Competing interests?
This brings us to the issue of fairness more generally in CVs and the potential for conflicts of interest in these deals. As Luepertz points out: “CVs are an interesting setting because you have three parties at the table. There are the existing LPs in the legacy fund, the new LPs in the CV – which may also be existing LPs – and the GP, which has to manage both and represent all three parties, even though they have competing interests.”
The Luepertz et al paper finds that the financial incentives for GPs to launch CVs include carried interest resets and management fee extensions. “We wanted to quantify the economic effect on the GP of doing a CV,” explains Luepertz. “We found that CVs typically charge around 1% on invested capital in a CV; that compares with the 2% management fee during the five-year investment period that you’d see in a typical buyout fund, so it’s a lower headline rate. Say you invested US$100m originally, you’d be getting 2% on that in the legacy fund. But that asset may have doubled or tripled in size since then and fees are paid on this new base in the CV. So if you transfer it into a CV, you may not be getting substantially more each year, but you are extending that fee duration. That provides quite a strong incentive.”
Given the potential for conflicts of interest, Jolly highlights the need for GPs to manage CV transactions carefully. “CVs are not straightforward from a governance point of view,” he says. “There needs to be a watchful eye on how these transactions take place to ensure that governance and transparency challenges are addressed. Overall, these have improved a lot, but LPs have sometimes been more forceful in calling out situations they don’t think have been appropriately handled, and that is no bad thing.”
Many LPs opt to sell not just for resource or liquidity issues. If they have made a return, they can take capital off the table and deploy it elsewhere in investments that make sense to them. I’m not surprised many opt out. It doesn’t mean it’s a bad investment; it’s just not for them any more.
Gregorio Marini Clarelli, PFC
Jolly adds that, quite frequently, managing this well comes down to effective communication. “LPs’ concerns tend to centre on information,” he says. “In some instances, LPs may feel that they don’t have enough information to evaluate a transaction, while in others, there is too much for them to go through. GPs need to provide the right information and transparency, and communicate things in the right way.”
In practice, this means being crystal clear about what a GP is proposing, Jolly explains. “LPs should be asking GPs what return they expect for the CV,” he says. “But they also need help to understand the mechanics of the process as the asset goes from the fund to the CV and the cash flows that happen in and alongside that. There isn’t a standard approach, so GPs should straightforwardly spell out items such as, this is the crystallised carry from the initial investment, this is the carry that is being paid out to the team, this is the carry that’s going into the CV.” There are plenty of incentives to get this right and, perhaps more importantly, to ensure that the asset, or assets, in the CV perform well. And carried interest rolling over into the new fund is not key among them, according to Marini Clarelli. “I see that more as a marketing tool,” he says. “Actually, what really matters is that if things go south, their LPs get penalised, and the future fundraising prospects and performance of the overall manager will be impaired. That’s much more of an incentive.”
Luepertz agrees. “The conflicts of interest inherent in these deals are relevant for LPs,” he says. “But aside from mitigating factors, such as new terms and following industry guidelines, we find that reputation plays a big role in ensuring the conflicts are managed well. GPs do not want to risk their reputations with their investor bases for what are essentially side vehicles. Their flagship funds are still the most important ones for GPs to consider.”
