Partnership Terms Evolve—But Slowly

Partnership terms and conditions do change over time. Among the most obvious instances: the dozens of venture firms that advanced to 25 percent and 30 percent premium carried interests in the late 1990s, and the move by buyout firms in the 1990s to share more of their transaction and related fees with investors.

Our latest study of partnership terms, to be published this December, finds evidence over the last five years of a move toward more back-ended distribution waterfalls, which delays profit distributions until later in the lives of funds, and a falling out of favor of no-fault divorce clauses among buyout shops.

But such change takes place slowly for a number of reasons. One of the biggest is that the starting point for negotiations on anything but a debut fund is the contract governing the predecessor fund. Individual investors may want changes. But, often out of a fear of colluding, sometimes for fear of upsetting the general partner, they rarely rally enough support from fellow investors to make them. Divided and conquered, investors end up signing documents very much like the ones signed the last go-round. In fact, you can make a case that industry terms have more to do with the law firms that originally drafted them than the actual relative negotiating power of GPs and limited partners over time.

This spring I and my colleagues in the Deals Group of publications at Thomson Reuters, which includes Buyouts, embarked on the company’s first study of partnership terms and conditions in five years. Altogether 123 firms, including 30 U.S. buyout shops, completed online questionnaires about the terms and conditions of their vintage 2005 to 2009 funds, as well as ones still in the market raising money. Based on the results of this and previous studies I’ve worked on over the last decade, I’d offer some additional observations about the terms and conditions of buyout funds:

New terms occasionally arise in response to market developments: Over the last few years Congress has gradually gotten more serious about taxing carried interest as regular income, instead of capital gains. Nearly a third of the U.S. buyout funds in our sample now include a provision letting the GP amend the partnership agreement, without permission from investors, to reflect changes in how carried interest is taxed, provided it doesn’t impact LP economics.

Few terms are absolutely standard: The 20 percent carried interest comes about as close as you get to an industry-standard term, and even there you see plenty of variation. Three of the buyout funds in our sample, for example, have something other than a 20 percent carried interest. One has a 30 percent carried interest, while another features a performance-based carried interest that steps up from 15 percent to 20 percent to 25 percent based on how well the fund has performed. In other realms there’s nothing even close to an industry standard. On the question of who bears the expense of outside consultants—whether the general partner, the fund, or whether it’s shared between the two—the buyout industry is all over the map.

Tax considerations play a major role in terms: GP and LPs alike try to avoid paying a penny more in taxes than they have to. One of the clearest examples of this is the high percentage (close to 50 percent) of buyout firms in our study that funds at least a portion of its GP contribution through the partial waiver of management fees. In effect, the GP waives some of its management fees today, and instead agrees to collect them later out of fund profits. By doing so, the GP pays the capital-gains tax rate on the management fee when it eventually collects it (assuming the fund is profitable). Taxable limited partners also benefit because, while it is generally not possible to deduct management fees paid on their tax forms, they certainly don’t have to pay taxes on profits they send to the GP.

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