How do the negotiations change when dealing with first-time funds vs. follow-on commitments?
FB: When we're dealing with first-time funds, I think the biggest issue is the absence of a solid track record. This makes it more challenging to determine the fund's likely success going forward. Because of that relative uncertainty, I think we try to push a few terms that are more favorable for the client: higher hurdle rates or the delay or elimination of the catch-up, so the risk profile stays fairly attractive and the risk of underperformance gets shifted to the investment manager.
In follow-on funds, oftentimes what we are tying to do is tweak terms. We try to find ways for our clients to benefit from the relationships that we develop with managers and from our position in the industry by negotiating scale provisions—a lower fee or a different hurdle or catch-up if you invest in that fund up to a certain size, but, if you invested in the previous two funds, to a different size.
What were some hot-button issues in the past year?
FB: A lot of it still focuses on the economics: manager's fees and carried interest. What we have seen is perhaps more aggressive posturing coming from managers, particularly those top-tier managers with strong performance track records who can raise billions of dollars. We've seen preferred returns that have been reduced: they used to be routinely ten percent to 11 percent for opportunity funds and these have fallen to nine percent to eight percent. Catch-ups have been accelerated and in some cases we've seen 100 percent catch-ups proposed after hitting the preferred return. Catch-ups have hit at 80 to 20 in favor of the GP or 60 to 40 in favor of the GP.
MR: The changes mentioned are primarily attributed to the increased leverage a lot of top-tier managers have. It might also be due to lower return expectations on the manager's part. The key for investors is to remain focused on the fund's overall risk/return profile. Sometimes that means making some tough decisions. Either biting the bullet and going with a fund with terms that are less than ideal or walking away from a manager with a good track record because the terms are not sufficient.
How have negotiations with GPs changed as more capital has entered the market?
MR: A lot of managers are able to turn capital away, as well as raise capital relatively quickly. So, in addition to investors having to make difficult decisions regarding terms, investors are required to complete due diligence and submit subscription documents really quickly. In this environment, it is important to remain disciplined and make sure terms and conditions are not relegated to the back burner.
Have the important legal issues changed recently?
MR: If you made a list of all the significant legal issues today and compared it with a similar list from five or ten years ago, you wouldn't find many differences—management fees, core economic terms, key-man provisions and deal flow covenants [all remain important]. There has been some change in recent years. Confidentiality is more important today than it was five years ago and, as investors look more at funds with a global focus, tax structure is increasingly important.
Key-man clauses and succession planning have been a big issue in the private equity world lately. Have there been similar discussions in private equity real estate?
FB: Absolutely. We spend a lot of time trying to understand who owns what and what types of provisions are in place to keep senior and junior personnel intact, including things like vesting and ownership rights. We have seen enough lift-out and split-off in recent years to recognize that this is a serious issue for most of these funds.
What would be the biggest piece of advice you would give to LPs and GPs as they structure their private equity real estate partnerships?
FB: Pick your battles. If you are an investor, you can sometimes have a laundry list of issues you want to deal with, but probably you'll want to focus on a few issues that will be really important at the end of the day. Those will likely be the core economic issues that drive returns, as well as certain governance issues that ensure you have the team you bargained for at the table. So, have a focus on what will affect the bottom line.
On the GP side, it's the same point. If an investor raises a valid point, it's worth considering—even if you think you have the leverage to muscle someone down. This is a long-term game for most of these folks and you want to have a successful business and not raise one fund at a time. Therefore, think about the future. This is an environment that will last for some period of time and then it will change. When it changes, you may have investors that will remember how they were treated this time around.