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When fees cause GPs and LPs headaches

Management fees were hotly debated earlier this year and last as investors in private equity and venture capital funds that had seen exits held in abeyance for several months started to feel some of their GPs should realign their interests with those of their investors. The bulk of the frustration centred on US buyout and venture houses managing three or more large sized funds that meant they could get fat on the management fee and, in theory, not have to bother working their portfolios hard. In Europe investors appeared less concerned as John McCrory of fund-of-funds and secondary investor Westport Private Equity noted: “We don’t have any major concerns about management fees: some of our funds have taken management fee holidays and cut fees. Intransigence on management fees tends to come from those who cannot raise another fund.” (See the June issue of EVCJ, p38.) Lisa Bushrod reports

Now that investors have been able to affect some change, the fee debate has moved on, this time to the arrangements GPs make with placement agents engaged to manage their fund raising process. Anecdotal evidence from some investors favours the view that there are more funds securing placement agent services in the market at present, in part because of the poor fund raising environment. However, it’s likely that with many private equity and venture capital players well-funded and others choosing to stave off fund raising until the market improves, the level of contact with placement agents has raised their profile in investors’ minds.

Regardless of the predominance or not of placement agents in the fund raising process, since there are few funds to go round terms have become more flexible in some instances. It’s easy to see why. There have been several of new investment bank and independent entrants to this part of the private equity and venture capital advisory services market in the last two to three years, all of which are competing for placement work now more than ever.

“Certain placement agents that provide M&A and equity offerings, for example, might agree as part of their arrangements with the GP to credit a portion of the fees paid to its investment banking parent. People have to be careful that the placement agent parent getting the investment banking business is not being given business that it would not otherwise have earned, or at an uncompetitive rate,” says Mark Weisdorf, vice president of private market investments at Canada Pension Plan Investment Board.

Anecdotal evidence points to this happening in the US market on occasion and, on the whole, reaction from European LPs and GPs is uncomfortable with the concept. “Agreeing with a placement agent that in return for reduced cash payment of placement fees they will be given preferential investment banking business could clearly provide a conflict. In particular there could be a pressure on the fund management organisation to do deals with that investment bank in order to repay the fees. This is something we would not put ourselves into a position of having to do,” says Guy Hands CEO of Terra Firma, his new post-Nomura Principal Finance Group fund management company, which is currently engaged in the fund raising process.

Hands makes a valid point and one that any manager, whether of private or public equity, is only too aware of given the scandals in corporate governance currently dominating headlines. But the matter goes deeper than the possibility of pressure being exerted for deals to be done more quickly than a fund manager might choose. If investment banks do exert a downward pressure or defer placement agent fees in order to benefit from other types of advisory or underwriting fees at a later date the only beneficiary is the GP. The LP still foots the bill of transaction costs, which are attributed to the fund and ultimately dampen the return on the fund. Transaction costs are a fact of life but LPs may only need as much as a suspicion that transaction work is being channeled to a placement agent’s bankers to want an overhaul of the arrangement.

Developments like these that risk de-aligning GP and LP interests will continue to be debated by both parties. For the most part additions to the standard agreements, whether formalised agreements or not, are pursued by GPs and LPs alike. “We are focused on having rich, deep and broad relationships with GPs. We plan to make fewer, larger commitments than some others and we are not planning to have a portfolio of 150 commitments in three years time. Although we are looking for true relationships we do not have a preconceived notion as to what that means to each GP from a structural point of view. It could mean co-investment, a part ownership of the management company, lower fees, an increased level of financial commitment the GP makes to the fund or performance-related ratchets on the carry. None of these is a precondition to us having a relationship with a GP but we do look for an alignment of interest between the interests of the CPP Investment Board and those of the GP,” says Weisdorf.

Bank of Scotland as a dominant player in the UK leveraged loan market and increasingly so in European market has a slightly different perspective on its role as an LP when it is wearing its fund-of-funds hat. “Gearing up on your LP stake by seeking the opportunity to quote for business on all transactions can cover a number of areas – for example insurance, banking, advisory and co-investment. Some funds are clear they will not seek arrangements like these (perhaps at the request of key investors who have to mirror their own governance procedures) while others welcome it as a positive advantage something that adds to their proposition for both fund raising and in approaching potential investee management. The majority of managers are content on playing the field and dealing with people they can build strong business relationships with ultimately this transcends any arrangement,” says Graham Sturrock, head of investments and mezzanine at Bank of Scotland.

While Bank of Scotland invests the bulk of its GBP850 million worth of fund-of-funds commitments in its mid-market buy out, leveraged finance introducers, it is committed to making returns on both businesses in their own right. Consequently commitments are made to funds that have good quality deal flow and as an investor the bank expects its funds to work the market. “From a BOS LP investment point of view both limited liability and tax transparency are driven by the delegation of fund management decisions and part of the fund management process must be to get the best deal in the market,” says Sturrock.

Clearly additions to the standard LP/GP agreements can work without prejudice when introduced between the two parties as in the case of Canada Pension Plan and Bank of Scotland. This may only be because either party can resist any move that might de-align their interests. It is the introduction of a third party’s interests into the equation that can be a cause for angst.

The move to lever as many relationships as possible throughout an investment bank is partly a function of sensible business practice and partly a response to the economic downturn, which has focused attention on maximising business opportunities.

There is also a structural change in the way some placement agents’ activities now operate within an investment banking context. Where previously some were effectively ring-fenced, their integration with the parent may now be greater and inevitably the result is pressure to lever some potentially lucrative banking opportunities, formally or otherwise. “People who want to do business with each other for long periods of time will make accommodations to each other,” says Weisdorf. The principle is fine but transparency plus checks and balances are vital to successfully execute such accommodations.

As Weisdorf notes earlier: the transactor must be the best-placed in the market to carry out the work and it must be done at market rates. If the recipient of transaction work, placement agent-related or otherwise, falls short, the damage to the LP/GP relationship would be tremendous. Consequently some commentators suggest the typical treatment of placement fees should continue, namely that they are paid out of the management fee amortising over a three- to five-year period. LPs might consider negotiating a reduction in the management fee they pay if the GP is seen to have negotiated a good deal on the placement agent fees.

Where does this leave the GP? Another set of covenants to ensure arms-length banking relationships? Pressure to use independent placement agents? Neither is very attractive, the former thanks to the additional cost incurred and the latter due to the fact that independent placement agents sometimes don’t have either the appetite or the capacity or the capability for certain types of fund raising. Leaving it to the GPs whose time is by and large far better employed on transactions isn’t the answer either.

It’s not just fees that can come under the spotlight. Carry share with the placement agent, both investment banking-related placement agents and independents, is also on the agenda. This may have its place but the GP must be content that the fund manager’s proportion is sufficiently preserved that it does the job of incentivising the fund’s managers.