As with other sectors of global capital markets, private equity fund formation has been impacted by the credit crisis and economic downturn. Despite the widespread economic gloom, a number of commentators have noted that long-term interest in private equity as an asset class appears to still be strong among most pension funds and other institutional investors. With asset values dropping significantly, some believe this may represent a historic buying opportunity. With greater focus on risk mitigation, investors are looking positively at private equity as an asset class where successful managers are recognized for assessing and managing risk over the long term.
With institutional investors exerting more influence, and more attention being paid to risk, it is reasonable to expect a shift in bargaining power and a new focus on provisions not on the table in earlier negotiations. In a more detailed article, we provide an overview of some points to keep in mind when negotiating private equity fund terms in this new investment environment. Below is a summary of some of the issues discussed in that article.
Nailing Down the Strategic Focus and Avoiding Style Drift
General partner focus and strategy are key factors that limited partners assess in the fund investment approval process. The credit crisis and economic downturn have exposed ill-fated private equity fund strategies, particularly among large buyout fund sponsors. Some have sought to modify fund strategies and reposition portions of capital to take advantage of revised goals, such as investing in distressed debt and focusing on promising geographic regions. Even where this requires a modification to the partnership agreement or the consent of some threshold of limited partners, many smaller limited partners have little or no influence over such changes. We anticipate limited partners will impose more restrictive conditions on general partner sponsors, limiting them more specifically to strategies within their demonstrated areas of strength and expertise.
Greater Focus on Alignment of Interests
In structuring fund commitments, limited partners focus on aligning the interests of the general partner as closely as possible with those of limited partners. Recent fundraising experience suggests that limited partners will push even harder. The significant expansion in fund sizes in recent years has resulted in a commensurate boost in management fees income for some general partners. Some sponsors with a very substantial fee stream are seen as less motivated by carried interest distribution. Recent examples show some downward pressure on management fees and other fee income exerted by investors. Having 'skin in the game' also remains important ― key personnel (and other principals involved in the management of the fund) will continue to be expected to make a meaningful personal financial commitment to the fund.
Backing the Right Team — And Having a Say in Keeping or Changing It
Limited partners establish rigorous review processes in considering fund investment opportunities. While these due diligence efforts focus on many areas, the experience and performance track record of the management team is often cited by commentators as the single most important criteria. Success in a prior vintage fund is said to be the best indicator for success with a subsequent fund, and this success is often tied to a small number of senior managers. Not surprisingly, this leads limited partners to focus on 'key person' provisions and related fund terms as a means to keep the team intact.
Key person provisions enable limited partners to suspend or terminate further capital calls for new investments or terminate the fund altogether if one or more senior management team members leave or are otherwise no longer actively involved enough in the management of the fund. A recent trend has seen the growth of second-tier key person provisions where the suspension or termination can be triggered by the departure of a proportion of more junior investment professionals. As the fundraising environment remains challenging and limited partners exercise greater influence over fund terms, we can expect further tightening of these and other types of provisions in limited partnership agreements.
Putting More Capital to Work
Institutional investors with capital continue to be attracted to co-investment opportunities. Many private equity funds are structured to allow the general partner to seek additional capital from limited partners beyond the committed capital of the fund for investment opportunities that might otherwise exceed size or other fund restrictions. Amounts are invested alongside capital invested by the fund itself, but general partners typically do not charge a management fee or earn a carried interest on co-invested capital. This allows limited partners to take advantage of specific investments they consider particularly attractive. At the same time, a limited partner can lower its overall proportion of commitments paid in management fees or carried interest distributions. Where limited partners can exert more influence, it is reasonable to anticipate these types of provisions will play more prominently. We expect limited partners with significant bargaining power will seek broader discretion and flexibility in co-investment rights.
A Little More Attention Paid to the Default Risk
Private equity funds are typically structured as commitment funds with limited partners making capital available for investment over an extended period of time, typically five to seven years. General partners depend on timely capital contributions in response to often frequent capital calls for investment in portfolio companies. The consequences of failing to meet a capital call are usually severe. A defaulting limited partner may be subject to forfeiture of all or a portion of its interest in the fund or forced transfer of all or portion of its interest at a discount to other limited partners who are not in default, as well as other damages.
To avoid the inconvenience of a default, general partners often structure funds to address the risk of smaller investors who might be inclined to default on occasion. This can take the form of an escrow of capital contributions or a guarantee, line of credit or some other credit support. Large institutional investors have rarely been expected to default on a capital call, but the credit crisis has brought this well within the realm of possibilities. General partners will be inclined to consider the creditworthiness of some larger investors and use techniques employed with smaller investors ― such as escrows and credit support. Limited partners with significant influence may now attempt to build in more flexibility to manage potential defaults.
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