Developments in Private Equity Fund Terms Since the 2007-08 Financial Crisis (Part 1 of 3): Realignment of Economic Interests

In this month's President's Corner, Quinn Moss, Esq. and Dolph Hellman, Esq. of Orrick, Herrington & Sutcliffe LLP (and Co-Chairs of their firm's Private Investment Funds Group) discuss how economic interests between limited partners and general partners have become more aligned since the 2007-08 financial crisis.

Since 2008, the dialogue between GPs and LPs regarding fund terms and strengthening the alignment of interests among the parties as partners has been reinvigorated, in part due to market forces and also in good part by the publication and advocacy of the "Private Equity Principles" and best practices from the Institutional Limited Partner Association ("ILPA") in 2009 and again in 2011.

One area of significant discussion relates to management fees—particularly for sponsors of funds with significant management fee income streams from prior funds. Recently, many LPs have sought to return management fees to their original purpose of covering the sponsor’s overhead and salaries as they provided services to the funds. Examples of such efforts include:

1. "budget based" management fees,
2. anchor investors seeking fee discounts as an encouragement to sign on early and help a sponsor gain fundraising momentum,
3. reduction in "base" fee rates (e.g. from the perceived "standard" 2% per annum on committed capital to 1.75% or 1.5%),
4. making sure "step downs" were in place (i.e. making sure that at some point management fees were based on invested capital instead of committed capital),
5. applying the "step down" as soon as the investment period was terminated or a management fee was earned from a successor fund, and
6. reducing the management fee by negotiated fee set-offs. Regarding this last item—management fee set-offs have moved from the 50-50 or 80-20 splits common in the pre-2008 market to a 100% fee offset for any fees received by a sponsor and its affiliates (other than fees in the nature of real estate management, infrastructure project management or other similar fees that could reasonably be expected to be paid to a third party).

Another example of a realignment of economic interests relates to the GP carry. Since 2008, LPs have examined whether payments of carried interest on existing funds have provided the necessary incentive for a sponsor to make the long-term commitment to the fund expected by investors. The historical split between the "European-style" or "aggregate waterfall" on the one hand (providing for a return of all capital and, in some cases a preferred return prior to sharing with the GP 20% or more of the profits), and the investment-by-investment waterfall so prevalent in the United States on the other hand (with the GP receiving carry after providing a return on all disposed-of investments and, in some cases, a preferred return on the capital for such investments and expenses allocated to such investments), began to shift. While in some cases institutional investors have sought to lower rates on the carry—particularly if it had crept above 20%—more often than not the change to carry terms relate to:

1. retaining (or returning to) the more LP-favorable "European-style" waterfall,
2. permitting an investment-by-investment waterfall but requiring a return of all capital drawn for expenses (including management fees) and preferred return prior to the payment of carry,
3. permitting an investment-by-investment waterfall but also requiring interim clawbacks of excess carry and/or escrows of carry distributions until amounts distributed to the LPs have provided the stated return, and
4. examining the "after-tax" mechanism relating to clawback of excess carry to consider whether the GP or the LPs end up bearing the burden of any increased carry tax, and whether tax benefits enjoyed by the GP should be factored in for a better balance of terms.

In sum, fund documents for funds raised after 2008 now contain many variations on these terms, with a general trend towards a slower payment of carry to the GPs.

Partners are also actively negotiating expenses charged to funds for the operation of the fund and fund sponsor, an area receiving increasing scrutiny from regulators. Frequently, a fund will absorb start-up expenses for both the (special purpose) GP and the fund, as well as the filing of form PF in the United States. Recently, however, LPs (and in particular institutional investors) have started to push back on having the fund cover the negotiations of compensation arrangements within the GP, the preparation and filing of regulatory filings on behalf of the investment adviser related to the sponsor, and any other filings or proceedings relating to the registration of the investment adviser. Other specific expenses that have received greater scrutiny since 2008 included the charging to the fund of the use of private jets (better alternatives include first or business class airfare for the equivalent flight), excess travel/entertainment for unconsummated deals and fees for advisory boards and expert networks retained by the GP and outsourced day-to-day reporting on fund matters (not including audit reports, which are customarily borne by the fund). In fact, recent reports from the SEC that more than half of about 400 private-equity firms that the SEC staff have examined to-date have charged unjustified fees and expenses without notifying investors will only increase scrutiny by LPs of these expenses.

While the financial crisis of 2007-08 resulted in the pendulum of fund economic terms swinging back towards more LP-protective provisions, improvements in the worldwide financial market leads one to wonder whether it is just a matter of time before the pendulum begins to swing away from these provisions or if the market will retain a commitment to alignment of economics and risk in the private equity fund model.

In our next installment, we will discuss how fund governance terms (and in particular key person provisions and LP remedies) have evolved since the 2007-2008 financial crisis.