Something is eating at investors’ patience with their GPs. Management fees appear to be in line with, or better than, the historical average of 2 percent. Management fee offsets against other fees can range up to 100 percent. And transparency and disclosure of various fees has generally increased in recent years.

Yet 73 percent of LPs in this year’s survey say the fees charged by private equity funds are difficult to justify internally – up from 63 percent last year. And management fees once again top the list of fund terms that cause the most disagreement with GPs when conducting due diligence.

A fees minefield

So what’s going on? In part, industry players say investors continue to get miffed about fund sizes growing, resulting in ever-increasing management fees in absolute terms coming out of private equity funds. And as limited partnership agreements get longer and more complex, some LPs may be getting exasperated trying to find out exactly what’s what. That may illustrate why, even though many industry players say transparency and disclosure has improved, 60 percent of LPs – down from 65 percent last year – still say they have asked their GPs for more of it in the last 12 months.

There’s more transparency, but more complexity, too. “LPAs are often written in code,” says Eamon Devlin, partner at MJ Hudson. LPs are constantly just trying to catch up with changing fee definitions, he says. While two LPAs may charge the same rate on the same nominal service, the definitions of those services often differ from LPA to LPA, making it difficult to quantify exactly what is being paid for out of the funds.

“I’m sceptical about the industry adopting [the ILPA model LPA] on a large scale”

Christian Kallen
Hamilton Lane

And LPs are more aware of just how much money is being made from their investments. The trend in recent partial management committee sales illustrates how profitable they are, Devlin says. But it isn’t just uncapped management fees galling investors; it’s also revenue GPs are making off related business. “That’s definitely a sore point,” says Tim Selby, partner at Alston & Bird, speaking about GPs generating commissions off portfolio companies, which may not flow back into the fund. “The investment manager is using their investment dollars to get outside business opportunities…those should offset management fees.”

All this may go towards explaining why, even if LPs want more transparency on fees, 61 percent are still not likely to seek external help for fee validation. True, it is a new phenomenon, and many market players still do not even know what such a service might entail – though the California State Teachers’ Retirement System did exactly that, seeking to better understand whether the fees it pays are in line with the LPA terms. But also, investors don’t just want more transparency about what’s taking place in the fund, they want to know what’s happening outside of it, too.

“These are all truly related-party transactions, whether it’s within the fund or outside of the fund,” says Jeffrey Rosenthal, partner at accounting firm Anchin, Block and Anchin. That’s leading to greater scrutiny of all a GP’s revenues by regulators, auditors and investors alike.

After management fees, at 49 percent of respondents, LPs said the terms that caused the most disagreement with GPs were unsatisfactory/no key-person clauses (38 percent), the GP commitment (36 percent), lack of claw-back provision (35 percent) and structure of carry distribution waterfall (35 percent) – all fairly consistent with last year’s poll.

Levelling the field

To an extent, the level of improvement in various fund terms may depend on an LP’s industry weight. And since LPs do not know who else is in the fund, it is near impossible to tell whether they are getting good terms relative to their peers. To that end, in October the Institutional Limited Partners Association introduced a model LPA that could help level the playing field and make fund terms more consistent.

Unfortunately for LPs, the model LPA is not getting a lot of traction with private equity funds and their lawyers, although it is still early days. Christian Kallen, managing director in the fund investment team at Hamilton Lane, says the model LPA would be great for the whole industry. But, he added, “I’m sceptical about the industry adopting it on a large scale.”

The CFO view: What LPs really want

Our latest CFO survey reports a rise in due diligence requests from LPs as fund sizes grow

This year has been another bumper year for fundraising – and that means dealing with more investors. At the same time, those investors are seeking more information and demanding greater detail from GPs, suggests the Private Funds CFO Insights Survey 2019.

For the annual survey we polled 124 US fund CFOs in July and August 2019. Two thirds of respondents – dominated by mid-market firms with vehicles in the $100 million-$500 million bracket – expect their next vehicle to be larger than their current fund.

More transparency is increasingly important to LPs, according to survey respondents. LPs are “generally asking for more transparency into fund information”, said one CFO. Another elaborated that LPs also want transparency into “track record, reporting quality, and safety of electronic data”.

On due diligence, roughly a third of respondents reported that investors always ask about know your customer and anti-money laundering policies, cash management oversight and readiness for a cyberattack. Demonstrating good governance is clearly key.

But performance and track record data remain, unsurprisingly, the core requirements for LPs: Paramount to LPs are, “one, consistency of returns; two consistency of team, including next generation succession; and three, consistency of strategy and how you execute against that strategy, ie, – LPs do not like to see strategy stray”, one respondent said.

During due diligence, LPs like to interact with the CFO in person. The proportion that always demands to meet the CFO is rising (16 percent), while a solid majority (72 percent) sometimes ask. “Operational due diligence has increased greatly over the past few years too,” said one chief compliance officer.