Fund terms put emerging managers under pressure

Emerging managers may be prepared to cede some ground on terms to get their first fund away, but regaining control can be challenging

Investors will often look to secure attractive terms when committing to a first- or second-time fund, particularly if coming in at a first close.

Indeed, 61 percent of LP respondents to the sixth annual Buyouts Emerging Manager Survey, conducted in partnership with Gen II Fund Services LLC, concede they negotiate harder on terms with emerging managers, although interestingly the emerging managers themselves appear broadly unconcerned. Two-thirds of GP respondents described receiving little or no pressure on fees.

The standard 2 percent management fee remains the accepted norm, adopted by 79 percent of emerging managers. Investors recognize the importance of the management fee for funding the roll-out of the firm. “We look to influence terms and conditions, but we don’t try to nickel and dime managers, because fees are obviously important to their development,” says Paul Newsome, private equity partner and head of portfolio management at Unigestion. “We don’t try and get discounts for the sake of it.”

HarbourVest is another investor that believes heavy negotiation can be detrimental, according to managing director Carolina Espinal. “I know there are LPs that try to de-risk their investment by getting preferential economics, but we prefer market standard terms and equal alignment across all LPs.”

Enhancing alignment

Rather than squeezing young firms on management fees, investors are more likely to seek to enhance alignment by requiring substantial GP commitments and encouraging tweaks to the carry structure. Unigestion, for example, likes to implement a tiered carry system. “We also like shorter duration funds – two years plus five – which improves the cashflow profile of the fund, while reducing our downside risk,” says Newsome.

However, Scott Reed, co-head of US private equity at abrdn, believes it is reasonable to seek preferential economics, particularly if an LP is willing to provide a cornerstone or anchor commitment. “We will often use that as leverage to command a better terms package,” he says. “That could involve anything from fee breaks to changes to the carry waterfall, or preferential co-investment terms. It may even involve a small stake in the GP itself.”

The GP must weigh up the benefit of that cornerstone commitment against the concessions that need to be made, says Sarah Sandstrom, partner at Campbell Lutyens. “Ensuring a strong first close is highly beneficial for emerging managers, particularly when it comes to attracting other LPs at subsequent closes.

“That cornerstone commitment is also what enables the firm to hire more investment professionals and start doing deals, so if the manager needs to give a little around certain terms to nail that strong first close, that can sometimes make a lot of sense.”

Where a GP does give way on terms, however, it can be challenging to return to market norms in subsequent funds. “It is important to limit what you give away on firm economics as an emerging manager,” says John McCormick, partner at Monument Group. “It is also important to make sure whatever is given away is ringfenced. We always try to limit the tail on any concessions and to ensure it is a one-time only event.”