State plans such as California Public Employees’ Retirement System, New York State Common Retirement Fund, New York City Retirement Systems and the Washington State Investment Board, together with their advisers, are successfully applying pressure on GPs—and not just on softer items like key-person provisions but on core economic terms like management fees, said Michael Harrell, a partner at Debevoise & Plimpton who represents such blue-chip names as Clayton, Dubilier & Rice and Oaktree Capital. “Even the best, most established firms are pushing against the wind,” he added.
Indeed, it looks like Bain Capital, the Boston shop that upped its carried interest to 30 percent more than a decade ago, may have trouble staying at that lofty rate. One adviser to several state pension plans said he heard “from various sources” that when the firm returns to market with its eleventh core fund, perhaps in 2012, it will offer investors a 20 percent carried interest. “Bain didn’t want to be differentiated in terms of having worse terms than everyone,” said the adviser, who previously declined to invest with Bain Capital but now would consider it.
Dow Jones reported last month that on its next Asia fund, due out later this year, Bain Capital may offer investors a choice of a one percent management fee and 30 percent carry or a more customary two percent management fee and 20 percent carry. That may well prove to be the model for future Bain Capital funds as well. Said another source: “Broadly, the firm is thinking they have a group of investors that have done well with the lower fee, higher carry, more incentive-driven structure, and some of them will be happy to continue with it. Others that have had this as a gating issue will find a traditional structure more appealing.” Executives at Bain Capital were unavailable to comment.
Naturally, some buyout shops are in stronger negotiating positions than others. Spin-out groups and others on their first funds have a tough time securing dollars at the best of the times; they may well offer especially LP-friendly terms as a way to make the decision easier for risk-averse investors. By contrast, buyout shops that have compiled stellar track records and that are holding the line on fund size don’t have to give up as much ground, if any.
All that said, investors across the market seem to be making headway, taking advantage of a still-tight fundraising market, and a more unified approach to negotiations thanks to the timely publication in 2009 of “preferred terms” (and recent revision) by the Institutional Limited Partners Association. By dint of their size, large investors are also securing better deals for themselves, winning breaks on management fees, say, or securing co-investment rights not available to other LPs.
What’s especially noteworthy about this period of LP empowerment is the ferocity of the attack on economic terms. According to Harrell, for example, LPs are pushing hard on management fee step-downs. Traditionally buyout firms would agree to start ratcheting down the management fees at the expiration of the investment period, and a typical formula would be to switch from, say, two percent of committed capital to two percent of the cost basis of remaining investments. Now investors want the step-down to start at the end of the investment period or the raising of a new fund, whichever is sooner. Pressure is also being applied to lower the percentage and lower the base, Harrell said.
Following is a brief rundown on other areas of change in terms, based on conversations with Harrell, John Beals, a partner at Nixon Peabody LLP, well-known for representing state funds and funds of funds in partnership negotiations, Kenneth W. Fuller Muller, partner at Morrison & Foerster LLP, which represents funds sponsors as wells as funds of funds, and Thomas A. Beaudoin, partner at Wilmer Cutler Pickering Hale & Dorr LLP, which represents a diverse array of sponsors and institutional investors.
* Fee-Sharing: Twenty years ago it wasn’t uncommon for buyout firms to keep 100 percent of deal and related fees. By the mid-1990s, 50-50 sharing became the norm as responsibility for dead-deal expenses shifted to the funds from the GPs. After the Internet bubble burst, 80-20 fee splits became popular. Today, it’s rare for a buyout firm to offer less than an 80-20 fee split and a number offer 100 percent sharing. “I think we’re on our way to 100 percent offsets being the norm,” said Beals.
* Distribution Waterfall: ILPA has recommended that GPs leave behind the deal-by-deal approach to carry distributions in favor of the European approach, in which GPs don’t get to share in carry until returning at least all contributed capital. It’s not catching on, but more and more firms are agreeing to a compromise called the “enhanced waterfall” in which they return all organizational expenses, management fees and fund operaitng expenses (not just a portion), along with realized deal contributions, before sharing in carried interest.
* GP Clawback: Escrows, while hardly universal, appear to be making a comeback, as more GPs agree to hold back a percentage of carry distributions—25 percent is a popular number—to guarantee LPs they won’t end up with more than their fair share of carried interest at the end of the fund’s life. A minority of GPs, on the order of one in five, are also offering interim clawbacks, whereby the firm makes good on any clawback obligation at least once (such as at the end of the investment period) well before the end of the fund’s term.