ILPA has recently published a model limited partnership agreement (LPA) that reflects preferred terms and practices for the LP community investing in private equity funds. The Model LPA conforms to ILPA Principles 3.0 (published earlier this year), and is part of ILPA’s Simplification Initiative, designed to streamline the negotiation process and reduce fund formation costs. Time will tell as to whether or not the Model LPA is likely to emerge as the manager roadmap to attract LP capital and establish best practices, or instead becomes a useful benchmarking/reference point of investor representations in private funds. In either case, the industry should carefully consider the pro forma, alongside Principles 3.0, and be prepared for a healthy dialogue between investors and promoters during the fundraise and over the life of the fund.
We have provided a sample of those ILPA Model LPA provisions that we believe will be of interest to fund managers, sponsors and investors, along with our comments.
1. GP and fund economics
The Model LPA features a whole fund carried interest calculation (ie the European standard all-contributions-plus-preferred-return-back-first model) with illustrative typical market terms for a large closed-ended value added or opportunistic fund - being a management fee (unspecified in the Model LPA, but typically 1-2%), 20% carry, 8% hurdle and 80:20 GP catch-up arrangement. Although catch-up mechanisms, carried interest clawback, and post-investment period step-downs in management fees are now established market norms, the Model LPA terms move the pendulum further in favour of LPs. For instance, an escrow provision (albeit optional) as well as a GP clawback that is triggered both on specific interim events and on fund liquidation, mean that a GP may not receive any carried interest until close to the end of the term of the fund. It will be interesting to compare this against the deal-by-deal waterfall model (the market standard approach for North American funds) which ILPA intends to publish as a follow-up pro forma.
The ILPA Model LPA provides that no management fee is payable during the liquidation period, any extensions to the fund's term or any key person suspension period. In our view this latter approach in particular could prove problematic because a lack of fee income would hamper a GP’s ability to hire an appropriate replacement key person. Also, the suspension during winding up seems harsh when applied to other strategies, such as real asset funds, where illiquid assets may take time to realise.
For carried interest calculations where a credit facility is in place, the preferred return should accrue from the date that capital is at risk, ie when the credit facility is drawn, instead of when the capital is ultimately called from the LPs. This reiterates what is stated in ILPA Principles 3.0, as is also set out in the June 2017 ILPA guidance on Subscription Lines of Credit. However, this continues to be an area which may be challenging for GPs to support.
A more GP-friendly provision in the ILPA Model LPA is an LP giveback provision that requires LPs to recontribute certain distributed amounts (subject to limits on time and value) if needed to satisfy indemnification obligations of the fund, such as a third party claim
2. Express standard of care and GP protection
ILPA wants fiduciary duties of GPs to LPs under the relevant legal and regulatory framework to be expressly 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. Also, the indemnity provision in the ILPA Model LPA (that protects the GP from third party claims) excludes protection in the event of the GP’s contractual breach, including for any side letters it enters into, or behaviour that constitutes “gross negligence, fraud or wilful misconduct”. Excluding the GP indemnity for conduct constituting any breach of the fund documents is atypical, and in our experience it would be more common for the GP to lose the indemnity protection in cases of material breach.
To supplement these provisions, ILPA Principles 3.0 state that these carve outs should apply even if the governing law would permit it, and the exclusions should not be qualified with respect to the GP’s prior knowledge or material and adverse effect on the fund.
3. GP removal
GP removal for Cause (based on an LP vote by way of simple majority) includes typical ‘bad acts’ such as corrupt practice/criminal conduct or insolvency, as well as for material breach of a fund term (again, including terms in each side letter) or any breach of the standard of care. GP removal is also triggered by key persons ‘cause’ events - an LP-friendly provision, which is not necessarily related to a key person’s duties to the fund.
GP removal without Cause is based on the well-trodden approach of a meaningful 75% LP vote. ILPA has added a note suggesting that small or emerging managers could benefit from a 1-2 year hiatus before this removal right applies, and that the management fee should continue for 6-18 months after a without Cause removal.
4. Carry entitlement on GP removal
If removed for Cause, the Model LPA provides that carried interest payments cease, and escrow amounts are to be returned to the fund. On removal without Cause, the Model LPA provides an option for an automatic reduction of carried interest for investments made before removal (and that the GP will not receive any carry in respect of any investment made after the removal date), subject to GP co-operation and with the clawback provisions continuing to apply.
Although this approach reflects a ‘fair’ result that the exiting GP on a removal without Cause receives a (presumably) sizeable share of the carry from existing investments, it does not reflect a distinction which often comes up in practice between ‘cause’ (eg material, unremedied breaches with detrimental effect) and ‘bad acts’ (eg court decision for fraud or dishonesty); where the carry consequences for removal due to a ‘bad act’ are more severe.
5. LPAC best practices
The Model LPA specifies that the GP should seek to implement the best practices for the LPAC as set out in the Principles 3.0. Whilst not a compliance checklist, considerations in Principles 3.0 include:
- the degree of investor representation on the LPAC - ILPA recommends that LPAC is representative of the diversity of the LP base at large;
- 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; and
- 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 Model LPA also requires LPAC approval for all affiliate transactions, even if they are arm’s length, to ensure informed consent to conflicts of interest. We often see nuances around this in practice, for instance to allow for a carve out for the provision of accounting or administration services by affiliates on arm’s length terms and where the fees are disclosed to the LPAC.
The Model LPA includes:
- an automatic MFN provision that is not size-based and with limited exceptions;
- a provision that the fund will invest in accordance with the GP’s ESG policy; and
- LP information rights on fund subscription credit facilities.