Rich man’s game: The cost of fundraising in Asia

The sorry state of private equity fundraising in Asia can be gauged by the amount of paperwork involved. Go back a couple of years and a PE firm could expect five or so meaningful side letters from investors asking for concessions on top of those in the limited partner agreement (LPA). These were anchor LPs who knew the size of their commitments to the fund meant they could push for special treatment. Other letters would run to no more than three pages.

Now GPs are receiving side letters of up to 40 pages from dozens of LPs, regardless of investment size, and it can be difficult to reject these demands out of hand. As LPs know full well, many of the less-established fund managers are scrambling for every dollar they can get.

"We are executing 20-page side letters on $5 million investors in a $75 million fund - these guys used to be satisfied with only the documents," says Philip Culhane, an investment funds partner at Simpson Thacher. "They never even really expected the courtesy of an email from GP counsel. It was, ‘Where is your subscription agreement? Did you sign it? If not, you're not in the fund.'"

As recently as 2011, you could set your watch by an Asia private equity fundraising. A GP issued a private placement memorandum (PPM); the LPA and subscription documents followed one month later; and LPs submitted feedback a few weeks after that. Within two months of starting a first close would be in sight. The more popular a fund, the more a GP could dictate the schedule and therefore the amount of time spent on negotiation.

Asia PE fundraising peaked at $74.8 billion in 2011. The following year it sank to $50.9 billion and a paltry $17.3 billion was accumulated in the first half of 2013.

As such, the onus is no longer on LPs to seize the initiative and previous routines have been torn up. Rather than engaging five out of 30 investors in negotiations and then laying down terms for the rest, a GP might only reach a first close after one-on-one talks with all 30, resulting in a string of side letters. They no longer dictate the schedule and so costs are going up.

"Fundraising costs are certainly rising and that doesn't just mean legal fees," says Andrew Ostrognai, chair of Debevoise& Plimpton's Asia private equity practice. "You are travelling around, taking flights and paying for hotels."

More billable hours might appear to be a boon for lawyers, but they are caught up in a demand-supply dynamic of their own. Rising interest in Asia drew new players into the market - once home to about three established fund formation practices, Hong Kong now has at least 10 firms claiming competency in the field - but the drop in fundraising means there is more capacity than mandates to satisfy it. This has resulted in intense price competition.

It's unclear how long the imbalance can last, but ultimately this disconnect may be most damaging for GPs on their early funds. They have limited resources, there is less certainty of fundraising success, and so lower-cost options are attractive. However, the inherent danger of a market in which few are willing to pay a premium for quality is that industry best practice will be neglected and these fledgling GPs flounder, never able to generate sufficient LP interest.

Haves and have nots

Ostrognai describes a bifurcation in the market as larger funds continue to receive money while smaller funds come under pressure. But even the most successful GPs in Asia have found that the landscape is changing to some degree.

"We thought that, because it was Fund II, the due diligence might be a bit easier but in reality LPs' diligence standards are rising - they became more thorough," says Frank Tang, CEO of FountainVest Partners, a China-focused GP that closed its second fund at the $1.35 billion hard cap last year after about eight months in the market.

"They also spent a lot of time on the LPAs. In between Fund I and Fund II, the ILPA guidelines came out, so we made a number of changes to be more compliant."

To some, ILPA - shorthand for the Institutional Limited Partners Association's (ILPA) set of principles intended to deliver alignment of interest, governance and transparency - is a real game changer. It represents the point at which investors' concerns were codified into a set of standards to which the private equity community could aspire to exist.

But most fund formation lawyers argue that ILPA itself isn't so much the issue; it is the hawkish environment from which the principles emanated. The cyclical push and pull between GPs and LPs currently lies in favor of the LPs and they are making their leverage count.

As one industry participant puts it, many institutional investors "are engaged in a massive exercise of cover-their-ass." They saw the damage caused by the global financial crisis, are fearful of being made scapegoats for future poor performance, and so try to negotiate every point.

The investors might have a different take: a member of the PE division at a US public pension fund, for example, could be under pressure to justify the risk of committing capital to what is a comparatively expensive asset class.

Either way, this attitude appears to be percolating through into the small print. Several lawyers claim that LPs now want to see a lot of the information that goes before the investment committee. These demands are usually resisted because they can lead to recriminations - LP to GP: "You couldn't tell from there that the deal wasn't going to work?" - and maybe even legal proceedings.

In addition to excessive wariness there is also opportunism. One lawyer recalls a fund-of-funds offering to anchor an Asian GP's fund in return for a 50% discount on all management fees and carried interest. This was politely declined.

To be fair to the Asia-based fund-of-funds, they may be attentive on terms and conditions but their approach is at least guided by a familiarity with the region, which means they might equally act as arbiters for best practice.

"It was one of those classic conversations, where they said, ‘We are a newish manager, we are expanding and want to open a new office, and we need the money to make it work,'" a fund-of-funds LP tells AVCJ of a recent negotiation. "We said, ‘What you are asking for is just not market. No one gets this, not even first-time funds.'"

More annoying are the requests from US investors that fail to take into account the context of the fund. For example, a China-focused GP seeking to raise $300 million for Fund II doesn't have the in-house processing capacity of The Blackstone Group. If an LP insists on capping fundraising costs that can be passed down along to investors then launches into intensive one-on-one negotiations, the GP's economics will come under pressure.

"It used to be the case that I could work through the side letter and say, ‘Rubbish, rubbish, rubbish, fine, tweak it,' tell the LP's counsel what we won't do, and then 70% of the time they would drop those points," says Simpson Thacher'sCulhane. "Now they aren't dropping any of them."

Wheat and chaff

Many of the provisions raised in side letters are justifiable, such as requests for a particular type of reporting format, confidentiality clauses, and exemptions from certain investments.

"I once worked on an extremely successful fundraise with 100 investors and we had nearly 100 side letters," says Dean Collins, partner at O'Melveny & Myers. "If prepared properly, these letters are no problem at all. It's when they start to dictate issues of governance and what should be in the fund agreement that the dynamic changes."

Focal points stretch into conflicts of interest, tax and co-investment as LPs demand special treatment that goes above and beyond the main partnership agreement, specifying what will happen in particular circumstances.

A tax provision, previously seen as imperfect but acceptable, is now the subject of a dedicated three-page side letter, even though the provision might have come into play three times in 15 years in Asia. Some LPs also demand the GP commits to operating the fund in the most tax efficient manner possible. On one level, a manager is incentivized to do this so why is a pledge required? On another, how does one identify the most tax efficient manner when there are investors from 40 different jurisdictions?

This, essentially, is where formation lawyers add value. Working on a number of different funds, they have an innate sense of current thinking among LPs - which terms are potential deal-breakers and where there is room for compromise - and so can advise clients on how to pitch their products.

Much like a placement agent whose job it is to know if a fund is suited to a particular LP, a formation lawyer can offer insight into concessions the LP made in its previous set of negotiations.

Success not only hinges on assessing whether or not a provision is unreasonable and ensuring it is vetoed, but also on limiting the number of side letters a GP agrees to overall. One of the worst case scenarios starts with the blanket acceptance of all requested provisions and ends with the GP not really appreciating what they have agreed to do and how much effort is required in fulfilling it.

"Every LP comes in with their own confidentiality provisions, which are slightly different from everyone else's," says Debevoise'sOstrognai. "What we try and do is get everyone to agree on a single provision. You look at where the changes are and what is really important and what is filler."

When it goes wrong

There are plenty of case studies of inexperienced formation lawyers getting it wrong. Perhaps pride of place should go to the provision that appeared in one agreement allowing for the removal of the manager if the GP ceased to have any employees - failing to appreciate that the advisory entity retains staff, not the fund itself. The PE firm contrived to trigger a default situation as soon as it started business and the LPs did subsequently get rid of management on this technicality.

Other frequently cited problems include poorly drafted agreements that open up potential tax liabilities or simply fall short of industry standard practice. If institutional investors are involved then LP counsel can usually pick up on these shortcomings.

In situations where first-time China funds, for example, hire local lawyers with little or no formation experience so as to minimize costs, LPs have been known to insist that an international-caliber player is brought in. Similarly, they might only agree to re-up if the manager uses a different law firm to last time around.

In this way, the value of using an experienced, and more expensive, formation lawyer is forced home, but it isn't happening uniformly across Asia. "Some people take a long-term view and are willing to pay for quality and value relationships with external advisors," says O'Melveny & Myers' Collins. "And some people don't."

The first category would include a recent fundraise in which the law firm agreed to a fixed fee for documentation plus a dollar amount per investor. One LP ended up coming in through several different entities, each of which required separate negotiation. When it came to calculating fees, the GP agreed to alter the original structure so payment was commensurate to the amount of work involved. It was a first-time fund and the manager was keen to build good will.

The second category, meanwhile, features several PE firms in the region that have used a different law firm for each fund raised.

This dynamic is in part driven by issues of culture and maturity: managers from emerging Asia often seem hardwired to go for the lowest-cost option and they haven't been hardened by the experiences of several fundraising cycles. But competition among law firms lurks in the background.

The top-tier fund formation practices in Asia are the same as those globally: Debevoise, Simpson Thacher and Kirkland & Ellis. Several other firms have recognized formation practices in Asia and still more are seeking to establish themselves.

Price-cutting still extends all the way up from the aspiring leaders to the top tier. One lawyer tells AVCJ that he refuses to do discounts and most GPs are aware of his policy. Another started offering them 2-3 years ago in response to increased competition in the market. A third notes that the long-standing incumbents are able to double-down on existing clients while his younger firm "has really had to hit the market, build new relationships, and develop a geographically diverse play."

Reports abound of law firms offering to do formation for free in return for downstream M&A work, but the fee-generative models being proposed may turn out to be just as unsustainable. Fees vary depending on the nature of a fund, not necessarily its size - a $2 billion Fund V with plenty of re-ups is much easier than a $300 million first-time vehicle. But the critical factor is time.

A formation lawyer might quote an initial fee of $750,000 but leave it open-ended to accommodate unforeseen difficulties; a rival them trumps him by saying they will do it for a hard cap of $400,000. If the fundraise takes six months there is no problem. However, if momentum is slow to build and the manager has to stop and revise the PPM, the months and the billable hours begin to stack up.

Another important variable is the number of investors, which also impacts the length of time spent on negotiations. A $1 billion fund with five anchor investors who push hard on terms but come in early and set a precedent for those who follow is a very different proposition from a $500 million vehicle with 15 LPs committing $30 million apiece but in dribs and drabs.

Climate of uncertainty

The uncertain fundraising environment hardly helps matters. Lawyers talk of the need to receive a portion of the money up front to cover some of the initial negotiations but also because asking for a retainer is the only way to judge if the GP really believes it will raise a fund. However, the chances of getting what they want ultimately depend on how low others are willing to go on price and whether or not a GP is willing to pay a premium for quality.

It is a vicious circle. Just as the shakeout currently underway within Asia's GP community as PE players without track records struggle to raise money from increasingly discerning LPs, the imbalance between demand and supply on the formation side is expected to right itself.
The hope is that a leaner phalanx of law firms finds itself dealing with GPs who are no longer only interested in the lowest-cost option.

It is not so much a question for the larger, more institutionalized private equity firms that are better equipped to write off fees as a cost of doing business, but those in Fund I-III territory. They want to appeal to a broader LP base but are they willing to pay for the experience and market credibility that a more seasoned service provider brings?

"The proof of the pudding is will they use you next time around," says O'Melveny & Myers' Collins. "I was dealing with one fund where the CEO was complaining about our invoices. Then he joined in a call with some investors that covered some tax points and finally he realized how sometimes four clauses in a document can take hours to debate.

"Everyone moans about fees but this particular client was pretty good about it after that."

SIDEBAR: ILPA principles - A sticking point or not?

The publication of the Institutional Limited Partners Association's (ILPA) private equity principles has certainly changed the way GPs and LPs communicate. But what does it really mean for fund terms and conditions?

"If every GP agreed to be 100% compliant on ILPA then it's done, it's over," one Asia-focused fund manager tells AVCJ. "But ILPA's model LPA sets a perfect standard, offering a position from which LPs can negotiate with GPs and in the end there will be some kind of compromise."

This particular GP went as far as to switch out his US-style distribution waterfall for the European variety: rather than allow the GP to start accruing carried interest before an investment has been fully realized, it must wait until all drawn down capital has been repaid to LPs and an IRR hurdle rate has been met.

The move is very much in line with the ILPA proposals on alignment of interest between GPs and LPs.

Fund formation lawyers have mixed views on dealing with ILPA. When the principles first came out a number of funds in the market at the time asked for ILPA audits - comparing every provision in their private placement memoranda (PPMs) to the LPA model and assessing what changes needed to be made. One lawyer recalls telling clients it wasn't worth the money or inconvenience to try and preempt demands because no LP walks away from a fund if the documentation isn't wholly in line with ILPA.

It is not so much a question of voluntary capitulation as knowing where to stand your ground.

"Anyone who fights ILPA now is misguided," says Philip Culhane, a partner at Simpson Thacher. "If you want to fight ILPA and there are 22 points then you can pick two of them; give the rest away immediately. If a GP positions itself as the one fighting additional reporting requirements, it's like raising your hand and saying ‘Don't pick me.'"

He draws a contrast between the transparency and conflict of interest provisions in the ILPA principles and the pure business terms. The former may not be ideal but they are not unreasonable, and to the neutral observer they can appear quite sensible given investors are allowing GPs enormous discretion over what to do with their money. The latter are fair game to fight over.

The European-style waterfall - an ideal provision from an LP's perspective but often a headache for first-time fund managers who worry about retaining junior staff if carried interest payments are pushed several years down the line - is a bone worth fighting over. However, Culhane notes that resistance on the part of smaller GPs in Asia has crumbled markedly in the last 12-18 months.

Certainly, there is a feeling among fund managers that ILPA has yet to deliver the egalitarian communication it promises.

"While we are not facing issues with our current, concentrated base LP base, the objective of ILPA shouldn't just be to impose minimum standards on GPs but also to try and impose some standardization among LPs so they aren't negotiating customization over and above that," says Paddy Sinha, managing partner of Tata Opportunities Fund.

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