Planes, trains and due diligence

A recent survey of general partners around the world revealed that many are anticipating more strenuous fundraising efforts going forward.* This trend will be manageable for firms that develop efficient fund administration systems, but it will be a shock to GPs who have grown overly used to businesses unrestrained by reasonable budgets.

Indeed, the current fundraising market makes the fundraising markets of yesteryear appear almost easy by comparison.

One fundraiser says that “fundraising going forward will be slower. If [your returns] are average, your success rates will be lower than before, because in 2007 or early 2008 just being in the asset class you could potentially raise your fund. Even if you weren’t a star you had a pretty good chance. Today that chance is pretty low.”

One GP with a substantial track record, who closed a fund recently, reports that LPs took much longer than previous fundraisings to get approval from their internal investment committees. GPs interviewed that are currently in the market said enhanced due diligence by LPs was extending the normal fundraising process by at least six months.

“LPs in the fourth quarter of 2008 and the first quarter of 2009 went through a near death experience,” says a GP. “Going forward, instead of 10 pages, we’ll probably get due diligence memos with 30 pages.”

The quantity as well as quality of due diligence is changing. Most fund managers expect to hear more questions on how they operate their own business, on top of questions verifying their investing track records. LPs are starting to interview rank-and-file investment professionals employed by GPs as well as internal compliance and finance teams. GPs should also expect their service providers – administrators, attorneys, consultants, custodians, and operating partners – to receive phone calls or a visit during the due diligence process.

In response to greater LP demand for third-party verification of valuations and desire to save on costs, some GPs interviewed began outsourcing this function instead of doing it in-house. In these cases, the outsource providers will become critical sources of information to interested potential LPs.

Flying farther

Many GPs have found to their dismay that once-solid LP relationships are having trouble committing meaningfully to follow-on funds due to over-allocation issues, liquidity constraints and an appetite for smaller commitments.

In response, GPs that have just raised a fund or are planning new fundraising campaigns are increasingly looking well beyond their existing investor bases for capital. This means going overseas and to geographies not historically frequented by private equity fundraisers. Asia was frequently cited as a popular new fundraising destination. GPs cited Asian LPs and Middle Eastern LPs has having a strong appetite for the asset class, many of them having relatively young programmes with significant target allocations to put to work.

Fully 28 percent of GPs specifically said that their future fundraising efforts would likely take them for the first time to Asia-Pacific and the Middle East. These are the most notable new fundraising regions for GPs, ahead of Europe, a region in which eight percent of respondents said they will fundraise for the first time.

In addition, some GPs have sought out new types of LPs who may never have been involved in private equity before, such as sovereign wealth funds. One venture capital fund we spoke to noted that some large corporations had an increased appetite for venture in order to access to new technologies – an expansion on the traditional research and development strategy.

Pressure on fees

When asked which partnership terms and conditions they expected to most closely negotiate with LPs during their next fundraisings, the most frequent and highest priority response was fees, particularly the management fee and transaction fee.

Several GPs said they had received operating budget information requests from LPs to ensure that management fees are being efficiently spent. One GP now raising a first-time fund said such requests may presage LP demands for management fees that closely match operating budgets. “We are comfortable taking a smaller management fee just to cover costs, not necessarily a fixed 1 or 2 percent”, he said, referring to a perception among many LPs that a fixed-percentage management fee may be arbitrary and not necessarily reflect the costs of running the firm.

Other GPs were confident that their own fixed-percentage management fee schemes did indeed match their expenses. Said one: “There will be pressure on the management fee, but that is fund-size dependent. A 2 percent management fee for a target fund of our size is reasonable.”

In fact, many LPs noted that mega-funds in particular were most likely to charge management fees that far exceeded their operating budget needs.

Not every GP is “building wealth” by collecting management fees greatly in excess of operating budget. In fact, many are keenly aware that a smaller follow-on fund might bring the flow of management fees very close to, or beneath, current operating expenses.

With a smaller fund size from which to draw management fees, GPs might not be able to attract and retain the personnel it needs to run successfully with a reduced operating budget.

A senior partner at a large private equity firm said he was “positive” about his firm’s outlook and the outlook for the industry, but admitted that smaller fees and funds might cause his and other firms to “end up having. . . a slightly smaller business. We have a fantastic platform and model, but it was scaled for a [larger] fund.” He added that if the next fund “is meaningfully smaller than that, we can continue along the same [investment] themes, but on a current income basis we are receiving much less.”

Other fee pressures cited by respondents include the elimination of transaction fees, and monitoring fees, through the 100 percent use of such fees to offset the management fees charged to LPs. Several GPs predicted that the offset term would indeed go as far as 100 percent toward the LP in future partnership documents. Such a trend would dry up what for many GPs has been an important source of income (and, as many LPs were quick to point out, an important profit centre).

Despite all the talk of management fees, the traditional 20 percent carried interest term appears to be sacrosanct. However, some US GPs are anticipating encountering debate on the issue of whether they should adopt a more “European style” waterfall distribution formula, by which the LPs get back all of their invested capital in aggregate, across all portfolio investments, plus a preferred return, before the GP begins to collect carry. For many US private equity fund managers, such a term concession would mark a big shift away from so-called “deal-by-deal” carry, which allows for GPs to begin collecting carry earlier in the life of the fund. More broadly, some GPs noted that the discussion of “waterfall distribution formula” calculation came in the broader context of an attempt to avoid clawbacks, a highly unwanted event that can occur at the end of a fund’s life if it is determined that the GPs have paid themselves too much carry.

It should be noted that aside from fees, GP respondents confidently gave the next highest priority to “no major changes” as an expectation for their next fundraising partnership negotiations. One such GP said: “Terms and conditions in our new fund are like our last fund. Our terms have always been investor friendly and thus it’s less of a shift back to normal for us. Underlying our terms and conditions is good performance, which our investors are after.”

Some GPs noted that LPs seem eager to win term concessions, whether major or non-major. One GP said: “We have 80 percent offset that will go to 100 percent. We expect to lower overall fees – from 2 percent to 1.75 percent for our next fund. We heard that a big investor said that their management was expecting them to come back with a great victory on terms after negotiating with us.”

While some GPs with loyal investor bases and outstanding track records may succeed in dictating the same terms and conditions, and raise similarly sized funds, from prior fundraising cycles, many other GPs will need to adjust to market realities.

Luckily, as professional builders of businesses, most GPs have intensive experience creating efficiencies in portfolio companies and positioning them to thrive in changing markets. These skills will now increasingly brought to bear upon private equity franchises by their managers, many of whom expect fundraising and budget challenges, but who told us they are confident in their abilities to meet these challenges and help their firms thrive in a new era of growth.

*A version of this article appears in the recently released “Private Equity Faces The Future: Candid Views From The Market”, a white paper jointly produced by PEI Media and BNY Mellon.