Investors in US mid-market private equity funds continue to flex their muscles 


Financier Worldwide Magazine

October 2014 Issue

October 2014 Issue

The 2007 financial crisis precipitated a shift of the balance of power in US-based mid-market private equity funds from general partners (GPs) to investors. Prior to the crisis, abundant capital and high rates of return created an environment where GPs generally dictated investment terms to investors on a take-it-or-leave-it basis and, as a result, investors often did not pay close enough attention to some of the more material terms of the fund. Investors with the temerity to ask the GP for concessions were often unsuccessful. If a fund’s governing documents were too GP-friendly for one investor, there was inevitably a long line of other investors willing to pony up capital. With the financial crisis, however, even successful GPs found themselves competing for capital and the halcyon days of no questions asked, GP-friendly terms, were over. Investors, buoyed by their newfound economic leverage and the assistance of sophisticated counsel, began demanding – and receiving – concessions from GPs. Even as the economy has begun to improve, investors in mid-market private equity funds have remained successful in negotiating more favourable investment terms.

The rise of the European waterfall and full fee offsets

The clearest evidence of the shift in power from GPs to investors is the rise in use of the European distribution waterfall over the American distribution waterfall. In the American waterfall, investment proceeds go through the waterfall on a deal-by-deal basis. This means that when the fund sells a portfolio company, the investors will only receive back their capital contributions (and a preferred return) relating to that deal and then, if there are proceeds left, the GP will receive its carried interest. In a European waterfall on the other hand, when the fund sells a portfolio company, the GP does not begin to receive any carried interest until the investors have received back all of their capital contributions (and preferred return) to date, whether or not such capital contributions relate to the deal at hand or other portfolio companies that have not yet been sold.

From the investors’ standpoint there are typically two key issues with the American waterfall – first, the investors’ internal rate of return (IRR) generally suffers compared to the European waterfall because the investors are waiting longer to receive a return of their invested capital. Second, if there are big ‘home runs’ with the fund’s early divestures, the GP may receive carry that later needs to be returned (through the GP clawback mechanism at the end of the fund’s life) and there is the risk that the GP will default on this clawback obligation. The European waterfall on the other hand is a whole-fund model, through which the GP does not receive its carried interest until investors first receive all of their contributed capital and preferred returns. In addition, the European waterfall arguably creates a greater alignment of interest among the GP and the investors on each portfolio investment.

Prior to the financial crisis, the highly GP-friendly American waterfall was commonplace for US funds, while the investor-friendly European waterfall was most often seen in non-US funds or funds without a track record. Post crisis, the European waterfall has gained traction and many mid-market US funds have fallen in line. In funds where the American waterfall is still used, investors have seen some of their concerns mitigated by a variety of provisions that address the default risk on the GP clawback. For instance, interim GP-clawbacks (say, at year seven of the fund and yearly thereafter) have become the norm. Providing for interim clawbacks eliminates the concern that there will be an extremely large clawback at the fund’s dissolution. Investors have also been successful in requiring that the GP escrow a portion of the carry in addition to the customary personal guarantee of the clawback by the GP’s principals. This helps ensure that the money will be available to fund any clawback. Less often, investors have been successful in negotiating minimum value tests or payout tests to address these issues.

Investors have also seen improved economics by pushing for full fee offsets. Historically, GPs made a not-insignificant portion of their money through various directors, consulting, break-up, monitoring and other fees levied on the fund’s portfolio companies. Today, the majority of mid-market funds provide that 100 percent of these fees will be offset against the GP’s management fees. In those funds that do not have 100 percent offsets, it is rare to see more than 20 percent of such fees going to the GP with the remaining 80 percent being offset against the management fee.

Given these trends, investors have not been hesitating to push back on GP-favourable economic terms.

Continuity of control by principals

To potential investors, the identity of a fund’s principals is perhaps only second in importance to a fund’s track record. The principals are the fund’s management team – they control the GP and the fund’s investment decisions (through the GP or the investment manager). All too often, however, fund documents provide cursory information at best regarding the ownership of the economic and managerial control of the GP/investment manager (other than to say that the GP/investment manager is controlled by the principals). In addition, some fund documents provide for potential changes in the ownership of the GP/investment manager without input from the investors. Without a firm understanding of the fund documents and a careful review of the interplay between various fund provisions, investors may discover that a fund’s management team has materially changed over the life of the fund and that the folks they thought they were investing with have moved on. Increasingly, investors have been pushing GPs to provide assurances that this will not be the case.

It is becoming more common for potential investors to seek to understand, at a minimum, what percentage of each of the GP/investment manager is owned by the fund’s principals in the aggregate. Even more useful for investors is to understand how such ownership is allocated among the individual principals and to review the GP/investment manager documents, including relevant organisational agreements, to understand the internal dynamics at play. This information allows investors to assess whether the key principals have enough skin in the game, or whether third parties or employees other than the principals currently have, or in the future could have, too much control. This information is also critical to assess a fund’s viability in the event of an internal crisis where the principals don’t see eye-to-eye or a principal leaves or dies. It further helps determine methods to protect investors’ capital in the event there is a change in key persons.

Key partnership agreement terms to assess the continuity of control by fund principals include covenants requiring the principals to control a specified percentage of the economics and management of the GP/investment manager, key person provisions and the flexibility given to the fund’s advisory board to approve new principals. The advisory board provision is a recent hot topic for investors, with investors speaking up against provisions that allow the advisory board to replace fund principals without input from investors. Since the financial crisis, investors have been having more and more success in negotiating continuity of ownership provisions, having input in approving new principals and asking to review the organisational documents of the GP/investment manager.

Co-investments vehicles with legitimate purposes

One area that has the potential for abuse is the use of co-investment vehicles, which are investment entities set up by the GP to allow investments in portfolio investments outside of the fund. The fund, the investors and the GP can all benefit where co-investments are used to facilitate the consummation of an investment that the fund does not have full capacity for, or to permit a strategic partner of the fund’s targeted portfolio investment to co-invest alongside the fund. Trouble can arise, however, where co-invests are permitted outside of these limited scenarios. Many funds contain broad co-investment provisions that allow the GP to allocate portfolio investments to non-investors, just certain investors or even the principals with few limitations. With these open-ended provisions, there is the potential for the cherry-picking of portions of the fund’s best investments for the benefit of non-investors.

Since the crisis, investors have been more successful in prescribing the conditions where co-investments are permitted – for example, for limited strategic purposes or if the fund does not have the capacity to take the full investment itself. In addition, investors are now insisting that the terms that apply to other parallel vehicles apply to co-investments as well – any co-investment in a portfolio company will be made and sold at the same time as the fund’s investment and all on the same terms. Another investor push is to require that the fund’s advisory board bless co-investments in order to help alleviate conflicts of interest.

While investors are still viewing fund documents holistically in making their demands on GPs, and while some GPs remain unamenable to investor requests, there has been a definite shift to more investor-friendly mid-market private equity fund documents. Indeed, certain pro-investor terms which pre-crisis were the exception are now the norm. Thus, despite the current more favourable fundraising environment, GPs may find it difficult to go back to those halcyon pre-crisis days.


Michael B. Gray is a partner and chair of the Fund Formation & Investment Management practice group, Kurt J.H. Mueller is counsel and Chloe A. Milstein is an associate at Neal, Gerber & Eisenberg LLP. Mr Gray can be contacted at 1 (312) 269 8086 or by email: Mr Mueller can be contacted at +1 (312) 827 1045 or by email: Ms Milstein can be contacted at +1 (312) 827 1081 or by email:

© Financier Worldwide


Michael B. Gray, Kurt J.H. Mueller and Chloe A. Milstein

Neal, Gerber & Eisenberg LLP

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