FEATURE: More power to LPs

In a perfect world, fund sponsors hope to get their ideal terms inserted into the PPM, with the ambition of replicating them in the Limited Partnership Agreement (LPA).

In 2009, that didn’t work out as a strategy as limited partners railed against terms which often proved disadvantageous in the downturn.

It should come as no surprise therefore that a study by Zurich-based asset management and advisory firm Strategic Capital Management – and published exclusively here – suggests that last year a rather different sequence of events occurred.

Instead of a seamless transition of terms from the PPM to LPA, some managers changed their terms and conditions as they negotiated LPAs, while others were left open for debate later in the process. The latter scenario was owing to the simple fact managers were unclear about what terms limited partners would accept. Rather than give up all negotiating power on terms already in the PPM, many GPs left open the option of further negotiation.

Winning the fee war
 
In SCM’s research document, entitled “2009 – Annual Review of Private Equity Real Estate Terms and Conditions”,  the firm concedes that with so few funds closing last year its research is limited in relation to what terms made it from PPM to LPA in 2009 alone. Nevertheless, an examination of negotiations by SCM for prior years suggests several terms that favour the LP have made it passed the negotiating table.

One example relates to management fees. LPs have gained enough bargaining chips to force an increasing number of funds to charge management fees only on invested capital from the start of a fund’s life, rather than on the committed capital.

Clearly, LPs were troubled that too many managers were using their funds as a fee-generating machine rather than an investment vehicle. Many argue shifting the fee emphasis onto invested capital rather than uninvested capital avoids that particular conflict, but it also brings with it a fresh concern, according to SCM.

LPs were troubled that too many managers were using their funds as a fee-generating machine rather than an investment vehicle

The firm points out that this increasingly popular structure creates a conflict because it incentivises managers to deploy equity more quickly, rather than allowing a GP to wait for the opportunities as and when they arise. The implication is that current fund documents increase the temptation for the manager to get the equity out of the door perhaps in deals that they might not necessarily have done were they able to earn fees while still sat on their dry powder.

For their part, managers tried to push LPs on terms in 2009, not least through a performance-based step-up of the carried interest rate. Some GPs tried to get a 20 percent carried interest for meeting an 8 percent hurdle and a step- up to 25 percent if a hurdle of 15 percent was met. SCM says though this term stood “no chance of success” for GPs keeping the initial hurdle at 8 percent. To agree to such a deal the LPs needed a higher-starting hurdle.

One of the most important changes to terms and conditions took place to the waterfall provision, according to SCM.

No LP enjoys having to claw back carried interest paid to the GP when later investments in the fund prove unsuccessful. In 2007, nearly 60 percent of real estate funds that closed on capital commitments agreed a deal-by-deal carried interest model. By 2009, that norm was switching. Last year, negotiations suggest this figure has fallen to under 40 percent.

Taking the place of deal-by-deal carry was a paid-in capital waterfall model. Nearly 60 percent of funds stipulated that the GP had to return the paid-in capital plus a preferred return before the manager could get their carried interest. Benjamin Baumann, vice president at SCM, says the research shows “LPs are pushing GPs hard to lower their management fees” in the current fundraising environment.

The market won’t know how far the balance of power has shifted towards LPs yet, but this study suggests the pendulum is moving significantly in their direction.