Representatives of The Lawyer Awards Funds Team of the Year shortlist gathered in London recently to debate the hottest topics in the sector
The Lawyer: Why are private equity (PE) houses struggling to raise funds from investors at the moment?
Tim Simmonds, head of financial services, Osborne Clarke: There’s probably no single reason, it’s a mixture of things. The market is incredibly competitive and there are lots of funds still on the road, probably as many now as there were in 2006/07. Some have no track record and some have a really bad track
record that they’re trying to avoid.
So it’s a competitive market, with people who have good, bad and indifferent track records all chasing the same investor pool.
Alex Amos, partner, Macfarlanes: It’s not such a difficult market in the sense that there are plenty of PE funds being raised and lots of investors allocating capital.
What we are hearing a lot is that they’re cutting back their general partner (GP) relationships. That means if you’ve got some sort of skeleton in the cupboard you may struggle.
Funds are being raised but they’re taking much longer because investors are more sophisticated in their approach to carrying out due diligence on GPs.
John Daghlian, head of investment funds, O’Melveny & Myers: We’ve been busy with mid-market funds. They can deal with the legal processes in under a month because there’s a shortage of supply, they can only admit so many investors, their record’s there and everyone knows the manager cannot get rich on the fees.
Jonathan de Lance-Holmes, UK head of investment management, Linklaters: There’s a flight to quality among the top tier. If you raise less or much less than you did last time round, or than your peers did, at that end of the market you’re seen as a failure. Investors don’t want to be with the failed funds, they want to be associated with success.
The Lawyer: So are there investors who are holding back but who come in at the second fundraising?
De Lance-Holmes: Certainly, the interest rate deterrent for coming in late is not seen as much of a deterrent. The terms, let’s face it, are only going to move one way between first close and later.
Daghlian: Do you think the early-bird discounts we’ve been seeing on the mega-funds are not delivering?
De Lance-Holmes: Have they increased the size of successful first closes? Probably not. Have they made them possible to achieve when they otherwise would have taken forever? Possibly yes.
The Lawyer: What type of investors are coming in for first close?
Kerrie Walsh, partner, Schulte Roth & Zabel: From the hedge side – which is a slightly different structure because we have multiple openings and multiple times you can go out of the fund – first closings are not necessarily an issue. That said, if you get the right kind of investor the first time it makes it much easier. Probably 80 per cent of the money is coming from the US, mostly from pension funds.
De Lance-Holmes: Whether you get the fund away or not, the smart investors are fighting harder in a more structured and tactical way than they used to, and they have thought much more about what they want from a fund and the relationship with a manager.
Simmonds: In the PE world first-close investors already know the managers. I think it would be more unusual and more difficult now to get a first-close investor coming in who’s never had any relationship with the manager.
The Lawyer: Does this mean the balance of power between investor and manager has changed?
Sharon Ayres, partner, Wragge & Co: We act for a lot of institutions and have certainly seen them push much harder and achieve a lot more provisions from the GP, such as warranties in relation to performance, knowledge about the underlying portfolios and other provisions relating to reporting and transparency.
De Lance-Holmes: There are lots of good reasons for a GP to say no to seemingly reasonable requests from the point of a view of an investor, but you’ve got to explain them and intellectually justify your position.
There are a limited number of absolute must-have GPs for certain investors. They can be more aggressive than they were in the past.
Amos: For the newer managers one thing we advise is to keep your terms and structure as simple and down the middle of the fairway as possible, because you don’t want to give investors an excuse to turn away the opportunity. They should be turning it away because they don’t like the strategy or they have concerns about the team, but not because of the structure or the terms of your documents.
Walsh: That’s our byword too – keep the structure simple. It should never be a reason the investor walks away. With hedge funds you’ve got such pressure now in terms of all the regulatory pressure and all the operations you have to put into place that someone coming along with a big ticket is tempting. There’s huge pressure on hedge funds to get sized up in time.
Tim Page, senior associate, Norton Rose: Taking that to the next step, one thing we’ve seen is GPs wanting to keep the option open of having managed accounts so they’ve got the option of flexibility for certain investors while the main fund documents are more vanilla.
The Lawyer: Are you seeing pressure on fees and costs from fund managers?
Walsh: Historically, in hedge management fees have been 2 per cent, and there has not been a huge movement from that. The operations needed to support a hedge fund have increased dramatically.
What you’re seeing is some of the bigger tickets coming in and saying – fine, we’ll pay you the 2 per cent now, but we expect you to drop that when you get a certain amount of assets under management because it’s not meant to be a profit centre.
The profit is where the incentive fee comes in, and that’s the way it should be.
Page: It’s counter-intuitive really that the smaller managers who are almost starting up can charge a higher basic management fee. But we’ve seen in a number of projects that the investors actually say – hang on a minute, are you sure your business is sustainable on this basic fee? We don’t want you to realise in two years’ time that your best guys are leaving to go and work for someone else because they can get paid a better salary.
Daghlian: The two-and-20 rule is largely unchanged. In particular, the 20 seems to be sacrosanct. But you do see big investors now getting discounts in a way that wasn’t commercially acceptable a few years ago.
Simmonds: It’s not just about fees. A lot of investors are equally – if not more – concerned about governance, about key men, about no-fault divorce and so on. Those kinds of issues can become real bugbears.
Amos: It’s all about disclosure and transparency. In our experience investors will buy into it if they understand it and are clear about the level of fees being charged.
The Lawyer: The thing that’s been hanging over everybody’s head for several years is the Alternative Investment Fund Managers Directive (AIFMD).
A lot of people predicted a pre-AIFMD fundraising rush – did that happen?
Daghlian: Everybody that could get away did, but a lot of people couldn’t.
Amos: You cannot talk your investors into a fund, you’ve got to go with their timetable.
De Lance-Holmes: What you may see is a slightly artificial pre-D-Day rush as member states who haven’t got their act together in time allow you to use transitional provisions if you’re already marketing or managing on 22 July.
Walsh: Because of the transition between the FSA and the FCA there was also a mini-rush earlier in the year, trying to get some applications in to the FSA to get the process going.
We’ve seen a lot more of what we call ‘soft launches’ to establish alternative investment funds with
investors falling within the regulations and people wanting to keep the momentum up and build a track record.
De Lance-Holmes: People underestimate the effect of speed in regulation. People accept that they need to be regulated, what they hate is uncertainty, delay and the time implications. I’ve seen more people going offshore because of the speed of getting regulated than because of the relative ease of regulation.
Simmonds: It’s also partly to reduce uncertainty. If you look at some of the funds that have been structured offshore it’s so they can sit offshore and work out whether they want to be in a third jurisdiction or an EU member state. They can make that choice when the
clarity of regulation comes through.
The Lawyer: Are many people choosing dual offshore/onshore structures?
Daghlian: A few, but it’s relatively rare. People have been looking at places other than Luxembourg. There have been some focusing on Malta because that’s part of the EU and Luxembourg is so painfully slow. There’s probably been more of a move offshore than anything.
Habiba Boughaba, Luxembourg managing director, JTC Group: Our clients choose as much as they can the offshore route, from a cost perspective. The cost of the regulation will be too high.
The Lawyer: Will AIFMD put people off Europe rather than attract them?
De Lance-Holmes: A lot of the
important and legitimate questions clients ask me I can give no honest answers to except a ‘should’ or a ‘maybe’. Certainly, you’re not going to jump into a regulatory space unless you have to when you could get hit with a pile of costs and difficulties, but you don’t even know yet.
Walsh: Our US clients are interested in where they can market through Europe. The uncertainty over what kind of private placement regimes are going to be in place in another couple of months and the sort of overlay European countries are going to put into place does cause some concern.
Historically, Europe has been high-net-worth private offices, but a lot of that money has gone away.
The impact is really on the investment managers’ business – how do they have to structure their funds, how are they going to pay their people and what are the remuneration rules going to look like? Those are the big issues.
Simmonds: The key point is whether you’re a manager or an
investor. If you’re an investor from the States it’s going to look confusing, but you’re probably going to
be no worse off. But if you’re a
manager it’s deeply confusing and worrying.
The Lawyer: What will be the greatest impact of AIFMD?
Daghlian: There’s going to be more cost borne by investors. I think the investors are going to end up sucking it up, at least in the mid-sized funds, because the fees aren’t there for the GPs to be able to take them.
The Lawyer: What’s the most compelling platform for a fund right now?
De Lance-Holmes: The first question anyone ought to be asking, certainly when they’re looking at where their manager will be, is where do I want to do the work? Where are my people going to be?
Amos: There’s a distinction between hedge funds and private equity (PE) funds. You can’t be a PE fund manager doing Nordic deals with the team based in Switzerland. Operationally it doesn’t work, whereas it could work in a hedge fund context.
Walsh: You can put teams offshore, but we’re still seeing UK asset managers happily set up here with Cayman funds. There hasn’t been a lot of movement away from that.
De Lance-Holmes: In terms of vehicles, never underestimate familiarity although there’s one interesting new vehicle on the horizon which has some possibilities, and that’s the Luxembourg limited partnership.
Frankly, you might not invent it today if you were sitting down with a blank piece of paper to structure a fund vehicle. You might not write
it that way, but it’s like a Qwerty keyboard – they all know it.
Page: You don’t want to have to spend time educating investors on why you’ve got this particular structure. When you have a Cayman LP they go – that’s fine, tick that box, move on to the next question. It’s time you cannot afford to waste.
The Lawyer: What are people looking for in terms of what they’re investing in?
Page: Real assets are popular. That’s infrastructure, real estate and asset-backed loans. It’s not traditional PE stuff but funds backed by solid assets that throw off income.
Daghlian: Infrastructure’s always interesting because there’s some genuine innovation in the way people do infrastructure deals and funds.
On the whole, PE tends to be more hide-bound – it tends to be two-and-20 whereas a lot of other stuff is more mixed practice. Mid-market’s been popular and big buyouts have been suffering.
Amos: We’re hearing a lot about Turkey. Obviously, that’s quite a hot market, but a lot of emerging markets are difficult to access because you can’t necessarily just parachute team members in there and expect to raise a fund.
De Lance-Holmes: But one of the reasons funds exist is because the investors themselves cannot go in. You’re buying expertise or access.
Daghlian: This is the year of Africa.
De Lance-Holmes: There are resources and real assets funds. There’s a lot of money chasing the Levi Strauss who sells the jeans to the miners and the consumer businesses you hope come along if resources make a country rich.
Daghlian: There’s African-owned business funds, classic PE funds, venture funds – there’s much more than there used to be. It obviously doesn’t compare with Western Europe in terms of volume, but it’s happening in a way I haven’t seen before.
The Lawyer: Is that the same in other types of funds?
Walsh: Long/short equity is still the number one investment style. It kind of comes back to institutionalisation. They want less volatility because they’re pension funds. Hedge funds are a different part of a portfolio.
Page: Liability-driven investing is a massive thing now and pension funds want those long-term instruments that throw up a steady yield that matches their liabilities to annuity holders. It’s up to the industry and the fund managers to come up with products.
Amos: One of the interesting things about credit funds is that target returns can be as little as 5 per cent for senior debt and up to 20 per cent for mezzanine or equity kickers. So lots of these credit fund managers are effectively saying – in terms of the risk-reward profile, this is a better offering if you look at historic PE returns over the past five years than you might get going into a PE fund. That’s why we think credit is very compelling.
The Lawyer: Where will the funds industry go over the next couple of years?
Amos: There’s a trend in certain sectors of the industry towards a ‘more assets under management’ play than a ‘performance for your carry interest’ play, and I suppose that’s driven partly by the desire to exit in the future. It’s easier to exit on a multiple of assets under management than on performance fees.
De Lance-Holmes: It’s much tougher being in the middle than it used to be. Regulation costs money, so some of my bigger clients see regulation as a good thing for them – a barrier to entry for smaller players is a chance to snap up operations that are sub-scale.
Walsh: There are just not as many hedge funds able to operate in that middle space because it’s rather like what they say about travelling second class – you have none of the fun of third class and none of the luxury of first. That’s what you have in the middle right now. You have all the burdens and none of the ability to be nimble and go into the investments.
Simmonds: I worry about people at the bottom though. We’d all like there to be innovative clients doing great things, different things and coming up with new technologies, but it’s a hard market to do that in. It might take a fundamental change in the overall economy before that part of the market starts to come back.
Daghlian: The most entertaining stuff is going to be in the emerging markets, but to be fair that’s where it’s been for quite a while anyway.
Ayres: An intriguing piece of the puzzle that we’ve seen of late is public sector money starting to appear in funds.
There’s a lot of money being devolved into regions to boost the economy and employment opportunities. I think that trend will continue over the next few years and it’s going to be interesting to see the structures that come from there.
Page: The key thing we’re seeing is consolidation. Big asset managers who’ve had a good crisis have got the money now to capitalise and pick up smaller businesses on the cheap and build up their teams that way and also to fill gaps in their product portfolio. M&A teams will be quite busy, I reckon.
Boughaba: What we see from our end is a choice of jurisdiction from our clients.
Recently, one of our clients gave up a product in Europe to go to Singapore because one of the cornerstone investors was from Indonesia. So we see funds migrating from one place to another – Cayman to Asia – because of the cornerstone investor putting pressure on the GP to have the fund close by.
De Lance-Holmes: As lawyers I suspect we’re going to take some value away because we’re all going to be in an environment where no one can quite agree what the law is in some really important areas of our practice.
Sponsor’s comment: post-2008 pressures
There was certainly lively debate among the expert panel gathered from the shortlisted candidates in relation to the private equity (PE) sector and some of the challenges faced post-2008.
There was also commonality on a number of key subjects. As administrators of PE funds, we found it a useful insight and reinforcement of what we are seeing as service providers to PE funds from lawyers who advise some of the key players in the market. Examples include the pressure that mid-market fund promoters are having in fundraising and launching their structures, and the difficulty that new entrants have when trying to get their first fund away.
This is in contrast to the smaller niche players with a track record and those of the ‘super’ PE funds that continue to have success in attracting investors and finding targets to invest in once the fund has launched – in many ways we are seeing, as was said, a ‘flight to quality’.
The ability of significant investors to dictate terms to the PE house is also evident, with many putting pressure on fees and asking for extra safeguards and concessions that would not have been done previously. There is a shift to ‘Limited Partner’ power versus ‘General Partner’ power, very much a new dynamic.
It was also good to hear that the Channel Islands and Luxembourg (with its new LP law imminent) are still the jurisdictions of choice for most PE houses for the location of their funds.
As for the future, we all know that nothing is certain. There is, however, agreement that AIFMD, FATCA and greater regulations will continue to act as barriers to entry going forward, it will be tougher for those houses occupying the middle ground and headline fees will reduce with greater transparency being demanded.
That being said, we firmly believe that PE is here to stay.