This article was published in the Going the Distance: The Expanding Lifecycles of Private Equity Funds report published by Pepper Hamilton and Mergermarket.
It should come as no surprise that for many GPs the time spent fundraising is longer today than it was five years ago. The relationship with their LPs has become more demanding, as investors capitalize on their bargaining power and exercise greater diligence.
This is in no small part the result of tighter regulation. Under revisions made to the Advisers Act in the wake of the financial crisis, any PE house with more than US$150m in assets under management must register with the Securities and Exchange Commission (SEC). The threshold is so low that virtually all houses must comply with the rules. Not only that, state regulations usually require that any manager with more than five clients in a given state must register at the local level unless they are already registered federally.
This trend favors large-scale managers, who are able to leverage economies of scale. With bigger and more various funds generating higher fee income, these GPs can cover the cost of compliance by sharing their resource across multiple vehicles. Smaller managers are not so fortunate and must levy proportionally larger costs on their smaller funds, raising legitimate concerns about the pipeline of emerging talent in the industry.
Additional regulatory requirements have added another layer to the due diligence process. LPs are scrutinizing compliance procedures, checking whether managers have, for example, been issued disciplinary notices from the SEC, and whether what the GP is reporting reflects reality. Any managers whose story doesn't match the regulator's records will be given short shrift.
Enforcement is also on the rise. In the last two years the SEC has made efforts to clamp down on fees and expenses where it feels investors have been misled. In 2014 the regulator said it was putting the industry “on notice,” and has since fined major players such as KKR and Blackstone as much as US$39m in connection with monitoring fees and other costs passed on to LPs.
This attention has prompted LPs to put more weight on transparency. They are questioning hidden fees and charges that would have previously gone unchallenged. In this scenario, investors will seek out managers who are open, collaborative, relationship-driven and - perhaps most importantly - have developed stellar track records. It is easier for those GPs who can demonstrate consistent outperformance to be honest with their clients.
As part of their due diligence, investors are also probing how GPs generate their returns. Are they financial engineers dependent on abundant leverage? Do they only make money in bull markets? Are they operationally minded and truly develop their portfolio companies during ownership? And do they have specialist skill-sets that enable them to repeat performance deal after deal?
Only when they are satisfied with the answers to these questions will LPs commit to a fund, and even then only after considerable negotiation on terms and conditions in the LPA. In recent years investors have been more aggressive, demanding rights on everything from fund extensions, fee offsets, indemnification carve-outs, recycling provisions and review rights. Side letters have become more common and more onerous, giving LPs more control over the contracts that define their relationship with their PE managers. The intensified negotiations of LPAs and side letters have driven up costs of fund formation dramatically.
So the question is not whether LPs are in PE for the long haul. On the whole, private equity continues to deliver the returns investors have come to expect of the asset class. The industry will continue to raise funds. The question is - are LPs devoted to their incumbent managers for the long term? With more regulation and negotiation than ever before driving up operating costs, that will depend entirely on a GP's transparency and ability to meet heightened due diligence requirements while delivering just-as-good performance.