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‘Skin in the game’ becomes a challenge as fund sizes approach record highs

Triggered by both limited partner (LP) requirements for more ‘skin in the game’, and the rising demand for private equity funds pushing up fund sizes, GPs are struggling to free up funds for increasingly large personal commitments, according to the 2018-19 Investec GP Trends survey.

The research, which surveyed 289 private equity professionals around the world, revealed that GPs expect to commit an average of 2.9 per cent to their next fund. While this is a drop from 3.3 per cent 12 months ago, the rise in average fund sizes – up from USD1,765 million for the five years from 2014-2018 – means that GPs are having to find a higher commitment in absolute terms for this generation of funds. With the average target size of funds currently raising reaching USD1,903 million, the amount that GPs and their teams are expected to personally commit now stands at approximately USD55 million.
 
This challenge is likely to become more acute as funds continue to grow: Over half (55 per cent) of respondents expect that their next fund will be more than 25 per cent larger than their current fund, and one in eight (12 per cent) expect their next fund to be twice as large as its predecessor. For larger buyout, infrastructure, distressed and secondaries funds, figures quickly reach eye-watering levels. 
 
More than one in eight (13 per cent) GPs don’t know how they will finance these personal commitments in their next fund, a rise of 5 percentage points compared to 12 months ago. This is particularly challenging for future leaders, with nearly a quarter (23 per cent) of those below partner level unsure of how they will meet commitments.
 
Jonathan Harvey, Head of European Fund Finance at Investec, says: “Fund sizes continue to climb: in 2018, 250 funds worth more than USD500m closed, with an average value of USD2.299 million. The optimism of the industry makes sense given the continued demand for private equity from the buy-side in their hunt for yield, but GPs face a challenge in funding their commitments.”
 
Jennifer Choi, Managing Director for Industry Affairs at the Institutional Limited Partner Association (ILPA), says: “Next generation leadership may not have accumulated the wealth to commit the right amount to the GP commitment.”
 
To personally fund their portion of commitments, 39 per cent of GPs surveyed in the report stated that they are planning on reinvesting carry and/or co-investing proceeds from previous funds, while 14 per cent will use external debt financing. However, relying on carry can become risky when expected returns are not generated and in turn funding lines become uncertain.
 
Simon Hamilton, Head of Fund Finance, Investec, says: “Funding commitments with carry simply means that GPs don’t have the cash available, now. This can be risky, particularly as the uncertain outcome of unfolding political events coupled with concerns around the growing amount of dry powder in the market are becoming harder to ignore.”
 
“We hope that the optimism in the industry is well-founded, but it makes sense for GPs to explore the options available to finance these commitments. This is particularly true for GPs where individuals below partner level are expected to commit meaningful sums. These individuals, from which future generations of firm leaders will emerge, may still be some years away from any carry payments.”
 
“It is important for LPs to see that the GP commitment to a fund comes from the entire investment team – it is a key alignment mechanism. The fact that so few team members below partner level know how they will fund this is an issue.
 
“Investec can help provide certainty around GP commitment financing, allowing staff to focus on what they do best: investing and generating returns for their investors.”

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