Commitment issues: GPs have more skin in the game than ever before

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Together with the carried interest that general partners earn when their funds bring in the big bucks, the GP commitment is what keeps the interests of LPs and fund managers tightly aligned. Investors have long understood that this “skin in the game” mitigates risk as GPs will suffer personal losses if they make poor investment decisions.

This is backed by solid research. A paper published  by the Norwegian School of Economics and the Goethe University Frankfurt found that private equity managers who put more of their own money into their funds typically make more deals of a smaller size, diversifying risk. Perhaps surprisingly, they also use more, not less, leverage (the logic being that they pick dependable businesses with robust cash flows and balance sheets that can handle servicing the additional debt).

Now, a new piece of research from Investec reveals that GP commitments are bigger than ever. It’s generally accepted that fund managers should chip in between 1% and 2% of their fund’s total committed capital from their own wallets. According to this survey, that now comes in at a sizeable 4.8% on average.

This is also understated, averaged down by secondaries funds, which are lower risk by nature and for which the norm is 3%. For large buyout funds, the standard GP commitment now comes in at a weighty 5.8%.

Standard fair  

There is no set standard to which the industry must abide. In its most recent guidance, the Institutional Limited Partners Association (ILPA) merely recommends that GPs should put up a “substantial equity interest” in the fund. For sure, 5.8% is substantial and this trend should be music to LPs’ ears.

To understand how the industry got here, you have to consider how PE has evolved in recent years. Even prior to the pandemic, capital had begun to concentrate with the largest fund managers as LPs tidied up their portfolios and brand-name buyout shops offered the full suite of private capital strategies. This was exacerbated by the pandemic, LPs re-upping with familiar faces in lieu of visiting new teams. Preqin estimates that first-time funds accounted for just 16% of fund closures in 2020. This is the lowest level for 20 years, although a trend that should reverse as travel restrictions ease and LPs venture out to meet new teams.

Couple this with another fact—smaller PE firms employ more people relative to their assets under management. This means that, adjusted for performance, the big boys take home more money from their funds, in both absolute and relative terms. Which also means they can put more money in the pot when it comes time to raise that next fund.

One size does not fit all

This puts smaller firms at something of a disadvantage, even more so for first-timers who may lack the wherewithal to contribute more than 1%. This is a point LPs have to consider when reviewing investment opportunities and managing risk in their portfolios.

One solution for GPs is to obtain debt facilities to cover their contribution, but this comes with a caveat. ILPA advises that the GP commitment should come in the form of cash and not through the waiver of management fees or via specialized financing facilities. Investors may have to make concessions on this point, especially when backing debut funds. As GP commitments rise across the board, loans are likely to become an increasingly popular solution to bridge the gap, especially for more junior team members.

There is more to consider than just how big the GP commitment is. How the commitment is structured can massively skew incentives too. If GPs cherry-pick deals that their contribution goes towards, rather than pooling their whole equity interest across the fund, this misaligns interests, weakening the trust on which PE investor relationships are founded.

The most LP-friendly arrangements will see fund managers not only pool their commitment but pitch in as much as they can reasonably afford. Exactly what that sum is, and how effectively it achieves LP-GP alignment, is for investors to decide.

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