- Firms are demanding better terms on funds from their backers
- Private equity funds allowed to pay by the deal, drop hurdles
Just two years ago, even successful private equity firms were jumping through hoops to keep investors happy. Now, bombarded with offers of money for their latest funds, top-performing firms are turning the tables.
In the last year, buyout firms including Advent International, EQT Partners and BC Partners have demanded -- and got -- better terms from their backers. With a combined fundraising total of $25 billion, the changes could be worth tens of millions to partners at the firms.
Some want to take more fees, like an extra five percent of profits on asset sales. Some have asked backers to drop the minimum rate of return, known as the hurdle. Others want to take a share of profits, known as carry, on a deal-by-deal basis instead of waiting for the fund to close. That can help them link pay to performance and reward teams for successful deals -- a system known as eat what you kill.
Investors, whose money usually affords the ability to prevent such changes, are not only allowing such terms, they’re writing bigger checks to the managers demanding them. Lesser firms, meanwhile, are being ignored.
The number of firms successfully raising capital fell by 20 percent from 241 in 2013 to 194 in 2015, according to data compiled by Bloomberg. Meanwhile, overall capital committed to buyout funds rose 18 percent to $249 billion last year from $211 billion in 2013.
“The industry is going through a wave of top managers being able to demand better terms from investors, whether it’s how they split the profit, how much they decide to charge or what kind of hurdle rate they offer,” Erik Gordon, a professor at the University of Michigan’s Ross School of Business who studies private equity, said in an interview.
Potential backers don’t have much choice. Interest rates are still close to historic lows, so the high returns that are more likely to come from top performers are particularly attractive.
Paying a percentage of profits from the sale of companies to individuals that worked on those deals -- the eat-what-you-kill model -- is difficult to achieve under the terms of many funds. Often, profits will be shared later in the pool’s life, sometimes years after it was raised.
To get round this practice, known as the European waterfall, buyout firms including EQT are asking investors to treat each deal separately. This allows them to divvy up proceeds as soon as the deal is completed, and distribute them to the people that managed the sale.
Stockholm-based EQT pushed investors to allow a profit cut after every asset sale for its latest 6.75 billion euro ($7.7 billion) pool, raised last year. The move was a turnaround for the group, which had been asked by backers to use the European waterfall for its 2011 predecessor.
It also helped incentivize EQT’s junior staff, who are paid lower than industry standard salaries, to stay with the company, Thomas Von Koch, the managing partner, said in an interview with Bloomberg last November.
For their latest funds, both BC Partners and TPG are aiming to double backers’ money over a decade. In return they’ll take a 20 percent profit on deals during the fund’s life, of which as much as a fifth will be handed to executives on an eat-what-you-kill basis once backers have been paid. Assuming the firms meet their fundraising and profit targets, hundreds of millions of dollars could be shared between the most successful members of staff.
Representatives for BC Partners and TPG declined to comment.
These aren’t always popular moves. Refraining from taking profits until investors have been paid back reduces the risk that they have to claw back money if the fund’s performance deteriorates. Sharing profit equally can avoid tension within teams.
Hand Money Back
Demanding better conditions from investors comes with risks. If a fund gets to the end of its life without making a profit, executives that have already been paid on a deal-by-deal basis could be forced to hand the money back.
In 2014, buyout firm GMT Communications Partners Ltd. faced calls for executives to repay profit from earlier asset sales, because a restructuring of the fund would force investors to absorb a loss, people familiar with the matter said at the time. Investors had been given the right to claw back money if the fund didn’t meet targets.
It’s not all about pay. The industry standard for hurdles -- the minimum return on their money that investors are promised before any fees are taken -- is also up for negotiation.
Advent International decided to break with consensus when it began raising its seventh fund last year. Backers were told that the firm was going to drop the 8 percent hurdle rate, which would be key for most managers trying to raise money, people familiar with the matter said.
A representative for Advent declined to comment.
Despite the change, Advent received interest for $18 billion against its $12 billion target, the people said.
EQT, meanwhile, exceeded the initial 5.25 billion-euro target on its latest fund to reach 6.75 billion euros, to satisfy demand from backers, according to a person familiar with the matter. The fund was oversubscribed and more than 70 percent of commitments were from repeat investors, the firm said at the time.
Advent joins Warburg Pincus and Hellman & Friedman in choosing to raise funds without a hurdle. But investors will only let them do it if the fund’s performance is consistently strong, according to Mounir Guen, the chief executive officer of MVision Private Equity Advisers, which counsels firms on fundraising.
“The second returns drop, a hurdle will be in the next fund,” Guen said.
KKR & Co., one of the world’s biggest buyout firms, is proof of that. The group added the mechanism to its most recent North American and European buyout funds after pressure from investors, said people familiar with the matter. Its 2006 European fund is set to return 50 percent more than backers’ original commitments, well below the 150 percent managers were aiming for over the same period.
A spokeswoman for KKR declined to comment.
Investors used to wield their power more fiercely. Three years ago, Apollo Global Management LLC agreed to give investors all the transaction fees levied on companies in its flagship pool, after first proposing that they would get an 80 percent share.
In 2013, Apollo finished raising its largest fund since the financial crisis, bringing in $17.5 billion from third-party investors. Its previous fund, which was raised in 2008, generated a net internal rate of return of about 30 percent through end-2015.
“It’s now a tale of two markets,” Ethan Vogelhut, executive director at Adveq Management, an investor in private-equity funds, said in an interview. “If you’re a top decile performer, regardless of size, then you have a far stronger hand in negotiating terms.”
Cases in point: Denver-based Excellere Partners and Harvest Partners, based in New York. These mid-market buyout firms were able to arrange better terms with investors, asking them to hand over as much as 25 percent and 30 percent of profits to managers respectively, according to people familiar with the matter. Representatives for the firms didn’t respond to requests for comment.
Excellere’s previous two pools and Harvest’s most recent fund are ranked in the top quartile of peers raised in the same year and of a similar size, according to data compiled by Bloomberg.
(An earlier version of this story corrected the fundraising amount in the 21st paragraph.)