In simple terms, limited partners put up at least 99 per cent of the capital, pay a management fee of between 1.5 per cent and 2.5 per cent of committed capital over the life time of the partnership and in compensation are allocated between 70 per cent to 80 per cent of the gains. Is this a marriage made in heaven? I think not.

Look at it the other way round. General partners put up under one per cent of the capital, receive more than adequate current compensation and are favoured with between 20 per cent and 30 per cent of gains. More incredible is that investors are effectively locked into partnerships for ten years or more. Convicted felons are in for less time. General partners appear to be compensated for lack of liquidity while limited partners are actually being penalised. This is evidenced by the discounts to NAV available to limited partners in the secondary market. Questions need to be asked as to why management fees are calculated on commitments rather than invested capital and why at a level of 1.5 per cent to 2.5 per cent?

Way back in the 1980s when the industry was in its infancy, fund sizes were relatively small and the fee covered the cost of running the fund. Today, fund sizes have grown exponentially. General partners may be deriving current income from two or more funds. Each subsequent fund generates additional contributions, which flow directly to the bottom line of the general partners' management company (an entity usually shrouded in mystery). Perversely, for some groups the management fee has become more significant than the carried interest. This can't be right. Again, at the dawn of private equity time, carried interest was relatively modest in money terms because fund sizes were equally modest. In today's climate, at the top end, fund sizes are over E1bn. At these levels unassuming multiples can produce very decent levels of carried interest, thank you very much.  

In terms of business risk, most private equity groups are reasonably secure because of long tail management fees. This is not the case for money mangers such as INVESCO. We are at the mercy of volatile markets and capricious investors who liquidate their positions at a moment's notice. For full-blown equity risk exposure we receive a princely fee of under 50 basis points. Either our general fees are too low - or private equity fees are too high.

It has become an accepted wisdom that carried interest has to be 20 per cent of gains that becomes payable to general partners after capital has been returned to investors. In many instances there may be, additionally, a preferred return based on a less than onerous hurdle rate. Once limited partners receive back capital and the preferred return, further proceeds - good or bad - are automatically shared 80:20. The problem is that they are not subject to any performance test. For example, an investment may not even return cost but 20 per cent of the proceeds will still go to the general partner.  I do not begrudge paying carried interest, but there should be subject to an element of performance.

A simple solution would be to have a graduated carried interest where each increment, after the repayment of capital, attracts a rising level of carry. If capital is returned, general partners receive 0 per cent carry; next £50 million, five per cent; next £50 million ten per cent up to, say, a maximum of 30 per cent. That way, only superior performance would generate superior carried interest.

The BVCA Performance Measurement Survey for 2000 makes interesting reading in showing excellent performance, on average, over the past 20 years. However, it excludes funds raised after 1996 when the industry really took off and a significant proportion of the underlying investments remain unrealised (at higher valuations than today). But the key point is that over the long term, half the funds have under-performed the FT All Share. The average may be fine but it is not as relevant as the median. Moreover, the buy-out funds in the survey used debt to enhance returns and it can be argued that if an equity portfolio was modestly geared, the returns, over the ten-year period surveyed, would have exceeded the private equity net returns.

Range of returns - ten years

Source: BVCA Venture Capital and Private Equity Performance Measurement Survey 2000

The private equity market has matured. But to survive over the longer term, it needs to reassess thoroughly its compensation structures. At the same time investors, should be taking a lead to promote terms that are fair to both limited and general partners.

Copyright © Ray Maxwell 2001

Ray Maxwell is managing director, private equity, INVESCO Asset Management