28 May 2015

The evolution of fund terms

At our seminar in London earlier this month (which we are repeating next week), we discussed the themes that emerged from our annual review of the funds we worked on in 2014.  This year our sample included over 60 private funds, 77% of them European, across a range of asset classes, and we concluded that – although there has not been a revolution in the last twelve months – terms have continued to evolve in response to investor concerns, many of them informed by experiences in the immediate aftermath of the financial crisis. However, we also found evidence that in some areas, especially those where interests may be more closely aligned, some emergent shifts seem to have halted. 

A good example of the continuing moves to address investor concerns is the protection against over-payment of carried interest during the life of the fund.  This has always been an issue, and is addressed in two main ways: by an escrow account, which means that carried interest is held back until a particular performance test is met, and by clawback, which gives investors the right to recover overpayments from the executives, if necessary.  Last year we saw an abundance of caution, with over 50% of funds in our sample adopting both mechanisms.  Protections of this sort have become a "hot button" for investors, who are more worried about downside scenarios than they were pre-crisis.  At the same time, there is no overall impact on fund managers, other than to make them wait longer for their carried interest in funds that perform well in the early years (which can make it harder to keep a high performing team motivated).

More funds with both escrow and clawback

Similarly, while most European funds have always included a right for the investors to terminate the manager's appointment by an investor vote and without having to establish fault – so-called "no-fault divorce" – it is rare for that right to be exercised.  It is a useful backdrop to discussions with under-performing GPs, but it is expensive to trigger because of the level of compensation payable to the outgoing manager.  This is another area on which investors have brought pressure to bear, and we have seen a gradual reduction in the level of compensation payable on removal.

However, moves towards establishing an alternative way for investors to take collective action have been less marked, perhaps because interests between the manager and investors are more closely aligned.  In many US funds, investors have a right to terminate or suspend the investment period of the fund before it has run its normal course.  Our survey shows that most GPs still resist that term in Europe and Asia.  Managers find it difficult to accept it because the right can be exercised when investors are financially stretched or over-exposed, rather than because there is anything inherently wrong with the fund's strategy or performance.  In addition, many investors are not keen on it because it could mean that a minority suffer because the circumstances of the majority change. 

Another battleground has been the Advisory Committee, with most investors wanting a seat for themselves, while at the same time not wanting it to get too large.  That inherent tension may be resolving itself: our survey shows that an increasing number of funds cap the number of Advisory Board seats.

Overall, while fund terms will continue to evolve, our survey confirms our view that the debate between managers and investors is not the only show in town.  We are seeing the different views and interests of investors playing themselves out in negotiations, and they are having an equally important impact on the outcome.

We have a few places left for our seminar on 4 June, when we will discuss our annual survey in more detail and give an update on structural, tax; legal and regulatory developments.  Click here for more information.

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