For many years after the birth of the asset class in the late 1970s and early 1980s, the economic terms of private equity funds were set on a relatively fixed and predictable basis, with only fairly minor variations from the typical '2-and-20 percent' management fee and carried interest levels. This standardized approach to compensation persisted for several decades, even as the industry experienced significant growth and attracted increasing amounts of capital.
PE firms largely adhered to these established norms, and even lower profile terms and conditions, such as funds' catch-up and clawback provisions, generally did not deviate much from standard norms. All in all, relatively straightforward formulae underpinned the operation of fund terms, ones sufficiently simple to require only a standard Excel spreadsheet to compute, not with standing the often large sums derived by their calculation.
Why Standardization Persisted in a Dynamic Industry
Why did such standardization persist in an asset class concentrating on generating returns from pursuing uncorrelated strategies, targeting out-of-favour assets with longer-term potential, financing innovative new products or services or applying best practices to improve corporate performance, all forms of open-minded and convention-challenging investment? The answer lies in the historical context of the industry. Most likely because of the limited scale of the asset class compared to those consuming vastly larger shares of the institutional investment pie - quoted equity, fixed income, and real estate. This factor resulted in limits on the time and attention paid by investors to fine-tuning the terms and operations of private equity partnerships.
For the most part, buyout and venture capital partnerships (the dominant forms of private equity funds for the first several decades of the asset class' history) performed powerfully well on a longer-term basis, beating comparative benchmarks handsomely and producing sufficient outperformance to justify (and, indeed, mask) their incremental costs on a net return basis. As such, many investors (particularly big institutions, with already overburdened staffs, making large commitments that notionally could have 'moved the dial') had neither the time nor the motivation to break the mould of largely fixed pricing and terms on investment vehicles.
The Rise of Nuance and Complexity
Nonetheless, however simple these formulae may have appeared in 'headline' form in the past, and still do, there can be many nuances in the detail of their construction and application. These nuances reflect a variety of factors, including the degree of previous success and the negotiating leverage of the general partner (GP), as well as a gradual tightening of terms over time at the behest of limited partners (LPs) made wiser by imperfect outcomes on partnerships producing skewed rewards for the GP for subpar performance.
As the industry has matured, and the number of funds and the aggregate capital raised for its players has increased exponentially, in-house fund selection teams at LP institutions have grown in scale and expertise and more legal talent have turned their attention to funds' terms on behalf of LP clients. As a result, thought and care have been applied by highly skilled professionals to drafting and debating sometimes minute points and low probability scenarios. Consequently, the small print of many private equity funds' economic terms and conditions has become more complex and lengthy over time, however similar to the mainstream those terms and conditions may appear on the surface.
The Impact of the Global Financial Crisis
Yet no amount of careful lawyering and detailed negotiation among sophisticated professionals on a case-by-case basis, prior to 2009, could substitute in impact for the global financial crisis (GFC). Its shocking, seismic effects on private equity funds' valuations and prospects in 2009 and 2010 forced industry-wide change on what was (notwithstanding earlier observations about nuances and 'devil is in the detail' amendments) a largely static economic bargain between GPs and LPs until then. PE firms, particularly those managing larger funds, faced significant challenges during this period.
Institutional investors, often facing paper losses of up to a third of their overall assets under management at the bleakest moment in early 2009, understandably became far more focused on investment management expenses and fee levels, particularly on higher cost asset classes like private equity, where net returns moved rapidly in this period from being solidly in the black in most mature portfolios to worryingly in the red. Mega-funds raised during the boom times of 2005-07, often in orders of magnitude larger than their predecessor funds, proved to be key factors in this erosion of returns. This was a consequence of their disproportionate size and the fact that most GPs were still constructing portfolios in the deepest valley of the traditional J-curve when the effects of the GFC hit them hard, both in terms of company trading and profits and peer quoted equity valuations.
The Evolution of Bargaining Power and the Rise of New Markets
In the aftermath of this meltdown, LPs became more organized in their collective bargaining, whether officially (in the form of industry-wide initiatives such as the Institutional Limited Partners Association (ILPA) Principles and its codification of best practices and preferred terms) or unofficially (in the form of larger investors, in particular, seeking improved economic terms from GPs, either via individual negotiations, separate accounts, enhanced co-investment opportunities or general fee discounts available to all LPs and applied on the basis of the scale of commitments and timing of closings). PE, as an asset class, has always been adept at adapting to changing market conditions.
While these amendments and improvements to terms for LPs were substantial, they were evolutionary rather than revolutionary and, especially as market and private equity fund performance have recovered in recent years, the 'balance of power' has begun to revert in the GPs' favour, especially on sought-after offerings. The emergence of new markets and investment opportunities further complicates the dynamics between PE firms and their investors.
This chapter will seek to describe the fairly standard 'headline' economic terms of private equity funds and their formulae, and also to shed light on nuances in their design and implementation that have evolved as funds have increased in number, variety, and complexity. It will also take account of where the post-GFC conditions and capital shortages have made a difference in altering levels of market-clearing terms on a likely, or potentially, permanent basis. Understanding these nuances and trends is crucial for both PE firms and their investors as they navigate the evolving landscape of private equity investing.
