By Jonathan Blake, O’Melveny & Myers
The year 2017 has been another record year for fund raising, with global fundraising levels exceeding those preceding the global financial crisis. This trend has been strongly contributed to by a number of mega funds which are getting larger fund by fund and are often oversubscribed. In the mid-market, however, there have been a few notable failures of fund managers to gain momentum in their fund raisings, even where their track records have been reasonably strong. A mid-market fund needs to tick all the boxes in order to gain momentum and raise capital quickly, but if it does so it is also often oversubscribed. This polarisation has an effect on terms and conditions. It has always been the case that a poorly performing fund cannot gain momentum by offering cut price terms, which leads to a tendency for there not to be much competition on terms even for averagely performing funds. However, super performing funds are increasingly able to command better terms like more preferential carried interest waterfalls, better management fees, lower or zero hurdle rates, US deal by deal style fund waterfalls even in Europe and also some funds with elective waterfalls where investors can choose between, for example, a standard management fee with a 20% fund as a whole carried interest subject to an 8% hurdle and a lower management fee with a deal by deal waterfall.
We are also seeing something of a trend in some cases towards longer term funds, partly because many funds are exceeding the standard ten plus two or three year term set out in their partnership agreements. Some of the large funds of funds are reporting that the average life of a normal ten plus two year fund in which they are investing is 15 years with some lasting more like 20 years. Limited partnership agreements are often silent about what happens when the fund continues beyond its stated life. So some funds are being raised with longer terms such as 15 years with extension or even 20 or 25 years, particularly in longer term asset classes like venture capital and infrastructure but also in some cases for private equity and growth capital. In some markets, and in some asset classes, e.g. Africa, Venture Capital and Infrastructure, there is a tendency in certain cases towards permanent capital vehicles either on the basis that they are able to reinvest the proceeds of sale of realised investments on an unlimited basis or with a fixed long term liquidation date. The question then is how investors exit such a vehicle. This can either be by the vehicle being quoted, but in many cases the secondary market is now active enough that people often just rely on that. Another question affecting permanent capital vehicles is how to incorporate a carried interest. In some cases the permanent capital vehicle invests through successive limited partnerships, each being set up with a 1 to 3 year investment period and then continuing so that each successive vintage limited partnership looks more like a normal limited partnership fund and incorporates a normal carried interest. Others have arrangements for the carried interest to take the form of a share in the fund either through options or through automatic conversion at valuation taking place every year or at regular intervals.
Some managers who either have no track record or who prefer more flexible arrangements are raising funds on a deal by deal arrangement. Although this has the disadvantage that they are having to look for funding at the same time as closing each deal, it has the benefit of giving a deal by deal carried interest. We are also seeing some pledge funds which are funds where the investor is able to choose which investment to invest in and maybe are paying a lower fee on a commitment basis with most of the fee being on a draw down basis.
The use of structured secondaries is gaining momentum to deal with a much wider variety of liquidity solutions. Whereas some of these strategies using secondaries were originally principally seen in distress situations, they are now part of normal investment management. Much of the secondaries market is now focused on more innovative solutions combining secondaries with new funds or giving investors increasing choices. Thus, we are seeing secondaries being offered to investors to receive liquidity on an elective basis for the investments that have not yet been exited and investors are given a choice between either selling their interest or approving the sale of the assets to a new fund managed by the same manager. Alternatively they can sell at valuation. There have been some objections to these arrangements if the investor is not also given the option of doing nothing and remaining in the same fund. There are also stapled secondaries where a secondary of investments in a particular fund or of the underlying portfolio of a particular fund is offered to a secondary investor on the basis that they can only acquire these interests if they also invest in a new fund. In some cases the existing interests are rolled into the new fund and in some cases the secondary relating to the old fund is separate from the new fund. Some fund managers are also making a secondary facility available to existing investors whereby they can sell their interests in prior funds of the same manager and the liquidity is used to help the investors invest in a new fund.
I always think that one of the best indicators of the market is the attendance at conferences themselves and at the SuperReturn International conference in Berlin this year the attendance was at a record level of over 2,300 attendees, and there was also a separate conference SuperVenture being run by the same organisers for venture capital, itself showing increased confidence in the venture capital asset class. While different speakers had slightly different predictions, most of them were saying that, although the current strong market could come to an end unpredictably, the economic indicators were not currently indicating that the market was about to crash. So perhaps, on a cautious basis, we can look forward to the market continuing to be strong for a few more years.
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