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Private Equity: Some ideas for better alignment between LPs and GPs

14 May, 2012

The Indian private equity industry is going through some tough times. On the supply side, there is excess capital (and even more being raised as we speak!), too many private equity (PE) funds, high levels of intermediation leading to open auctions, and volatile currency fluctuations. On the demand side, there are inadequate ‘high quality’ investment opportunities in the private space, demanding entrepreneurs and promoters, high valuation expectations (still linked to and sometimes at a premium to already irrational public markets), rising costs and declining margins in the economy, an ineffective government, continuing issues of corporate governance, and a perceived lack of appreciation of private equity’s ‘value add’! Indeed, it looks like a perfect storm. 

We probably are in the ‘worst part of the cycle’, and I am optimistic (like many others) that the situation will improve over time (like all market cycles do!), though it’s tough to forecast the timing and extent of recovery. However, there are two clear near term outcomes we cannot escape – overall muted returns for the average private equity investor, and a gradual but significant separation (in terms of returns delivered) of the really good PE teams versus the average players over this period. 

With this as background, it’s a great time to probably introduce some thoughts on improving alignment of interests between GPs (General Partners) and LPs (Limited Partners) in the Indian market. In an environment when everyone is making superb returns, the debate about alignment is (unfortunately) often ignored. However, in tough times like these, when overall returns are muted, the harmful effects of poor alignment show up pretty starkly. In my mind, true alignment between an LP and GP happens when both are interested and incentivized to meet the same objective – highest possible returns for the overall Fund in question. True alignment is also a situation when the gains (or losses) are fairly split between the two, both in good times and in bad times!

 While alignment can have many aspects, I will discuss the main parameters that truly impact it – fee-carry-hurdle rate arrangements, GP’s contribution to the fund, and overall fund size. All these are obvious, but sensitive issues, and most LPs may not discuss the ‘elephant in the room’, at least not directly, but everyone can see it! Let me hazard to state the issue and potential solution for each parameter separately, although they are all inter-related:

Fee for GP team’s remuneration and expenses

 Most GPs charge a 2% (it may vary, but this is the norm) fee per annum on committed capital (for the investment period), and then the same % on the invested portfolio after that. This is meant to maintain a high quality team that can execute the investment strategy. However, in situations when this fee number becomes large enough to more than adequately pay PE teams (salary plus large bonuses), alignment with LPs suffers dramatically. Indeed, in most of the larger PE funds in the country, the average base plus bonus compensations are significantly HIGHER than what the same individuals would get in a very senior corporate/ finance role. I have no issue with that – you need to pay to attract the best talent. Unfortunately, the alignment with LPs breaks down when the GP team can continue to get this high base salary plus bonus for the life of the fund, irrespective of returns to LPs. The fee is an issue especially in fund sizes larger than $300 – $400mn, and is exacerbated in situations where the GP has raised multiple funds! I am not suggesting that fee should be stripped down completely, but GP teams getting a fee income of $10mn-$20mn pa for a team size of 10 people is an obvious issue! 

GPs often commit to contribute to the fund themselves as well – typically about 1-3% of the corpus. In my view, this is grossly insufficient, especially when you think that a large part of this contribution can and does actually come from fees itself over the life of the fund! A true ‘skin in the game’ GP contribution would be at least 5-10% of the fund, especially if it comes out of fee.  I think it’s time to either do a bottom up calculation of reasonable fee required to support a team (some GPs in the US publish a budget based fee system, and also have maximum overall limit to fees on a fund through its life), or GPs continue the 2% benchmark, but commit significantly to the fund corpus – at least 5-10% over the fund life. 

Carry paid to GPs on hitting a specified rate of return (hurdle rate)

Most GPs are entitled a carry of 20% of the net gains, assuming the hurdle rate (usually 8% return) is achieved. Again, both these numbers are borrowed from the western model of PE. I don’t think I would grudge the 20% number (1/5th of the gains on investment to the GP is fair, I think). The issue I have is with the hurdle rate in an emerging market like India (with GDP growth rates at 7-8%!), where 8-10% returns are quite possible with lower risk in debt products. I do think it is very odd for a GP to be paid carry for delivering a 12% IRR in a market like India, especially as LPs have had to bear with illiquidity over 5-9 years for this level of return! 

Let’s do a simple back of the envelope calculation (a quick disclaimer at this stage – ALL calculations are estimates. They are meant to illustrate the points, NOT stick numbers in your mind) – a GP with a fund size of about $400mn, with a ‘very average performance’ of 12% IRR before carry will earn about $75mn in carry over the fund life of approx 8-9 years (assuming average hold period of 6 years for each investment), in addition to earning estimated fees in excess of $40mn. The LPs in this fund will take home a net IRR of about 10% after carry (actual numbers may vary due to catch up clauses, but that is another discussion). So a GP team has been paid $115mn (or $14mn pa over 8 years) for delivering a very average 10% return – the LPs could have just invested in a safe and liquid debt instrument! Just to make matters more interesting, if the GP has raised another fund subsequently, he stands to earn another revenue stream from there as well (his effective payouts will double), while those LPs are also earning the same 10% net IRRs! The lack of alignment gets more dramatic if we increase the fund size! 

I think the issue is not the carry of 20%, but the accepted hurdle rate of 8%! What if the hurdle rate is more like 12-15%? What if the hurdle rate is 8%, but 20% carry paid only for returns ABOVE that? Would carry payouts be better aligned to performance? I think so. (One could make a technical point that hurdle rate is usually in $, and there are currency risks. Well – there are solutions around that if someone really wants to go that way. Even better, keep the $ out of the picture as the GP is not doing anything to influence the exchange rate either way anyhow)

Fund size and pace of deployment

 This is an often neglected and ignored part of the private equity business (probably because there is no real science to establishing the right fund size), but can have a dramatic impact on fund performance. Most GPs are unable to (indeed, many don’t even plan to) deploy anything more than 80-85% (let’s call this ‘percentage deployed’) of their fund commitment! The gap is due to fees paid during the investment period (4-5 years at 2%pa), and genuine inability to find good deals to deploy the funds effectively. The ‘percentage deployed’ parameter, driven by fee and fund size, has a dramatic effect on fund returns. 

Imagine that a $100mn fund has been able to deploy 80% of the fund in its investment period of say 4 years. About 8% has gone towards fees, and another 6% or so is reserved for future fees (so $94mn total drawn). So even if the fund team is able to invest in deals that get a 2x across the investments ($160mn), the actual multiple to LPs drops to 1.7x ($160mn divided by $94mn). When LPs look at doing a due diligence on funds, the percentage deployed and net returns at the fund level are important criteria, but GPs usually focus on deal level multiples (which are important, but don’t show the real picture as they get dampened at the fund level). 

Most GPs size their fund with a mind set of being ‘comfortable’ on deployment (more than enough capital for deals they are able to close), and being ‘comfortable’ on fee earnings (adequate compensation for the team). Most teams raise larger subsequent funds, arguing that they will be able to fully finance deals that, in the past, they had to share (this is the rationale for many venture funds raising much larger funds today), and do larger deals that they could not evaluate earlier. Both these arguments run contrary to the very basis of the team’s success in the first place – they were probably able to identify promoters and businesses earlier than others (and made the most returns from the initial explosive growth of the business, which probably tapered later for the subsequent investors), and were able to operate in a deal size segment that did not have too much competition. Changing both these would lead to a larger fund with lower returns. 

To maximize net returns, it makes sense to raise a fund that is JUST SHORT of what you can reasonably deploy (so you get to near 100% deployment, and are almost at the point of letting go of a good deal as the fund size is very tight!), reinvest any returns in the early years, and not to reserve money for future fee – rather, take that from future distributions rather than calls on LP’s capital. 

This will also help in subsequent fund raises – LPs will look favorably at the team that already has a great pipeline of 2-3 deals ready when it starts raising its next fund (instead of struggling to close the 2-3 deals still to be done in the previous fund!). 

For GPs who have already raised too big a fund, there is still time. Be proactive and bold, reduce the fund size voluntarily, improve the ‘percentage invested’, cap and postpone fees where you can and take them out of distributions, rather than additional calls on LP’s capital. These are not my ideas – there are examples of people having done a combination of the above actions already in the market. You will find that LPs will reward you when the IRRs improve, and the effort will eventually result in higher carry earnings for you! 

Summary

These suggestions will always be tough to swallow, and difficult to implement – they are designed to move GPs into a zone of discomfort – of challenge, of putting their money where their mouth is. I am not sure how many GPs would agree to them (indeed, even some conservative LPs may frown on them!) – but I do think these are win-win solutions, and the time has come to look at some provocative steps to correct the situation. Some version of the suggestions above will improve returns for everyone in the business, and improve alignment between LPs and GPs – at least thinking in this direction will start. It will enable GPs to live up to their roles as true ‘fiduciaries’ for their LPs, and hopefully kick start the next cycle of high returns in Indian PE. 

(Praneet Singh is a managing director of Siguler Guff & Company – a multi-strategy private equity investment firm, which together with its affiliates, has over $10 billion of assets under management. The views expressed are his own.)

 


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7 Comments
Ram . 6 years ago

Great article. Finally someone has laid it out threadbare. Misalignment of incentives is a fact, not an assumption anymore, and needs to be addressed by LPs with courage and conviction. This will be good for everyone, including the GPs.

Nilesh Trivedi . 6 years ago

Hi Praneet, Nice way to put the LP-GP alignment issue in perspective. This is a pretty hot topic here in the US Private-Equity domain as well and while the needle will take some to move, I’m pretty sure new fund activities will have to make provisions for these very real concerns.

I have never quite understood the rationale behind raising large funds and then limiting investment to 80-85% of the committed capital. Keeping dry powder handy just in case an awesome deal comes along isn’t a good explanation. During the life of it’s fund, GPs will see deals that they wish they’d invested but couldn’t for multiple reasons but that no reason for limiting their investments. On the carry issue, I do think that the PE industry needs to align towards pay-for-performance guarantee rather than blindly committing to certain percentage at the time of fund raising. If the GPs feel that their talent and acumen deserves the carry they should be taking home, let their performance speak for themselves. Maybe an annual review on this topic is needed.

Anil Kamath . 6 years ago

Keeping it short and simple, the article has hit bull’s eye. Bingo.

Raja Kaushal . 6 years ago

Well done Parneet to challenge the 2-20 ! Its a wake up call for all fund raisers across the globe, I suppose. No doubt, the business world is becoming “performance oriented” and transparency is key for long term relationship between LP’s and GP’s. In addition to what Parneet said, I think it will be useful for LP’s to ask for active pipeline in advance just before they decide to invest with the GP’s. Typically in PE deals in real estate sector, the hurdle rates are pegged at much higher rate than 8% due to higher risk and volatility of the sector itself. I think today many sectors are as volatile as real estate so one need to peg it higher, a few basis points above,central rates may be.On deployment front, a lot of times there is a lack of active and timely debate on live deals. A quick TAT ( turn around time) is essential to say YES or NO. An alignment within IC is important. Sometimes, the ability to fund large ticket size itself is the key differentiator to secure better returns, so I feel that size is still important. For a country like India, maintaining strong social relationships with your GP’s is also key for LP’s.

nirajchhajer@gmail.com . 6 years ago

Nice Article. Few ideas

1)Carry: LPs can ask GPs to have a higher carry with no catch up and a reduced management fees. Win-Win situation for both LPs and GPs. If fund does good GPs are rewarded and if fund does bad LPs loss is restricted.

2)Co-investment Option: LPs can ask Co-investment option on fund investment deals. Normally on the co-investment line, GPs earns a much lower management fees (say 0.5% to 0.75%) and a lower carry share (10%-15% above hurdle rate), Plus the management fees is due when the LP commit the fund to a particular deal.

sabareesan . 6 years ago

Greed is the primary driver and Praneet has in subtle and honest way brought out the merits of a realignment in the comp structure. I’m sure difficult markets will determine the course on their own

Phoenix . 6 years ago

Finally, one gentleman writes the truth!

Most of this is commonsense. One wonders why LPs keep sleeping thru and play along. Its even more confusing to see them start to blame others when things don’t work out on issues they themselves agreed to !

Most honest men would have concluded that LPs for some strange reason enjoy shooting themselves (or whomsoever’s money they represent)in the foot. Do you need to be a rocket scientist to figure the terms and conditions are one sided and foolish? Why have they been agreeing to all this? How different is this from LPs using public funds to buy Facebook IPO ? Whose loss is it ? How will you blame that on others?

Private Equity: Some ideas for better alignment between LPs and GPs

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