It is perhaps surprising that the headline economic terms of European private equity funds have remained pretty constant for decades - despite the changing market environment in which they are being raised. If a fund cannot raise enough to close it is rarely because its terms are too rich, and improving the terms is unlikely to help. And an oversubscribed fund with a good track record will still find it hard to raise management fees or carried interest rates above well established market norms.
In our annual review of fund terms and conditions, we have once again confirmed that there has been no change in the core economic terms, and - despite a little pressure on management fees - we are not seeing any real moves by investors to disturb the status quo. But, as in previous years, the interesting data is in the detail.
First, to reconfirm the basic terms: management fees range from 2.5% for smaller (venture) funds, between 1.75% and 2% for larger and mid market buyout funds, and fall to 1.5% (sometimes a shade less) for mega funds (which we categorise as those raising ?2 billion or more). Carried interest rates are stuck firmly at 20% and (in Europe) still operate on a "fund as a whole" basis (so the 20% is of profits of the fund not, as is common in the United States, of the profits of each deal). Carry is typically only paid out when investors have received a hurdle rate of return of, normally, 8% (but sometimes 6% or 7%). Once that return is achieved carried interest holders "catch up" with the investors (so that all profits are shared 80/20, even if payment of the carry is deferred until investors have received their preferred return). Only a very small number of (usually venture) funds manage to avoid a hurdle altogether.
None of that will come as a surprise to anyone involved in private equity, but there are some emerging trends that can be discerned from the results of investor negotiation which do signal some important shifts. In the current market, with strong fund managers raising buyout funds reasonably easily - and having to scale back prospective limited partners - investors choose their ground carefully and tend to focus on a few key areas. So we are, for instance, seeing an increasing tendency for investors to require managers to share the transaction and other fees which it earns. Downside protections are also subject to scrutiny: for example, there is a continuing focus on key man clauses, so that there is an automatic suspension of new investments if certain people leave the manager, and carried interest is increasingly at risk if the general partner is removed (even in a no fault situation).
One trend that has been emerging over the last few years - and which continues - is a softening of the approach to payments of carried interest. Historically in Europe (in contrast to the US), funds have been reluctant to pay out carried interest at all until it is clear - on any basis - that it cannot be clawed back. So, if the carried interest is calculated on a "fund as a whole" basis and the fund has returned to investors all the money they have invested (plus any preferred return), in theory the carry holders can start to benefit from profits on future realisations. The problem, of course, is that if that happens while there is still further money available for drawdown from investors, it is possible that - once further money has been invested - the fund will not have made a profit overall for limited partners, and too much carry will have been paid from the proceeds of earlier sales. In that case, some carry would need to be clawed back and, in the past, European funds have preferred not to pay the cash out (or not to pay all of it out) until there is no theoretical possibility that it could be clawed back.
That caution is something that we are seeing changing - a little. An increasing number of funds (although still only around 20% of our sample) are agreeing that carried interest need not be held back (and placed in an escrow account), and in a few cases are not even imposing an obligation on carry holders to pay some back if it turns out to be overpaid. That is being driven by a need to get some carried interest to members of the team more quickly, especially younger team members who might otherwise have to wait some time for their cash.
But the main conclusion of our survey, once again, is that - despite some interesting tinkering around the edges - there are no significant changes to core terms. Perhaps that demonstrates that the tried and tested model continues to work.
08 June 2007