The Changing Types of LPs

Given the broad availability of capital, the pendulum appears to be swinging back in favor of GPs. 

• One GP participant reflected that in 2010 they were engaged in “hand to hand combat” with LPs on the LPA terms and had a tough time raising the fund, whereas today LPs are quite willing to collaborate.
• Despite the European waterfall model being popular last year, several GPs agreed that they are benefiting from increased utilization of the “Modified American” waterfall structure.
• The new environment lends itself to compromise and negotiation rather than a take-it-or-leave-it scenario. Sponsors at the table concurred that they need to prepare their strategy and goals in advance in order to quickly address what fund term trade-offs they would accommodate while in the negotiation process.
• Attending LPs indicated that fund size and fee levels (both management and incentive) are the core negotiating points. However, they advised that proactive communication with LPs and thoughtful alignment of interests can mitigate negative pressures.

LPs increasingly require co-investment rights, but exercising these rights is dependent upon the class and structure of the LP.

• Early LPs frequently want co-investment rights as there typically are not fees nor carry charged on co-investments.
• One GP participant stated that “often LPs cannot get to a decision quickly and do not have appropriate personnel and process infrastructure.” An endowment LP at the table countered that “though they may not do any co-investing now, they are interested in learning what is required to carry out co-investments for the future.”
• During co-investing activities, LPs also want to learn about the process of co-investing in an effort to refine their manager selection protocols.
• Infrastructure intensive organizations like sovereign wealth funds, large public pension funds (particularly Canadian), and multi-family offices have the team bandwidth to assess, make decisions, and act quickly.
• Family offices often act more rapidly as they largely base their co-investment decisions on history and trust in the GP, without as much fiduciary burden as an institutional LP.
• As one GP noted, “some LPs co-invest on pre-final fund close deal deployments as means of diligence in advance of a fund ‘blind pool’ commitment.”
• A few LP attendees concurred that for certain LPs, co-investment may also provide a hedge for their portfolio positions or strategic access to companies, technologies, IP, etc.

GPs are adapting to the evolving co-investment environment in different ways, depending on their existing LP composition and growth strategy.

• Some GPs will set short timelines for co-investment processes and quickly gauge LPs’ ability to act.
• While appearing to be a simple solution, some sponsors have developed parallel co-investment funds, often offered to specific LPs under a “side letter.” However, substantial care must be taken and these agreements must be structured in order to avoid conflicts.
• One participant indicated that under the new regulatory regimes, SEC stipulations that offer all LPs the same provisions cause the traditional benefits of a LPA side letter to be lost.
• GPs are increasingly willing to offer co-investments at the end of their fund lifecycle in respect of secondaries transactions that incorporate some form of primary staple. This increases as such transactions are viewed as opportunities to engage and foster new LP relationships for follow on funds.

SMAs are increasingly prevalent at large multi-asset investment managers.

• While resonating with the public markets experience of such managers, for private equity the “spider web” of SMAs makes for complicated and challenging diligence and creates conflict issues.
• SMAs offer the ability to scale more rapidly than the traditional blind pool route, but entail substantial administrative complexity.

LPs view GPs as “businesses,” not just conduits for deal investment. It is not simply about returns but also about the team, processes, and founder commitment.

• One LP participant noted that the GP’s investment in their own fund is the most critical issue versus management fees and fee offsets.
• “Have conversations with your LPs and be reasonable” advised a GP participant to the other GP attendees. For example, this particular GP has an 80% offset on fees, but they are aware that 100% offset on fees is more standard.
• Fee offsets also depend on fund size. The smaller the fund the more critical current fee income is to managing essential overhead.
• An LP said, “the larger the GP commitment to their fund, the more we are willing to negotiate on other points.”