A new survey reveals a shift in fund terms in favour of investors. There is still room for improvement but some investors are pushing managers too hard, as Sam Meakin reports

Fund terms and conditions have been a prominent issue for private equity investors during the past year. As the rates of distributions have slowed and as fund managers have struggled to reach fundraising targets, limited partners (LPs) have sought a greater say in negotiating terms and conditions.

Since 2009, LPs have put fund terms and conditions under the spotlight to show areas of concern for investors. The Oregon Investment Council (OIC), which manages the assets of several of the state's public retirement systems, adopted a set of private partnership investment principles intended to guide the council on decisions about prospective investments in private equity funds, aiming to promote greater transparency and more reasonable fees.

The US-based Institutional Limited Partners Association (ILPA) released its own set of private equity principles that were quickly endorsed by the California Public Employees' Retirement System (CalPERS). More than 100 institutional investors have since endorsed ILPA's principles. Another industry body, the British Private Equity & Venture Capital Association (BVCA), launched the LP Advisory Board in April. The advisory board features representatives institutional investors including HarbourVest Partners and the Abu Dhabi Investment Authority, and is tasked with "enhancing relationships and levels of understanding" between general partners (GPs) and LPs.

There is evidence that such activity is finding success in engaging GPs. OIC persuaded real estate fund manager Lone Star Funds to "revise its long standing fee structures and governance procedures to make its funds more LP friendly." Additionally, management fees for the largest private equity real estate funds have fallen significantly for the most recent vintages (figure 1). The mean investment period management fee has fallen by more than half a percentage point for funds US$1bn (€760m) or more in size of vintages 2009 and 2010 (including those still fundraising and yet to begin investing) from its peak of 1.75% for vintage 2007 funds.

This shift in prevailing fund terms has been recognised by LPs. Preqin conducted a survey of institutional investors in Q2 2010 to discover their attitudes towards the terms and conditions of private equity funds. We asked about their experience of any changes to prevailing fund terms in the past year and as figure 2 shows, 71% of respondents that have actively invested in the past year stated that they had seen a movement in fund terms in favour of LPs. The most common changes cited by respondents were management fees (50%) and the rebate of deal-related fees (41%).

Preqin also conducted a survey of placement agents in Q2 2010, and their sentiments on which fund terms had moved the most in favour of LPs tallies with what the LPs themselves said (figure 3). More than 80% of the placement agents surveyed felt there had been a shift in favour of LPs on the issue of management fees, and 75% of respondents said they had seen movement in the rebate of deal-related fees, such as transaction and monitoring fees.

The institutional investors surveyed were also asked whether they thought that GP and LP interests were properly aligned. As figure 4 shows, the majority of LPs surveyed said that interests were properly aligned. However, despite recognition of the movements made in fund terms already, some investors still feel there is some way to go, with 42% of respondents either disagreeing or strongly disagreeing that interests were properly aligned between fund managers and investors. This is higher than the 31% of investors stating this in a similar survey conducted in 2009, and the 18% that were of this opinion in a 2008 survey.

The surveys highlight management fees as the area most commonly recognised, by investors and placements agents, where shifts in favour of LPs have occurred. Despite this, they were still by far the most frequently cited fund term when investors were asked for the areas where they believed alignment of interests could further be improved, with 64% of respondents naming this area. Some investors feel there is an over-reliance on management fees rather than performance fees as a source of profit for GPs.

Several placement agents, however, suggested that investors were being too tough on GPs. One suggested that LPs do not always appreciate the extent of costs incurred by GPs or understand for what the fees are used. The source claimed that despite the downturn, not all GPs suffered the same capital losses.

As such, LPs should choose their GPs carefully rather than focusing solely on campaigning for fees to be reduced across the board. Another supported this view, suggesting that some GPs feel they are being punished for the transgressions of others. They went on to say that this has led to resentment in the GP community and in some cases has resulted in a misalignment of interests within the partnership, concluding that "some LPs are driving too hard a bargain".

Overall, the evidence shows that the terms and conditions of recent private equity real estate funds have moved in favour of LPs. The rebate of deal-related fees is one area where the surveys suggest that significant changes have occurred, and LPs seem to be fairly satisfied with this movement. Investors also recognise that there have been changes in management fees recently, but feel that even more can be done. However, some placement agents have emphasised that LPs should not use their increased bargaining power to push GPs too far, believing that LPs should consider the performance, strategy and prospects of the individual fund manager in question, rather than viewing all GPs as homogeneous and pushing for widespread change. For their part, GPs should be more transparent in justifying their fees and showing how they are used.

Sam Meakin is managing analyst at Preqin In search of a balance