Walkers Fundamentals White Paper 2020 – Private Equity Part 2

Welcome to Walkers’ 2020 Fundamentals White Paper Series, in which we discuss certain trends identifiable among the hedge funds and private equity funds that we helped our clients launch over the last twelve months.

In last year’s White Paper, published in November 2019, managers and their funds appeared to be positioning themselves for market turbulence in the face of global uncertainties and a volatile economic and financial environment. One year on, with the benefit of hindsight, this was something of an understatement. 2020 has tested all aspects of managers’ businesses, from the boardroom to the back office, and in many parts of the world out of the office altogether. All of this, of course, is not to overlook the broader global context of the pandemic and the significant health, economic and political challenges that 2020 has brought and continues to present.

To visit the other parts of the series, please use the direct links below:

Private Equity Trends Part 2

Among the uncertainty and turmoil of 2020, closed-ended fund formation activity has continued at pace, as managers and their advisers have negotiated side letters, launched funds and continued downstream activity, largely operating in a virtual world. In the Cayman Islands, the enactment of the Private Funds Law has seen Cayman closed-ended funds subject to a registration regime for the first time, with existing and newly launched private funds required to provide certain registration information to the Cayman Islands Monetary Authority (“CIMA”). Private funds will also be required to comply with ongoing obligations with respect to operational matters such as audit, safekeeping of assets, valuations and cash monitoring, which obligations largely codify existing best practices familiar to most managers domiciling their funds in the Cayman Islands.

The new regime ensures that the Cayman Islands remains the offshore financial centre of choice for global fund managers launching closed-ended funds, and supports the Cayman Islands’ broader aim of adopting global standards in areas such as anti-money laundering and economic substance.

FUND DURATION

8 - 10 years remains the most common term generally, with slightly shorter 5 - 7 year terms continuing to be popular in Asia and for credit funds.

There has also been an increase in funds with 10+ year terms. The willingness of investors to give managers more time to execute investments is also shown in the extension periods available to managers under fund partnership agreements. Two single year extension periods remain most common but there has been an increase in the number of three single year extension periods.

8 Fund Terms

Managers have also been more creative in agreeing extension provisions to allow themselves even greater flexibility to source and execute the best investments at acceptable prices, with multiple two and even five year extension periods being agreed with investors.

This understanding is also reflected in investment periods having lengthened a little, with 5-7 year investment periods superseding 3-4 years as the most common duration.

As always, industry specific trends remain, with distressed credit funds in particular often having investment periods of three years or below.

FEES

The “two and twenty” model has broadly remained dominant, although with some downward pressure, particularly from the management fee perspective, where the most common management fee is now a little less than 2%.

There is some flexibility around the edges, with some first-time funds charging carried interest as low as 5%, but 20% remains the standard amount.

9 Fund Fees

Managers continue, however, to experiment with preferred return. Technology funds in particular, in light of the “all or nothing” nature of a number of their investments, have sought to lower preferred return expectations, with certain managers receiving carried interest immediately upon investors receiving their money back.

Management fee pressure has been coming to bear for a number of years and this is the first year where fee rates between 1.5% to 2% have outnumbered those in the 2% and above range.

Investors are willing to pay for performance, but are tightening the purse strings on ongoing management fees.

GENERAL PARTNER REMOVAL

Providing investors with the ability to remove the general partner following wrongdoing remains relatively standard, with general partners typically being required to discount any accrued carried interest in the event of a termination for cause scenario.

Managers continue to strongly resist the ability to be removed without cause, conscious of being removed from a portfolio that they have painstakingly crafted for no reason other than investor sentiment. This term is more commonly conceded for start-up funds managed from Asia, although managers will typically negotiate some form of compensation payable on removal, typically determined as a multiple of the annual management fee.

One interesting alternative to no-fault removal is providing investors with the right to wind-up the fund early rather than removing the general partner. This is a powerful tool for investors, while protecting the manager from seeing a competitor pick up and managing a fund portfolio that they have used their expertise to identify and construct. While no-fault removal remains the most common remedy for disgruntled limited partners, the forced winding-up may become more prevalent going forward.