In the competitive, and at times challenging fundraising environment in the Asia-Pacific region since 2008, overall we have seen a slight shift to more investor-friendly private equity and venture capital fundraising terms. The shifts that have occurred have been more evolutionary rather than revolutionary. Whilst some GPs have adopted new and innovative investment strategies in attempts to stand out from their peers in an increasingly tight market, the majority of GPs have maintained traditional fee and investment structures. This article highlights the key changes in recent private equity and venture capital fundraising terms in Asia and the likely trends in the coming year.
Our experience has been that most funds have been able to stick with the traditional 2 and 20 fee structure - that is, 2% management fee and 20% carry. This is despite a general increase in fund size leading to the management fee often covering more than basic salary and expenses for the GP. In the venture capital space, the management fee has often been as high as 2.5% - which isn’t surprising given the smaller size of these funds.
What’s next for management fees is unclear, particularly in Australia. Some Australian superannuation funds have seemingly moved away from private equity investments because of high costs. There is a concern that some investors are focusing on fees to the exclusion of returns. After all, a rational investor should prefer a 12% IRR with a 2% management fee over an 8% IRR with a 1% management fee. However, if private equity funds can find other investors to take the place of Australian superannuation funds (and several appear able to achieve this), it seems unlikely the 2% management fee will come under real pressure any time soon.
Greater offset of miscellaneous fees but fewer ‘early bird’ incentives
While LPs have generally had little success in reducing management fees, they have had far greater success in obtaining offsets against the management fee for miscellaneous fees earned by GPs. LPs have been successful in their argument that GPs should not be focused on the generation of these miscellaneous fees and that, as fiduciaries, they should account for such fees to the LPs on behalf of whom they are making investments.
We see many Asia-Pacific funds providing for a 100% offset of directors fees, transaction fees and other miscellaneous fees. Whilst pre-2008 offsets were often only around the 50% level, or even less, more recently GP retention of miscellaneous fees appears to be the exception.
Contrasting with the trend to greater offsets for miscellaneous fees, we have seen a drop-off in “early-bird” incentives. These incentives emerged after the financial crisis to help build momentum for fundraising and to displace the extended fundraising periods which were becoming common. At that time, investors were being offered discounts on management fees if they committed to the first close of a fund. However, despite some investors still expecting to be incentivised to commit at first close, there are now fewer examples of these rebates.
A 20% carried interest provision continues to be the standard in Asia-Pacific private equity funds. Venture capital funds have often provided for greater carried interest, often as high as 25% or 30%, reflecting the smaller commitments invested in these funds.
While many private equity funds are still providing for a 100% catch-up mechanism (where the GP receives 100% of all distributions until it receives 20% of the amount of preferred return distributed to the LPs), lower catch-ups are becoming more common, some as low as 50%.
Preferred return rate remains stable
The preferred return or ‘hurdle rate’ is the minimum return to investors to be achieved before carried interest is distributed to the GP.
Generally, private equity funds in the Asia-Pacific region provide for a preferred return of 8% and any variances from this rate have tended to be within a relatively tight range.
In the venture capital space there is often no preferred return provision.
Whole-of-fund waterfall structure now the norm
Most funds raised in the Asia-Pacific region now have their carried interest structured as a whole-of-fund waterfall, rather than a deal-by-deal waterfall.
Pre-2008, there was no settled position in the region as to whether funds would follow the deal-by-deal waterfall structure that predominated in the United States or the whole-of-fund waterfall structure that predominated in Europe. It appears that the argument has now been settled. In our view, by far the most common structure currently in the Asia-Pacific fund market is the European whole-of-fund waterfall structure.
Security for GP clawback obligations has increased
Almost all Asia-Pacific private equity fund documents contain a GP clawback mechanism, requiring the GP to return at the end of the life of the fund any excess carried interest it may have received. It has been increasingly common to see additional security for the GPs’ obligations under these clawback provisions. We are now commonly seeing personal guarantees signed by the individual recipients of carry from the GP being provided as security and, less frequently, the GP setting aside a portion of any carried interest distributions in an escrow account.
Greater scrutiny of fees generally
Since the US Securities and Exchange Commission (“SEC”) commenced its inspections of private equity houses in October 2012, and especially since its “Spreading Sunshine” speech in May 2014, we are seeing more rigorous scrutiny from investors about fees charged to their fund.
Of particular concern to the SEC during its inspections in the US has been the types of fees being charged and the allocation of these fees between funds and their managers. The SEC stated that a “lack of transparency and limited investor rights” had been “the norm in private equity for a very long time”.
We understand the SEC’s drive for transparency has resulted in GPs receiving numerous requests from investors and gatekeepers in relation to the charging of expenses, particularly in cases where numerous funds are managed by the same sponsor and conflicts may arise.
Those concerns from the SEC are very much reflected in LP attitudes in Asia-Pacific.
Organisational costs cap on the rise
Organisational costs are charged to cover the costs of setting up and structuring the fund. It is quite common to have a capped amount stated in the fund documents, which varies depending on the complexities associated with the fund.
Recent trends show an increase in the capped amount in Asia-Pacific funds over the past decade. Pre-2008, the organisational fees were usually capped at US$1 million. Now, we are more commonly seeing a cap of US$2 million, which is reflective of the general increase in the costs required to set up funds, particularly regulatory and administration costs.
Fund life extensions being scrutinised
There is an increasing trend of investors scrutinising the ability of GPs to extend the life of Asia-Pacific private equity funds. LPs are frequently pushing for advisory committee or investor consent being required the second or third time the fund life is extended. There has also been increased “noise” from LPs around the fees charged during fund extensions.
Innovative investment strategies
2014 showed GPs adopting new and innovative investment strategies.
Traditionally, GPs in the Asia-Pacific region had focused on providing growth capital to relatively mature companies in need of capital injection to facilitate expansion or restructure. While growth capital funds continue to predominate, there appears to be growing interest in control-type buyout funds. LPs have grown wary of minority stakes, which have seen mixed results in Asia.
We are also seeing interesting developments in the relationship between LPs and GPs generally. GPs have been developing innovative alternative investment structures to attract LPs who are seeking more flexible or tailored arrangements and wish to play a more active role in investments.
For the same reasons, we have also seen an increase in the number of co-investments taking place across Asia. Larger investors, in particular institutional pension plans and sovereign wealth funds, find co-investments an attractive proposition whilst, at the same time, the co-investments offer the GPs much-needed capital and rapport building which solidifies their LP base for other investments.
With many experts foreshadowing that 2015 will be a tougher year for sponsors seeking to raise funds, we expect GPs in the region will need to continue to adapt in the face of increasing investor scrutiny.