To understand why GP commitment is so important, a little background on agency theory is in order. Agency theory explores the relationship between a principals and agents in an enterprise, and the problems that can arise. In private equity, the LPs are the principals and the GP is the agent. In private equity funds, the GP has pretty much unfettered control over the management of the fund, and LPs have limited visibility into the management of the fund. In fact, by law, LPs must be passive investors in the fund and cannot be active participants in the management of the fund, or there may be some very unhappy tax and legal consequences. Because of the control GPs have in the fund, they will be incentivized to maximize the cash flows the GP will receive, often at the expense of the LPs. If however, the GP (and the owners of the GP) invest a meaningful amount of
their own personal capital into the fund, their interests are more aligned with those of the LPs, which is very important.
How much should the GP commitment be? As mentioned above, it was historically 1% of the committed capital of the fund. However, to me the GP commitment must be a "meaningful amount of the investable assets of the owners of the GP." Let's look at two examples to put this in perspective.
Example 1. Fund 1 is raising $100 million. The fund will be managed by two partners, who own the GP of the fund. The GP commit will be 2% of the fund, or $2 million. These partners are young, capable and smart, but they don't have a lot of money. Partner A has investable assets (think of net worth less primary residence and other illiquid assets) of $3 million. Partner B also has investable assets of $3 million. Each will be responsible for $1 million of the GP commit. In this case, the GP commitment represents 33% of each partner's investable assets. That's meaningful.
Example 2. Fund 2 is also raising $100 million, and the fund is also managed by two partners who own the GP. The GP commit will be 2% of the fund, or $2 million. The partners are also young, but both have become billionaires from an early venture capital company they founded and took public. Each partner is responsible for $1 million of the GP commit. As both GPs are billionaires, a $1 million share of the GP commit represents 0.1% of their net worth. That's not meaningful.
Each fund will be different, and so the GP commit must be evaluated on a case-by-case basis.
One other important point about the GP commitment. I expect to see this as a cash contribution from the GP, not as a management fee offset or a loan from the fund to the GP. In my view, the GP commitment is coming out of the partner's pocket, for it to be meaningful. Management fee offset or fund loans defeat the purpose of the GP commitment.