The rise of 'Super Carry'

Back to 2006 again? Top funds charging higher fees and LPs still rushing to subscribe?

However, it is good to know that some of the large institutional investors are happy with the 'alignment of interest': “Super carry is not necessarily something investors are entirely comfortable with because levels of reward and alignment are already healthy at the moment.”

Here is the must read FT article on the subject:

The rise of ‘super carry’ unsettles private equity investors

Big buyout groups are upping their share of profits from 20 to 30 per cent on some funds

Some of the largest private equity groups are raising the performance fees they charge investors to well above the industry’s norm at a time when institutions are fighting to put money into the best funds.

Institutional investors are in some cases paying 30 per cent in “carried interest” — the share of profits taken by the private equity groups — up from the traditional 20 per cent share of profits that the industry has charged for decades.

Funds charging this “super carry” have been launched recently by Carlyle Group, Vista Equity Partners and Bain Capital in the US and EQT, Eurazeo and Altor in Europe. Advisors to large private equity funds have defended the rise of “super carry”, arguing it is only the top-tier funds with stellar results that can get away with it.

They also say that higher carried interest often depends on higher returns, or lower management fees, and is usually optional. But the practice has unsettled some investors. Graham McDonald, head of global private equity at Standard Life Aberdeen, one of the UK’s biggest institutional investors, said: “Super carry is not necessarily something investors are entirely comfortable with because levels of reward and alignment are already healthy at the moment.”

“The pendulum has swung in terms of fundraising principally due to the wall of capital available and managers are taking the opportunity to improve the terms in their favour,” he said, adding: “Investors are feeling a bit sore about it.

Neil Harper, chief investment officer at Morgan Stanley Alternative Investment Partners, said the introduction of higher performance fees has been accompanied by increasingly aggressive behaviour by some groups. Speaking at the recent SuperReturn conference in Berlin, he said: “You end up having interactions with people who deal with their investors in a professional manner but you get others who develop a huge amount of arrogance.“

A rise in carried interest hit the industry during the boom years leading up to the financial crash in 2008 but it went away when funds struggled to raise money in the lean years that followed the crisis.

“Twenty per cent carried interest has been the market norm across the industry for decades so it is very hard to shift,” said Jason Glover, a London partner at law firm Simpson Thacher, on the sidelines of the Berlin event.“

However, there is clearly an argument to say that significant outperformance would merit even greater rewards. In that context, there is the opportunity to be able to charge higher carry.”

Investors worry that private equity groups can dictate terms when they are able to raise funds at their fastest pace since the crash. Buyout groups take on average 12 months to raise a fund compared to 20 months in 2010, according to Preqin.

“This shows a complete rebalancing of power in favour of buyout funds,” said the head of a multibillion-euro private equity group in Europe.“[After the crash] the industry was shaking like rats in a cage because of fears that we were going to have to reduce our carried interest and, lower our management fees.”

In the US, Bain is raising its second life science fund and it is giving investors an option to pay a 1 per cent management fee — which is lower than the 2 per cent usually charged — in exchange for 30 per cent carried interest.

Bain’s fund, which is seeking to raise more than $800m, is also ditching its hurdle rate — the return that must be met before a buyout group can claim carried interest. Bain’s first life science fund has a hurdle rate of 7 per cent.

In Europe, Sweden’s EQT has been charging some investors lower management fees in exchange for higher carried interest of 25 per cent in some recent funds, according to multiple people familiar with the move. Still, people close to EQT said the trade-off was optional. All companies declined to comment on the terms of their funds, except Altor, which did not respond to requests for comment.“

It’s about supply and demand,” said a legal adviser to private equity investors. “This is another example of private equity groups grabbing power in a hot market.”

This is not the first time buyout funds have tweaked the terms of their engagement with their investors. In 2016 Advent International, the Boston and London-based group, lost some longstanding investors after it dropped its hurdle rate for its $13bn flagship fund. Recommended Private equity Upstarts challenge private equity’s top tier CVC Capital Partners, the former owner of Formula One racing, cut its hurdle rate from 8 per cent to 6 per cent. CVC also scrapped early-bird discounts for initial investors.

Investors seem to have a weak hand when it comes to negotiating terms. Large institutions — under pressure to seek yield in a low interest rate environment — do not complain about terms because they fear being cut back or being completely excluded from a popular fund.

“Investors are fairly open-minded on terms for excess returns,” said Mounir Guen, chief executive of the MVision placement agency, which helps funds raise capital.

Michael Wolfram of Bfinance, a London-based financial services consultancy, said at the recent Berlin event that not every investor is accepting new terms but that “if private equity still delivers more than public equity then regardless of the fee level that’s fine”.

Some investors regret not pushing for better terms when they had the chance. Fondly remembering a short period after the 2008 financial crisis when investors “actually called the shots,” Robert Coke, who runs the Wellcome Trust’s £3bn private equity portfolio, said at the Berlin conference: “It was fantastic. I still think of all the things I should have tried, but didn’t.”

Buyout bosses, on the other hand, are conscious of the risks of being too cocky. “These relationships are long and investors remember when you try to take advantage of a situation,” said Joseph Baratta, global head of private equity at Blackstone in New York. “We’re not trying to optimise every penny.”