In recent years, private equity has become a truly global industry. Large buyout firms now have worldwide reach and as the traditional distinction between US buyout firms and European buyout firms disappears, the differences in terms between funds raised by US-based managers and Europe-based managers are being steadily eroded.
Private equity funds are raised on an international basis; last year, 72 per cent of capital raised by UK-based fund managers was raised from non-UK investors. Wherever they are based, fund managers looking to raise a new fund are likely to be talking to pension funds, insurance companies, fund of funds managers, government agencies and other institutional investors across the world.
Many of these entities are sophisticated private equity investors that review hundreds of funds a year. They will be fully aware of the terms being offered by other fund managers, which – in a global market – are likely to be offering a very similar product. In this environment, historic differences in fund terms have become increasingly unsustainable.
Of course, not all private equity fund managers are the same. We are still in a fundraising climate where top funds are heavily oversubscribed and top-performing fund managers can largely dictate their own terms. This flexibility, and the scope for individual negotiation, is a hallmark of private equity. But in relation to many fund terms, it is increasingly possible to identify a global norm.
(Almost) universal market norms
Some headline commercial terms have been more or less standard for many years, regardless of where the fund manager is based. For example, almost all private equity funds take 20 per cent of the fund’s profits as carried interest (essentially a reward for strong fund performance), although a handful of top fund managers are able to negotiate a higher percentage.
Most fund managers, wherever they are based, are also required to achieve a compound return of 8 per cent a year for investors before they are entitled to that carried interest (known as the ‘hurdle’ or ‘preferred return’), although a few fund managers are able to negotiate this percentage downwards.
Likewise, the management fees charged by US and European fund managers have in general been broadly the same, and the recent downwards pressure on management fees charged by e/$1bn-plus ‘megafunds’ has been felt on both sides of the Atlantic.
In other areas, historically there have been significant differences between funds raised by US firms and those raised by European fund managers, and it is these differences that are slowly disappearing.
The most noticeable convergence has been in what are loosely called ‘corporate governance’ provisions, meaning the terms in the fund agreement that enable investors to ensure that the fund manager performs properly.
Keyman clauses, which suspend the manager’s right to make new investments if certain key team members leave, are now standard for almost all independently managed funds. Similarly, most fund agreements include a clause allowing investors to remove the fund manager for fraud, negligence or other misbehaviour.
‘No-fault’ divorce clauses, which allow investors collectively to remove the fund manager at will (usually for underperformance falling short of negligence, but also simply if market conditions deteriorate), have been common in European funds for some time, and are now increasingly appearing in fund agreements issued by US-based fund managers.
A further area where there has been considerable convergence is on the confidentiality – or otherwise – of information. Both investors and fund managers are under increasing pressure to disclose more information about the funds they invest in or manage. The changes in this area have been driven largely by external political pressures, yet still reflect the increasingly global nature of the private equity industry. At one time, the proposals for increased transparency put forward by the Walker working group would scarcely have hit the radar of US buyout firms. Now, following the much-publicised takeover of Alliance Boots, US buyout giant Kohlberg Kravis Roberts has reportedly been one of the first to sign up to the Walker proposals and it seems a number of big US firms will follow.
Conversely, the decision of the California Public Employees’ Retirement System (CalPERS), a major investor in private equity funds, to publish fund performance information on its website in response to US freedom of information legislation has had a significant influence on the willingness of European fund managers to disclose information about the performance of their funds. The upshot seems to be a real shift towards greater transparency on both sides of the Atlantic.
What remains different?
There are, of course, still some significant differences between the terms offered by US-based fund managers and those offered by European managers.
The major difference is in the payment of carried interest. US-based funds have traditionally operated on a deal-by-deal model, where carried interest is paid out based on whether each individual deal has made a profit.
In contrast, the European model works on a ‘fund-as-a-whole’ basis, where carried interest is paid out after investors have received back all amounts invested, including in investments that have not yet been realised. This means that US investment executives typically start to receive carried interest much earlier in the life of the fund than their European counterparts.
In the manager-friendly fundraising climate that has prevailed in recent years, it was thought that European fund managers might seek to move to a deal-by-deal model. This has not yet happened to any significant extent, but there is still some evidence of convergence of terms.
Investors in European funds have historically required a ‘full escrow’, so that carried interest is not paid out to executives until there is no possibility that investors will not receive back the full amount of their investment. However, under pressure from fund managers, investors have progressively relaxed this requirement, and partial or early-release escrow arrangements that allow investment executives to receive carried interest earlier are becoming increasingly common. The flipside of this is that US-style clawback mechanisms, which require executives to pay back any over-distributions of carried interest at the end of the fund’s life, are also becoming more common.
Private equity funds by nature are highly flexible and are continually evolving. They will never operate to a standard model in the way that retail investment products do, and exceptional fund managers will always be able to negotiate away from the market norms. In addition, the legal and regulatory regimes operating in different jurisdictions will continue to require structuring tweaks.
However, it seems likely that, under the combined forces of globalisation and increasing investor sophistication, the commercial terms will continue to converge. The million-dollar question is whether European fund managers will attempt to move to a US-style deal-by-deal model for carried interest. If the fundraising climate becomes more favourable to investors in the wake of the credit crunch, this may not happen any time soon.
•Mark Mifsud is a partner and Stephanie Biggs an associate at Kirkland & Ellis