Fee structures: adventures in LP flexibility

Oscar Geen
09 August 2018

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After a sustained period of above average performance, some PE funds are testing different fee structures. Oscar Geen speaks to key players about the economics behind these changes

The classic private equity fee model of 2-8-20 with 100% catch-up still exists and is still accepted as the normal standard. However, there is growing evidence that some GPs, from both ends of the performance scale, have been exploring alternatives.

Ben Yeoh, associate at law firm Goodwin, has published research into this phenomenon; he spoke to Unquote about his results: "We have seen some instances of successful managers negotiating a higher rate of carried interest or setting a lower preferred return."

This can be controversial, and an adviser speaking to Unquote on the condition of anonymity describes their experience of such situations: "Two extremely high-profile GPs adjusted the hurdle on their last funds downwards, and this didn't go down well with their LPs," they said. "The largest (previous) backer of one of these firms said they would have backed the fund without blinking if the carry rate was 10% higher, but they ended up not investing due to the lower hurdle."

With the maturation of society, you get hierarchy, and the same applies to private equity. Private equity has been around for a long time now, and people know what they like" – James Coleman, Quest Fund Placement

It goes both ways, though, as Goodwin's Yeoh attests: "Additionally, we've seen managers that need to concede terms or offer incentives so that LPs commit, particularly before first close," he says. "In both of these situations, managers need to be fully aware of how these changes will impact their profit flows in different performance scenarios."

This is not as simple as it sounds, especially when more than one term is being tweaked at once, Yeoh explains. "Obviously a lower preferred return benefits a manager, but this benefit can be offset if a lower preferred return is paired with a lower catch-up. For example, we found that 8% return with 100% catch-up was essentially equivalent to 6% return with 45% catch-up in the scenario where a fund triggers carried interest in year seven."

Supply and demand
Quest Fund Placement's James Coleman emphasises the role that a manager's position in the private equity pecking order plays in determining how structures are negotiated. "With the maturation of society, you get hierarchy and the same applies to private equity. Private equity has been around for a long time now, and people know what they like."

However, funds that are well-liked come in different shapes and sizes, and their managers will be inclined to ask for different arrangements. Coleman gives a hypothetical example: "If you are a €300m fund that does 3.5x per fund and you're on your third or fourth generation, you're sometimes quite a small team of mostly quite senior people, and you might try to push for a bit more carry," he explains. "Obviously, there's a limit to what you can charge before you start to look less attractive than a fund of the same size that does 2.5x with standard terms."

Unquote learned of one, well-established US-based manager that gave LPs an option between 2-20 or 1-30, which is perhaps close to the limit, but it expected 90% of its existing LPs to opt for the latter.

"On the other hand, if you're a €2bn fund you probably have a much bigger staff, with more expenses and more junior members, and you probably want to get some cash back a bit quicker," says Coleman. "So you might push for a slightly lower hurdle rate or a bit of carry on a deal-by-deal basis." His second example has many referents in recent news about large-cap managers, as TPG, Hellman & Friedman, Blackstone and Apollo have all reportedly increased management fees on large funds in the past year.

If I see a punnet of strawberries reduced from £3 to £1 and there are a lot of them left, I'm asking myself what's wrong with them. The same is true of funds" – James Coleman, Quest Fund Placement

For funds that are considering giving their LPs a discount, there are different variables and factors to consider. First close discounts have been promoted by some in the advisory community as a way of increasing demand for funds and building momentum in a fundraise.

Coleman is wary of this logic: "There's also the psychological effect of seeing something discounted. If I see a punnet of strawberries reduced from £3 to £1 and there are a lot of them left, I'm asking myself what's wrong with them. The same is true of funds."