Private Equity LPs Seek to Impose "Best Practices" on Sponsor Community

Posted on September 13, 2009 by Geoffrey Parnass

The Institutional Limited Partners Association, a trade association that represents 220 institutional investors in private equity funds, recently published a set of Private Equity Principles, designed to guide future dealings between its members and the private equity sponsor community. The Association’s members include public and corporate pension funds, endowments, foundations, family offices and insurance companies with more than $1 trillion in private equity funds under management.  The publication of the Principles is the first time that a group of influential limited partners has collectively published a set of core requirements for private equity fund documents.
The Principles were developed by the Association and its members to “correctly align” the interests of private equity sponsors and institutional investors in private equity funds. The concepts reflect “suggested best practices” that should shape the private equity industry in the future.  Among the best practices endorsed by the group, it is significant to note that no change in the basic 80/20 profit split is recommended. The Principles say this split has “typically worked well to align interests”. 
What comes up for scrutiny and criticism are provisions relating to carried interests, claw back liabilities and management fees. In particular, the Principles urge tougher provisions on carried interest escrow reserves (a 30% escrow), a 2-year repayment of claw back liabilities, tougher provisions on the size and application of management fees, and the payment of all transaction and monitoring fees to the fund rather than the GP or other sponsor affiliates.
Here is a summary of the key provisions:

Waterfall Structure

  • The LP’s capital contribution plus preferred return should be paid first, before any distributions are made to the GP’s carried interest
  • Establish GP carry escrow accounts with reserves of 30% or more to cover potential claw back liabilities
  • Carry on recapitalizations should be paid only when the full amount of LP capital is returned on the recapitalized investment

Calculation of Carried Interest

  • Carried interest should be calculated on net profits, not gross profits
  • Carry should not be paid on current income
  • Carried interest should be calculated only on an after-tax basis

Claw back

  •  Claw back liabilities should be determined and reported periodically
  •  Claw back liabilities should be paid within 2 years and should be gross of taxes paid
  •  Effective joint and several claw backs should be implemented to make sure that full claw back liabilities are met

Management Fee Structure

  • Management fees should be based on reasonable operating expenses and reasonable salaries, so that fees are not excessive.
  • Management fees should reduce upon formation of follow-on fund and at the end of the investment period
  • The management fee should be used to pay all normal operating costs of the GP, including interactions with the LPs. The LPs should have the power to review the partnership expenses annually
  • Placement agent fees should be paid by the GP
  • All transaction, monitoring, directory, advisory and exit fees should accrue 100% to the benefit of the fund.     

The Principles also include detailed suggested changes to the fiduciary duty requirements of the GP. For example, provisions of fund documents that disclaim or reduce fiduciary duties should be eliminated.  We will discuss these recommendations in more detail in a later post.

The Association is currently gathering formal endorsement of the Principles from its members and promises to publish a list of the endorsing institutions on its website.

How will the Principles be received by the sponsor community? That awaits to be seen. Institutional investors would love to establish a set of best practices across the sponsor community in order to make their investments in the asset class more uniform, and more favorable. They would like to reign in the variations in how sponsors define and enforce rules governing distributions, claw backs, and fees.  The sponsors will certainly resist any uniform treatment, and look for advantages at the margins, whether in the area of distributions or discretion in the application of fees.  Assuming a large number of institutional investors formally endorse the Principles, it may become difficult, if not impossible, for the GP community to ignore the recommendations.  The LP community has taken to heart the motto: United We Stand, Divided We Fall.         

Related Post:  Increased Capital Calls and Diminished Distributions for Private Equity LPs

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