Is shareholder activism relevant to investors in private equity? Well for a start private equity hasn’t had the type of problems faced by the listed company sector. Namely hiding losses, committing fraud with the apparent aim of increasing share price so that the members of the board received tremendous bonuses and their stock options were the equivalent of winning the lottery. Some of those problems have existed for the investors in private equity where the frauds have not been carried out by the GPs but by the companies in which they have invested.
There are already a lot of clauses in use by LPs in private equity funds, which aim to give them some of the powers now being enjoyed by investors in listed companies. There are four or five standard investor protection provisions on the standard PE fund model limited partnership model, which you will always see and which investors will request. At the drastic end of things is the removal of the GP clause. This is the solution of last remedy for anyone. There are generally two types of removal clause; fault removal in which LPs can remove a GP with a certain percentage of votes; and no fault removal where LPs can remove the GP provided they get a higher percentage of votes. The latter is normally provided to deal with situations where the GP or manager may just not be performing or is guilty of sharp practice but not fraud, for example. Funds now have both clauses but five years ago most had the fault removal only clause. Institutional investors now feel very strongly about having the no fault and fault removal,” says Blair Thompson at SJ Berwin.
This is in many ways just an opportunity for LPs to weld the big stick and remind the GP that theirs is a two-way relationship. “The use of the no fault removal is extremely uncommon. They have been threatened a couple of times but it’s very much a last resort and I could only realistically see them used where the situation is so bad that things have fallen to bits anyway,” says Thompson.
Also part of the fund formation is the possibility for LPs to limit the ability to GPs to go off side. “If there is not enough control GPs could engage in activities outside the fund, such as co-investments or raising another fund. There are general restrictions that can be put in place if you are concerned about things like PIPEs, investment pace and geography. For example, if we like a fund for a particular geography we can put a restriction on how much it can invest in a new geography,” says Wanching Ang at Allianz Private Equity Partners.
Corporate governance, which is essentially the banner shareholder activists are charging under, has shifted the fund formation focus of late. “Of all of the terms in a typical private equity fund’s limited partnership agreement (LPA), the economic provisions have historically been the subject of most negotiation between the GP and the potential LPs. However, the recent market developments – and a small but growing number of disgruntled LPs – have focused increasing attention on those other provisions of the LPA that could best be categorised as partnership governance’. By this we mean those provisions dealing with the operation of the limited partnership, and the duties of the respective partners, from initial closing to dissolution,” says Timothy Spangler of Berwin Leighton Paisner.
When chairing the EVCA technology conference in Barcelona last month, Daniel Muzyka noted: “It is the best of times, it is the worst of times. It is a time shaped by negative news the dot.com evaporation, stock market downturn, exit markets under pressure and LPs becoming more aggressive in terms of accountability.” Accountability for the listed investor environment has seen a move towards publishing agreed standards of conduct between investor and company, whereas in the private equity sphere much is put in the initial investment documentation. Fair enough given that investors in listed companies can sell tomorrow if they don’t like the way things are panning out but investors in private equity are for the most part locked in for a ten-year period so the ground rules need to be clear.
Aggressive seems a strong word to use but it is probably not an undue reaction given the wild promises of riches private equity and venture capital funds laid claim to when fund raising in the late 1990s and 2000. Even many of the so-called brand names have disappointed and LPs are rightly asking themselves what they can do to gain a greater degree of control hence the rise in the use of no fault GP removal.
This began in the US market and like the bulk of financial and legal innovation it is worth watching developments Stateside to see where Europe might soon be headed. This is no exaggeration in the case of private equity. Europe still relies heavily on US LP’s fund commitments.
But even though LPs seek greater control it is not even close to absolute.
“Going forward [after committing to a fund] the things that cannot control are the discipline and stability of the team,” says Ang. That said Simon Witney points out: “The philosophy of PE investing – picking a team to manage the fund on your behalf – is not changing.” After all too much LP involvement would invalidate the LP structure.
LPs have found themselves busy working towards controlling the discipline and stability of the investing GP team through the clauses at the stage of fund formation. They also have a particularly strong focus on the economics given the current climate. “I don’t like egregious fees, particularly in a low returns environment. When you are talking about returns in the mid teens then absolute fees and carry really start to eat into your returns,” says Ang. It was George Anson of HarbourVest Partners who noted at the EVCA annual symposium in Athens this summer: “In today’s climate, expectations of IRRs from private equity are being adjusted down from 30 to 35 per cent to somewhere around 18 to 20 per cent over a ten-year period. But these are still very attractive compared with current estimates of around six per cent returns from the public markets.”
But it’s impossible to plan for every eventuality, not least the current economic environment and depressed performance and write offs. LPs are having to look, many for the first time ever, to wind up funds where the losses are so bad and sector outlook so poor in the medium term that there is no hope of getting the fund into carry. As such it is unlikely the GP investing team will stay together and so the LP is effectively faced with cutting its losses early rather than leaving the situation to fester.
Spin-outs of private equity and venture capital teams from banks and other institutions have caused LPs untold headaches, not least because there are effectively two parties to negotiate with rather than one. But most note that it is how the situations are handled that ultimately colours their view of a firm. Some of the recent downsizes in fund raisings are commended for the level of GP to LP contact and explanation that was undertaken before the situation moved into the public domain. Ang says this contact and explanatory relationship should extend to the telling of bad news too.
“There are a lot of things that go wrong in 10 years, particularly in this environment. If GPs don’t build up trust and have goodwill pennies in the bank with the LPs the only thing we can do is to say no to the next fund. If GPs build up enough trust so that people understand what has happened they can give them the benefit of the doubt next time around. When I look across our funds I can imagine we will invest again with some even if they have made mistakes – it’s those that when they had issues they were quick to bring them up and discuss so we knew what was happening,” says Ang.
Witney utters words of caution: “Investors have to think about what they are going to do with the information when they receive it. There seems little point in having an investee company’s accounts if they are not going to get read.”
In essence it seems that the private equity community has a number of valid issues that broadly fall under the corporate governance/ shareholder activism banner and some are doing as much as they can, piecemeal, to address those issues in line with their own corporate governance standards.
Since LPs are made up of institutions, corporates, family offices and individuals from across the globe it’s hard to envisage their requirements converging on more than a handful of key issues. “Some investors are not primarily motivated by returns, and for these investors there are often other issues, a good example is the EBRD which has environmental guidelines that a fund must follow,” says Thompson.
But the mixed nature of the LP community has wider implications. “It’s very difficult for LPs because they are such a disparate group, which diffuses your bargaining power. I wish there was a more coordinated approach because if nobody does it we will never get the improvements that the industry deserves. But whatever you do has to involve US investors because they are the biggest group, by value, of investors in Europe so I’m not sure how effective a European-only lobby could be,” says Ang.