Summary and implications
The Institutional Limited Partners Association (ILPA) private equity principles, the second version of which were released in January 2011, were devised as a means to restore and strengthen the basic “alignment of interests” position within private equity, and thus aid recovery and growth.
They represent a key trend for investors, as they are now speaking with a unified voice. With over 130 organisations, including public and corporate pension funds, sovereign wealth funds and some general partners (GPs) having endorsed the principles, GPs have to be aware of them and be prepared to explain their position if not adopting them. It is considered that GPs in the established markets, who are not used to negotiating terms and marketing extensive disclosure will be more resistant to adopting the principles than those in emerging markets.
It is possible that greater collaboration between GPs and investors might lead to better relations between them. If managers were free to focus efforts on delivering returns rather than having to appease investors, the chances of a profitable fund may be increased – a positive for everyone.
This briefing examines the background to the ILPA principles and their effect on the market.
How did the ILPA Private Equity Principles evolve?
Following comprehensive discussion, surveys and questionnaires involving its members, the ILPA published its private equity principles in September 2009 with a view to creating a framework for industry best practice.
The principles were originally devised during the most difficult period on record for the real estate fund sector. High levels of friction existed between investors and GPs as the global financial crisis had a crippling effect on the leveraged debt model commonly adopted in funds. The lack of liquidity in the market served to make the gap between alignments of interests of GPs and investors even more pronounced.
Against such a backdrop, and considering the inherent difficulty for a group as large and disparate as investors in conducting negotiations, it is easy to see the attraction for investors of a framework for fund terms. The balance of power in negotiations was shifting regardless of the principles, as managers, struggling to close funds, conceded ground on matters such as fees and reporting.
On close inspection of the principles, many are hard to criticise, being conscious of the need to keep the GP incentivised and working hard for the fund. The principles are not intended to be used as a checklist and it is acknowledged by ILPA that flexibility is needed.
What are the principles and have they had an impact?
ILPA considered that the terms and conditions of the legal documents governing funds needed renewed attention so that:
- The interests of the GP and limited partners are correctly aligned;
- Fund governance is enhanced; and
- There is greater transparency for investors.
- Alignment of Interests between investors and GPs
The principles consider that to correctly align the interests of investors and fund managers the following outcomes should be incorporated into fund documentation:
- Distributions should be structured in such a way to ensure investors are repaid in full and receive their additional return before any performance fees are paid. In US funds, this model does not appear to have been adopted extensively, whereas it appears to have become the norm for European and Asian funds;
- Management fees should be fair and take into account the lower level of expenses on a follow-on fund and at the end of the investment period. They should be structured so as to cover the reasonable costs of the manager firm and its principals – this has proved to be unpopular with larger established firms;
- Transactions and monitoring fees charged by the GP should accrue to the benefit of the fund rather than the GP. Whilst momentum seems to be shifting away from retention of these fees by the GP, funds have been slow to rebate these fees totally to the fund;
- The GP should have a substantial equity interest in the fund which should be predominantly in cash as opposed to being contributed through the waiver of the management fee. This is a powerful way for the GP to demonstrate alignment with investors. Often investors are looking for more from the GP than the typical one per cent commitment;
- Carry escrow accounts should be used, with significant reserves. ILPA recommends that individual GP members commit to joint and several liability for payment of GP claw back amounts, but where that is not provided, a creditworthy guarantee may be acceptable; and
- Fund extensions should be in one year increments and require approval by a majority of the advisory committee or investors. If there is no LP consent, the GP should liquidate the fund within one year.
- Governance Structure of Funds
On the basis that most private equity fund are long term structures, where the GP has sole investment discretion, it is important that robust legal documentation reinforces the backing investors place in the GP’s professional team. The governance principles seek to enhance the governance structure of funds to best address the concerns of investors. They include that:
- The GP should present all conflicts to the advisory committee;
- When considering important matters of fund governance, advisory committee members should be able to engage independent counsel at the fund’s expense;
- A majority of LPs should have the ability to elect to dissolve the fund or remove the GP without cause (i.e. no fault divorce);
- A ‘key person’ or ‘for cause’ event should result in an automatic suspension of the investment period. This may be permanent unless a super majority of investors vote to re-instate within 180 days;
- The reviewing and approval roles of the advisory committee should be clear;
- There should be flexibility in the LPA to cater for the possibility of changes to be made to it; and
- Approval by 66 per cent of LP interests needed for termination or suspension of the investment period.
- Transparency and Reporting
To achieve greater transparency for investors, the principles below are recommended:
- GP should provide estimates of quarterly projections on capital calls and distributions;
- LPs should be informed immediately of any breach of fund documents or any material liability or contingency arising; and
- Standard reports to be delivered on a quarterly and annual basis.
ILPA has recently published the first of a series of templates aimed at simplifying and standarising reporting. It is hoped by having a base document which has been approved in advance, expenses can be reduced and transparency enhanced. Efficiencies generated from standardisation should benefit GPs and investors.
The first templates focus on capital calls and distribution notices, the former in particular being a document that has caused issues recently with investors requiring significantly more than a figure and banking details. The template proposes large amounts of information to be given to investors each time a cash call is made.
This may place too high an administrative burden on smaller funds who may already be stretched. Also, there is a danger of information overload for LPs who may be invested in multiple funds.
What does this mean for investors and GPs?
In a competitive market, investors are becoming much more aware of the terms of the fund they invest into and need little excuse to select one fund over another. Whilst the ILPA principles may not be the sole reason for not investing in a fund, they may be a reason cited by investors for not investing and may in part be a determining factor.