The Institutional Limited Partners Association (“ILPA”), the body that represents members of the international limited partner community, has recently revised its Principles for Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners (the “Principles”). As with earlier versions, the Principles aim to facilitate dialogue and set expectations between limited partners in private equity funds (“Limited Partners”) and the managers of such funds (“General Partners”).
Since the Principles were last revised in 2011, the industry has developed significantly (both in terms of the commercial and political environment and the development of regulation – the investor protections included in the EU Alternative Investment Fund Managers Directive (“AIFMD”) were not yet in force, for example), and the latest Principles have been developed to try to adapt to this. The increase in complexity is reflected in part by the Principles now running to over 40 pages.
The Principles continue to be agnostic on a fund’s jurisdiction and regulatory treatment and are principles-based. As was the case in respect of previous versions, the Principles focus upon three guiding themes: (i) alignment of interests, (ii) governance and (iii) transparency. In addition to providing guidance on fund economics, key person, LPAC and fiduciary duties issues, the Principles have been expanded to cover new emerging topics, including:
Environmental, social and governance factor (“ESG”) integration; and
General partner-led secondaries transactions.
In respect of some of these topics, including subscription lines and general partner-led secondaries transactions, ILPA had already issued detailed guidance1, which is largely replicated in the Principles.
Whilst the Principles focus on private equity, some of the content would also be of interest to (and has been/is likely to be adopted by) stakeholders in other alternative asset classes, such as private debt or real estate. In contrast to the previous Principles, ILPA is not seeking endorsements for this edition. However, we expect the content of the Principles to continue to be referenced by the investor community and to inform and influence commercial negotiations.
The Principles themselves acknowledge that a single set of preferred terms and practices cannot provide for the breadth of the market or account for individual circumstances. What is also clear is that whilst the Principles include a significant number of new Limited Partner-friendly statements, there are also a number of instances where balance and dialogue is encouraged between the parties (particularly in the ESG section).
Below is a brief discussion of certain new provisions.
Fees and expenses
The Principles cover various aspects regarding a fund’s fees and expenses. Notably, the Principles now list expenses which should be allocable to the fund, specifically noting that any travel expenses related to deals prior to entry into a term sheet should be borne out of the management fee (presumably because an agreed term sheet is a way of defining a more mature transaction, although it is not clear if the term sheet should be binding in whole or in part).
The Principles also deem it unreasonable to recharge to a fund a portion of the General Partner’s staff costs. This is counterintuitive if it is more efficient to provide these services in-house rather than through an external provider and is in contrast to the suggested approach for allocating a portion of internal legal staff’s time to a fund (which is acceptable to ILPA, provided Limited Partners are provided with the rationale and the market basis for applying the charges).
The Principles also detail the expenses which ILPA believes should be fully offset against or covered under the management fee – ESG-related expenses and "unforeseen" expenses are included within these (which may or may not be reasonable depending upon the nature of such "unforeseen’ expenses).
This version of the Principles reverts to a recommendation that any clawback of carried interest is made gross of taxes (in contrast to version 2.0). Paying such amounts gross of taxes is likely to be problematic for the carried interest vehicle and/or the carried interest recipients since they are funding the taxed shortfall from their own pockets. We would therefore expect that most General Partners would seek to push back on this point. ILPA has changed its position on the basis that artificially high tax rates were being applied in computing tax under the previous formulation, so the decision was made to revert to a gross-of-tax model. However, acknowledging that this may be excessively burdensome or impractical in certain circumstances, the Principles note that, to the extent a net approach is taken, the hypothetical marginal tax rates applied should reflect the actual marginal rate that would apply and account for factors such as loss-carry-forwards and carry-backs. Any net amount should also take the impact of the preferred return into account.
Limited Partner Advisory Committee (“LPAC”) best practices
The new Principles further build out the existing LPAC provisions and add extensive and prescriptive guidance on what ILPA believes is the best practice. This includes curating a diverse LPAC membership in terms of commitment size, type, tax status and quality of relationship with the General Partner. It may be difficult for General Partners to navigate this point when negotiating with larger Limited Partners who would be passed over for diversity reasons (especially as the ILPA standards are not universally adopted (whether formally or informally)). The "best practices" are also prescriptive with respect to issues such as the LPAC’s mandate, how meetings are conducted, the LPAC’s governing processes and members’ responsibilities and powers.
Notification and policy disclosures
As noted elsewhere within this OnPoint, the Principles contain a number of notification and policy disclosures. Whilst not entirely new to the Principles, it is worth noting that this section includes new disclosure triggers upon the occurrence of a legal or regulatory inquiry or examination into the fund and, upon request, full access to the results of any such regulatory inquiry or examination. This version of the Principles is helpful in that it clarifies that an examination must be in respect of the fund itself (rather than the General Partner or investment advisor, for example), but fund sponsors should be mindful that (i) there may be confidentiality issues with disclosure, (ii) there is no materiality threshold in respect of the inquiry and (iii) the General Partner may be reluctant to disclose such information at the time of its occurrence (as the examination may be completely unfounded, for example).
Subscription lines of credit
The subscription line references largely repeat ILPA’s separate guidance on the matter, although the Principles expressly state that Limited Partners should be offered the ability to opt out of a facility at the onset of the fund. This is unlikely to be practical in the context of the terms of most facilities. The Principles also recommend at least 10 business days’ notice of a capital call.
There is a more significant emphasis on co-investment issues in the latest version of the Principles, with greater focus on broken deal expenses, fee offsets (where it is recommended that, where transaction fees are collected, the allocation between the fund and other co-investors should be disclosed along with the application of any offsets) and co-investment allocations more generally. The Principles try to present a fair playing field with respect to existing fund investors and co-investment opportunities but this does not, of course, take into account the pressure that managers may be under from co-investing investors in respect of negotiating co-investment rights.
The Principles recommend advance disclosure to Limited Partners of the framework for how co-investment opportunities (including any allocation priorities) and expenses will be allocated among the fund and co-investors. Whilst (depending upon the level of granularity of the disclosure) this is not out of line with market practice, General Partners may not wish to be too prescriptive and should also ensure that such framework is practicable operationally. In respect of allocations, ILPA recommends that all suitable investment opportunities are first allocated to the fund (assuming they fit within its strategy and capacity). In reality this is an over-simplification (especially for General Partners who manage more than one strategy) and other issues, such as predecessor funds, should be taken into account as well.
The Principles note that any side letter rights to evaluate or participate pro-rata in co-investment opportunities should be disclosed to all Limited Partners. Such terms are unlikely to be disclosed to all Limited Partners in the normal course (subject to the particulars of any most favoured nation clause, the requirements of AIFMD and any other regimes mandating a certain level of disclosure). Other potentially controversial points include the proposed disclosure to Limited Partners of differentiated economics offered to co-investors and that any fees payable to the co-investment vehicle should accrue to the underwriting fund to be offset against the management fee.
In respect of broken deal expenses, it is recommended that these are allocated between the fund and any co-investment vehicles (and/or parallel vehicles etc.) on a pro rata basis. Whilst logical in principle, this may be hard to enforce where the proposed co-investors have not entered into a binding contract obliging them to fund the co-investment – the Principles deal with this point to an extent by noting that any preliminary due diligence costs should not be considered broken deal expenses.
It is also recommended that Limited Partners be notified of co-investments as they occur.
This topic is new to this version of the Principles. The Principles recommend that the number of overlapping investments between funds are limited and a maximum threshold is stated in the offering document, either by number of deals or investment size. It is also recommended that the fund’s financial statements disclose information about overlapping investments and that any fees received by the General Partner from any overlapping positions also be disclosed. It is not clear whether the Principles intend this section to cover investments that overlap in funds of different vintages and/or strategies. These provisions are not likely to be practical for large managers managing multiple funds and/or managers who manage a number of separately managed accounts.
The Principles also recommend that the treatment of carried interest and application of fee offsets be consistent across all funds that invest in a given investment, even where the funds have different terms. This may prove difficult to operate in practice.
General Partner ownership and key principal compensation issues
There are repeat references in the Principles to ownership of the General Partner (which in this context means a sponsor entity) and how a change in ownership should be handled during the life of the fund. Whilst there were already recommendations regarding the General Partner commitment and the transferral of interests in the General Partner in the previous version, the Principles now suggest that the General Partner proactively discloses the ownership of the management company and notifies all Limited Partners if the ownership of the management company changes during the life of the fund (particularly where ownership passes to a third party). However, it is not unusual for the former to be disclosed in the fund’s private placement memorandum and the latter may already form part of certain Limited Partners’ side letter requests, so these requests may not necessarily be too cumbersome.
The Principles also recommend that certain compensation information per individual partner is shared with Limited Partners during due diligence or on a pre-agreed schedule (including salaries, bonuses and carry split by individual partners and in respect of current and previous funds). It also recommends that Limited Partners are informed of the carry/ownership percentages in the management company. This information is likely to be highly sensitive within many organisations given the personal nature of the request. Relevant data protection legislation issues will need to be considered carefully.
This topic is of increasing importance in the funds industry and the fact that ESG concerns are scattered across the Principles reflects this. With respect to ESG policies and reporting, the recommendations are not especially cumbersome; General Partners are invited to consider maintaining an ESG policy, for example. The reality may well be that General Partners already have these in place or are under existing pressure to do so. It is recommended that any such policies identify procedures and protocols that can be verified and/or documented rather than a vague commitment of behaviour. Further input is required to the extent that a fund pursues a responsible investment or impact investing strategy.
The ESG section strikes a balance between Limited Partner requests and the ability of the General Partner to deliver them, noting that Limited Partners should take into account the ability of the General Partner to deliver bespoke or detailed ESG-related disclosure requirements and also that the General Partner’s approach to ESG will likely evolve over the life of the fund.
The Principles also recommend that notifications should be made to Limited Partners in respect of any incidents presenting a potential breach of ESG policy.
The latest version of the Principles is comprehensive and tries to reflect a number of changes to the private fund industry since the prior edition. As the terms of the Principles are likely to inform Limited Partner negotiations, General Partners should be abreast of the provisions and prepared to discuss the points covered (including why they have not been complied with) when speaking to Limited Partners. However, as with previous versions of the Principles, given the practical (and, in some instances, commercial) issues raised by the Principles, General Partners should treat the Principles as an industry resource and not as a blueprint for the terms of their next fund.