The third edition of the ILPA Principles was published in June 2019, replacing and updating the January 2011 second edition. Although the overall goal remains the same, one of improving the private equity industry for the long-term benefit of all its participants, the ILPA Principles 3.0 represent a fresh mindset – not just in addressing new and emerging issues (for instance, subscription lines of credit, non-financial disclosures, co-investments and GP-led secondary transactions) but in expanding, clarifying and providing detailed guidance on familiar themes (for instance, fund economics and LPAC responsibilities). The funds industry will want to carefully consider the Principles and be prepared for a healthy dialogue between investors and promoters during the fundraise and over the life of the fund.
With application across the industry, the Principles are not to be treated as a compliance checklist, as each fund should be considered separately and holistically. A dynamic and flexible approach is key: ILPA acknowledges that a single set of preferred terms and practices cannot cater for the broad variability of products, strategies and investor preferences across the market at any given time, nor account for every individual circumstance. In many cases fund managers and investors will need to consider Principles 3.0 alongside other industry guidelines and codes of practice, which do not necessarily follow a standardised approach.
ILPA seeks to encourage industry-wide adoption. It welcomes GPs to express support and to notify their LPs of their progress in adopting elements of Principles 3.0. ILPA advocates current and prospective LPs to communicate to GPs the extent to which adherence to particular tenets are significant to them in terms of their specific investment approvals and/or policies. This is instead of past requests for organisations to indicate support by public endorsement of the Principles.
We have picked out a handful of the main elements of the changes found in Principles 3.0 that we believe will be of interest to fund managers, sponsors and investors. We would be happy to discuss with you in more detail any of the issues raised in this briefing.
Subscription Lines of Credit
As anticipated, Principles 3.0 broadly incorporate the key propositions in the June 2017 ILPA guidance on Subscription Lines of Credit. Subscription lines should be used primarily to benefit the partnership as a whole (rather than chiefly for the purpose of enhancing the IRR to accelerate the accrual and distribution of carried interest) and not to fund early distributions. For carried interest calculations where a credit facility is in place, the preferred return should accrue from the date that capital is at risk, i.e. when the credit facility is drawn, instead of when the capital is ultimately called from the LPs. This is likely to be an area which may be challenging for GPs to support; ILPA suggests that GPs will understand that there’s a need to mitigate what might be behaviour-altering effects of the use of these facilities.
In addition, Principles 3.0 recommend specific thresholds for the use of these facilities, including, for example, a maximum of 180 days outstanding and that they are limited to a guideline 20% maximum percentage of all uncalled capital. ILPA recommends that LPs should be able to opt out of the credit facility when a fund is set-up, that specific information on fund credit facilities is disclosed to LPs in annual and quarterly reports, and that facility terms themselves are provided to an LP on request. On the basis that they are typically a short-term revolving line of credit, ILPA recommends LPAC (limited partner advisory committee) approval for the use of credit facilities with terms of more than one year.
Mentioned in passing only in the previous version, Principles 3.0 contain detailed provisions on best practices on co-investment, illustrating the now ubiquitous theme of a desire for significant discretionary and non-discretionary co-investment allocations by LPs alongside the fund. ILPA Principles include a broad disclosure duty on GPs in this area: for instance, that GPs should disclose to all LPs in advance, through both PPMs/offering documents and LPAs, the allocation framework of any interests and expenses for participating co-investors, including whether any prioritisation is applied, how opportunities are allocated and how conflict and risk issues (e.g. concentration limits) are mitigated. ILPA suggests that GPs could consider employing a pre-qualifying assessment during fundraising, and at intervals during the investment period, to confirm LP interest and ability to execute on co-invest opportunities. Further, GPs should give prospective investors the strategic rationale for co-investment to explain why the entire amount is not being allocated to the fund itself.
LPAC best practices
Principles 3.0 include a reminder that individual LPs serving on the LPAC act in their own interests with no fiduciary duty to the fund beyond the duty to act in good faith, albeit as part of a committee with roles and responsibilities clearly outlined in the LPA.
ILPA provides more detailed guidance on the degree of investor representation on the LPAC, an issue that GPs and fund managers often have to grapple with in practice. It recommends that the LPAC is representative of the diversity of the LP base at large, therefore composed of a cross-section of investors by commitment size, type, tax status and quality of relationship with the GP. ILPA has acknowledged that this approach is currently “the exception and not the rule” – given that commitment size is often a major determinant and that the LPAC should be limited in size to a workable number. There are various options to consider in order to broaden composition across investor types, for example, collective representation of smaller investors and rotating seats among a broader group.
Other new areas of best practice include the appointment of a rotating LPAC chair; that LPAC meetings are held in private both between the LPAC members (with feedback to the GP given afterwards) and between the LPAC and the auditor. Also that LPAC members are held to account in terms of minimum participation standards, with consequent penalties for repeated failure to attend meetings or vote on matters presented (for example, revocation of a member’s seat or right to vote). The LPAC mandate should be clearly articulated, including reviews of any material ESG incidents and/or risks to the fund’s portfolio.
Fiduciary duties of GPs to LPs should be reinforced in fund documents, namely the obligation of the GP to put the interests of the fund as whole before that of a subset of investors or the GP itself.
Principles 3.0 provide that an indemnity clause that protects the GP from third party claims should exclude protection in the event of the GP’s contractual breach or behaviour that constitutes “gross negligence, fraud or wilful misconduct”, even if the governing law would permit it. Further, these exclusions should not be qualified with respect to the GP’s prior knowledge or material and adverse effect on the fund.
Recycling of distributions
ILPA’s framework on the ability for the GP to recycle capital (which is then added back to the LPs’ undrawn commitments and available for further drawdown) empowers LPs to establish some boundaries in this area. For example, Principles 3.0 state that the amount of total distributions subject to recycling provisions should either have a mutually agreed cap, or a monitoring threshold (based on factors such as the GP’s track record and the strategy of the fund). This will allow LPs to project their cash requirements more accurately. Reflective of the current market norm, recycling provisions should only apply during the fund’s investment period.
GP and fund economics
Principles 3.0 are more explicit in their approaches to waterfall structures, carried interest calculations, clawback and fees and expenses. Of particular interest is that carried interest should be calculated based on net (not gross) profits and that the impact of fund level expenses should be factored into the calculation. The 2011 edition simply referred to improved alignment on the basis of net profits in the calculation. Whole fund carried interest calculations (i.e. the European style all-contributions-plus-preferred-return-back-first) are still preferred to the deal-by-deal model.
On its analysis of clawback on carry, the main new point to note is that Principles 3.0 recommend that the industry move to a gross-of-tax clawback model, paid back within 2 years after the liability is recognised. This differs from the previous edition of the Principles and means, where put into practice, investors will no longer have to seek that GPs repay any tax that has been paid on carry which is subsequently subject to clawback (or otherwise absorb the loss on the GP’s behalf).
Reflecting a rise in third party investment in GPs, a new Principle provides that GPs should proactively disclose the ownership of the management company and notify all LPs if this changes over the life of the fund. This feeds through to best practices for LPAC voting members, who should disclose a GP interest to the other LPAC members. More granular restrictions on transfers of GP interests highlight this critical aspect of alignment of interest with the LPs in the fund.
Fund term extensions
ILPA best practice on fund terms builds on the earlier guidance: fund terms should only be extended by one-year increments and limited to two extensions, which should first be approved by the LPAC and then proceed only with approval of a super majority of LP interests in the fund (reference to the two year extension limit and the LP two-thirds vote are new). Absent LP consent following expiration of the fund term, the GP should fully liquidate the fund within a one-year period.
Principles 3.0 note that management fees should be rationalised where possible – specifically, they should be stepped down significantly to take into account lower expenses burdens for a follow-on fund, or on a term extension (notably where the GP has raised successor funds). ILPA recommends that the GP should absorb both the costs and expenses associated with the results of a regulatory examination (conversely, regulatory approval for a transaction should be a fund expense), as well as for a technology implementation that chiefly benefits the GP.
No additional management fees should be charged to portfolio companies as they should be 100% offset against the fund management fee and subject to standard disclosure. Unless prohibited by the LPA, a GP may charge management and other fees, such as transaction fees, on co-investments.
Substance beats form in how this topical issue is addressed in Principles 3.0: “to the extent that a GP claims to pursue an impact investing strategy specifically, a framework to measure, audit and report on the impact achieved by the fund should be adopted.”
Alongside investor disclosures on ESG factors that may impact the fund materially (along with regulatory compliance and issues that present legal, reputational or business risk to the GP), GPs should consider maintaining and updating an ESG policy, which should identify procedures and protocols that can be verified or documented, not just a vague commitment of behaviour. Annual reports should refer to any ESG risks at fund and portfolio levels.
Three other points of interest:
- GPs should seek to include those provisions common across the majority of a fund’s side letters into the LPA itself, to minimize the cost and complexity of side letter compliance.
- New guidance on cross-fund expenses - that GPs should seek to limit the number of overlapping investments between funds as well as avoiding transfers of assets between funds.
- Principles 3.0 need to be read in conjunction with previously published ILPA standards and guidance, for instance the Reporting Template for Fees, Expenses and Carried Interest and separate guidance on GP-led Secondary Fund Restructurings. An ILPA model LPA is expected to be published (although no timescale is given).