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March 27th, 2015

The Emperor Has No Close

“The Emperor has no Close” fairly describes the evolving compact between limited partners and general partners in private equity. Shallow observers of the private equity world continue to call for standardization of the partnership agreement, the portfolio reports, the offering memorandum and the general partner’s shoe size. Such suggestions sound reasonable at high altitudes, but do not survive the common sense test when applied at terra firma. Standard arrangements for investors are no more applicable than would standard deal terms be for purchasing a company. Imagine offering the same equity package to a $10 MM EBITDA management team as offered to the team of a $200 MM EBITDA purchase. A request for the same financial terms on both these deals from one’s lenders would not make it to the second sentence. Quality, experience, size, industry, and strategy all dictate prescriptive terms and are as critical when buying a general partnership as when buying a company. Market dynamics dictate the terms that will lead to a close in both the fund interest purchase and in the company purchase. Attempts to standardize the meaningful portion of either will be blunted by reality.

If we hop on board a private market Delorean and adjust our flux capacitor we can arrive at the early days of private equity to track the evolution of the broad economic terms of a partnership. In the late seventies and early eighties the firms that had the large share of the nascent market were Forstmann Little, KKR, Butler Capital and Wesray. Either by design or by serendipity those firms had partnership structures, in which, an investor would describe the general partner’s deal as “Heads I win, tails you lose” when it came to risk sharing.

Until the 1990’s the PE Fund structure was described as “2 and 20”, meaning two percent management fee and twenty percent of the investment profit. Actual practice was very different. The two percent management fee was added to an investor’s commitment, not treated as a subset of it. The twenty percent carry was applied only to profitable deals, not to the net portfolio profit, meaning that general partners could receive well above twenty percent of the net profits as there was no “collective guilt” accounting for the portfolio. Monitoring and all other fees were simply revenue streams for the general partners. Carry could also be earned on cash in the bank in an era when treasury yields were 14%. The preferred return concept did not appear until introduced by Olympus’ first fund. Side letters did not exist nor did Advisory Boards. One counsel represented all limited partners instead of the dozen that need to be coordinated today for a closing.

Market forces have led to substantial changes in the last two decades. Fees average 1.5% and are a subset of committed capital. Absolute fee dollars have multiplied. Carry is calculated on net portfolio profit, and is subordinate to preferred return, but now ranges from 20-30%. It is interesting that investors have not pushed any first time funds to less than 20% carry. Monitoring and other fee streams are now partially or fully credited to reduce management fees. No carry is earned on cash balances and Advisory Boards convene frequently for many funds. Side letters now occupy a floor at the Library of Congress as does the attorney roster for any fund closing.

Within these large shifts in fund terms and practices there are still broad differences in economic, legal and reporting arrangements among funds. These differences arise from the historical circumstances of each fund, from the fund manager’s track record, from the relative demand for the fund’s product, from the paucity or the waterfall of capital available in the market at the time of fund raising and from the relationship between the fund’s manager and its investors. These circumstances will continue to keep fund structures different from each other as investors price fund managers differently.

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