Giving A Little To Keep A Lot

Fortunately, limited partners usually don’t go after general partners at the negotiating table in a spirit of greed or vindictiveness for past slights suffered. And they rarely present a united front, given their varied needs and desires. But if there is a common theme to their aims in partnership negotiations it’s a desire to bring their interests and those of GPs into closer harmony.

One strategy buyout firms may pursue in the months ahead to placate LPs is to give ground on non-fee terms that serve to better align LP-GP interests, while trying to hold the line on the key financial terms of their partnerships—the carried interest, management fee, transaction fee formula. The non-fee term that perhaps best achieves this is the GP commitment, or the commitment that the GP makes to its own fund. With a big slug of their net worths tied up in a fund, partners of a buyout fund would arguably have a tough time acting against the interest of themselves and their fellow LPs.

The recent success of Texas turnaround shop Prophet Equity in raising an oversubscribed debut fund of $250 million can be traced in part to a generous GP commitment. Employees of the firm agreed to commit an especially high 10 percent of the fund, or $25 million, and even negotiated the option of doubling that amount down the road to $50 million. Founder Ross Gatlin said he was determined to offer terms such that no LP would walk away from the fund over the issue.

GP contributions appear to have risen across the board over the last several years, a reflection not just of a desire to inspire faith in LPs, but also of a maturing industry in which professionals have more money to invest in their own funds.

According to PE/VC Partnership Agreements Study 2010-2011, newly published by Thomson Reuters, more than half of the U.S. buyout funds in our sample (55.6 percent) contributed somewhere in the neighborhood of 1.1 percent to 5 percent of their latest funds; another one in four (25.9 percent) contributed 5.1 percent to 10 percent; and 7.4 percent actually contributed more than 10 percent.

Advisors to our study see GP contributions rising even more in coming months. With LPs in a miserly mood, buyout professionals will be reaching into their own pockets not just to help convince others investors to join them, but also for the practical reason that if they don’t they may not reach their targets.

Also expect to see fewer GPs fund their contributions through waived management fees, a practice that has grown prevalent across the buyout market. (Our study found that nearly half of U.S. buyout funds in our sample fund their GP contributions at least in part through a management fee waiver.) Many LPs, of course, prefer that partners of a fund put real money to work in their funds, rather than waived management fees, fees that they evidently don’t need to run their funds in the short run. With more power at the negotiating table investors may well pressure GPs to stop the practice. In addition, proposed legislation that would tax carried interest as regular income, if passed, would presumably eliminate the tax advantage to GPs of converting management fees today to carried interest later.