I recently sat down with my asset management colleagues, Emily Brown in London, and Vince Ip and Chune Loong Lum in Hong Kong, to consider what drives a successful GP-LP relationship in the current climate.

With a choppy fundraising climate and uncertainty about broader global macro trends, both GPs and LPs are nervous these days. Many of our GP clients are asking how they can lure committed LP capital while preserving flexibility for their longer-term success. At the same time, LPs are particularly focused on how they can ensure GPs deploy their capital with appropriate discipline and are wondering what the most meaningful “asks” may be as they negotiate new fund commitments.

While there have been some banner fundraises lately, bluntly, it is harder to raise capital. Some LPs are liquidity-constrained because of the recent mismatch between fundraising and exits – as GPs are coming to market with new and larger funds more frequently, the pace of exits has not kept pace.

Further, some LPs’ portfolios are skewed away from their target allocations between public and private investments because of recent declines in the public markets, particularly as private valuations tend to lag public company marks. Depending on where an LP sits, currency rates can also play a role. For example, with the decline in the British pound, some UK LPs have found themselves comparatively capital shy in terms of their available capital for commitments to non-GBP denominated funds. Another factor at play is that a number of LPs have been concentrating their portfolios with a smaller number of managers than in years past.

Meanwhile, target fund sizes keep growing, and meeting those targets is proving harder. Many GPs are finding that it is taking longer to get from their first closing to their targets and that they are having to raise capital from more LPs to reach a given target. The challenges faced by a GP depend on the sector and historic returns, among other factors but, as a general matter, most GPs would admit it’s harder to raise capital today than it has been in the recent past.

And therein lies a quandary for GPs: What concessions can they make that are likely to help lure dependable capital commitments without making promises that hurt the larger platform? How can they cement their relationships with existing and new LPs? Are there structural options a GP can offer to nudge LPs toward larger and longer-term commitments?

A few “carrots” that GPs have found useful in the past have included:

  • Access to coinvest opportunities – whether on a deal-by-deal basis or through dedicated overflow or sidecar vehicles.
  • Economic enticements such as early closer discounts or size-based fee discounts.

We are seeing GPs offer both types of arrangements to significant LPs, but quietly we also are seeing GPs ask if they should be offering more to lure commitments from certain “high value” LPs.

All of our GP clients – whether larger and more established sponsors, smaller sponsors, or sponsors marketing newer strategies – are keenly focused not only on how they can attract capital, but how they can attract those commitments from LPs whose participation in a fund may help with fundraising and/or whose capital they anticipate to be “stickier” over the years to come.

Coinvestment opportunities

Larger LPs are often expecting both economic concessions (particularly if they come in at the first closing of a fund) and a certain level of coinvest allocation. That said, some of the larger LPs may be comfortable relying on soft comfort with respect to coinvest allocation, on the basis that the GP is more likely to reach out to them to offer coinvest opportunities, because the value of maintaining a relationship with a large LP dwarfs that of keeping a smaller LP happy (and also because as a practical matter many of the larger LPs have the institutional resources to evaluate coinvest opportunities quickly, as well as the capital to execute on such opportunities).

Some GPs are, however, trying to lock in their relationship with an LP through how they structure coinvest priority provisions in the LP’s side letter. For example, a GP may condition a certain volume of coinvest opportunities upon the LP’s investing at least a certain threshold with the platform over a few years. 

These provisions can be very granular: For example, if the LP invests at least $250 million with the platform – and note these provisions are often phrased with respect to the platform rather than a particular fund, as ultimately the GP is focused on raising reliable capital more generally – then the GP will guarantee coinvest capacity of at least an agreed percentage of the LP’s commitments to the platform. It’s effectively a back-door way to a fee discount for the LP, but documented in a way that can sit outside the reach of typical MFN provisions, so doesn’t erode fees more generally.

Economic enticements (and penalties)

In some cases, the GP also conditions economics with respect to the coinvests on the LP making those commitments to the platform – expressly stating that if the LP doesn’t make those commitments by a set date, any coinvests after that date will bear economics. (Note that these ‘penalty’ provisions typically do not apply to coinvests that are consummated before the deadline, so they serve only to caution the LP that if it doesn’t make the targeted commitments, coinvesting won’t be as attractive.)

These provisions can be mutually beneficial. From an LP’s perspective if the relationship proceeds as anticipated, the overall economics and exposure are improved. From a GP’s perspective, this can be a way to incentivize an LP to commit more broadly to the platform (a softer form of requirements we’ve seen GPs impose in the past where any LP that wants allocation to a ‘hot’ fund also needs to make a commitment to a fledgling strategy).

While still not common, we also are seeing more requests for stapled commitments by GPs as secondary buyers acquire interests in older funds or even stapled commitments in connection with access to a coinvest opportunity. Note that staples can be a shade thorny from a conflicts perspective for a GP.

Negotiating new fund commitments

Flipping hats, a number of our LP clients have been particularly focused on what they should ask for when negotiating new fund commitments. There’s been a general erosion of terms in favor of GPs over LPs in recent years and, with the current fundraising climate, LPs are asking us where they should focus their efforts to reverse some of that slippage.

For example, in recent years some of the core tax protections in LPAs have been softened materially and we are seeing LPs start to press for more protections. Likewise, LPs are demanding more oversight over conflict transactions – asking that related party transactions be presented to a fund’s LPAC for approval rather than a weaker standard where LPAC consent is at the GP’s discretion.

Many LP clients are also particularly focused on including protections to ensure the sponsor is properly disciplined, particularly given the choppier and rapidly evolving macro climate. For example, clients have been worried about the pace at which GPs have been deploying capital, particularly given concerns about a potential recession, and have been including speed bumps to manage the risk of an overly exuberant GP. LPs also are very focused on sector and/or style drift as GPs face tougher market conditions and have been focusing on appropriate guardrails.

Another commercial item that’s been receiving much more focus recently is borrowing, particularly given the rise in interest rates over the past year, and many LPs are more focused on the use of leverage by funds, with particular focus on how leverage caps are defined (as some sponsors have tried in recent years to exclude certain types of leverage from the caps entirely), and whether the proposed caps are appropriate for the anticipated strategy both in terms of time and amount. 

Clearly, we’d all agree that navigating these issues in a way that suits both GPs and LPs is in the longer-term interests of both.

For more information on this topic or other areas of interest to the asset management industry click here, and if you would like help in navigating any of the topics discussed, please don't hesitate to get in touch with a member of the team.