Given the level of detail and the nuances of design that now underpin private equity structures' economic provisions, however similar their headline levels appear on the surface, it would be a misjudgment to state that those provisions have not adjusted over time. LPs have generally been the beneficiaries of better-crafted and more complex agreements, as they have used their experience, weight of capital, and negotiating power to narrow definitions and to anticipate differing outcomes. The intent of these more closely honed provisions has usually been to protect against 'downside' scenarios that could harm LPs' economic interests and potentially lead to their misalignment versus those of the general partners.

A Look at the Stability of Headline Terms in Private Equity

This said, it is fair to observe that the basic outlines of private equity structures' principal economic provisions have remained remarkably static over the last few decades. The 20 percent carried interest stake for general partners and 'published' management charges of at least 1.5 percent still apply even to mega-structures, where the potential current and long-term income streams for the general partner can be prodigious given the billions of funding these structures have in firepower (however, as discussed above LPs have begun to erode that full rate through various forms of discounts and cost savings).

Many LPs were concerned generically for years about the relatively fixed nature of these provisions, but they either did not seek or were not able to change them specifically until the GFC. This resistance to change underscores the power dynamics at play in the private equity industry. Fundamentally, management charges are loaned by LPs to general partners, and LPs drew comfort from the fact that virtually all private equity structures in the past have at least returned their original funding plus a modest profit sufficient to cover the preferred return. In addition, generally speaking, the net returns earned by LPs on private equity structures (that is, after payment of carried interest to general partners) were sufficiently compelling in absolute terms and sufficiently superior relative to public equity benchmarks to justify continued commitments to the asset class despite its higher costs.

Notes: Includes fully and partially realized deals; all figures calculated in US dollars; post-2018 data not shown, as most deals entered later than 2018 are still unrealized

The Impact of the GFC: A Catalyst for Change

However, beginning in late 2008 and through to mid-2009, financial markets and virtually all asset classes, including private equity, experienced significant losses, at least on a mark-to-market, if not a fully realized, basis. A long period of slow recovery in macroeconomic conditions set in thereafter, with financial markets rebounding (largely as a result of massive quantitative easing by central banks) well ahead of clear evidence of rising earnings and renewed corporate health 'on the ground'. The GFC exposed vulnerabilities in the private equity model and forced both LPs and GPs to reassess their strategies. As such, exiting investments profitably and generating cash returns to LPs was problematic for most general partners well into 2012. It was only in 2013 that revived portfolio company performance, highly liquid and attractively priced debt markets, renewed trade buyer M&A activity, and supportive and open equity markets all coalesced positively to allow a huge flow of realizations and cash back to LPs and a real recovery in private equity vehicle performance.

Shifting Power Dynamics: LPs Gaining Ground

In these volatile circumstances over the last five years, some long-held preconceptions that have affected the balance of power in the past between general partners and LPs in negotiating private equity structures' economic provisions were shattered. The GFC shifted the balance of power, giving LPs greater leverage to negotiate more favorable terms. Some funds did not return their committed funding, turning the 'loans' that are management charges into bad, irrecoverable debts. In addition, while their relative performance may have remained reasonably compelling on a longer-term basis versus public equity returns, in this troubled period private equity structures also fell well below their historic norms in the net, absolute performance they produced, leading to much greater investor focus on costs and expenses. Finally, at least until 2012, funding for new commitments to structures was in short supply and withheld by LPs in large measure from all but those private equity structures that met particularly high thresholds as to quality and provisions.

In these circumstances, it was not surprising that investors had a long-anticipated opportunity to adjust, in practice, the headline, foundational economic provisions of private equity structures, in particular reducing management charges (especially on larger structures via discounts). They also made significant progress in eliminating an ongoing general partner share of net transaction charges, under the provisions of most private equity structures formed after the GFC. This period marked a turning point in the negotiation of private equity terms, with LPs successfully pushing for greater transparency and alignment of interests. On smaller, more technical points affecting the inner architecture of structures' mechanics, LPs were also not shy in suggesting changes favorable to them, leading often to dozens of LP comments on draft limited partnership agreements and protracted legal processes when a new vehicle is formed.

Carried Interest: The Last Bastion?

However, with the exception of an important move to near uniformity in its computation and waterfall mechanics (such that whole structure methodologies are now market standard, not just in Europe but also now the US), the largest 'line item' of cost to LPs arising from private equity vehicle investments (assuming vehicles perform and produce material gains) remains at its pre-crisis level. The persistence of carried interest at its traditional rate highlights its importance as a performance incentive for GPs. This is, of course, carried interest, which overwhelmingly is still a fixed 20 percent share of a structure's profits delivered to its general partner, once preferred return requirements have been satisfied.

As a result, LPs have added extra downside protection via the whole structure methodology (as it makes a material impact on the division of rewards between a general partner and its LPs, particularly when a vehicle produces a mix of successful and failed investments) but have allowed significant upside to remain available to a GP managing a successful fund by not reducing the 20 percent stake. There has been some talk of tiering of carried profit, such that the full 20 percent rate would not kick in until the achievement of a certain threshold of returns, and with lesser rates applying to less satisfying results (say a 10 percent rate above a 10 percent net IRR, a 15 percent rate above a 15 percent net IRR). To date, however, LPs have not exercised sufficient collective will to bring about these innovations and appear content that, by definition, carried profit is a payment for performance and is therefore self-financing and not a fixed expense.

Striking a Balance: Containing Excesses While Preserving Incentives

In striking these balances - cutting the shorter-term expense load of investing in a private equity vehicle and eliminating transaction cost leakage to general partners, while allowing general partners to retain a huge longer-term incentive if they perform - LPs have acted sensibly to contain the excesses of the asset class while preserving the profit motive that leads to its superior performance. This balancing act reflects the ongoing evolution of the relationship between LPs and GPs. While undoubtedly there will be more and more negotiation on the margins of provisions over time (as LPs show no signs of dropping their now sharpened pencils), it seems likely that this sensible balance on the major provisions of private equity partnerships will form the mainstream of the general partner -LP market for the foreseeable future. The probability is that further change will only come in response to significant shifts in macroeconomic or market conditions, rather than from continuous or incremental adjustments.

Private equity's remarkable resilience over the past decades has its foundation in the alignment of interests between general partners and LPs. This alignment is crucial for the long-term health and success of the industry. A changing landscape does not signify a fundamental break from the past but rather an adaptation to new realities, as it has always done. The industry's ability to adapt and innovate will be key to navigating future challenges. The partnership model, with its evolving dynamics and provisions, will continue to ensure that both parties reap the benefits of their collective efforts and investments.