The recent recommendations outlined by the Institutional Limited Partners Association, which called for a greater alignment of interests between GPs and LPs and higher levels of transparency and partnership governance, received a major endorsement this week from the California Employees’ Retirement System (CalPERS). But although ILPA scored a seal of approval from the largest pension in the US, not everyone in the industry is as enthusiastic about ILPA's “Private Equity Principles”.
ILPA’s membership includes 220 of the most influential private equity investors in the world, who roughly together control $1 trillion in commitments to funds around the world. The ILPA principles perhaps not coincidentally come at a time of increased negotiating power by LPs.
Among the “best practices” put forth by ILPA were that LPs should be repaid first on all contributed capital plus a preferred return before GPs get carried interest, clawbacks should be gross of taxes paid, management fees should “step down significantly” once a follow-on fund is formed and deal fees should go completely toward the benefit of the fund. They also call for limited partners to be given stronger rights to suspend, terminate or dissolve a fund.
As ILPA begins collecting endorsements for its principles, Private Equity Manager sought out feedback from various non-LP players in the industry. Although they focused on different aspects, several of the respondents voiced similar concerns: if adopted wholesale, some of the guidelines do not represent a true alignment of interests; and smaller or newer firms will be affected more than established players.
The responses from those surveyed by PEM are below. Some are sourced, and some are anonymous:
This debate has been going on forever. At times like this, the LPs get uppity, but as soon as the pendulum swings the other ways LPs are crawling over each other just to get into funds – no matter how onerous the terms are. Unless big chunky-bite sized investors take the lead here, little will happen, or new and small guys will pay the price. Until the big guys – US public plans – pay their investment staffs market rates and staff them appropriately, as is done by plans in other countries, little will happen.
– US placement agent
Frankly to me it all makes sense, if it was your money you’d want these things too. To me I think it’s fair, it looks straightforward. Some of this stuff on the governance is a little over the top, but on partnership expenses, fees and carried interest calculations, that stuff is all pretty straightforward. All of it is a little more hand-holding than I would expect from them, but on the other hand I think they are really trying to make sure there is no confusion. I think all of it is practical, we do most of this stuff so it doesn’t to me feel like a big burden. I do think it is interesting that it came out now and it’s so thorough, there has been quite a bit of frank conversations through the fundraising process about alignment of interests. And at least in the venture space I am seeing more venture mangers starting to realise if they are going to have any real value they have to get their investors a return, not just raise money.
I think the new firms will have to do most of this, in some ways they’ll hold it out as ‘look at us, look at how pristine we are because we are following the ILPA guidelines’. I think there is a general sense in the investor community that it is time to get these funds managed right. The other thing is these managers are all deal guys and they forget that they are really in the asset-management business, so I think you need to be far more respectful of what the type of structure we have and how much of a good thing we do have and how we have to manage money correctly to make it stick.
– US managing director
I have read the ILPA publication and did not find many surprises in there, though some of the issues they propose do not, in my mind, resonate a true alignment of interest. For example, clawback being pre-tax will/can leave the GP in a negative cash position if a refund is not available, or if there is a mismatch of capital loss and ordinary income. And the aversion to management fee waivers/credits towards capital contributions is not necessarily alignment because the principals will often be using management fee cash to pay capital calls anyway, so it is better to use pre-tax cash than after-tax. Alignment of interest is a motivation behind most sponsor groups that I represent, which is why I have often guided them to a management fee step-down based on rate and not based on invested capital. Basing it on invested capital skews, or potentially skews, motivations. I advise my clients to avoid clawback situations from an operations management standpoint, almost at all costs. I think GP clawbacks, like LP clawbacks, are a huge setback in the ability to raise a subsequent fund.
Management fees should be geared towards operating budgets; that should not be the profit center for the fund. I completely agree with ILPA there. The profit reward/bonus should be the carry. But operating budgets cannot be predicted for 10 years up front so they should not be so tightly drawn that variations in the operating environment hamstring the management team several years in. Often it is transaction-based fees that make the difference in this regard, so a split of those may be appropriate. This is easier to assess when in Fund III or IV or later, because you have an operating track record and a transaction fee track record. As counsel to a sponsor, I would prefer to see a cap on transaction fees at some percentage of budget or some number rather than a 100 percent offset.
I am not used to seeing a [limited partner advisory committee] with such an active governance role as they are proposing. So practically it is not a problem what they have stated, I just don't see that happening, even now. In terms of indemnification, some of the limitations they articulate should always be the case (intra-principal disputes for example), but I don't think caps are a good idea. Insurance is a more appropriate solution than caps. Removal of the general partner without cause is not something I think generates an alignment of interest. It is indeed difficult (and expensive) to prove cause, so if the percentage is high enough that one can say that SO many LPs want out that there must be something amiss in the management, then that can work. But that supermajority should be a very high standard. So these provisions need to be carefully tailored to each individual situation.
– Julia Corelli, partner at law firm Pepper Hamilton
My thoughts overall are that the guidelines are generally reasonable and clearly designed to be favorable to the LP. Very importantly, this attempts to return many of the components of the GP/LP relationship to what they were when this industry first started. Investing in private equity is a privilege accorded to very few, and it is important to make sure that the terms under which private equity is managed are fair to both the GP and LP, are of high ethical standards, provide appropriate incentives for all and, most importantly, are consistently applied and sustainable over time. I think that this document seeks to achieve these objectives. It is not clear how many of these changes will be largely or totally adopted over time. Change tends to happen incrementally in our industry. However, the ILPA guidelines provide a very good framework for working through these issues.
– Managing partner at a US private equity firm
Nothing really startling [in the guidelines], sort of every LP’s wish list. Adoption is another matter. There are still GPs out there that LPs want to get access to desperately (KPS’ latest top-up comes to mind, Kleiner and Sequoia as well) who in many ways can still set their terms. As GPs fundraising prospects become weaker and weaker, they are more willing to accept more of these terms. The only problem is, if a GP is weak enough to bow across the board, do you really want to invest with them at all? At the end of the day, terms don’t drive returns, fund manager acumen does. That does not go to say that I don’t want to invest with someone whose interests are totally unaligned with mine, but where is the breakpoint? And how do I balance between terms and prospective performance?
– US placement agent
They are talking about these advisory fees being 100 percent offset, which I can never understand how you can go charge a company to be on their board and provide them advice and then take 100 percent of that cap home when the money that was given to you by the investor base is why you are on the board of that company, that always seemed like a big conflict. So I think in general that’s the biggest problem for the buyout industry today, and it’s something that people can get figured out and be a part of their programs. But to me this is just further institutionalisation of the asset class, which is going to make us finally earn our keep. Because if you are chopping your fees in half once you raise another fund, you have to worry about your overhead, you can’t just jack up your salary and take home $4 million at the end of the year because there are LLC dollars there. Is charging the company management fees the right thing for the company, because it is certainly not going to benefit you any longer. All of that stuff to me makes for a better performance, and a better industry.
Some of this stuff will stick, but most of the economic stuff will depend on the popularity of the offering and the ability to access the offering, and so in a perfect world everybody would love to have this stuff be immediately adopted, but most of these firms that aren’t restricted by their capital base have a lot more say over how their fees come together than the ones that are. So if you are struggling to raise money you are going to bend, and if you’re not struggling to raise money you are going to have a philosophical conversation about alignment of interests but not a lot of change.
– US managing director
While most of the “preferred terms” in the report are on many LPs' standard “wish list”, several of the suggested terms go well beyond what we regularly see LPs request. The best funds are those that generate the best returns net of fees, not the firms that charge the lowest fees. It is not clear that deferring or reducing GP incentives will always lead to better net returns; it could be counterproductive.
Appendix A of the report recommends as standard a distribution “waterfall” providing for the return of all capital contributed by investors, plus a preferred return on those capital contributions, before any carried interest is paid out to the GP. I expect that many US private equity firms will strongly resist adopting the “return all capital first” approach, which can delay carried interest payments to the GP for many years. While many LPs will favour the “return-all-capital-first” approach recommended by the report because it reduces clawback risk, LPs should consider carefully whether deferring carried interest payments for several years (as compared with the US “deal-by-deal” approach) is the best way to incentivize GPs to maximize returns to LPs–particularly.
The report's recommendations on reporting and governance (including avoidance of conflicts of interest) are thoughtful, and are the parts of the report that are most likely to be well received by GPs. Not all of the suggestions are practical for every fund. But as private equity firms have grown, conflicts of interest have become more common, and require more careful attention.
– Michael Harrell co-chair of the private funds group for Debevoise & Plimpton