Every year, MJ Hudson surveys the terms of a large, diverse sample of recently-closed private equity (PE), venture capital (VC) and growth capital funds, for which we have advised either the fund manager or a prospective investor. In this article, we assess the recent trends in core economic terms. For more information, please contact one of the authors of this article or download our full report (https://www.mjhudson.com/download/private-equity-fund-terms-research-2021-part-one/).
A. Management fees
The traditional annual fee of 2% of capital commitments is, for the fourth year running, the most 'popular' fee level: 53% of the funds in our 2020 survey charged 2%. But these funds only accounted for 20% of total capital targeted or raised.
Meanwhile, funds charging no more than 1.5% scooped 44% of investor commitments (compared with 52% in 2019 and 80% in 2018). A further 25% of capital was allocated to funds which charged no more than 1.75%. At the other end of the spectrum, 15% of funds (by number) set fees above the 2% mark (compared to 21% in 2019 and 12% in 2018). These only represented 1.5% of total capital sought or raised.
Partly because of their smaller average fund size, growth and VC funds tended to charge higher rates of management fee. Consistent with last year's data, all but one of the VC funds in our sample attracted fees of 1.75% or more.
B. Fee discounts
Headline fee rates do not tell the whole story. Management fee rates may be discounted by a GP in order to secure the commitments of an especially large investor, or to entice an LP to commit early to the fund.
Arguably the most 'above board' way to do this is to codify the discount program in the LPA. That makes an investor's qualification for a particular discount an objective matter. 12% of the funds in our 2020 survey offered conditional fee discounts in their LPAs, down from 18% in 2019 and the nearly 25% reported in our 2018 sample.
This should not be taken to mean that managers are discounting less, because they can and do negotiate lower fees for investors ad hoc, via side letters. Depending on how comprehensive the fund's most favoured nation (MFN) obligation is, these individual investor discounts may remain hidden from view or, if disclosed, will seldom be eligible for extension to the wider investor base. The persistence of these practices means that a fund's true fee level is likely to vary from investor to investor.
In funds which spell out their discount program in the LPA, the most popular discount trigger remains commitment size: we saw that in 88% of discounting funds last year, up from 64% the year before. In addition, 50% of the 2020 cohort of funds (a big jump from last year's 27%) offered an 'early bird' discount for investors who subscribed at the fund's first closing, a stratagem that can be used to lend momentum to the fundraise.
C. Management fee step-down
It is conventional for the management fee to change after the investment period ends. The rationale is that, as the fund transitions from making new investments to divesting them, it repays investors' drawn down capital, reducing both the capital base and the portfolio management burden on the manager. Moreover, once the investment period ends, the manager invariably ceases to be subject to any constraints on closing a successor fund, an activity that demands a certain portion of the manager's time.
The percentage of funds with a 'step-down' declined slightly to 88%, in 2020, compared to the previous year's high of 95%, but it was still broadly consistent with the figures we reported in 2018 (87%) and 2017 (78%). The funds in the 2020 cohort which skipped the step down were all VC and growth funds with well-established track records of success, giving them greater scope to depart from market convention.
The step-down formula may involve a lower fee percentage rate (14% of the surveyed funds did this last year), or it may retain the same percentage but change the baseline: the latter method was chosen by 55% of the 2020 fund cohort), or some combination of a percentage reduction and baseline change (31% of sampled funds). These proportions are broadly consistent with what we found in previous years. The baseline usually changes from total commitments (during the investment period) to "invested capital" (i.e., the total acquisition cost of unrealised investments), after the investment period. Less commonly, the baseline may change to net asset value, at this point. If the fund invests wisely and macroeconomic conditions are benign, an NAV-based formula is likely to generate a higher baseline than an invested capital formula.
After 12 years of rock bottom interest rates, the traditional 8% hurdle is under pressure. 68% of funds in the 2020 cohort had an 8% hurdle. This contrasts with 60% in 2019, 76% in 2018, and 71% in the 2017 survey. Notably, 2020 was the first year in which we saw no funds offering a hurdle greater than 8%. Only 3.1% of the 2020 cohort pitched a sub-8% hurdle, down steeply from the 13% observed the year before. More significantly, 29.2% of the funds dropped the hurdle altogether, a marked increase from the 23% of funds which did so in 2019.
Historically, hurdles have not been as common in VC funds as in buyout funds. This differentiation shines through clearly in this year's data. Only 7% of buyout funds were able to convince investors to sign up without a hurdle for the manager to clear, compared to more than 70% of venture funds that dispensed with the obstacle.
Trends in GP catch-up are broadly stable year on year. Almost 84% of funds have GP catch-up (the same portion as 2019's research indicated). 74% of those funds set the catch-up percentage at a GP-friendly 100% level, whereas only 79% of funds did this in 2019.
F. Carried interest
The vast majority of funds in this year's survey (as in previous years) have 20% carry. 7% of the 2020 cohort pay 'super carry' (i.e., more than 20%). Of these, half were turnaround funds, with the remainder split between buyout, venture capital and growth capital funds. Fewer than 2% of funds pay carry below 20%.
Managers continue to look at alternative ways to structure carried interest. The ratchet (which adjusts the carry percentage according to the overall level of aggregate investor returns) has shown steady growth in popularity, in the last three years, perhaps because it is easily promoted as improving GP/LP alignment. Among funds in the 2020 cohort, 23% employed ratchets. The percentage of funds where tiered or stepped carry was available to the GP stood at 22.7% of funds surveyed, compared to 19.4% in 2019.
Similar to the 2019 cohort, 82% of funds reviewed in 2020 prohibited the payment of carried interest on income or proceeds of recapitalisations, prior to the return of invested capital to LPs.
Originally published January 28, 2021
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