Negotiating private equity fees and terms has previously been challenging due to limited capacity among high-quality general partners and the restricted ability of limited partners to pool their bargaining power, according to Watson Wyatt.
In a paper, entitled Private equity fees and terms, the firm suggests fairer fees and terms for the asset class with the aim of encouraging debate in the LP community, with the ultimate purpose of eliminating some of the more egregious terms seen in private equity.
The paper introduces features of terms that are not yet common in the private equity community but would represent progress in improving alignment for LPs. It also covers additional changes that are likely to be simple to implement, such as a significant step-down in management fees after the investment period, as well as other changes that represent a more significant step-change from the status quo, such as the introduction of a hurdle rate (rather than a preferred return).
Jane Welsh, global head of private markets research, says: “Management fees form too high a share of a GP’s compensation and are therefore the most significant factor misaligning the interests of a GP relative to those of its LPs. This misalignment is exacerbated by the manner in which performance fees are most commonly calculated in the bigger markets.”
In the paper, the firms suggests that the following changes would represent significant steps in redressing this imbalance:
• The basis upon which a manager sets its management fees must be reconsidered. For example, there is a strong case to budget for management fees on the basis of the number of investment staff and other fixed costs.
• GPs should consider phasing in management fees over the investment period to reduce the significant fee drag from paying on commitments early in the life of a fund.
• GPs should not generate additional fees from working with portfolio companies, for example transaction and monitoring costs. Where they do this, these fees should accrue to the fund.
• All GPs should employ a European waterfall — that is, the LP receives all its capital and its preferred return before the GP receives carry.
