Access to private funds is broadening due to ongoing democratisation and changing investor expectations, which is shifting the balance of negotiating power between managers and investors.
In today’s more challenging fundraising environment, there's positive news for investors. Managers are moving away from increasingly General Partner (GP) friendly terms towards a more collaborative approach that places greater emphasis on investor priorities. In addition, 're-ups' are becoming more straightforward, as managers focus on ensuring investors reinvest and managers are increasingly limiting changes to more legal/technical issues.
In this article, we examine some of the recent trends in private equity fund terms and how investors have been seeking to approach those.
NAV facilities
A net asset value (NAV) facility is where the manager will borrow funds, which are typically secured against the underlying portfolio companies. This is unlike more traditional borrowings in the form of subscription line facilities, which are secured against undrawn commitments. NAV facilities are a useful credit line for sponsors, particularly in the later stages of the fund life where commitments have been largely drawn down, to facilitate growth and offer liquidity. The concern for investors, however, is often to ensure that NAV facilities are not utilised to make artificial distributions. While the funds finance market continues to evolve and mature, it's clear that NAV facilities will continue to be widely used.
With that in mind, investors are increasingly seeking to place limitations on the amount and purpose of NAV facilities and are seeking prior investor/ Limited Partner Advisory Committee (LPAC) consent on these facilities being used to make distributions.
Co-investments
An increasing number of investors are seeking access to co-investment opportunities to reduce their blended fee rate and gain greater exposure to pre-identified assets. Certain investors, especially those investing with earlier-stage managers, are increasingly seeking pre-emptive side letter confirmation that co-investments will be offered on a no-fee/no-carry basis. Investors may also seek confirmation that co-investments will be offered in priority to existing investors over any third-party investors, and/or at the very least, an acknowledgement of the investor's interest in participating in co-investment opportunities.
Ultimately, access will depend on the amount of the investor's commitment to the fund and its ability to transact on relevant opportunities. Where co-investments are offered on a 'fee-free' basis, consideration should be given to any other form of economics being charged by the sponsor, including transaction and/or monitoring fees.
SMAs
Certain larger sponsors are increasingly raising capital outside of funds through separately managed accounts (SMAs) with key investors. Given the rise in the use of SMAs, non-SMA investors are seeking comfort and protections around the sponsor's use of SMAs, including up-front disclosure of any existing SMAs and/or confirmation that the manager won't manage any SMAs without the consent of the investor and/or the LPAC. This is principally to ensure that the manager is focusing its time on managing the activities of the fund and ensuring all suitable investment opportunities are presented 100% for the fund's benefit.
Where managers are unwilling to provide confirmation, there are other ways to receive comfort. For example, if the key person time commitment provisions are sufficiently robust, ie if the LPA clearly states that key individuals will devote substantially all of their business time during the investment period to managing the fund (or any predecessor or successor funds), investors can take comfort that sufficient attention will be given to advancing the fund’s activities.
Separately, a sufficiently tight deal allocation policy can provide further comfort, so that any investments which fit into the investment strategy of the fund are first offered to the fund, unless otherwise approved by the LPAC.
Carried interest for follow-on investments
With respect to follow-on investments after a GP removal, managers are increasingly attempting to secure the payment of carried interest to the removed GP for follow-on investments made post-removal. However, there are clear concerns about how an incoming manager/GP can then be suitably incentivised. The Limited Partner (LP) favourable position is to ensure that, for both a 'for-cause' and 'no fault' removal, the replacement manager/GP is entitled to receive carried interest on follow-on investments, to ensure that it's sufficiently incentivised and aligned with investors. From the sponsor's perspective, it may argue that the original investment was sourced by the removed manager/GP, and therefore any follow-ons made in respect of such investment should still entitle the outgoing GP to carried interest. Given that the incoming manager/GP is required to diligence the investment and manage any follow-ons, there are credible reasons to resist this argument, however.
ESG terms
As investors (especially in Europe) pay increasing attention to a wide range of Environmental, Social and Governance (ESG) issues, sponsors are adapting and fund terms are evolving to suit investors' needs. This can be seen on a bilateral basis, through the agreement of certain investor-specific ESG terms in side letters. This can relate, for example, to particular investment restrictions/excuse rights in respect of certain categories of investments and/or investor-specific reporting terms.
More generally, sponsors now typically include ESG reporting as part of their standard quarterly and/or annual reporting to investors, measured against certain pre-defined ESG/impact-focused metrics. Dedicated ESG teams are also increasingly available for ongoing dialogue with investors. For more impact-focused funds, LPAs sometimes even link an element of managers' carry/profit entitlement to pre-defined ESG KPIs, with an annual assessment undertaken by an independent third party.
Fee waiver mechanisms
Post the 2007-2008 financial crisis, there was an industry-wide move to a 100% offset of all fee income against management fees. However, there have been recent noteworthy shifts in market terms on offsets against management fees.
Firstly, an increasing number of more established sponsors with larger teams are charging for 'value creation' services, with the fees charged not offset against the management fees. Where this is the case, LPs are looking to ensure that these fees are charged on an arm's length basis and by a completely different team within the sponsor. Secondly, it's becoming increasingly common for placement fees to be initially charged to the fund and then subsequently offset against management fee income. Investors will often push back on this fee waiver mechanism and require, from a point of alignment, that any placement fees are borne directly by the sponsor.
Cause removal
Regarding 'cause' removal provisions, it's common to see the court's determination to establish whether a 'cause' event has occurred to be a final appellate court.
From an investor's perspective, this means that disputes can be tied up in the court appeals process for prolonged periods of time. This means that the preference is to request a court of first instance for the determination of 'cause' (or at the very least no later than a first appellate court determination). This is important if the 'no fault' removal provisions are weak, for instance with a long initial grace period (during which a removal cannot be effected), or are non-existent.
From the sponsor's perspective, given the potentially punitive measures taken on a 'cause' removal, including in particular as relates to its future carry entitlement, the appellate system allows for the allegations of 'cause' to be properly investigated, and hence this is often a heavily negotiated point.
Term extensions/continuation vehicles
With an increasingly challenging exit environment, it's no surprise that standard fund terms are becoming longer, often from ten years to twelve years, and extensions of an additional two or three years are also now common.
From an investor's perspective, it's important to assess whether these extensions require investor consent (often the first one or two may not), and if not, ensuring that the management fee ceases to be payable at the end of the standard fund term so that a discussion can then be had with the manager regarding any future fees to be charged.
Alongside that, the market for continuation vehicles has evolved considerably over the last three to five years, and certain sponsors are now building in the right to form a continuation vehicle and transfer investors' interests across. Where this right is present, sophisticated investors will ensure certain upfront protections, including consent rights, or at the very least no more favourable economic terms being charged by the sponsor in respect of the continuation vehicle, alongside prior LPAC consultation and obtaining a third-party valuation or fairness opinion in relation to the assets being sold.
At Taylor Wessing, we have a specialist Private Funds team that advises institutional investors across a wide range of investment fund strategies and fund sponsors on the formation, structuring, and negotiation of their private investment funds. If you have any questions about investing or raising capital, please don't hesitate to get in touch.
