Negotiating favourable terms is one of the most effective ways buyers have of creating alignment with sponsors and sellers in GP-led deals. The norms around how much a sponsor should roll, how much they can accrue in fees and carry, and what targets they must hit to trigger that carry have changed as the market has transformed into a tool for top GPs to keep their best assets.
Buyers would once have expected 100 percent of a manager’s crystallised carry to be rolled into the continuation vehicle to ensure alignment. While the sponsor being “excited” to roll all their carry is still a key sign of alignment, as Evercore senior managing director Nigel Dawn notes, a growing number of GPs chose to roll less following the covid-19 lockdowns, taking advantage of the fierce competition for high-quality assets among secondaries buyers. This remains a feature of the market today.
“We are more likely to see lower numbers [today] – 50 percent or 75 percent,” says Leor Landa, head of Investment Management at law firm Davis Polk. “But sponsors should be ready to have a conversation with buyers about why they are not rolling 100 percent. As a matter of alignment, Buyers do not want sponsors to get rich off of the secondaries deal, they want sponsors to get rich off of realising it.”
Pushing for more
Activity in recent years has challenged the assumption that a continuation fund should offer LPs more favourable economics than a commingled fund. While the bulk of continuation funds (43 percent) charge a 1 percent management fee, compared with the standard 2 percent, according to law firm Paul Hastings, three-quarters now offer ratcheted carry. As a consequence, sponsors have three return hurdles linked to increasing proportions of carry.
Some sponsors have pushed ‘super carry’, where they receive more than the typical 20 percent profit share. They have also brought down the hurdles at which this carry can be obtained, by one or two percentage points or more. Bain Capital and Accel are among the groups known to have employed super carry, according to asset management consultancy MJ Hudson.
“Certain GPs do it because they can get away with it,” says one senior London-based secondaries investor. “If it’s super carry over a certain hurdle and there’s a lot of commitment from the GP, and the GP has high conviction and has rolled in a lot, I can live with it… [For example], if it’s 25 percent [carried interest] over 2.5x [hurdle], or 25 percent over 3x, or something like that.”
Some LPs are happy to pay a higher performance fee, particularly if there is a low management fee or none at all – outperformance is good for LPs as well as the GP, after all. Others worry that super carry incentivises GPs to push businesses beyond what they are capable of, whether by applying excessively aggressive growth strategies or overusing leverage.
“You want to set GPs incentives to achieve what they are expecting to achieve. You don’t want them to shoot for the moon and take overly aggressive positions,” says one LP.
Some are beginning to see the tide turn against these sponsor-friendly terms. A lack of buy-side capital is making it increasingly difficult for large GP-led deals to get done, says Jeff Hammer, global co-head of secondaries at Manulife. At the same time, he says, the GP-led market is beginning to “internalise the valuation reset” that has occurred in public markets. “Together, these emerging vectors are creating a market that is more responsive to investor concerns.”
After two years of being terms takers when it comes to driving alignment, the shoe could soon be on the other foot for LPs.
– This report appears in the September Secondaries Special of affiliate title Private Equity International.