Assignment 1

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Advantages:

1. Limited liability: LPs have limited liability, meaning their personal assets are shielded from the fund's
liabilities. Their risk is limited to the amount of their investment (minimum MoIC of 0.0x).

2. Tax advantage: LPs benefit from tax advantages, such as pass-through taxation, where profits and
losses pass directly to the investors' personal tax returns.

3. Passive investor: LPs have a passive investment role, requiring no expertise for fund management.
They contribute capital without engaging in day-to-day operations, relying on the GPs to leverage their
expertise in fund management. LPs simply write a blank check before the fund, entrusting GPs to make
decisions in their best capacity for the fund's success. This arrangement enables LPs to concentrate on
their own areas of expertise and activities.

4. Diversification: With minimal responsibility placed on LPs, they can invest in multiple funds without
the need for direct management, resulting in diversification. This approach allows LPs to gain exposure
to a varied portfolio of investments, effectively spreading risk and augmenting the potential for returns.
As discussed, Manulife does the same to achieve diversification for its infrastructure and other
alternative investment mandates.

5. No direct ownership: LPs can access exposure to PE companies without direct ownership, a practice
that aligns with regulations in certain regions where direct ownership may not be permitted. For
example, insurance companies like Manulife are restricted from directly owning PE companies.
Nevertheless, the GP-LP structure serves as a workaround, enabling these institutions to access exposure
to PE companies without holding direct ownership.

6. Co-investment opportunities: LPs can gain access to higher deal flow from co-investment
opportunities. Drawing from my experience, the organization I am associated with has made several
small investments as an LP. Whenever a portfolio company experiences significant growth, the GP
provides an opportunity to participate in these companies as a co-invest (to potentially lead or co-lead
the round), allowing us to double down in breakout PE companies.

Disadvantages:

1. Lack of direct control: LPs lack direct control over investments, as decision-making authority resides
solely with the GP. Attempts to address this issue include incorporating terms in LPAs related to
investment discipline, including but not limited to the terms related to the fund's strategy, the number of
investments, EBITDA range for target companies, geographic focus, and guidelines to prevent
overconcentration in a single company. Nevertheless, despite these safeguards made in the LPAs, LPs
cannot directly control or force the actions of the GP.

2. Management fee and carry: LPs are charged significant fees, which result in drag in return profile. The
standard PE fee structure includes a 2% p.a. management fee and a 20% @ 8% carry, which is
considerable. In my experience, VC funds achieving an impressive gross IRR above 40% often see a drop
to the mid to low 30% range due to the drag effect of fees, which is significant.

3. 10-year fund term: LPs typically commit to a 10-year term, which is relatively lengthy. While secondary
sales offer an avenue for exiting the investment, the LPA (usually as part of the side letter) may contain
provisions protecting the stake from selling. Based on experience, this safeguard is particularly prevalent
for cornerstone LPs, often defined by significant ticket sizes.

4. Limited cashflow visibility: While the LP capital is not called all at once, which is a positive aspect, LPs
must consistently maintain available cash for drawdowns or capital calls happening during the
commitment period. This requires ongoing liquidity for LPs. Furthermore, since LPs lack control over the
managed deals, GPs may autonomously decide when to distribute capital. Based on experience, GPs
occasionally retain capital for reserves (this happened a lot during the COVID-19 when real estate PE
funds stopped distributing cash to build reserve) or recycle it for new deals without immediate
distribution to the LPs.
LBO funds diversify their investments across PE companies, typically ranging from 5 to 15, depending
upon various factors such as the strategy, the fund's size, market focus (low or mid-market), among
others. In situations where one LBO investment within the fund faces challenges (has gone under), yet
the GP still collects carried interest, it is likely due to the fund's overall profitability was positive,
potentially driven by the success of other investments outperforming investments. There is a possibility
the other investments in the portfolio may have not only recovered the capital loss of the specific
company but also produced significant returns, pushing the overall IRR beyond the 8% hurdle. As such,
even if a specific company within the fund goes bankrupt, the GP may still collect carried interest based
on the fund's overall performance.

On a side note, the GP's ability to collect carry at the end of the fund's life suggests the use of a
European waterfall structure for performance fee.

In the scenario of an American waterfall structure, the calculation of the performance fee would occur
on deal by deal. Even in this case, there could still be a situation where the GP has the opportunity to
receive carried interest based on the exceptional performance of specific companies.

Recallable distribution?
The likelihood of competition between the growth equity and buyout funds is minimal due to differences
in strategy, target companies, and team focus, as explained below:

Growth equity focuses on companies in the Series B to E+ rounds, after these have developed products,
getting product-market fit, gaining some initial traction and ready for potential takeoff. These companies
typically exhibit strong revenue growth (revenue CAGR of greater than 100%) with EBITDA profitability in
sight in the near future. The primary need capital injection for growth equity companies is to accelerate
revenue growth and make them breakout companies.

The LBOs are completely different with focus on companies that are more mature but encountering
challenges, marked by stagnant or slow revenue growth. In some cases, revenue growth may even be
negative, with profitability under pressure. The PE firms pursuing buyouts seek 100% (or majority)
ownership of these targets to revitalize these companies, expedite growth, and enhancing profitability
by addressing inefficiencies overlooked by the existing management.

There are examples out there, such as HIG Capital, they have both growth fund and LBO fund, which do
not compete with each other.
A GP with a strong track record spanning several funds is likely to have a positive impact on the terms of
the LPA when raising a successor fund (positive impact for GP and negative for LP). The strong track
record serves as a testament to the GP's ability to generate strong returns for the LPs. There is research
that shows that top quartile GPs continue to provide strong returns, therefore this provides negotiating
leverage for the GP when it is finalizing terms with the LPs.

The following terms could be negotiated:

Some top-quartile VC firms deviate from the standard 2% annual management fee, opting for higher
charges up to 2.5-3% p.a. Similarly, certain private equity firms have been known to charge as much as
25% carried interest, surpassing the conventional 20% due to their strong performance. As discussed in
class, negotiations with LPs can lead to adjustments in the hurdle rate, potentially lowering it from 8% to
6%, with a 100% catch-up rate (as a 0% catch-up is unfavorable for the GPs). Moreover, the GP might
introduce an American waterfall structure, on a deal-by-deal basis, without imposing any clawback
provisions, a fee charging mechanic that may be unfavorable for the LPs.

Negotiations may also grant GPs more flexibility in the commitment period and fund term, potentially
introducing extensions, often structured as 2 x 1-year extensions. In addition, a GP's successful track
record can help to raise the minimum acceptable ticket size from the LPs, as well as facilitate the raising
of a larger successor fund and putting a higher cap for the fund.

Drawing from experience, prominent VC firms like Sequoia and Andreessen Horowitz (A16Z) often
leverage their strong performance to selectively choose LPs for the GP-LP relationship, highlighting the
significance of a successful track record in shaping the terms of LPAs and eventually fund management.
Over the 10-year life of a fund, economic conditions, interest rates, and market dynamics can experience
substantial shifts, potentially rendering the initially agreed terms, such as 8% hurdle rate inappropriate.

During the fund's 10-year term, extreme events, similar to the interest rate surge experienced in 1981
when the 10-year treasury rate reached ~16%, could render the 8% hurdle rate unreasonable and
impractical. Based on brief research, 10-year treasury rates were consistently higher than 8% for 17
years, from 1974 to 1991. [In this example, the 10-year rate has been used for like-for-like comparison.]

Consider another example: the 10-year treasury rates were near 0% in mid-2020, but they had surged to
almost 5% by late 2023. This drastic change implies that the premium associated with the 8% hurdle rate
plummeted from 800 basis points to 300 basis points in less than three years.

Therefore, considering the above examples, it is safe to say that there are challenges in relation to the
uncertainty about the relevance of the predetermined hurdle and other terms in the LPA, which are
accepted at the start of the fund’s term.

Nevertheless, LPs may choose to continue committing to successor funds, acknowledging the inherent
uncertainty as no one possesses a crystal ball to predict whether the agreed-upon terms will become
unreasonable over the holding period of 10 years. The analysts typically form a view on the manager
based on the information available to them, including but not limited to the track record, cross-cycle
experience, re-up rate and conviction by the other LPs, stability and experience of the team, and market
outlook. If everything checks out and given that the analyst does not have any solid ground that the term
in the LPA would become irrelevant in the future, they are most likely to recommend and continue to
commit.

In the case where analysts foresee potential deviations in interest rates and economic conditions, a side
letter can be executed with provisions aligned to their views. These provisions might include trigger
clauses, such as a readjustment of the hurdle rate if interest rates surpass a specified threshold, allowing
LPs to safeguard their interests based on specific expectations.

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