Attracting and retaining investors in private funds

Introduction

The fundraising market for private fund sponsors remains highly competitive, and for many sponsors, offering inducements to investors has become a core element of their fundraising strategy.

Inducements can broadly be divided into three categories:

1. economic inducements;
2. ownership inducements; and
3. non-economic inducements.

In this article, we outline the most common forms of inducements observed in the market and how these have evolved in recent fundraising cycles. We also consider the importance of maintaining investor fairness and the implications of any most-favoured-nation (MFN) provisions throughout the process.

Economic inducements

Economics within the private fund industry have come under scrutiny in recent years. The 2% management fee: 20% carried interest model is no longer accepted as the norm in several private capital strategies and more frequently requires justification. As a result, sponsors have for some time offered discounts to investors, either through a defined “rate card” made available to all investors or through “relationship-based discounts” negotiated with specific investors or investor groups i.e. not necessarily available to all.

Rate card discounts

The first category, rate card discounts, has seen relatively little change in recent years. Many private fund sponsors (and most private credit sponsors) establish a tiered rate card for management fee discounts at the outset of fundraising, following market testing. Discounts are typically offered based on an investor’s commitment amount and timing of investment.

One notable development has been the extension of “early bird” discounts beyond the first closing date. For example, eligibility may extend to:

• a date falling (x) months following the first closing date; or
• any date prior to the date on which the fund has accepted commitments in excess of (x) million (including any commitments accepted on that date which take the fund over that threshold).

Some sponsors also provide that an investor’s “date of investment” reflects the first date on which any of its affiliated investors commits to the flagship fund program (rather than the date on which the investor itself makes its commitment).

Relationship-based discounts

The second category, relationship-based discounts, has seen more innovation in recent years as managers have become increasingly flexible and creative in incentivising long-term partnerships. Sponsors now more commonly provide discounts that take account of broader investor relationships, for example by offering volume discounts based on commitments to predecessor funds or across strategies.

An investor’s aggregated commitment for these purposes can vary from sponsor to sponsor, but may include:

• size of the commitments of investors introduced to the sponsor by the same “gatekeeper” or investment consultant as the investor;
• size of the commitments of the investor’s associates, or investors managed or advised by the same manager or adviser; and
• size of the investor’s commitment (and its affiliated investors’ commitments referred to above) to one or more prior funds, which may include other fund strategies managed by the sponsor.

These relationship-based discounts have not only become more common but also more broadly defined. Two notable developments include:

• forward looking discounts: where an investor agrees to commit a certain amount of capital to future funds or strategies, and once that commitment's been made, the manager reduces or rebates fees in the current fund; and
• aggregation across investor types: where certain groups of investors, such as UK Local Government Pension Schemes, negotiate volume discounts by aggregating their commitments.

In some cases, sponsors have also offered preferential terms based purely on investor type, regardless of aggregated commitments. This is less common and not always accepted. It is typically only seen where certain investor categories face regulatory constraints that limit their ability to accept traditional fee structures.

Some sponsors will specify in the fund documentation that an investor’s aggregated commitment is its commitment when aggregated with such other commitments as the sponsor determines in its discretion. Those investors with whom the sponsor may aggregate continues to widen beyond just those within the same investor group and investing in the same fund.  

Co-investment

Co-investments have become an increasingly common feature of fundraising in recent years. They are often linked to economic inducements, as the lower – or in some cases, zero – fees charged on co-investments can improve an investor’s overall economics when viewed on a blended basis (alongside their commitment to the flagship fund programme).

Sponsors are increasingly reassessing how they offer co-investments. Many private equity managers are frustrated with giving away upside on a fee-free basis, while private credit sponsors are contending with more sophisticated investors seeking greater control rights – for example asking to be named as lender of record or requesting escalation rights in a workout scenario. In response, some managers are setting up dedicated co-investment vehicles to retain flexibility and, in some cases, introducing fees (albeit lower than the flagship). However, these structures can add cost and complexity, and the expectation of fee-free co-investment remains difficult to shift.

Preferential co-investment rights can take several forms, including:

• non-contractual, relationship driven, priority allocations of co-investment opportunities with key investors that have the ability to transact quickly on co-investment transactions (which is more common in private equity);
• a confirmation in the side letter that, to the extent offered to an investor, a certain amount (e.g. an amount equal to an investor’s commitment to the flagship fund program) of co-investment opportunities will be offered to an investor on a “fee free” basis;
• priority allocations agreed in side letters providing for co-investment opportunities to be allocated between key investors (often allocated pro rata to the commitments of those key investors who elect to participate in a particular co-investment opportunity);
• a dedicated “top-up fund” raised alongside the relevant flagship fund, with key investors having priority to make commitments to such a “top-up fund” which then co-invests alongside the flagship fund on a discretionary basis (typically with lower or no management fee and carried interest); and
• dedicated co-investment SMAs raised alongside the flagship fund to provide key investors priority access to co-investments alongside that flagship fund (whether on a discretionary or non-discretionary basis).

In this context, by “co-investment” we are referring to opportunities to invest alongside a flagship fund where that flagship fund is constrained from taking up the entire investment opportunity (rather than separately managed account (SMA) arrangements where SMAs co-invest alongside a flagship fund in all investments by reference to an allocation policy)

Other economic inducements

While less common, some sponsors also offer other forms of economic inducement. These typically include, in order of prevalence from our experience:

• a management fee discount or holiday limited to a particular period of time (for instance, during the fundraising period);
• a reduced carried interest rate;
• a waiver of equalisation interest due on equalisation contributions relating to management fee;
• a reduced carried interest catch-up rate;
• an increased preferred return/hurdle; and
• in relation to open-ended funds and evergreen funds, preferential liquidity terms (for instance, reduced redemption charges).

Some sponsors have also entered the fundraising market offering investors greater optionality through alternative fee structures. For example, managers may provide:

• a standard management fee and carried interest rate; alongside
• a lower management fee paired with a higher carried interest rate (or vice versa).

This added flexibility can be effective in appealing to different investor groups, particularly those constrained by fee caps or other regulatory requirements. However, for managers, it necessitates detailed modelling to ensure that the various options offered do not produce materially different economic outcomes.

Ownership inducements

GP stakes

Historically, the relationship between GP stake transactions and fundraising has often been indirect. This results from the fact that traditional GP stakes funds will normally only look to acquire minority stakes in the sponsor itself, without making a commitment to funds managed by that sponsor.

Nevertheless, having a GP stake investor may still provide certain indirect benefits to a sponsor in terms of its future fundraising. For example:

• there may be reputational benefits, with an investment by a well-known GP stakes investor seen as stamp of approval which in turn gives investors increased confidence in the sponsor;
• the proceeds from a stake sale can be used by the sponsor to grow its business, for example by funding increased GP commitments in a manner that achieves increased alignment with investors, or by funding working capital for new initiatives such as geographical expansion or team hires, all of which may ultimately increase AUM; and
• the GP stake investor is often a strategic partner to the sponsor rather than just a passive owner, and many GP stake investors will emphasise their ability to assist with capital formation by facilitating introductions to investors.

As the GP stakes market has grown and matured, its connection to fundraising has become more direct. We are seeing a rise in in hybrid models where a GP stake investment in a sponsor is directly linked to investor commitments to funds managed by that sponsor.  

These hybrid models often involve innovative structuring, such as equity warrants under which the GP stake investor has the option to increase its percentage ownership stake in the sponsor if it meets certain monetary thresholds in respect of capital commitments to funds managed by that sponsor.

We also see variations on this model where the equity warrants were not linked solely to capital commitments by the relevant GP stake investor. Instead, they are linked to investments made by any investors located in the same geography, on the basis that the sponsor’s association with that investor creates a halo effect which would assist with raising capital in that region.  

A factor contributing to the rise of these hybrid models is the increasingly prevalence of secondary trades by GP stake investors, where the syndication of part of an existing investor’s stake in the sponsor may be linked to the purchaser also making capital commitments to funds managed by the sponsor.  

Another factor is the increasing range of players in the market outside of the traditional GP-stakes funds. For example, investor surveys have shown that sovereign wealth funds, who have previously invested into GP stakes funds, are increasingly considering going direct and taking their own stake in an underlying sponsor, particularly where they may already be an investor in funds managed by that sponsor. Private wealth and family offices are also prevalent in this area - acquiring stakes in sponsors alongside making commitments to their funds. That is in part driven by the wider convergence of private wealth and private capital, with hybrid investments in sponsors and their funds providing an appealing way for private wealth to increase exposure to private markets but without taking single-company risk. In addition, the ability of private wealth to provide patient capital fits well with the nature of GP stake investing, particularly for emerging sponsors.

The growing market, the wider range of players in that market and the increasingly prevalence of hybrid models all provide opportunities for sponsors to actively seek to link GP stake transactions with commitments to their funds.

Revenue-share arrangements

Another trend we are seeing is the increased use of revenue-share arrangements as an inducement to fundraising. These arrangements involve an investor seeding a fund in return for receiving a revenue share from the sponsor equal to a percentage of all of the management fees and carry of the whole fund.

From an investor’s perspective, this can provide more upside than would be achieved through a management fee waiver, as a management fee waiver is capped at the investor’s own management fees whereas the revenue-share operates on a whole fund basis with unlimited upside.

From a sponsor’s perspective, a revenue-share arrangement can be an appealing form of ownership inducement without constituting a full GP stake transaction in the traditional sense, as it only gives away economics in respect of a single fund rather than granting the investor a share of economics referable to future funds. In addition, legally documenting a revenue-share arrangement is easier to implement than a traditional GP stake transaction.

Non-economic inducements

Investors’ non-economic requirements have continued to become more complex over time.  Being able to accommodate a particular investor’s legal, regulatory, tax, ESG and reporting requirements (whether via a side letter or a bespoke SMA) can be key in attracting and retaining investors.

While the more usual non-economic inducements (advisory committee seats, information rights and additional reporting) are well understood, some of the more novel inducements recently offered by certain sponsors include:

• access to sponsor investment teams through regular meetings;
• reciprocal sharing of secondees and offering training to an investor’s investment team;
• participation in an investor’s annual survey programme and presenting at an investor’s AGM; and
• in relation to open-ended funds and evergreen funds, preferential liquidity terms (for instance, shorter lock up periods).

Most favoured nation issues

When a sponsor is considering offering any form of inducement, it will be important to ensure it considers the impact of any most favoured nation (MFN) provisions.

Investors will expect that, at a minimum, they receive the same economic terms (and often non-economic terms) as other investors who have made the same commitment to a particular vintage of a strategy.

Fund sponsors will often try to distinguish the economic terms that are offered to investors based on: (i) date of investment; (ii) wider relationships with particular investors; and (iii) perceived negotiating strength of particular investors.

When offering preferential economic terms (and, in some cases, non-economic terms) fund sponsors need to take huge care in ensuring that, regardless of the legal terms of the MFN provisions, an investor does not, without justification, receive better terms than an equivalent investor.

In a private credit fund context, MFN provisions are more complicated where a fund sponsor establishes a number of SMAs alongside the flagship fund.  Typically, fund sponsors will try to exclude terms agreed in an SMA from being subject to the MFN provisions of the flagship fund and any other SMAs raised alongside the flagship fundraise.  

While separating SMAs from the MFN provisions of other vehicles in the same vintage is common market practice, sponsors must ensure there is some level of transparency around preferential economic terms offered to SMA investors to maintain trust. This is especially applicable given they are ultimately all gaining exposure to the same underlying investment.

Conclusion

Taking a strategic approach to inducements – whether economic, non-economic, or ownership-based – is an important aspect of any successful fundraise. Sponsors are best placed to succeed when they define, from the outset, the range of inducements to be offered to investors and ensure that these are supported by a robust MFN framework that allows for a tailored yet consistent approach. Sponsors should also consider how any GP stake transactions may intersect with their fundraising strategy.

Finally, seeking the guidance of placement agents and conducting market testing with key investors and investment consultants are essential steps to ensure a consistent and transparent offering throughout the fundraising process.