Top priority on terms? LPs say GP commitment

Two thirds of institutional investors responding to a recent survey picked the “level of general partner financial commitment to the fund” as the partnership term they focus on most when deciding whether to invest in a fund or to advise a client to do so.

Investors like to see a healthy GP commitment because it so neatly knits their interests together. Should the fund manager hit home run after home run, both investors and the GP cheer; whiff on a series of deals and they both suffer.

According to the latest edition of PE/VC Partnership Agreements Study 2018-2019, general partners are, by and large, making healthy contributions to their own funds. Forty percent of North American buyout funds participating in the study have a GP contribution of between 1.1 percent and 5 percent of total fund commitments; 20 percent have one of between 5.1 percent and 10 percent; and 15 percent have one greater than 10 percent.

Of note, some firms fund at least a portion of their GP contribution through a partial waiver of management fees, rather than through cash contributions. More than one in five (23 percent) North American buyout funds in the partnership agreements study do it this way. Arguably, funding the GP contribution through fee waivers doesn’t align interests as strongly between fund manager and investors.

In responding to the question about fund terms on which they focus most, investors could pick no more than four from a list of more than a dozen (see table below). The question was included in a late 2017 survey of 98 investment professionals around the world. Placement agency Probitas Partners conducted the online survey as part of an annual series.

The size of the GP commitment was followed, in descending order of investor focus, by “distribution of carried interest between the senior investment professionals” (49 percent); “cap on fund size” (47 percent); “overall level of management fees” (42 percent); “structure or inclusion of a key man provision” (37 percent); and “ownership of the management company” (36 percent).

Caps on fund size tends to become more important to investors in strong fundraising markets, when fund managers may be tempted to raise more money than they can comfortably invest. In some cases fund managers negotiate a premium carried interest of more than 20 percent in return for an agreement to cap the fund size. This gives them the bigger carry pool–and the bigger potential payout to attract talent–that would otherwise come only by successfully investing a larger fund.

Of note, the “presence of a long-term subscription credit line” appears to command little investor focus, despite it being the subject of controversy. Just 8 percent picked it in the Probitas Partners survey. Fund managers can use such lines, which often delay capital calls between three months and a year, to artificially bolster IRRs and reach their priority return hurdles earlier. That is a source of hand-wringing for some investors. They have begun trying to negotiate a term requiring that the effect of the loans be excluded from the IRR calculation.

Other investors have no problem with capital call lines, seeing them as a useful tool for cash-flow management. Better to know in advance when capital calls are coming, they say, than to have to respond to capital calls shortly after every new investment is consummated. Investors whose own bonuses are tied to IRR targets also have reason to like them.

Action Item: Get a copy of the Probitas investors survey at https://goo.gl/KgG4GD