The relationship between GP commitment and fund’s returns

In the previous article we introduced the concept that Qualitas Funds seeks to forecast the returns of a private equity fund based on Key Success Factors (KSF). Although these elements are not capable of guaranteeing a fund’s returns, a thorough and insightful analysis of certain variables that influence results allows us to evaluate future opportunities based on experience and statistical analysis. The selection of these key variables can be carried out thanks to a robust and exhaustive collection of information that Qualitas Funds carries out, which allowed it to build a large proprietary database full of this sector’s knowledge. Within this dataset, c.50 variables are identified for each fund through the Scoring tool, which allows comparing the available opportunities and choosing the most interesting ones. The Scoring results in an x-ray of the fund which is analyzed by different categories that include the key variables. In this article, we look at one of the main metrics: the commitment of the management team (also known as General Partner commitment or GP commitment).

The GP commitment refers to the capital contribution made by the management team in relation to the size of the fund they are fundraising. Following the industry standard, the average manager’s contribution is typically 2%¹ of the final fund size, a commitment through which the manager promotes its alignment with the investors’ interests (also known as Limited Partners or LPs). By contributing its own capital to the fund the manager provides a clear statement and implicitly commits to achieve successful returns. This will generate higher trust among potential investors, who see how their incentives and those of the manager are aligned.

Having said this, it is important to differentiate between those managers who make industry-standard capital contributions and those managers who contribute a higher percentage than the market practice. The reason behind the last point is that, after analyzing the factors that most influence the returns of a private equity fund, the GP commitment arises as one of the main ones. As can be seen in the graph below (Figure 1), which takes into account the returns (as of Q3 2023) of funds in the Qualitas Funds database, there is a significantly strong relationship between the GP commitment and the results obtained by these funds.

Figure 1: Net IRRs by GP Commitment clusters. Source: Insight.

As can be seen, funds in which the management team commits less than 2% of the fund size (below the market standard) performed worse than those in which the team contributed a higher percentage. Funds where managers committed up to 2% of the fund size achieved an average net IRR of 21.2%, those that contributed between 2-5% achieved 23.4%, while those that committed more than 5% achieved an average net return of 46.6%. The data highlights the clear relationship between the GP commitments and the funds’ returns.

That said, there are a few things to keep in mind to strengthen the manager’s alignment with investors. These include that the management team’s commitment should be underwritten in cash, invested across all of the fund’s assets, and underwritten primarily by the manager’s key executives. As for cash underwriting, third-party studies suggest that it is more effective if the commitment is made through a cash contribution compared to other methods². The rationale for the commitment to be allocated to all the fund’s investments is to avoid it being invested on a discretionary or selective basis, a decision that an investor would not be able to make. Finally, the fact that the manager’s contribution is primarily underwritten by the GP’s top executives confirms the alignment between the fund’s management and its investors’ interests.

Having an extensive, complete and updated database is essential to obtain relevant and useful conclusions. Thus, Qualitas Insight’s proprietary database allows for detailed monitoring of each of the funds’ performance. The return over the life of the fund, and the relevant Scoring information for each opportunity, opens the door to an in-depth study of the factors that the most successful funds have in common.

Several recent sources report on the growing interest of investors in selecting managers whose contributions are significantly large relative to the size of the fund. In the United States, for example, about 60% of managers commit more than 5% of fund size³. The reasons behind the increased focus on the commitment of the management team may lie in the fact that the GP has more “skin in the game” so the risk of losing that capital along with its reputation increases. This increased risk motivates managers to avoid making suboptimal investments and increase scrutiny in due diligence before selecting an investment. These characteristics serve as a greater guarantee of satisfactory returns since it is based on the motivation of the management team, which capitalizes on the team’s individual and collective incentives (along with those of the investors) to achieve higher returns.

In conclusion, this article seeks to draw attention to one of the factors that help predict the returns of a private equity fund, namely, the commitment of the management team. Based on a large database and statistical analysis, there is evidence of a significant correlation between the GP commitment and fund returns. Thus, greater commitment usually leads to better returns for the managers and, therefore, for their investors.

Note 1: CMS 2021.

Note 2: Institutional Limited Partners Association 2019.

Note 3: PE/VC Partnership Agreement Study 2018-2019.