It is not exactly a good time to ask top-performing firms to cut their carried interest percentage or to accept a no-fault divorce clause. Demand for slots in top funds is way too intense. Still, institutional investors continue to fight hard for LP-favorable terms with first-time funds and other emerging managers.
Much of the negotiating centers on fees, with sponsors pushing to collect management fees on successor funds sooner rather than later and investors arguing for later rather than sooner. Likewise, negotiators have begun focusing more attention on the payment of management fees toward the end of a fund’s life, such as during any extensions of the fund term. A third issue that is suddenly topical: how the fund IRR should be calculated in light of the growing use of capital call loans that boost returns without meaningful changes to the actual economics of a deal.
To be sure, most buyout firms still follow the standard practice of starting to charge management fees on a successor fund once it holds a first closing. That is according to Brad Mandel, a partner at Winston & Strawn LLP and a member of the advisory board for Buyouts Insider’s 2018–2019 PE/VC Partnership Agreements Study.
But many firms have taken advantage of a strong fundraising market to close successor funds before wrapping up investments in the predecessor. These are sometimes referred to as “dry closes.” That raises a question: When do management fees start accruing on the successor fund? Should it be when the predecessor fund has reached some threshold of investment — perhaps 75 percent, including deals under letter of intent? Fund managers might ask for that. Or, if in a more conciliatory mood, they might ask to start charging fees only once they have initiated operations and begun to source deals.
But investors concerned about early fees creating a drag on fund performance can push back. They may ask the fund manager to defer charging fees until they have a platform teed up in the new fund.
Meantime, the industry has matured to the point that both fund managers and investors have a lot more experience dealing with aging funds and how fees are charged on them. Traditionally fund managers have agreed to step down their management fees once the investment period ends on a fund. Doing so reflects the reduced workload associated with harvesting a fund. It also prevents the fund manager from collecting full fees on more than one fund at a time.
One common formulation is for the basis of the management fee percentage charged to switch from committed capital to invested capital after the investment period ends. Such a formula works well for established managers with a regular pipeline of funds coming online. But what about a first-time fund manager whose second fund comes in well under its target size?
According to Mandel, some emerging managers ask investors to eliminate or reduce the step-down on a fund should the successor fail to reach a certain size. Investors then have to decide whether to go along with that or hold out for something more favorable, such as budgeted fees they get to review and approve every year.
Investors also care more these days about how management fees are handled after the fund term — typically 10 years — expires without having fully liquidated. In some cases these conversations are colored by investor frustrations over how long it has taken to fully exit all their deals. Established fund managers whose services are in high demand don’t have to budge much on this term. They expect to charge fees during fund extensions according to the step-down formula.
But in negotiations with newer managers investors may try to cut off the fee stream at some point, said Mandel. Or they may ask the fund manager to switch to budgeted fees during any fund extensions. Fund managers that do agree to budgeted fees may, in return, ask that the fees not fall below some percentage of the prior year’s.
One final development to watch has to do with the growing use of capital call loans — typically short-term loans that sponsors use to consummate deals before drawing down capital from investors. Since the IRR clock starts ticking later on these deals, both fund managers and investors see a boost in their return. That, in turn, could lift the fund manager over its return hurdle more quickly, enabling it to collect carried interest sooner than it otherwise would.
To keep the practice in check, investors can ask fund managers to limit the duration of the loans to just a few months. If fund managers insist on longer terms, investors can ask that the IRR clock on a deal start when the credit line kicks in — if that’s earlier than the capital call.
Investors shouldn’t expect to get this concession from anyone but new and emerging managers or perhaps an established firm that has suffered through a poor-performing fund or two.
Action Item: Contact Brad Mandel, partner with Winston & Strawn LLP, at 312-558-7218.
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