Fund T&C: Carrot and stick

When raising its third fund last year, RRJ Capital emphasized a strong track record for a relatively young firm as well as the bone fides of its principals. Fund I, which closed a few months after the GP was founded in 2011, had generated a net IRR of nearly 16% by the end of 2014; Fund II was doing even better, tracking above 24% less than two years into its tenure.

RRJ's ability to accumulate $9.7 billion in the space of four years can also be put down to the status of the co-CEOs: Founder Richard Ong spent 15 years with Goldman Sachs before launching China-focused Hopu Investment; his brother Charles joined the firm in 2012 after holding a string of senior roles with Temasek Holdings. The pair had sufficient personal wealth to pledge a minimum $150 million to Fund III, following investments of $201 million and $114 million in the two previous vehicles.

A final close at the hard cap of $4.5 billion came last autumn. Assuming it does not exceed $150 million, the GP commitment is 3.33%, lower than the previous fund but high by regional standards, especially as it appears to originate from just two people. Bain Capital's third Asia fund closed at $3 billion last year with a further $250 million - or 7.7% - from management. However, this came from executives across the firm's global offices, not just the Asia team.

We tell managers, ‘The rationale is alignment, so we shouldn’t be negotiating against each other on this.' We are mindful of the challenges facing some younger GPs, but you have to be all in – Ralph Keitel

The RRJ GP commitment demonstrated "a strong alignment of interest with LPs," the New Jersey Division of Investment noted in a memorandum, before agreeing to invest $150 million in the fund. It was a speedy fundraise, placing the firm among the minority in Asia's bifurcating private equity universe that are able to dictate terms and conditions rather than morph themselves around LPs' requirements.

This is entwined with a second dynamic - the evolving GP-LP relationship - and the increasing incidence of differential terms. Large institutional players that come in early can expect bigger discounts on fees than their smaller counterparts, and priority access to co-investment: most favored nation status has not been bestowed equally for years, but the gaps between the tiers of LPs are arguably becoming wider. To some, it is not necessarily a healthy development.

"There are anchor LPs that are more focused on singular specific rights than they are about the bigger picture," says Wen Tan, co-head of Asia Pacific private equity at Aberdeen Asset Management. "They get fees down to 1.5% and have first dibs on co-investment, but not enough thought is given to the implications of how GPs are structured and what longer term issues might arise."

Viewed in this context, the GP commitment is particularly interesting. It is one of a number of economic and governance metrics used by LPs first to preserve an alignment of interest with managers, and second as a means to apply pressure should this alignment slip. The balance between carrot and stick, or even the amount of time LPs spend on these issues, says much about the fundraising environment.

Differing priorities

The most recent installment of Aberdeen's Asia Pacific private equity fund terms survey suggests that large LPs' pursuit of preferential management fees and carried interest is well established. A fifth of funds offer fee discounts and the size of an LP's commitment is the most influential deciding factor; and for GPs that do not use a pro rata model for allocating co-investment opportunities, check size and the timing of a commitment - i.e. coming into a first close - are the key criteria.

The extent to which industry participants see movement on other terms, notably economics and governance, largely depends on the segment of the market they occupy. The limited partner agreement (LPA) for a popular manager might change little between vintages, while others are fiercely negotiated. "There is more keen discussion around governance - successor funds, competing funds, allocation of co-investment, key man, and manager removal," says Dean Collins, a partner at Dechert. "They are all very bespoke to the GP."

In Asia, GP contributions to PE funds fall in the 2-5% range, and the average - although perhaps not the median - has risen over time. "As the sponsor gets larger and more established, people expect a bigger commitment to the fund, and as the funds grow in size they expect the increase to be commensurate with the size of the fund," says Justin Dolling, a partner at Kirkland & Ellis.

The caveat is that certain Asian firms have scaled up so rapidly and in such large increments that managers say they cannot feasibly keep pace. AVCJ is aware of funds currently in the market where the GP commitment is expected to be roughly the same in US dollar terms, but the percentage figure will slip from double to single digits. Even moving from 1% of a $300 million fund to 2% of a $600 million vehicle equates to a four-fold increase in the amount the manager has to put in.

Nevertheless, the general rule is that 1% is now too low; for first-time managers in less-developed markets it is considered the bare minimum. "We tell managers, ‘The rationale is alignment, so we shouldn't be negotiating against each other on this,'" says Ralph Keitel, regional lead for funds in Asia Pacific at the International Finance Corporation's (IFC). "We are mindful of the challenges facing some younger GPs, but you have to be all in."

IFC is one of a number of LPs that calculates a budget-based management fee, so the GP commitment can be placed in the context of the running costs of the private equity firm. This is especially important for first-time managers with small funds who cannot draw upon an existing fee pool and might struggle to make significant personal contributions. In some cases, GPs opt to convert future management fees into their fund commitment, so the question becomes whether the management fee is in fact too high.

"For a more mature manager, you can model out returns from previous GP commitments, the carried interest received and the management fee income received," says Doug Coulter, a partner at LGT Capital Partners. "There is a perception that GP commitments are often too small based on the amount of cash taken out of the management company and relative to the distributions. If you take that cash flow model and combine it with some insight into how wealthy the GPs might be, you can probably come up with an idea of a sensible GP commitment."

The end-game is to ensure that the commitment is meaningful enough for the individuals involved that they remain engaged in the investment process. As a result, the due diligence process can become quite personal, with LPs conducting background checks on the principals and perhaps asking to see bank statements and records of property and share ownership. There have been situations in Asia where investors have expressed dissatisfaction with a founder's proposed commitment because it was known he received a substantial payout on leaving his previous job.

Any notion of a market norm is therefore distorted by GPs whose founders have substantial personal wealth, but even then assessments should be made on a case-by-case basis. Indonesia-based Saratoga Capital is a well-known case in point. The PE firm raised $152 million for its second fund - though its first properly institutional vehicle - in 2009, and then upsized substantially for Fund III, which closed above target at $600 million three years later.

Edwin Soeryadjaya and Sandiaga Uno, who set up Saratoga in 1998, are two of three founding partners and key persons. According to the 2011 installment of the Forbes Indonesia rich list, released while Saratoga's third fund was in the market, Soeryadjaya was worth $1.35 billion while Uno had $660 million to his name. However, much of this wealth was tied up in a relatively concentrated number of assets; for example, they both still held reasonably large stakes in publicly-traded Adaro Energy, an early and informal Saratoga investment.

"Ultimately, the right way of doing it is from a bottom-up perspective: establish how much liquid wealth a person has and how much of that is tied up in a GP commitment," says one source familiar with Saratoga. "Edwin didn't have $1 billion in the bank and therefore for him an investment in the fund of, say $100 million, would have been a significant part of his liquid wealth. It made a personal difference to him and that satisfied LPs."

A year after the fund closed, Saratoga Investama Sedaya, a vehicle controlled by Soeryadjaya and Uno, went public in Indonesia, raising $151 million. It contained legacy assets that predate the private equity firm's institutional funds, including the Adaro interests. AVCJ was told at the time that the listing was intended to deleverage the entity and cover most of the GP commitment to Fund III.

Too big to chew

There are also situations in which the GP commitment is regarded as being so high - the most any of the industry participants AVCJ spoke to can recall seeing in Asia is 27% - that the alignment of interest with LPs could break down. Two scenarios are offered, one involving governance and the other investment pace.

First, when there is a sizeable GP contribution, the manager might push for voting rights. Kirkland & Ellis' Dolling notes that steps are usually taken to address governance issues. The GP is generally unable to vote on fund issues, which means it has no say over downside protection for investors and manager removal, or LPs can vote to suspend investment on the main fund and to replace the team but they have no jurisdiction over a parallel entity that comprises the GP commitment.

On pure investment matters where there are no other conflicts of interest, though, Dolling does see "situations where it is bifurcated." For example, the GP could argue that it deserves a voice that reflects the amount of capital it has put in and as a result gets to have a say on whether the fund is allowed to exceed the diversification cap on a particular investment.

The second scenario sees senior executives become hyper-cautious, prioritizing capital preservation above all else, so deal flow dries up. "You don't want the tail wagging the dog. You go in thinking, ‘It's a 20% contribution, that's great, it means more skin in the game,' but it's a naïve approach," says Aberdeen's Tan. "The figure that matters is you need something that is material enough as a percentage of the GP's wealth and you need to be comfortable the GP has sufficient liquid resources to be able to deal with that."

In some instances, managers are permitted to increase their commitment after a fund closes. This usually happens when a GP is anticipating a carried interest windfall from an existing vehicle. However, public markets can play havoc with these arrangements. LGT's Coulter recalls one Asian GP that wanted to put in 10%, pending the expiry of the lock-up on a listed company in which it was invested. But when the markets fell and the firm was unable to sell at an acceptable price, the fund commitment fell to 3%.

"Sometimes you see situations where they offer to put in X now and Y later, conditional on carry coming from earlier funds," he adds. "That's okay - and the more visibility on those exits the better - but the reality is when they promise something up front, that's in the bank."

What doesn't appear in the documentation is how much different individuals within a team are putting in money. The New Jersey memorandum, for example, only names Richard and Charles Ong as contributors to RRJ's third fund, without specifying whether other investment professionals are participating. Rather, this issue is dealt with as part of the due diligence process and goes to the heart of whether an LP can get comfortable with the long-term sustainability of a manager.

For many, it goes hand-in-hand with efforts to understand the distribution of economics within a fund. Assigning carried interest to someone outside of the team usually requires advisory board consent, but formal agreements on internal economics are less common. First, there is a general acceptance that the principals decide how to incentivize junior team members. Second, in Asia particularly there has been a willingness to accommodate a founder who retains a disproportionately high share of the economics because he is a strong performer.

There is plenty of anecdotal evidence of mid-level investment professionals leaving firms because founders do not make good on economic promises, but the circumstances can be unclear. An individual might indeed be the victim of an unscrupulous leadership team that places self interest above the retention of people who might one day assume ownership of the firm. Equally, some GPs earmark a portion of the carried interest for allocation during the life of a fund and reward up and comers as circumstances dictate. Not everyone is selected to share the wealth.

However, Andrew Ostrognai, a partner at Debevoise & Plimpton, observes that in many cases positions on the distribution of carried interest are very clear. "I know of other plans that are structured more as a discretionary pool, but there are plenty of GPs with plans that say a certain person gets X points out of 1,000 in the carry," he says. "They also go into detail on what happens if you leave on good terms, on bad terms, how much vests."

Long-term game

This goes beyond alignment of interest for a single fund and encompasses the ability of a manager to institutionalize and win LP support across multiple vintages. But failure to address the issue can expose more immediate cracks in the GP, as exemplified by the departure of mid-level talent. The situation is likely to be exacerbated by the fact that a number of founders across the region are nearing retirement age and not all have put in place succession plans that gradually transfer fund economics and GP ownership to younger colleagues.

"It always amazes me how few people ask questions about fund economics. I have dealt with two managers who have been removed by their LPs and in each case they did not have a proper carry scheme in place. I think there is a correlation," says Dean Collins, a partner at Dechert.

The broad point is that the chances of instability and underperformance are higher at poorly managed private equity firms. Nevertheless, Aberdeen is among those looking closely at the specific impact of generational change on GPs in Asia and it is already influencing approaches not only to the economic structure of new funds, but also the terms and conditions covering governance.

The no-fault divorce clause is a natural starting point. Removing a manager is time-consuming, not least because it requires support from a majority of LPs. An anchor investor with a sizeable interest in the fund might still have faith in the manager and block any action, or a collection of disaffected LPs may not be willing to devote time and effort to recruiting a new manager to revive a portfolio they see as a lost cause. Either way, as Wen observes, the 9% difference between a threshold of two thirds and three quarters support for removal is worth pursuing in negotiations.

Steps can also be taken to smooth the path leading to no-fault divorce, such as by removing bureaucratic stipulations in LPAs for cooling-off periods and face-to-face meetings with the manager. Triggering the clause might still be worst-case scenario, but strengthening the LPs' hand can make it easier to exert influence on management.

"A lot of funds in Asia have a single-person trigger on the key man, which does present a risk for the succession of the sponsor if something happens to that key person. The natural follow-on is what plan do you have if something happens to the key person," adds Kirkland & Ellis' Dolling. "Some of the larger LPs are starting to focus more on that and it will be interesting to see if this begins to impact the contractual protections requested in fund documentation beyond the typical key person suspension."

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• Topics
• Fundraising
• Advisory
• Greater China
• Southeast Asia
• LPs
• GPs
• Asia
• professional services
• LGT Capital Partners
• IFC
• Aberdeen Asset Management