Following several years of stunted performance and investor confidence, private equity firms are adjusting to a “new normal” in their relationship with limited partners who are increasingly exercising the power of their purse to forge more favorable terms. In its 2011 Global Private Equity Report, Bain & Company revealed several new trends in how private equity general partners and limited partners are beginning to redefine their relationship, with the GPs taking their cues from the LPs.
As recently as 2009, private equity GPs generally called the shots. But, as LP disenchantment grew over fund
performance and the overall lack of transparency in fund expenses and returns, the GPs have gradually come to recognize that their fortunes are inextricably linked to LP commitments which, until recently, had been declining. Thus far, LP demands for more favorable terms have not had a widespread effect on negotiation results, but, where any shift in LP influence was once non-existence, the slight inroads to date are very telling.
Chief among the changes sought by LPs are financial terms including reductions in management fees and a restructuring of other deal-related fees to include rebates or more ties to performance. There is also a push to restructure carried interest, although that may prove to be a larger hurdle.
The biggest challenge for LPs in gaining greater acceptance by the GPs is their fragmentation which has, thus far, impeded their ability to collectivize their principle demands. GPs are, therefore, more compelled to only respond to the larger, more influential LPs, such as the pension funds. This presents a greater challenge to smaller LPs that struggle to gain access to the better performing funds where demand continues to keep GPs in the driver’s seat.
Separately, LPs are growing louder in their insistence that their private equity partners put more of their money where their mouths are. As the overall performance of private equity funds over the last few years raises the issue of the GP’s performance incentive, the typical 1% GP commitment suddenly looks to miniscule to LPs. Many LPs are linking commitment levels to GP commitments to ensure a greater incentive to perform.
Private equity GPs now find themselves in a position in which any hesitancy to accept these conditions is likely to reflect on their own confidence in their management capability. A greater stake in their own funds creates the opportunity to reap larger rewards as well as steeper losses. GPs unwilling to assume a greater stake in their own fund will be telegraphing their lack of confidence in their investment.
While the “new normal” in the private equity sphere hasn’t quite turned the balance of power between GPs and LPs on its ear, it has created enough incentives for the two sides to revisit their relationship to find a new equilibrium. Negotiating terms more reflective of current market conditions and asking for more skin in the game would seem to be a reasonable course at a time when both sides need a boost of confidence.
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