What LPs want: Walking a fine line on fund terms

An overwhelming 93 percent of limited partners surveyed in the fifth annual Buyouts Emerging Manager Survey conducted in partnership with Gen II Fund Services, LLC, said they would be prepared to back a first-time fund, up slightly from 89 percent last year. Meanwhile, close to a third have a formal emerging manager allocation.

Anecdotally, one of the primary reasons why investors decide to get serious about emerging managers is that it allows them to achieve preferential status with the stars of tomorrow, particularly when it comes to accessing co-investment.

Indeed, almost half of investors surveyed said co-investment opportunities were an important factor when evaluating such a proposition and 61 percent described themselves as being active co-investors with emerging managers. In fact, almost 40 percent expect to complete three or more of these co-investments over the course of the next year.

“LPs in emerging managers are highly focused on co-invest at the moment,” says Monument Group partner John McCormick. “The thesis is that these emerging managers are going to be sought after once they are established, and if you don’t get in early, you may miss the opportunity to become one of the preferred ­co-investment partners – to establish that pole position. GPs can be very protective of their co-invest. They will use it as a way to hook investors and can be very successful in doing so.”

Other critical factors, of course, include track record, cited as important, very important or extremely important by 89 percent of LPs surveyed. This figure increases to 91 percent when it comes to deal-sourcing processes, to 96 percent for investment strategy and fund terms and conditions, and 100 percent for team composition.

“LPs are going to look first and foremost at past experience,” says Alli Wallace Stone, managing principal and consultant at Meketa Investment Group. “They are going to want the GP to demonstrate past experience managing similar types of investments. They are going to want to be able to attribute past investments at prior firms to the lead investors at the emerging firm and understand their approach to investing, lessons learned and how they are going to source dealflow and make enhancements to new companies going forward.

“Team composition is also very important. Do these individuals have a history of having worked together before? Have they invested together over multiple cycles? Have they had to make decisions together at a ­prior firm and how well do they know one another? During challenging times, will they be able to stick together over multiple funds? Do they have the skills necessary for the strategy and how will they divide up responsibilities and economics?”

“We tend to look for sponsors that are investing in their businesses to build a firm and not just raise a fund,” says Patricia Miller Zollar, head of Northbound Equity Partners, Neuberger Berman’s specialist emerging manager business. “We also look for a verifiable track record; a strong committed and stable team; strong alignment of interest through the GP commitment; appropriate fund sizes and terms; a differentiated investment strategy and appropriate infrastructure and processes.”

ESG has also become an increasingly important consideration, coming under scrutiny from 70 percent of investors. Focus on formal diversity and inclusion policies and initiatives is growing, but still lags, at 41 percent.

Points of negotiation

Many investors will also try and use their willingness to back an emerging manager to negotiate on terms. Indeed, almost three-quarters of respondents said they would negotiate harder on fees with them than with an established firm, while two-thirds of manager respondents said they had received pressure from investors regarding fees.
Nonetheless, the 2 percent management fee remains the norm, having been employed by 72 percent of emerging managers surveyed. A further 13 percent are charging a lower level of fee, while the remaining 16 percent are charging more, including 9 percent charging fees of 6 percent upwards.

At the top of LPs’ lists of priorities, however, is LPAC participation, which 55 percent of emerging managers surveyed said they had offered. This was followed by contractual co-investment rights, offered by 49 percent. Other points of negotiation include discounted management fees based on the size of commitment, also offered by 49 percent; opt-outs on certain investments, offered by 13 percent, or even a stake in the general partnership or management company.

“We would always encourage anchor investors to think about the fund’s targeted strategy and scalability”
Derek Schmidt
Marquette Associates

And the list goes on. Other points of contention include details around the key-person clause, no-fault divorces, information rights and distribution waterfalls. Some investors surveyed even said they would seek to pay no carry, or indeed no fees at all, if they believed they could add value. “We seed as a strategic and so no fees are paid,” said one.

Others take a more pragmatic view, keen to avoid harming future performance by pushing too hard on economics. “We like to be early in the case of founder’s share class or first close if we become comfortable quickly but will not rush our diligence for the sake of a discount,” said one. “We will also not engage in fee compression as we want such managers to survive and therefore look to support their business.”

“You have to be careful about asking for material fee discounts which then compromise the GPs’ ability to hire the right talent and build out the organization,” says Scott Reed, co-head of private equity in the US at Aberdeen Standard Investments. “You might feel good about having negotiated preferential terms in the short term, but in the long run, if the GP can’t be the kind of firm that you want to be invested in, then that makes you a fool.”

Firmly anchored

Of course, investors are especially likely to expect preferential terms if they come in as an anchor investor, which is something close to two-thirds of LP respondents said that they were willing to do.

There are risks, particularly the risk that a fund will not reach its stated target, leaving the LP over-represented and the manager under-resourced. “We would always encourage anchor investors to think about the fund’s targeted strategy and scalability,” says Derek Schmidt, director of private equity at Marquette Associates. “While a large early commitment is immensely helpful to an emerging manager, that capital should come with limits, including a minimum first close requirement and a hard-cap to ensure that strategy is deployable.”

But, of course, there are also advantages. Indeed, 63 percent of investors surveyed said they would expect discounted carried interest as an anchor investor; 59 percent said they would expect discounted management fees and 53 percent co-investment rights. Less common, but still cited by almost 40 percent of respondents, was the more controversial discounted fees on subsequent funds, while 31 percent expressed interest in owning a stake in the GP and 28 percent in the management company.

“Reduced fees or preferred economies are typically expected for LPs that are anchoring the fund or investing sizable capital,” says Molly LeStage, managing principal and private markets consultant at Meketa Investment Group. “We also infrequently see stakes in management companies being negotiated.”

Indeed, there are a number of big-ticket investors that have made this their strategy. Groups like Capital Constellation, backed by the Alaska Permanent Fund Corporation, will write sizable checks but expect that ownership stake in return.

“For the most part, investors will get a preferred economic stake but won’t look to take any kind of governance role,” ­McCormick explains. “That plays better with other LPs coming in.”

Meanwhile, 43 percent of emerging managers surveyed said they had had an anchor in their latest fund. But securing an anchor is not a fundraising panacea. “Having a cornerstone can help accelerate the process,” says McCormick. “But it isn’t a guarantee. Having a referenceable LP on board can help, but it depends who that LP is. LPs can also be turned off by the anchor investor, particularly if that anchor has negotiated highly preferential terms.”

Indeed, anchor investors can be seen as both a positive and negative by the LPs that follow. “An anchor investor adds credibility to an emerging manager’s fundraising effort. It can act as a catalyst to the development of the GP,” says Rick Spencer, co-head of Barings’ funds and co-investment platform. “Having an anchor in place means the spade work has been done for the structural and operational requirements of being a manager and that there will be working capital support for team retention and build, as well as capital availability to allow the manager to pursue opportunities.

“The disadvantages, however, are the potential for diluted alignment,” Spencer adds, citing an anchor’s potential influence around governance and investment activity, as well as preferential co-invest access.

There are also pros and cons for the GP itself. “Emerging managers can’t always be picky but should give strong consideration to how they build their LP base,” says Schmidt.

“Some anchor investors will ask a lot and emerging managers need to consider if an anchor’s capital is worth it, as this can often limit the ability to attract future investors. Building a too concentrated, or friends and family, LP base can create challenges for Fund II or Fund III as a manager looks to scale.”

Two-thirds of those anchors did receive discounted management fees and 57 percent received discounted carry. Close to a quarter received contractual co-investment rights, 17 percent a stake in the GP and 9 percent a stake in the management company. The sale of ownership stakes, however, can be particularly counterproductive.

“We vigorously object to the habit that many LPs now seem to have of taking a part of the business,” said one investor respondent. “We actually walk away from GPs that have sold their dream.”

LPs have their say