It’s no secret that private debt fundraising is a tricky business at the moment, particularly in Europe. The asset class had enjoyed steady growth from 2016-2021, but 2022 bucked this trend.
Chief amongst the reasons for this recent slowdown are the denominator effect, rising risk of defaults, and general uncertainty about senior lending’s place in the coming years.
All this means that rumours about discounted private debt funds are starting to circulate. One consequence of this is that private debt secondaries could take off, as a steeper discount on existing portfolios opens up their purview to a wider universe of funds. Another is that desperate fund managers (particularly those that are new or newer to the European private debt landscape) are beginning to get creative with the incentives they offer to large investors to come into their funds in the first place.
But something new is also potentially in the works. Last week rumours circulated that a large European private debt fund was raising on a “fee-only” basis, meaning that they pay only the management fee (usually 1.5/2%) and there is no incentive-based performance fee or carry (usually 20% of returns over a 6-8% hurdle).
The rumours are likely just that, but several private debt managers reported suggestions of big LPs demanding big discounts on fees in order to secure commitments.
Most private debt funds offer an “early bird” discount for investors that commit before the fund holds a first close, and this is a commercially sensible decision. For one thing it mitigates the J-curve effect where an early investor in a fund actually gets a lower IRR than one who comes in just before final close because their capital is put to work quicker, but also it helps a fundraiser build momentum, as potential investors often look for clusters of other well-known limited partners to reassure them of the decision to make a commitment.
But pushing fund managers to give up a significant portion of their performance-based incentive fee, either in part or in full, could turn out to be a false economy.
You don’t have to look too far in European private debt to see what happens when a team is not properly incentivised to ensure robust credit work is done. The deployment may be ok, but if the team members that did the deals have little reason to stick around and see them through to realisation, limited partners may rue their decision to hold back on carry. After all 80%, 90% and 100% of returns over 6% are the same number if the fund return never gets over the line at all.
An important lesson from private equity is that when funds get bigger, it is the management fee that tends to be discounted. After all, 2% of a $25bn fund is still enough to make a lot of people very rich, before taking into account the performance of their investments at all, and — despite the track record needed to get to that size of fund — it’s not really the incentivisation structure you want either.
Private debt is still a way off of these fund sizes (especially in Europe) so cutting the management fee is probably a premature solution. This is particularly true for first time managers that need cash to get up and running, so anyone considering it as an option should think carefully before trying to reinvent the wheel.