George Orwell’s 1945 novel Animal Farm is a fascinating satire of dictatorial rule. A group of animals overthrow the negligent farmer in charge of them. All is well until a hierarchy develops among the animals themselves. The old “All animals are equal” slogan is corrupted to “All animals are equal but some animals are more equal than others”.
Can we say the same for private equity investors?
The equitable treatment of shareholders has been a longstanding talking point in investment circles. On many stock exchanges globally, equality is enshrined in listing rules and company’s constitutional documents. The push towards equality of treatment has increasingly been a major focus of corporate governance advocates.
In private equity, however, there has been a trend away from a level playing field towards a multi-tiered one, with a small subset of larger and/or quicker-acting limited partners (LPs) benefitting from preferential treatment from general partners (GPs)1.
Unlike in George Orwell’s Animal Farm, this trend towards ‘differential equality’ is not necessarily negative. There is no malice aforethought, no Machiavellian scheming and no pre-planned strategy of investor oppression.
Rather, it is the by-product of each GP and LP acting in their own best interests. We expect this trend to continue (or even Snowball) and lead to a noticeably different private equity landscape.
In private equity, there has been a trend away from a level playing field to a multi-tiered one
Haves and have-nots
As private equity practitioners globally are well aware, it is now both a time of plenty, and a time of famine. An increasingly broad divide has appeared in the GP universe between the ‘haves’ and ‘have-nots’, with a portion of private equity managers being able to raise funds quicker, in larger sizes, and to negotiate LPA2 terms in their favour.
Conversely, vast swathes of the GP landscape have struggled with fundraising. In the Asia-Pacific region, two-thirds of GPs failed to meet their fundraising targets within two years of commencing fundraising, while, in contrast, less than 20% met or exceeded their targets in less than a year3. GPs facing slow burn fundraisings have been increasingly willing to provide preferential terms to certain investors in order to catalyse fundraising.
In a similar trend, an increasing divergence has appeared in the LP universe. The combination of consolidation in the LP/ fund-of-funds landscape and the emergence of extremely large pension funds and sovereign wealth funds are leading to the proliferation of preferential terms for such investors. Larger investors are now benefitting from tiered fee and carry discounts and/or preferential co-investment rights.
In recent years, many LPs have taken this a step further, moving away from a standard relationship altogether and instead adopting tailored separate account structures that typically offer a range of benefits beyond lower fee terms.
In the current edition of our longstanding annual survey of Asia-Pacific private equity funds, a fifth of funds now offer preferential fee terms to selected LPs in the form of fee and/or carry discounts.
The data in the current survey sample suggested an increase in differential fee terms, but that preferential terms are increasingly being granted through separate accounts.
We expect an ongoing proliferation of separate account mandates given the increasing emergence of large LPs as well as the willingness of GPs to take up separate accounts.
GPs are starting to allocate fee discounts primarily based on the size of an LP’s commitment. Meanwhile, early closers in a fund have also gained favour from GPs to benefit from fee discounts. This is expected given the difficulty that many funds – particularly those being raised by relatively newer managers – face in reaching a first close as compared to subsequent closes.
While LPs are generally more able to negotiate terms with smaller funds, it can often be counterproductive to do so, given that the small fee base of such funds means that GPs need every dollar to build and support a team with sufficient resource.
Conversely, LPs often have limited negotiation leverage over larger funds, despite the ability of many of the GPs managing such funds to generate substantial profits on management fees alone.
We like small and mid-market focused funds that offer more target-rich, less efficient and less intermediated markets, and a superior alignment of GP and LP interests
As a result, Aberdeen’s preference across many of our global and regional private equity mandates is for small and mid-market focused funds. In addition to the advantages of operating in more target-rich, less efficient and less intermediated markets, we believe the alignment of interests between GPs and LPs is superior.
Co-investing the right way
In recent years, co-investments4 have become an increasingly important element of the private equity landscape. Co-investments provide the ability to generate strong performance, reduce the overall fee burden from third-party fund managers, and ameliorate the typical private equity J-curve5. GPs are cognisant of the increasing LP appetite and regularly offer access to co-investment opportunities as a carrot to LPs.
As co-investments from underlying GPs now typically tend to be on a no-fee-no-carry basis, the key differential levers that GPs and LPs can use are around preferential allocations and the right of first refusal on co-investments.
The question then is how GPs allocate co-investment opportunities, and the transparency by which this is conducted. Broadly speaking, there are three main approaches: (a) on a pro-rata basis with each LP’s proportional commitment to a fund, (b) on a preferential basis to certain LPs on the basis of size and/or early closing of a commitment to a fund, and (c) on a discretionary basis.
Our survey data suggests that around 40% of Asia-Pacific GPs allocate co-investment opportunities on a pro-rata basis, and another 40% or so grant preferential allocation rights to larger and/or earlier closers. The remaining 20% or so have policies that effectively equate to a discretionary approach.
While there is no necessarily right or wrong methodology, for practical reasons we believe that there will be a shift away from pro rata towards larger/earlier closers, as well as increased GP discretion.
Where does this all lead us? Is this positive or negative for private equity? How will smaller LPs react?
Differential equality is here to stay, at least until cyclical conditions change the dynamics between GPs and LPs
Clearly larger and/or quicker-acting ‘thought leader’ LPs are happy with the emergence of preferential terms as they are rewarded for backing a GP in bulk and/or at a first close.
The lion’s share of GPs – those whose fundraisings are slow burns rather than open-and-close affairs – seem to treat these as a necessary evil: giving away fund economics is often not a matter of choice, but rather a required condition to get to a first close and/or to attract a large commitment.
The figurative 20% of GPs who have no trouble fundraising are likely to be indifferent to these trends: there is little pressure on them to offer fee discounts given the strong hand with which they enter fund term negotiations.
It is the smaller, slower LPs that may feel aggrieved. However, there appears to be a grudging acceptance of the facts: few LPs will decline a good GP. It seems that differential equality is here to stay, at least until cyclical conditions change the dynamics between GPs and LPs.
Several of them would have protested if they could have found the right arguments George Orwell, Animal Farm
Where do we go from here? Is the emergence of differential equality just an aberration? And how will such trends affect LP behaviour?
1. Size will become increasingly important
Whether it’s the ability to extract better fee terms, have representation on advisory committees, or preferential access to co-investment opportunities, there are benefits to committing a proportionately large cheque into a fund.
With size comes responsibility: it is invariably the larger commitments that allow a fund to get up and running. The larger LPs sit on the advisory committee and take the lead in addressing issues relating to the GP and fund for the benefit of the broader LP base. Better treatment can arguably be apt compensation.
2. LPs will become leaders rather than followers
We expect an ongoing shift from a “Final close good, first close bad” attitude to a “Final close good, first close better” mindset.
In delaying a potential commitment, an LP may miss real economic and strategic benefits. Conversely, LPs who are willing and able to conduct their own due diligence and use their own judgment to decide on whether to commit to a GP at a first close will be better positioned to negotiate superior terms.
3. If you can’t beat them, join them
For smaller investors who are reluctant to lead, all is not lost. A smaller investor can still be a materially important LP if it invests only in smaller funds. Even in larger funds, there may potentially be some limited scope for smaller investors to band together under special purpose vehicles (SPVs) to achieve sufficient scale.
LPs would be wise to bear these factors in mind if they aim to be more equal than others.
1 LPs are investors into private equity funds
GPs are the managers of private equity funds.
2 Limited partnership agreements
3 Bain & Company Asia-Pacific Private Equity Report, 2015
4 Where GPs and LPs invest alongside each other
5 The tendency of a private equity fund’s returns to be negative in the first few years before turning positive in later years