The world according to LPs

PEI recently sat down with a panel of private equity LPs, including Michele Kinner of Quilvest, to get their insights into top issues in the industry.

Guidelines published by the Institutional Limited Partners Association last year – known as the ILPA Private Equity Principles – have done much to advance the conversation between LPs and GPs and are a good “starting point” for better alignment of interests.

That’s according to a panel of LPs who sat down with Private Equity International in October for a wide-ranging discussion about some big issues facing LPs today, including ILPA, GP reporting, private equity fund sizes, amendment requests and the future outlook of the asset class.

The ILPA Private Equity Principles were published last year and cover a variety of hot-button LP issues including fees, how carry is distributed, clawback provisions, key-man provisions and enhancing the quality of GP reporting.

While the guidelines focus on an important dynamic in the industry – alignment of interests – they give “too much voting and decision making power to the [LP] advisory board”, according to Sheryl Schwartz, the former head of alternatives at Teachers Insurance and Annuity Association, College Retirement Equities Fund (TIAA-CREF).

“I think all LPs should have a vote in major decisions. That’s one reason I was apprehensive in supporting [the ILPA principles]”, Schwartz says.

Earlier this year, Schwartz left her position with the TIAA-CREF to join Washington, DC-based Perseus, a mid-market private equity firm focused on growth capital deals.

Schwartz says she also would have liked the ILPA principles to suggest the LPs in a fund have one law firm to represent all investors, which is standard practice in fixed income deals.

“[Now], each firm negotiates the give and take separately. Aside from the cost being quite high, to me that’s called divide and conquer from the GP perspective,” Schwartz says. “If one counsel represented all investors, the GP could never say, ‘Oh, you’re the only one asking for that’.”

David Turner, Mike McCabe and Sheryl Schwartz

The idea of one counsel representing all LPs in a private equity fund sparks vigorous discussion among members of the panel.

“I buy that to a point: to the extent the GP says, ‘Oh, you’re the only one asking for that’ and holds you hostage,” says Michele Kinner, a partner at family office Quilvest in charge of all private equity fund investments in the US. But every LP in a fund has different interests, so organising LPs around specific points of contention can be tricky, she says.

Also, Kinner points out, “We’re not a large investor in most funds, so the last thing I want is to share in a pooled cost of other large institutional investors’ legal negotiations. We know we can’t really move the needle much, so we check to make sure the terms correlate to the offering documents,” she says, “but we don’t usually try to change major structural elements like the waterfall or the intricacies of the clawback timing.”

GPs have been slowly coming around to accepting certain ILPA principles, and especially seem to be compromising on sharing more of the transaction fees with the fund, says Jamie Ebersole, senior investor director with SL Capital Partners, a fund of funds. The presence of the principles has empowered LPs to confront GPs on terms important to them.

“A lot of the LPs, including some of my former colleagues and other folks I talk to in the market, have gone directly to GPs and said, ‘Look, if you don’t sign up to a lot of these principles, we’re not going to sign up for your fund’,” Ebersole says.

Form many LPs, however, the ILPA principles are a starting point for negotiations between LPs and GPs, rather than a binary checklist.

One term that always gets pushback from GPs is how to time a clawback, says David Turner, head of private equity at Guardian Life. “There’s always multiple issues that always seem to be debated in a very live manner,” he says, noting that interim reporting and true-ups – also known as clawbacks – during the life of the partnership are high up the agenda.

Power, like a pendulum, has swung to the side of the LPs since the financial downturn, Turner says, and the codified ILPA principles are an important reason for that swing. “But the thing about pendulums is they swing back,” Turner says. “We just happen to be in a particular time in the cycle which favours LPs. [The pendulum] will continue to move back and it will be a sellers’ market again in two or three years, perhaps longer.”
Since the ILPA guidelines were published, there have been concerns raised by GPs that the principles amount to “collusion” among LPs. But the publication of the ILPA guidelines does not represent the first instance of LPs trying to get together to talk terms and conditions.

Before the ILPA principles were created, large institutions committing to private equity funds did get together once in a while during LPA negotiations to discuss terms and conditions issues in the industry on a more informal basis, Turner points out.

“We had conversations. We got together and picked a few key points. If they happened to be sticking points we could create a sense of force,” Turner says. “It didn’t always work. A lot of capital came into the market between 1998 and 2000, and created a sense of ‘pulling back’ from wanting to have a common negotiating base, because we were also competing with each other in a lot of ways for spots in top groups.”

There’s a bubble building in Asia right now – a capital bubble – and it’s being exacerbated by accelerated investor interest

ILPA has done wonders for organising LPs into a more coherent group with similar goals, the LPs agree. But LPs will always be somewhat at odds with each other because of conflicting interests and fiduciary duties relating to their individual client bases, SL Capital’s Ebersole says. For this reason, organising LPs is a bit like “herding cats”.

“You can get a common agreement on certain points like fees – and the ILPA principles are good to get you on that path – but LPs are still competing to a certain extent,” Ebersole says.

In a down market, though, “collaboration isn’t a problem, because access isn’t a problem”, Schwartz says. “However, two years from now, it will be a more frothy market where it will be hard to get into some funds and access will be limited. In that environment, where LPs are competing for allocations, collaboration over deal terms will be less.”

LPs also work to build relationships with GPs and each institution has its own way of negotiating with a manager, Quilvest’s Kinner says.

“How you negotiate with managers – who puts your requests forth – that’s all part of the building blocks of the relationship, which governs your future access and your priority in the co-investment world,” Kinner says. “We all like to apply our own style to developing those relationships.”

If you put a bunch of private equity LPs in a room, inevitably talk will turn to fees. Fees have been an issue for LPs since the dawn of the industry and, as Ebersole stresses, most LPs have no idea where the idea of “2 and 20” even came from, despite being the industry norm.

While a 20 percent carried interest rate isn’t usually debated by LPs, the management and transaction fees have become a major issue in limited partner agreement negotiations. Many LPs get frustrated over fund sizes because they have to pay management fees on huge pools of capital that might only be investing slowly, or might not be performing well.

Are there better ways of working out a fee structure? A fee model based on the operating budget of the firm is a concept returning to LPs’ vernacular. This model would require LPs to have extensive, detailed knowledge of the firm’s operating budget, and to review budget reports on a regular basis.

“Initially several VC funds tried it, but ran into issues surrounding the determination of the right budget,” Ebersole says. Disagreements could arise on things like compensation. How, for example, do you determine market rate for deal team wage packets? The question then arises about which LP should lead the charge on the appropriate pay levels, says Ebersole.

“It’s great in theory and I think it would be the best way to run a firm, but it is very hard to implement in practice,” Ebersole continues.

With GPs requiring their portfolio companies to provide not just annual budgets, but also quarterly and often monthly budget discussions, it would be interesting to see how they would react if the LPs ask for quarterly budgets from them, Schwartz says.

“But truthfully, if I were an LP, I wouldn’t want the job of reviewing a lot of budgets quarterly. That’s too big of a job for any LP. In addition, if the review of the budget were done by only the advisory board, it would probably give them more fiduciary duty than they are willing to assume,” Schwartz says.

Some up-and-coming managers are more amenable to tying fees closer to operating budgets, Turner says.
“I’ve actually even been able to get one partnership to agree to much more detailed disclosure on what they’re charging for partnership expenses,” Turner says. “With the more mature funds it’s quite difficult – if not impossible – to do. There’s little precedent behind it.”

Another fee idea the panel discussed was to only charge a fee on drawn capital, rather than on committed capital. One concern is that under this kind of fee structure, GPs would be incentivised to invest capital as quickly as possible, says Mike McCabe, a partner with private equity advisor StepStone Group.

“They’re here to make money and fees are part of making money,” McCabe says.

But carried interest “pays them more than the fee, and the way the waterfall works, usually the fee is repaid before the carry is calculated. In addition, under current tax law, one is ordinary income and one is not ordinary income. As a result, there’s a huge incentive for the GPs to make sure their compensation is largely carry instead of [the fee]”, Schwartz says.

Fund size will remain an issue as long as LPs are paying fees on committed capital, Schwartz adds. Over the 10-year lifespan of a fund, she explains, it is impossible to predict when the investment environment will be favourable and when private equity firms will be crowded out by competitors. With this in mind, LPs could find themselves paying management fees on a huge fund while the capital just sits there uninvested. “LPs would not be very concerned about the fund size if people weren’t paying management fees on undrawn capital,” Schwartz says.

A calculation that many LPs are making these days when considering commitments to competing funds is whether paying higher fees can be justified by higher return expectations for a particular fund. As the asset class becomes more “institutionalised”, the world will become more competitive for GPs, Ebersole says, increasing pressure on differential fees.

Justifying fee levels that become generators of wealth is getting hard for GPs. “In an increasingly more competitive market, the fees are easy to focus on because they are big numbers that come up front.  They are an easy target for boards to rip apart,” Ebersole says. “In all cases, we seek a holistic view on fees to ensure that management and other fees are aligned with the size, scope and strategy of the individual fund.”
With fund returns under pressure, the industry will see a “shakeup and shakeout” in the bottom performing 75 percent of GPs, Turner says.

Yet, says Ebersole, GPs achieving various performance levels – even those considered mediocre – may be able to stick around as long as they satisfy their LPs expectations. “LPs have to think about what required returns they are looking for on their capital and if it justifies making an investment in this asset class,” he says.

Michele Kinner

Some larger institutions have relatively low return thresholds and not every LP is looking for 15 to 20 percent returns from their private equity managers these days, says Ebersole. “Some investors think if private equity is going to earn above 10 percent, it’s still an interesting place to be based on their individual return criteria.”

“While we have been through a severe downturn where many managers have underperformed,” Ebersole continues, “You won’t get rid of everybody. There will continue to be a process of cleansing that will take place naturally. And groups that are median or third quartile – some of those groups will survive because they’ll continue to generate returns that are good enough for the folks that are invested in them.”
Looking forward, the LPs around the table are excited about the prospects for 2011 in private equity. They expect a flood of funds to come to market of varying strategies. Some investors will be backing away from the asset class, or at least contributing much less to new funds, giving LPs sticking with private equity a wide array of choices. Access could even be easier to the most exclusive funds in the market.

“We’ve had all these debt renegotiations successfully accomplished as financial institutions didn’t want to end up being the owners of companies through foreclosures,” says Kinner, adding that a lot of firms are preparing to bring funds back into the market. “We could have a lot of different things to choose from in the next couple years that should allow us to be more creative instead of being herds all going into the same things, like it’s ‘mega-cap year’ or it’s ‘small-cap year,’” she adds.

LPs also expect to be dealing with more amendment requests in 2011, especially because firms have to register with the US Securities and Exchange Commission by 21 July.

“In order to comply with a lot of those SEC requirements, GPs are going to have to invest in systems and compliance personnel and probably amend some of their documents. It may be in immaterial ways, but they will require amendments, so therefore GPs will have to go back to the LPs to get amendments in areas that conflict with the new regulations,” Schwartz says.

Anticipating tax law changes for more than two years, GPs also have been adding language in the partnership agreements to account for any changes in tax law that could affect compensation, Turner says.
Finally, LPs are intensely focused on emerging markets like Brazil, China and India, according to the panel members. LPs want exposure to the emerging markets for the yield, but there are certainly risks, including potential capital bubbles building in China and Brazil.

“There’s a bubble building in Asia right now – a capital bubble – and it’s being exacerbated by accelerated investor interest,” Turner says. “In Brazil, the local pension funds are being authorised to invest in local and regional private equity funds. [The flood of capital] will create a rush to create partnerships by some less experienced managers. Previously successful entrepreneurs may realise they can make more money being a GP, raising money and charging management fees, and they can be successful more quickly than if they were going long-haul and starting companies.”

The returns need to warrant the risk, McCabe says, and to some extent “the jury is still out” on whether they do.

Still, observing the growth first hand in an emerging economy can be a humbling experience, McCabe says. In China, growth is everywhere: “Every time we go to Shanghai and Beijing and look around, it’s pretty amazing. And even inland, the further inland you go, it’s still amazing,” McCabe says. “It reminds us of previous industrial revolutions with the roads and the bridges, the buildings, the dams, the infrastructure. Big money is being spent.”

The world is a complicated one right now for private equity LPs: from choosing which terms are most appropriate, to picking quality managers and finding the right strategies. The commitment to the asset class, however, remains firm.