Time and patience are the ace in the hole for LPs

There's a shift in the ongoing dynamic between LPs and GPs, with the former rediscovering leverage as a result of the sluggish market.

A well-established, large GP offered a big institutional LP an incentive last year that they had never seen before – the GP offered to set its preferred return well above the market rate of 8 percent to make the fund more attractive.

“What does that tell you about what they think their prospects are in this market?” the LP asks.

The offer comes as many GPs – even big, well-known brands – are having to stretch to convince LPs to open their wallets. Even more critical for many fundraising processes, GPs are struggling to find ways to get LPs to commit to the first close. Having influential LPs as early closers can bring a big boost to a fundraising process.

“We will continue to take our time to ensure we’re backing the right partners while getting appropriate terms – and we’ll weigh our options if that’s what is required”
Scott Ramsower, Teacher Retirement System of Texas

Controlling the clock is what several LPs say is a strong negotiating point that they have in today’s market. LPs are in no rush – they don’t have to scramble to get into most funds the way they might have over the past decade, when fundraising was frenetic.

As many LPs struggle with overallocations to the asset class, and sluggish distribution activity, they are slowing the pace of their PE programs and are likely choosing fewer funds for their money. This is reflected in recent fundraising data showing that 2023 was a record fundraising year for the buyout strategy, with the haul of money flowing into fewer funds than past years.

“Given that we don’t think the fundraising pace is going to pick up dramatically in 2024, then we will continue to take our time to ensure we’re backing the right partners while getting appropriate terms – and we’ll weigh our options if that’s what is required,” says Scott Ramsower, head of private equity funds at the Teacher Retirement System of Texas.

“From the GPs perspective, we’re seeing that they are definitely thinking through a variety of options to attract LP capital – things such as first-closing discounts, seeded portfolios, etc. We expect that to continue in 2024.”

Taking more time to make a decision is one area where LPs are exercising their power, but is that it? What is LP leverage, exactly? It’s a term that gets thrown around a lot in the industry, but how does it manifest exactly?

Well, it depends on who you talk to – are LPs really the ones with leverage? “The answer is yes and no,” says Jeremy Swan, a managing principal at advisory CohnReznick. “Because if you’ve seen one LP-GP relationship, then you’ve only seen one LP-GP relationship.”

And do LPs hold a royal flush or something more like a pair of sixes? That answer also depends on who you talk to, says Drew Schardt, vice chairman and head of investment strategy at Hamilton Lane. “A lot of what LPs are asking for, if they’re happening, they’re happening on the margins. They’re important, but it’s not a wholesale change in LP/GP fund terms.”

Chips on the table

“Performance reigns supreme,” says John McCormick, a partner at placement agent Monument Group. “If you’re an outstanding performer in a great space, and your fund size has not gotten away from you, you still have the leverage. But in this environment, those are fewer and fewer.”

“LPs aren’t necessarily asking for control but more influence” Jeremy Swan, CohnReznick

A handful of firms, as always, will attract capital fairly easily, but outside of that established elite, fundraising has been challenging. And in those cases, even for quality names, LPs are finding great opportunities to negotiate interesting deals.

“We hear it time and time again,” Swan says. “LPs see so many good opportunities, but they don’t have the capacity to review or meet with every single new GP.”

“It’s just really hard,” McCormick says, adding that he has heard about groups that had given up trying to raise a fund and shifted to a fundless sponsor model of dealmaking. “It’s as hard as it has ever been.”

One of the most important incentives GPs can offer today is access to co-investment opportunities, according to several LPs. Many LPs crave co-investing as a way to build exposure to private equity, alongside their trusted managers, on a no-fee, no-carried interest basis.

Co-investments have become an integral part of the GP-LP relationship. Raymond James found that 72 percent of LP respondents to its summer market survey said the availability of co-investment opportunities is a key factor when considering a GP relationship.

As debt has become more expensive, GPs are having to kick in more equity into their deals. Bringing in co-investors is a way to help alleviate that equity load, sources say.

“We may cut a GP down from $100 million to $80 million on our commitment size, but then we may see an opportunity to do a $20 million co-investment because they don’t have enough capital,” says the head of private equity at one large US pension. “There used to be much more focus from GPs in that they wanted to keep the ratio of commitment dollars to co-investment dollars lower but now they’re going to have to have a higher ratio.”

LPs looking for co-investment opportunities have to have some structure in place to execute on these deals, because GPs generally have a tight deadline to get together their financing. Agility and flexibility are key when it comes to LP co-investing, according to Jim Pittman, global head of private equity at British Columbia Investment Management Corp.

“I think during these times, if you’re a big investor for any fund and you come in with a significant commitment, you can negotiate to get better access and better looks at more deals,” Pittman says. “The question is always if you’re able to execute at the pace that’s required.”

Other LPs have also managed to arrange for co-investments before committing to a GP’s primary fund, according to Brian Price, partner and global co-head of relationship management with Aviditi Advisors. “It’s like saying, ‘Let’s date before we marry.’”

LPs short-arm their wallets

Co-investing may be the single most important term GPs can offer as enticement to come into their new funds. But what other points are being debated ahead of an LP pulling out their wallet?

“If you’re a big investor for any fund and you come in with a significant commitment, you can negotiate to get better access and better looks at more deals”
Jim Pittman, British Columbia Investment Management

Many GPs are offering discounts for early closers, like HarbourVest Partners and KKR. GPs are also holding out incentives like fee breaks, according to multiple sources. Recent negotiations have included hurdle rate considerations and waterfall structures, sources say.

“We have seen modest, and I emphasize modest, concessions on some of the economic fees that are associated with fundraising,” Schardt says.

Cagey GPs have also expanded where they’re seeking investor money. While the biggest managers have access to overseas sovereign wealth funds, smaller funds are eyeing commitments from smaller institutional investors closer to home in America, sources say.

Says McCormick: “Smaller endowments that weren’t getting a lot of attention or were undiscovered are starting to get more attention whether they want it or not. A lot of smaller investors might have a gatekeeper and maybe less direct contact with staff, but they’re more on people’s radars than they ever were before.”

Wielding sledgehammers judiciously

Leverage is an interesting concept – for large LPs able to kick in big money, leverage can be wielded like a sledgehammer. Smaller institutions may be happy just to get into a fund and won’t push back much on terms they don’t like.

“Many LPs are not using their leverage at all,” says Jean-Philippe Boige, managing partner at placement agent Reach Capital. “They may love to negotiate, but many times they don’t have the money to write a large enough check to get what they want.”

“The largest or larger LPs have seen some of the benefits of having leverage because of the scale and sizes of their commitments” Drew Schardt, Hamilton Lane

Seyfarth Shaw attorney Steven Richman says: “We’ve had many scenarios where persistence wins the day, especially for larger investors who are a bigger percentage of a fund’s capital raise. You might get three nos but if you stick with it and the business principals get involved, a GP might give you a yes.”

The largest institutional investors – those who routinely make nine figure commitments – have always had leverage no matter the market dynamic. Now they have even more, according to Schardt. “As usual in our industry, size and scale has advantages. The largest or larger LPs have seen some of the benefits of having leverage because of the scale and sizes of their commitments.”

The LPs with the biggest advantage are those that have avoided overallocations and other issues with capital to work, Pittman says. “They have a much better environment to pick and choose, and then they can decide whether or not they’re going to use their capital and leverage.”

Pittman estimates that 70 percent of North American and European LPs remain overweight to private equity. LPs in that category can still find leverage if they’re reducing their number of relationships. “They have to slim down the number of GPs they’re chasing and use their capital smartly.

“Many LPs have 40, 60 or 80 GP partners. In this environment, they may only be able to fund up to eight or 10 per annum in a similar way that they have done in the past. This will create significant pressure on their programs.”

Know when to hold ’em

Today’s fundraising market is providing LPs with a cushion with which they can patiently take more time to do due diligence and get to know a firm’s processes.

“LPs are sitting back. They’re watching fundraising. They’re watching how a portfolio comes together. They have time on their side to watch things marinate”
Brian Price, Aviditi Advisors 

This is true even for re-ups with long-standing relationships, which some sources in the past described as almost a “rubber stamp” barring any extraordinary disasters.

“LPs are sitting back,” Avitidi’s Price says. “They’re watching fundraising. They’re watching how a portfolio comes together. They have time on their side to watch things marinate. We’re even seeing it with re-ups.”

The investment staff at Teacher Retirement System of Texas focus on at least five areas of due diligence when they are considering a commitment. These include analyzing fundamental operating performance of portfolio companies; strategy drift; an analysis of whether a manager’s investment team can manage its number of investments; culture and team dynamics; and the limited partnership agreement.

The system employs its due diligence process for re-ups with existing relationships and new ones alike.

“The information requirements have only amped up even more from LPs,” McCormick says. “There’s more compliance and operational diligence that takes place. That’s where you really see the leverage at play.”

Sources say they’re also seeing LPs issue GPs their own specific, custom questionnaire templates as opposed to using those prepared by the Institutional Limited Partners Association or others.


Proportion of LPs reporting that PE investments fell below benchmarks over the past 12 months, compared with 13 percent last year, according to the latest LP Perspectives Study from PEI

Transparency also piggybacks on the increased questions regarding due diligence, especially after the US Securities and Exchange Commission’s looming regulations tackling the issue. A major focus in the SEC’s new rules is on preferential treatment of certain LPs, according to sources.

In particular, LPs are asking questions about ownership grants, the treatment of carried interest, Limited Partner Advisory Committee seats, co-investment rights, and portfolio company insights offered to investors who have already made commitments. Most Favored Nation provisions are also a routine discussion point, sources say.

“LPs aren’t necessarily asking for control but more influence,” says Swan. “But it’s throwing another wrench into the works as LPs have different opinions on how much they want to disclose and how different they want to be than other LPs for a fund that’s still out in the market.”

And many are voicing strong opinions on point-of-service providers, says one source. “Some LPs are coming in early and strongly to voice their opinions if they’ve had bad experiences with certain law firms or fund administrators, and they may say they have a preference for using certain ones.”

But to many, leverage only matters if it results in a financial benefit. “A lot of this stuff only impacts the lawyers,” says an LP source. “The only thing I care about is if it helps our returns.”

New money in the game

Emerging managers have had more of a challenge than anyone in the current environment, as LPs primarily stick with their deepest relationships. But emerging firms can be fertile ground for LPs to win a lot of flexibility around fund terms and structure, not to mention co-investment access.

Sources say emerging managers are doing a lot more work to impress increasingly choosy LPs.

“Going to say ‘We’re raising a first-time fund tomorrow’ can be challenging,” Price says. “We’re often seeing multiple deals and exits paired with mature teams that have invested together in pre-fund deals before they even go for a first fund. They know it’s challenging going into this market.”


Percentage of LP respondents who say they have been pushing GPs for a higher hurdle rate, according to PEI’s LP Perspectives Study

Once emerging managers are ready to fundraise, there are some LPs willing to commit to a first close that aren’t pressing for economic terms. Instead, they’re focusing on terms like having a say on targets, capacity and an outsized voice on what second and third funds will look like.

“They value that emerging managers need to be competitive when hiring talent and build the franchise, and they need to set the GP up for success,” says Price. “We’re seeing the trade-off about how some LPs will pay the full 2-and-20, but they’ll want to be influential in the firm’s growth plans. They don’t want to jump off the train after one or two funds.”

First thing’s first: let’s pay all the lawyers!

The one guaranteed winner amid feuds between LPs and GPs is the legal advisers paid to make their respective cases.

When LPs use their leverage, it results in more back-and-forth with GPs. That leads to one inevitable winner – lawyers who work in the industry, especially on the GP side, according to sources. “In some instances, certain aspects of the negotiations seem to be evolving as driven more by GP counsel legal side who then check in with the business principals, as opposed to the business principals driving the negotiations and then instructing their lawyers,” says Steven Richman, an attorney with Seyfarth Shaw.

This increases organizational expenses for funds. This category includes many of the costs related to fund formation like legal fees and accounting costs. It also sometimes, but not always, includes negotiations of side letters and similar arrangements, Richman says.

“Organizational expenses have increased substantially in recent years,” he continues. “It’s not uncommon to see organizational expenses go up by over a million dollars, or even millions of dollars, from one fund generation to the next. As the organizational expense bucket – which is indirectly paid by the LPs – gets bigger, managers and their counsel could be incentivized to dig in their heels, continually say ‘no,’ and extend negotiations rather than find a compromise position with LPs.”

NAV: not always valuable

NAV loans have been a hot topic in recent months, but Scott Ramsower, head of private equity funds at Teacher Retirement System of Texas, is lukewarm on the practice. His thoughts:

How do you view NAV loans?

We’re hearing more and more about it from our GPs. There’s a whole lot of chatter about it, but it hasn’t been executed upon a ton in our portfolio at least. But, when we do see it, we’re seeing it used for two main use cases. One is to create distributions for LPs and one is to support or add portfolio companies.

For that first bucket – creating distributions for us – we’re against it. First, they are cross-collateralizing the equities in our portfolios, which we’re not a fan of. Second, as we sit today, rates are pretty high, so to send us capital back at 10-plus percent, the best case, we re-invest that back into private equity and hopefully we can earn more than 10 percent. But the more realistic case is that it goes back into the trust pool where our cost of capital is 7 percent. Also, if we wanted to do it, we could do it cheaper than the GP could, just given our collateral base. So, overall, it’s a pretty inefficient use of our capital.

If they’re doing this to create distributions for us… they should know how we view these distributions. When we show our GPs track records, we’re showing actual DPI, but we’re also showing DPI ex-CVs and ex-NAV loans. So they’re doing it to give us money back, which is theoretically good, right? However, they’re not getting credit for it in our track record analysis, as all DPI is not created equal in our opinion. We call these use cases ‘synthetic DPI’ and we carve it out when we assess their performance. So, we’re telling GPs: this is awfully costly and if you’re doing it, you’re not necessarily getting full credit in your track record.