Co-investment opportunities, GP commitment help sway LPs on emerging funds

We had our annual emerging manager conference in late July. One interesting discussion focused on the appropriate commitment a new GP should make to his or her own fund. GP commitments generally fall in a range from 1 to 5 percent of total commitments, according to Buyouts Insider’s PE/VC Partnership Agreements Study 2018/2019.

But when it comes to a new manager, the size of the GP commit is not necessarily the biggest factor. Rather, it’s the level of risk the manager is taking in making the commitment.

“I’m not asking someone to impoverish themselves and risk their ability to feed their family [but] I have to believe that if this thing fails, I want you at home sobbing,” said Andre Rice, president of Muller & Monroe Asset Management, who spoke on a panel at the conference.

Along with a significant GP commitment, emerging manager GPs can gain traction with LPs by offering hefty co-investment opportunities.

The most popular term emerging managers offer limited partners is coinvestment rights, according to fresh research from Buyouts Insider and fund administrator Gen II Fund Services, LLC.

The survey found that 70 percent of respondents offered contractual co-investment rights to LPs. LPs use co-investing to gain direct exposure to deals, while still leaving the burden of managing the investments to their GPs.

Co-investments also give LPs a closer view into how a GP works an investment. They are seen overall as a sort of fee break— an equity stake in a company that comes without fees or carried interest. For emerging managers, co-investing rights can be a powerful incentive to attract investors to a fund. With enough co-investing interest, an early manager can conceivably raise a smaller fund but still stretch to do larger deals in preparation for raising larger funds in the future.

The common complaint is that every LP says they want co-investment rights, but when a deal is offered, many can’t make a decision. It’s important for an emerging manager to understand its LP base and whether it truly makes sense to offer everyone co-investment, or identify those groups who are likely to participate.

The second most popular term, which 46 percent of respondents offer to their LPs, is discounted management fees based on commitment size. A close third, at 43 percent, is giving an investor participation in the limited partner advisory committee.

Less popular terms include allowing investment in the GP or management company (26 percent); and optouts on certain investments (15 percent). Emerging managers, especially first-time funds, need to strike a balance between collecting enough fees to keep the lights on and offering interesting terms to investors who may need a little nudge to invest in an early fund.

Investors who back early funds usually agree that young firms need to collect enough fees, so they don’t put too much pressure on such teams to offer management fee breaks. But these investors usually want something in exchange for taking the risk of backing a young firm.

The survey found that 74 percent did not feel pressure from their investors on fees. In terms of fee levels, 70 percent said they charge a management fee in the range of 2.1 percent to 2.5 percent. Nineteen percent said they charge in the range of 1 percent to 1.5 percent, the survey found.