Terms proposed by The Blackstone Group for its latest buyout fund remind limited partners how far they have come, and how far they have yet to go in fund negotiations.
Blackstone has again proposed retaining 50% of net monitoring, transaction, director and related fee income, according to an investor who reviewed the terms. Over the years, LPs have convinced most buyout shops (but not all) to give them at least 80% of such fees, generally through management fee offsets. Still, many LPs would argue that 100% is the right number. Why, for example, should a buyout firm keep any portion of fees on a deal that goes belly-up? LPs also worry about giving buyout professionals an incentive to do any deal, as opposed to doing a good deal.
On the other hand, like many firms raising giant pools, Blackstone has proposed charging relatively low annual management fees in percentage terms. Under the proposal, the firm would charge 1.5% of aggregate capital commitments up to $10 billion during the six-year investment period, and 1 percent on commitments above $10 billion. (The fund could easily reach $20 billion.) After the investment period, the firm would charge 75 basis points on invested capital. LPs committing more than $1 billion may see additional breaks on management fees, according to the investor who reviewed the terms. I was unable to reach Blackstone for comment.
LPs are used to getting dealt lousy cards at the partnership negotiating table. Regardless of market conditions, an abundance of suitors always lines up for the most desirable funds. Got a problem with how the LP Clawback is worded? Tough luck: The fund sponsor simply replaces you with the next LP in line. Investors have more leverage with new and emerging managers, especially when providing anchor commitments. Anchor investors can often negotiate a reduced carried interest of, say, 17% or 18 percent. They may also secure in advance an allocation in a subsequent fund or two—a nice benefit in an era of invitation-only funds. Below, according to fund attorneys, is a rundown on where terms have settled on some of the hottest areas of fund negotiation:
Carried Interest Taxation
Chalk up a victory for LPs. Since last spring, when Congress proposed raising taxes on carried interest, fund sponsors have been proposing terms that would let them, without LP permission, amend partnership agreements to retain their original after-tax cash flow. “Are you kidding?” sums up LP reaction. The surviving provisions have been watered down. They typically let the GP amend the agreement only if the change would have no adverse effect on the LPs, no material adverse effect, or no adverse effect on the economic terms. In a few cases, LPs have agreed to let the buyout firm reduce the size of the fund should taxes go up; doing so would let the firm try to launch a new fund on more favorable terms.
Management Fee Scale-Downs
Somewhere in the dawn of the industry LPs negotiated management fee scale-downs on the argument that buyout firms have less to do after the investment period ends. But over time buyout firms have pushed back the start of the scale-down period. It used to be they started at the earlier of the end of the investment period or the launch of a new fund. Then GPs pushed the start back to the first draw-down of capital from the successor fund. Then it became the first payment of management fees from the successor fund. Today some GPs even insist on the successor fund attaining a certain size before the scale-down starts.
LPs love to see buyout professionals put skin in the game. And so they are, thanks to returns that have net worths soaring. Compared with 1 percent to 2 percent a few years back, GPs today often ante up with 4 percent or more of their funds’ commitments.
Most buyout fund agreements come with for-cause and no-fault divorce clauses. In the past, such clauses let LPs vote to terminate a fund, and sell off the holdings, either for causes spelled out in the partnership documents, or (with the no-fault divorce clause) for any reason at all. One problem: No matter how ugly the GP’s conduct, LPs would be reluctant to take a major haircut in a fire sale. Today, LPs often succeed in adding a “removal” option to the for-cause clause, and occasionally to the no-fault divorce clause as well. The option lets the LPs replace the fund manager without having to liquidate the partnership. In some cases LPs also negotiate the ability to slice the carried interest owed any GP removed for cause. The LPs can then use those funds to compensate themselves for losses, or to motivate the new fund manager.
For more on partnership terms call my attorney sources for this column: John Beals, partner at Nixon Peabody, at 617-345-1060; Kimberly J. Kaplan-Gross, partner at DLA Piper, at 617-406-6051; and Larry Jordan Rowe, partner at Ropes & Gray LLP, at 617-951-7407.
David Toll is editor of Buyouts Magazine, a sister publication to peHUB.