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Hard Terms

A lot of investors claim to be much tougher on negotiating terms these days than they used to be. But how much ground are they gaining (if any)? And what are the areas subject to discussion? Helix Associates' Sarah Clarke examines.

Private equity is a maturing asset class. As such, the agreements between investors and their fund managers have a core set of established terms and conditions that are not materially affected by swings in the market: 20 per cent carried interest, 1.5 to two per cent management fee, the eight per cent hurdle rate and so on. These key terms may shift in exceptional individual circumstances, but only by reference to widely recognised market standards.

Of course, there are terms that have not settled into a standard form, precisely because the industry is not yet fully mature and still throws up new developments. The relatively recent development of the mega-fund, for example, has refocused attention on management fees. Assets under management (and the associated fees) have often outstripped team size to the point where the team is no longer seen to be 100 per cent motivated by the carried interest. It is, understandably, in relation to these less stable terms that we have seen the greatest investor activism.

Investors seeking to negotiate terms are motivated partly by a desire to realign GP/LP interests and partly by a heightened awareness of the risks involved in committing to a potentially volatile and illiquid asset class. Almost all firms have come under pressure to set management fees at ‘reasonable' levels and to share transaction and other fees to a greater extent with LPs. Some investors - particularly those in the public sector - are uncomfortable with the idea of high personal wealth creation by individual GPs. But in general LPs' main concern is that GPs' interests are be more closely aligned with their own and that their personal enrichment should be dependent on carry.

Following the market crash, investors are also more interested in protecting their assets from the worst case scenario. Consequently, the last two years have seen tighter investor control through, for example, no-fault divorce clauses, lower compensation to GPs on divorce, stricter clawback controls, advisory board seats and proliferating sideletters and most favoured nation agreements.

LPs are negotiating with some success on all these points, whether a fund is oversubscribed or not. Management fees on large funds are falling: it is now standard to reduce not only the basis on which fees are calculated after the commitment period, but the percentage as well, and no-fault divorce clauses are starting to be widely accepted as market standard. In the latter case, the previous norm of paying the GP compensation in the form of two years' management fee is under attack. In the US, where terms are toughest, GPs routinely agree to zero to six months' compensation. In Europe, the norm is 12-24 months.

Longer due diligence
Market conditions have also affected the due diligence process - a condition of investment, if not a term. It is possibly the most important part of the fundraising process and, faced with falling returns and failing funds, investors have instigated increasingly rigorous processes. Only oversubscribed funds are able to apply any pressure on potential LPs to speed up their due diligence efforts. The majority of funds experience the reverse, as investment proposals are subject to intense (and time-consuming) scrutiny all the way to the investment committee. As a result, most GPs are having to go through up to 12 months of intensive due diligence before an LP is prepared to invest. In the long term this is a positive development for the industry as it weeds out underperformers. In the short term, of course, it makes life that much more difficult for fundraising GPs.

Demands - and determination - vary according to the investors concerned. Terms are often tougher in the US, and US investors are correspondingly more demanding, particularly on issues such as clawback. In part, this is because many US investors are invested in funds where escrows have actually been drawn on. There have been fewer such casualties in Europe. On the other hand, US investors are generally more pragmatic than their European counterparts. In an oversubscribed situation, most US investors are prepared to compromise rather than risk missing an opportunity. In general, European investors play closer to the book.

Pressure to invest
In our experience, the negotiations and due diligence that leading funds of funds carry out are always the most detailed and comprehensive. These firms generally spearhead the latest developments in terms. But their scope for negotiation can be limited. They are responsible for investing a certain amount of commitments over a certain number of years and as yet no fund of funds (to our knowledge) has returned capital to investors for lack of opportunities. They have certainly rejected funds on the basis of unacceptable terms, but this ultimate sanction can clearly be used only sparingly, particularly where more popular funds are concerned, and where there is a danger of earning a reputation for being difficult.

Funds of funds are not alone in feeling the pressure to invest. Research has shown that as private equity markets cannot be timed, it is vital to have exposure to all vintage years. All sophisticated investors are therefore subject to programmes that allocate a minimum amount to private equity investments each year. Although investors are currently cautious, the consequence is that the pressure to invest is still there, on both institutions and funds of funds. The tension between this pressure and increased risk aversion has caused a ‘flight to quality' - or at least to easily defensible investment decisions.

One of the attractive features of private equity is that there is a clearly defined group of top decile performers. And in this difficult environment, virtually all investors seek the ‘safety' that this group represents. As a result, a small number of funds have been heavily oversubscribed and, when dealing with this elite, LP leverage has been neutralised. Oversubscribed GPs can resist unfavourable innovations or case-specific demands such as stringent key man provisions.

In this situation, the onus is on the LP to negotiate skilfully. Size, as ever, is important. An investor will always have more leverage when committing E50m rather than E5m. But personal chemistry is also important. Much of this is common sense. An LP asking for five or six key points, who is prepared to act pragmatically and use commercially minded lawyers is more likely to win than one whose lawyers submit long lists of demands and insist on wrangling over minor points. LPs need to be very clear about what they want and why they want it.

Getting what they want
This fundraising environment is an opportunity for LPs to impose terms that work in their favour, according to their fiduciary duty. They are certainly doing a great deal with both carrot and stick to increase their control over their fund managers throughout the life of the fund. But it is important that GPs are not subject to overly heavy burdens (a GP with a minimal management fee, for example, will not attract high calibre junior staff).

However, LPs do not always use their leverage efficiently. Few realise the importance of engaging a business-like lawyer and much time is lost on every fundraising with arguments over points that do not have a material impact on the overall investment. Moreover, although LPs have similar concerns and consequently raise similar points, they very rarely join together, even informally, to increase pressure on their general partners.

In this fundraising environment, there is little need to seek extra leverage. But the pendulum will swing back as the cycle turns positive again; the number of GPs able to dictate terms will increase and LPs may lose again the ground they have gained. All participants in this maturing market have everything to gain by ensuring that any future standardisation of terms fully reflects their interests. It may be important to read the small print - but nothing beats actually writing it.

Sarah Clarke is an associate at Helix Associates in London.

Copyright © 2003 Helix Associates