By most accounts, fund terms are already heading in the direction of limited partners. Will the publication of an LP-friendly wish list by the Institutional Limited Partners Association serve to accelerate the trend?
The 15-page “Private Equity Principles” report, released by ILPA earlier this month, politely describes its wish list as “suggested best practices,” its report as an “educational medium,” and its motivation as trying to “restore and strengthen” the alignment of interest between LPs and general partners.
GPs may well feel threatened anyway. Among the more LP-favorable requests, the report recommends that investors receive all their contributions, plus a preferred return, before the GP takes carried interest. (Today, GPs typically have to return only a portion of contributed capital, plus a preferred return, before taking carry, according to a recent survey of terms by Thomson Reuters, publisher of Buyouts.)
The report recommends that individual principals be “joint and severally” liable for the full amount of any excess profits the GP ends up taking. (Several liability, in which each principal is liable only for his or her share of the excess profits, is today’s industry standard.) And it recommends that all transaction, monitoring and related fees go to the investors. (The vast majority of buyout firms keeps at least 20 percent of these fees today, while keeping half is the most popular formulation.)
Needless to say, these and many other recommendations on the wish list mark a far cry from industry practice. Thomas A. Beaudoin, a partner at WilmerHale who has represented both LPs and smaller buyout shops in fund negotiations, said that it’s fairly common for LPs to secure only about 20 percent of the ILPA-recommended terms in any given partnership, although sometimes they do better than that.
As for the potential impact of these recommendations, Beaudoin and other fund attorneys said that by far the most important factor in determining terms and conditions is the supply and demand for fund slots. Back in the mid-1990s, LP advisor William M. Mercer Inc. won a commission from nine state pension funds to study partnership terms and to recommend ways to better align their interests with GPs. Investors tried using the document as a negotiating tool for several years following its release, according to Beaudoin. But many eventually gave up after getting shot down again and again by GPs that, at the time, held more negotiating power, he said.
Today, of course, LPs hold the kings and Aces at the negotiating table, suggesting the ILPA recommendations could well be more influential than the earlier Mercer study. In addition, with almost 220 members managing more than $1 trillion in private equity assets, ILPA is well-positioned to keep momentum building for its wish list.
So what partnership terms recommended by ILPA are LPs poised to make the most rapid progress on? And where is GP resistance going to be stiffest? I took that question to Beaudoin, as well as David W. Watson, partner and fund attorney at Goodwin Procter LLP, and Raj Marphatia, partner and fund attorney at Ropes & Gray. Here are a few highlights of what one or more told me:
• LPs are already successfully convincing more GPs to calculate carried interest net of expenses;
• Investors are negotiating more protection against clawback liabilities, such as by negotiating regular true-ups and escrow accounts;
• Investors are compelling smaller GPs to make cash contributions to their funds, rather than financing them through management fee waivers, although bigger firms will likely resist;
• More and more funds are providing for automatic suspensions of the investment period upon triggering of the key-person provision;
• LPs shouldn’t have too much problem scoring more information from GPs, such as detailed financial data on portfolio companies, a list of political contributions made by the principals, or a list of limited partners in the fund, but GPs will resist requests for internal compensation data, fees paid to placement agents, and other data considered confidential;
• GPs will put up a big fight on moving toward a more LP-friendly distribution waterfall that delays carried interest payments;
• GPs, especially larger firms, are likely to successfully resist “joint and several” clawback liability;
• GPs are unlikely to agree to caps on indemnification expenses.
For a copy of the ILPA “Private Equity Principles” go to ilpa.org. Reach Beaudoin of WilmerHale at Thomas.Beaudoin@wilmerhale.com; reach Watson of Goodwin Procter at email@example.com; reach Marphatia of Ropes & Gray at 650-617-4721.