LP/GP relations - No more Mr Nice Guy?

At the AVCJ Beijing Roundtable this past February, Harbourvest Managing Director Philip Bilden remarked: "At 2% of $100m, we're paying a reasonable fee; when the fund value drops to $50m, that 2% is another story."

The fact is, as global venture player Qiming Venture's founder Gary Rieschel points out, the basic model governing LP/GP relationships hasn't changed much (if at all) in the past 25 years. Whether the manager is in the top decibel or the lower quartile, the fund gets 2% for management fees and there's a 20% carry after the LPs' money has been returned - all other transaction, monitoring, and management fees go to the GP. There are differences between the European and US models in terms of when and how the money is paid out, but as markets rise, fall and now plunge, the basic structure has remained the same.

As Bilden further noted: "The reality is the supply and demand of capital." Therefore if a GP is returning 30%, few if any LPs are likely to question the fee structure. In the current downturn, that's simply not the case in most instances. With portfolio markdowns of 20%-30% at year-end 2008, distributions likely to be far in the future, and capital calls looming on the horizon; is it any wonder that LPs are starting to grumble?

According to Martin Day, vice-chairman of the Institutional Limited Partners Association, although many LPs accept that GPs are going through their own issues, there is an underlying sentiment that they are to blame for much of the difficulties affecting both groups. "People believe this is a self-made problem," he says.

The head of private equity at one large investor adds: "LPs are definitely an angry group. They're trying to use the secondary market to help them out, but so far the market isn't co-operating. North of $60bn was put into the secondary markets last year; so far this year the amount is estimated at about $30bn. What is getting priced and transacted is a small fraction of this amount."

The fees debate

At the root of much of the unhappiness lies questions over the division of the enormous sums of money that have flowed into fund managers' hands over the past 5-10 years. "We can show that private equity has outperformed over a long period of time. There is an issue, though, in terms of distributing excess returns," asserts AlpInvest economist Peter Cornelius.

The starting point is simple economics. "People have lost a tremendous amount of money - up to 50%. In our lifetime, this is wealth destruction without precedent," states Ernst von Fischer, Sal. Oppenheim Private Equity Partners' senior adviser. However, with a number of private equity GPs landing on the Forbes' billionaires list, and the two co-founders of Blackstone walking away with over $2bn from what has become a "disappointing" IPO, it's not hard to understand why LPs are beginning to question who benefits from their money.

So, how are these 'excess returns' being distributed? "Management fees and transaction fees are very much a hot button and most LPs believe that this area was significantly abused in the past couple of years," says Day. "GPs should stop charging fees back to these portfolio companies - if these businesses are in dire straits, stop taking out the equity."

In the early days, private equity funds took money in the form of their 2% management fees, but generally made their money on the carry. Then after the stock market crash of 2001-2002, larger private equity funds began charging for services, with a list including advisory fees, monitoring fees, and straight dividends. "We want a 100% offset on transaction fees," Day states simply.

"Then there's the whole issue of clawback liabilities," says one US corporate pension fund investor. "GPs did a given deal at 6x Ebitda, and the value increased to 8x. Then they do a recap, declare a profit, take 20% of it and send it out. Now the deal is worth 4x, but the GP has already taken carry that he isn't entitled to in this market. They didn't treat it as a return of capital, but as a dividend. Generally, clawback is due at the end of the fund and LPs won't want to wait until the fund is fully liquidated to recoup those dollars."

Of course, though, there are those who take a different view. One senior institutional investor argues: "The fees are egregious, but they occur mostly in the megafunds. I was never fee centric: whether the fee is between 1.5-2% isn't going to make a difference if they return 30%; whether the hurdle is 6%, 7%, or 8% isn't going to make a difference." But he does admit that his fund "had a strategy of avoiding the megafunds."

Limited prospects

With all of these issues in the air one might think LPs are ready to strike, but the issue is not that simple. For starters, LPs are a disparate group that generally don't talk with one another beyond a fund's annual meeting. They come from different countries, different time zones, and have different investment profiles. And, for those who have won access to top GPs' funds - access that may have taken years to achieve - the last thing they want is a fight with the GP.

The lack of cohesiveness of the LP community is emphasized by Sheryl Schwartz, managing director of alternative investments at pension fund TIAA-CREFF: "Everyone has different issues that are important to them. One institution may be focused on fees, another on co-investments, another on reducing the carry. LPs have different priorities and this limits their ability to get together. Every negotiation is a trade-off."

Furthermore, in an effort to prevent uprising, many GPs have become more solicitous of their investors in recent months. "All of our questions are answered more fully now, and in a much friendlier manner," says von Fischer. Furthermore, despite increasing discontent over fees fuelled by the lack of deal activity, many GPs are truly working quite hard. "On our side we're very focused on operations, cash-flow, and monitoring our companies very tightly," notes venture house Walden International's founder and chairman Lip-Bu Tan.

But, the question remains, how far will LPs extend their patience in what looks to be a very difficult environment? Pennsylvania State Employee Retirement System's director of alternative investments, Bruce Feldman, suggests that going forward smart private equity investors " will try to negotiate more LP friendly terms in partnership agreements and side-letters." Another institutional investor adds: "Some LPs are saying something, but they will likely live with the terms they have unless fund managers come back to them for relief on other terms - then they will be pressing to make changes."

At the end of the day, the LPs are masters of their own fate. Though smart investors have overextended themselves, that won't deter them from investing; today's buzzwords are distress and secondaries, and LPs are still looking to deploy capital. That said, Eakman does suggest that GPs and LPs will have "deeper relationships" going forward. Indeed, he argues that such shifts will be pushed on both sides of the partnership divide: "GPs will want to know that their investors are good for the capital and understand the risks of the asset class."

Others are more cynical. "We lived through the 2001, 2002, and 2003 meltdown. LPs said they were going to cut fees, cut carry, and be on a level field - that never happened. GPs will cut the size of their funds to create scarcity, or the illusion of scarcity, and hold terms. The S&P recovered dramatically in 2003, and private equity went with it," argues one institutional investor.

But the current market slowdown is a very different animal from that seen at the beginning of the decade: "I think this is a structural shift, not just a downturn; there is a component of yesterday's market that will need to be rebuilt," says Bilden. If that's the case with GPs, then will LPs follow suit? Only time will tell.

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