Pension funds, whether in the pubic or private sector, have invested in private equity and venture capital funds historically through the vehicle of limited partnerships. According to Government statistics, the number of limited partnerships has grown significantly in the ten years from 1997 to 2007: there were approximately 14,400 according to the register of Companies House at the end of 2007. Although the law relating to limited partnerships has some variations between England and Wales and Scotland as a separate jurisdiction, the underlying statutory framework is based on the Limited Partnerships Act 1907 (the “1907 Act”). In a consultation document published in August this year by the Department for Business Enterprise and Regulatory Reform, significant proposals have been made to clarify the law relating to limited partnerships. Many of these will be welcome to institutional investors and the fund managers who use limited partnerships as an investment vehicle.
Reform of the 1907 Act has been a long process in itself; the DTI (as it then was) started the process of consultation by asking the Law Commission and the Scottish Law Commission to carry out a joint review of partnership law in November 1997 and several consultation papers and reports followed from that instruction. With the overhaul of company law in the Companies Act 2006, attention has finally been paid to the 1907 Act.
Limited partnerships should not be confused, by the way, with the similar sounding “limited liability partnerships”, which have been established by, in particular, professional services firms, but also some investment funds under the Limited Liability Partnership Act 2000 (the “2000 Act”). LLPs have gained favour over limited partnerships as they can offer more flexibility and a more corporate structure. However, for pension funds one key disadvantage is that income and capital gains derived from property investment LLPs are not exempt from tax (see Mark Simpson’s article on property investment structures below).
Why reform is necessary
The 1907 Act is a very short piece of legislation; that is how they wrote the law in those days. Unfortunately, its very brevity is a large part of the reason for reform. The 1907 Act’s genesis was the Partnership Act 1890 (the “1890 Act”), which still applies to all general partnerships. What the Government is now proposing is that the 1907 Act will be completely repealed and the 1890 Act will be amended to add in provisions which relate solely to limited partnerships.
The key characteristic of a limited partnership and that which distinguishes it from a general partnership, where the partners are all jointly and severally liable for the debts and liabilities of the partnership, is that limited partners are only liable up to the extent of the capital which they contribute to the limited partnership. A limited partnership does, however, require the presence of at least one general partner who has, under the 1907 Act, unlimited exposure for the liabilities of the partnership.
In benefiting from limited liability, limited partners are just like shareholders or bondholders in a company. However, in a limited partnership the price of limited liability is twofold: limited partners may not take part in the management of the partnership business if they wish to retain their status and, under the 1907 Act, if they receive back part or all of their capital contribution, they lose the benefit of limited liability.
Fund managers who act as general partners of, say, private equity limited partnerships have taken advantage of these legal restrictions on the rights of limited partners to construct partnership agreements which not only take advantage of the ban on involvement in management but also operate to lock in investors with draconian penalties for early withdrawal of capital.
On one level, the exclusion from management activities is not something that any institutional investor which is not itself authorised under the Financial Services and Markets Act 2000 would seek to argue with. Taking on managerial responsibilities or exercising rights to manage investments which are collectively owned would involve investors in requiring authorisation for managing investments and, because a limited partnership can be characterised as a collective investment scheme, for operating such a scheme. The big issue has, however, rested on the interpretation of what the word “management” means under the 1907 Act and how that interrelates with the exercise of what would be regarded as ordinary investor rights in a company.
The Government’s approach to this has been to adopt the recommendations of the Law Commissions by setting out those activities which are to be regarded as permitted activities of limited partners. These activities will not, by definition, be capable of constituting management activities. The permitted ativities are set out in what will be a new schedule to the 1890 Act and break down into the following seven categories:
- strategic decisions (such as taking part in the decision whether to approve or veto a type of investment by the partnership or a decision about whether the partnership should end or be wound up);
- the enforcement of rights under the partnership agreement;
- the approval of the accounts of a limited partnership;
- being engaged under a contract by the limited partnership or by the general partner;
- acting in the capacity of a director, an employee or a shareholder of a corporate general partner;
- taking part in a decision which involves an actual or potential conflict of interest between limited and general partners, and
- discussing the prospects of the partnership business or consulting or advising the general partner about its activities or its accounts.
All of these changes are welcome and will go a long way towards clarifying the law in what has often been an area which has required legal opinions to be given to prospective investors confirming that by investing they will not lose the benefit of limited liability.
Withdrawal of capital
The second recommendation of the Government, which is the only significant area where it has not accepted the recommendation of the Law Commissions, is to allow for a relaxation in the rule relating to the withdrawal of a limited partner’s capital. The Law Commissions recommended the continuation of the current law which essentially prohibits any withdrawal of capital (the price for which is the loss of limited liability). The Government has taken the view that limited partners should be able to withdraw capital, subject to any agreement to the contrary between the partners and the registration of the withdrawal at Companies House. However, the Government’s view is that a limited partner should remain liable for the debts and liabilities of the partnership up to the amount of capital withdrawn until the end of 12 months after the date of registering the withdrawal. The Government does not believe that limited partners should be subject to any further burdens.
Of course, the key concession here to continuing the status quo is that the partners may agree to keep the current law, in which case an agreement to restrict capital withdrawals would be overriding. No doubt private equity funds would argue that the facility to withdraw capital would undermine the necessity of requiring long term capital commitments by investors and that such restrictions should stay. However, from an investor’s point of view, liquidity is either taken for granted in other asset classes or, where there are restrictions (such as in the property sector or hedge funds), the lock-in periods are significantly less than 12 months, so the advent of the chance to benefit from the same liquidity would at least create some meaningful comparison between the risk characteristics of different forms of investment.
Another criticism of the current law relates to the way in which third parties are effectively deemed to be aware of changes to limited partnerships by virtue of registration with Companies House of the relevant changes. The Government is consulting on the need to keep a public register of relevant changes and partnership details in this way and has asked for views on whether a self-regulatory system could work as well. Under this model, a limited partnership would itself maintain a register of the relevant details, which would be accessible on request and where the partnership would only have to inform Companies House on an annual basis of any changes. There are clearly cost savings to the Government here in the operational burden on Companies House, but one has to query whether the detriment to third parties who deal with the partnership (and indeed limited partners) of making public access significantly more cumbersome outweighs the (presumably) marginal cost. Other administrative proposals include – to mirror Companies Act 2006 deadlines – tightening the deadline for registering significant changes to the general partner or where a limited partner changes its capital contribution or ceases to be a partner. In future the Government suggests these changes should be registered within 14 days rather than the current limit of 28 days.
One other key recommendation made by the Law Commissions was that limited partnerships in England, Wales and Northern Ireland should have a separate legal personality, which would have brought them into line with the position under Scottish Law. The Government has not accepted this recommendation because of the complexity and uncertainty which could flow in respect of how other countries may treat a UK limited partnership for tax purposes. Most jurisdictions treat partnerships as tax transparent vehicles – profits are taxed directly in the hands of the partners. UK limited partnerships are generally treated in this way, largely because they do not have separate legal personality. In contrast, limited liability partnerships established under the 2000 Act do have separate personality and some countries have taken the approach that they should therefore be taxed in the same way as companies. High level lobbying has resulted in some countries relenting on this (which has allowed professional services firms to form multi-national LLPs) but the issue still causes difficulties. The Government is clearly keen to avoid extending the debate to cover limited partnerships where the tax treatment is more settled.
Most of the recommendations contained in the Government’s consultation paper are likely to be welcomed by institutional investors and fund providers alike. It remains to be seen how general partners will react to the possibility of limited partners being able to withdraw capital (albeit with a 12 month period of extended liability in relation to the amount taken out) or whether they simply seek to ignore the possible relaxation in law by overriding the statutory change contractually. It will be interesting to see how the changes influence, if at all, the rise of limited liability partnerships.