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Fund arrangements are being forced to become more flexible as the investors start to call the shots, says Bridget Barker
Following the credit crunch there has been considerable upheaval in the private funds market. This has affected the private equity and real estate side, with many hedge funds also affected. The private fundraising market has been extremely slow.
Many funds have undertaken restructuring exercises - for example, extending investment periods or amending redemption rights - but this has frequently resulted in a renegotiation of fees. Liquidity has been an issue, with few realisations, so investors have been slow to commit to new funds.
With banks reluctant to lend, many mezzanine, debt and special opportunities managers have been able to fund transactions that fit their investment strategies. As a result, debt and credit-related funds have been more successful in raising funds of late than many traditional private managers. The banks seem, at last, to be disposing of their portfolios, giving a boost to secondary managers who are competing for those assets. Consequently, there has been more fundraising in the secondary arena.
In the past six months the fundraising environment has been better, with more managers considering coming back to the market and some even thinking about first-time funds. Niche funds seem to be faring better than some larger buyout funds, which are having to discount fees to accelerate a first close. Whether the debt crisis will affect those planning Q4 2011 or Q1 2012 launches remains to be seen.
The past three years have given investors the chance to look carefully at their portfolios and the arrangements they have with fund managers. In particular, investors have been focusing on fees, team composition and the level of control they have in relation to the fund. This in turn is leading some investors to cut the number of managers with whom they invest, but increase the amounts of money they give to those managers.
It is clear that the top-performing managers are still largely able to dictate terms. Conversely, managers whose portfolios are in trouble are finding it difficult to negotiate different terms or raise new funds. Those in the middle are being forced to adjust terms to accommodate investors’ demands.
The gap between ’good’ and ’bad’ managers has widened.
Fees are being scrutinised more closely. Although in the majority of cases carry or performance fees seem to be at the 20 per cent level, management fees are under pressure and detailed manager budgets are being requested by prospective investors.
The industry has seen generational change - senior managers have been moving on (forcibly or otherwise) and younger ones are taking over. Investors want to know who is managing their investments and how much of their time is being devoted to this. There is more focus on key man provisions and the procedural consequences of key man events.
Control rights come in several forms. Investors expect greater transparency along with better and more frequent reporting over the term of the relationship. They want early warning of problems or team changes.
In some cases, particularly for those with deeper pockets, this is leading investors to look away from the classic structure whereby all investors are treated the same, to discretionary management arrangements more tailored to the needs of investors.
Having a one-to-one agreement with a manager allows an investor to have more dialogue on investments and negotiate tighter terms without the manager having to give these to other investors. This, in turn, raises issues of transparency and fairness.
Another control trigger is the ability to exercise termination rights. Fault removal provisions have generally not changed, but investors want it to be easier to walk away, with fewer penalties if they do so.
Managers are also facing regulatory change, principally from the implications of the EU Alternative Investment Fund Managers Directive, which is due to come into force in July 2013. The Level 1 directive has been passed but the Level 2 implementing measures are still being negotiated. This has led to uncertainty for some managers, particularly those based outside the EU.
Managers are also facing MiFID II and Solvency II although the latter will mainly affect insurance company investors. Meanwhile, investors and managers are coming to terms with the implications of the Institutional Limited Partner Association’s private equity guidelines plus the effect of the US Foreign Account Tax Compliance Act (Facta) and potential US registration requirements.
All this means we are in a state of flux, with many investors looking to change their relationships with managers. The balance of power has swung towards investors and there is a focus on the terms on which they will agree to invest. Expect to see a greater variation in terms, with fewer standard fund arrangements in the future.
Bridget Barker is head of Macfarlanes’ investment funds and financial services group